Will we ever learn from our mistakes?


BANKING CRISIS:Economist and longtime collaborator with Milton Friedman, Annie J Schwartz argues that Federal intervention in the markets - from the Great Crash to today - is both dangerous and anti-capitalism

ON THE occasion of the 90th birthday of the Nobel-prize-winning economist Milton Friedman - celebrated at a symposium at the University of Chicago, in November 2002 - Ben S Bernanke, then governor of the US Federal Reserve Board, lauded Friedman and his longtime collaborator, Anna J Schwartz, for their seminal work, A Monetary History of the United States 1867-1960.

In this classic tome of American economic history, Friedman and Schwartz lay the blame for the Great Depression squarely at the doorstep of the Federal Reserve by arguing that, at the point of acute crisis, its tight policies caused the failure of more than 40 per cent of banks in the US and led to massive deflation.

At the very moment when capital should have flowed into the economy, they argue, the Fed staunched it and by its policies unleashed instead the pervasive suffering that followed.

Friedman's and Schwartz's insights about the role of the Fed contradicted the conventional wisdom at the time, but have stood up well. "This achievement is nothing less than to provide what has become the leading and most persuasive explanation of the worst economic disaster in American history," Bernanke said in his speech. He praised the book for its "development of historical detail" and for its "previously untapped" use of primary resources to craft its argument. "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve," Bernanke said. "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Much has changed since then. For starters, Friedman died, in November 2006, aged 94. Bernanke is the chairman of the Federal Reserve. And together with treasury secretary Hank Paulson, he is using every trick in the book to prevent the American economy heading into the greatest financial abyss since that chronicled by Friedman and Schwartz. Whether he can make good on the promise made to them in November 2002 remains in question.

In times of great market turmoil in years past, Friedman could always be counted on to espouse his laissez-faire, free-market views. But what would he make of the credit crisis that began in 2007? Certainly - unlike the Fed's policies in the 1930s - he would recognize that Bernanke and Paulson have done their best to repeatedly flood the financial system with capital. By last count, in the seven-day period ending on September 24th, through borrowings from the US Treasury, the Fed had increased its lending to the reserve banks by an astounding 18 per cent, to $1.134 trillion, from the previous week.

But what would he make of Bernanke's and Paulson's strategy of bailing out creditors of Bear Stearns, AIG, Fannie Mae, Freddie Mac and Wachovia while letting share- and debt-holders of Lehman Brothers and Washington Mutual twist in the wind? What would he make of all the talk of "moral hazard"?

Schwartz, now 92 and spry as a sparrow, can answer these questions. She still works most days in her Manhattan office - overlooking Fifth Avenue, around the corner from the Empire State Building - on a book she is writing about the history of Federal Reserve interventions. Unsurprisingly, she is appalled by Washington's efforts to date to solve the crisis.

"I think it's just terrible that Milton's not around," she said in a recent interview, "because I'm sure that if Milton were alive, he would be writing about the shortcomings of this Fed, and it would have a tremendous impact on the market and might even persuade the present leadership to abandon the kinds of policies that they've instituted."

And then she launched her fusillade. "I think whoever is the next president should relieve the chairman" - Bernanke - "and find another chairman," she said. "I don't see that there's anything that the Fed has done that's helped the economy, helped the market, and proved that its insights into the problems are insights that others would share."

Her concern is that both the Fed and the Treasury have been promoting anti-capitalistic policies. "Rescuing firms that are on the verge of bankruptcy is contrary to the way capitalism is supposed to operate," she continued. "And their fear tactic of the downside warning that a recession will be on the way unless they take action, warning that the market won't be able to respond to the elimination of firms that aren't able to meet the market tests, I think these are all doctrines that have no basis either in the behaviour of other central banks or that are supported by the Fed's own history.

"These are people who think they know more than they do," she continued, "and that's why they're supremely confident that the actions that they take, which are quite extraordinary, are defensible. I don't think they are. They came in with the notion that they should be aggressive. They should pre-empt. Well, that assumes that they know a lot more than they actually do. They have very incomplete knowledge of the current state of the economy, and certainly of what the future will be."

She explained that, since the Fed-orchestrated rescue of Long-Term Capital Management 10 years ago, a bias has developed in Washington toward rescuing the mortally wounded. "The Fed's approach is there will be a crisis if you don't rescue a failing firm," she said "And that's not true. The market knows when a firm isn't sound. And if the Fed didn't behave as if every failing firm is too big to fail, then it would permit the exit of firms that weren't really viable and the market would recognise this as a just decision. It's not the job of the Fed to be intervening to help such firms. People are knowledgeable. They knew that there were troubles with Lehman.

"They knew there were troubles with Bear Stearns because their portfolio was just full of assets that were risky and not valued correctly. They deserved to be eliminated. And if the Fed had taken such an action in the case of Bear Stearns, I think the market would have respected the Fed, and thought, 'these are principled people who know what they're doing'."

"If they're going to go into the business of rescuing every failing firm," she concluded, "we won't have a capitalist system . . . People are responsible for the decisions they make. If they've made wrong decisions, lost money and don't have the funds to operate, well, it's time to leave the market. And that's what the Fed's responsibility is, not to shore up firms that have no reason to continue."

How, in the name of Milton Friedman, did we get into such a predicament where the very future of capitalism can be openly considered? Why have Bernanke, Paulson and President Bush staked the future of our way of life on the passage of a $700 billion bailout bill when none of them have the slightest idea whether it will provide the salvation they are hoping for?

As usual, the answer lies in the most fundamental aspect of human nature: Greed. Wall Street has always been the embodiment of greed, even when numbers were smaller. In the 1970s, when New York City found itself on the brink of bankruptcy and Park Avenue duplexes were fetching the unheard-of price of only around $50,000, it was the Wall Street bankers and traders who were doing much of the buying. On a relative basis, when all hell was breaking loose, the Wall Street bankers and traders had the money to take advantage of the market to buy assets that are now worth $10 million, or more.

Wall Street has designed a compensation system for itself that rewards and celebrates those who generate the most revenue. More revenue is always better revenue. No other profession on earth compensates its employees with between 50 and 60 per cent of every dollar of revenue earned in a given year. What's more, there is no accountability associated with these rewards. Bonuses are paid and consumed long before anyone can be held accountable. Never are questions asked about the nature of the revenue generated. Is it risky? It is ethical? Will it come back to haunt us? And yet, this compensation system is largely responsible for creating the perverse incentives that have led to every bubble that has inflated and burst in the past generation - from the crash of 1987 and the credit crunch that followed, to the crisis at Long-Term Capital Management in 1998, to the internet bubble a few years later, to the disaster in the emerging telecom market, on to the current credit freeze that has capitalism on the edge of the abyss.

Wall Street started losing its way about the time, in 1968, that Merrill Lynch transformed its legal structure from a partnership to a corporation. Then, in 1969, Donaldson, Lufkin & Jenrette decided to go public, confounding the New York Stock Exchange rules that prohibited Wall Street firms listing their own stock. Merrill Lynch quickly followed DLJ's successful IPO with one of its own. Slowly but surely the rest of Wall Street followed their leads.

The genius of the old Wall Street partnerships was the shared liability clauses of their partnership agreements. Partners were paid a percentage of the pre-tax profits divined by the senior partner, and at the end of the year, the bounty would be divided up accordingly. The partners would also share liabilities ratably. If a partner screwed up and made a bad bet or brought shame to the partnership, or the firm found itself the target of a lawsuit, the offending partners were sure to hear about it. In any event, they would all suffer as a result. The bargain presented by the old Wall Street partnerships was a simple one: profits were to be shared, along with liabilities.

The IPOs of the Wall Street partnerships changed that dynamic. The present system evolved in its stead, whereby bankers and traders are encouraged to take bigger and bigger risks with the shareholders' capital, knowing full well that if the bet pays off, they will be rewarded fabulously. If it doesn't, the shareholders suffer. The apologists at Bear Stearns and Lehman Brothers argue that since employees at those firms owned between 30 and 40 per cent of the shares outstanding, they suffered along with the balance of the shareholders. But it is hard to feel sorry for them since, for years, they had been pulling out millions and millions in cash compensation, too.

Yes, Jimmy Cayne, the self-made chief executive of Bear Stearns, lost $1 billion as a result of his firm being sold for $10 a share to JPMorganChase, but he still has around $600 million to salve his wounds.

Whether the bailout bill passes or not is largely irrelevant, as is whether or not it actually works. The market has already parsed the winners from the losers in this profound crisis. Like France, the US has created five "national champions" in banking. At the top of the heap are Bank of America, JPMorganChase and Citigroup. They are the well-capitalised, highly regulated kings of the new Wall Street. Also among the survivors - for the moment - are Goldman Sachs and Morgan Stanley, who together took the extraordinary step on September 21st of transforming into bank holding companies. They will now become like the other three - highly regulated and less leveraged members of the Federal Reserve banking system. They will also be less profitable. But at least they will survive. The others are all gone or in the process of going.

Also among the survivors are the mergers and acquisitions (M&A) boutiques, such as Lazard and Greenhill, that are effected only by the overall decline of around 30 per cent in the volume of M&A transactions this year. These firms use little, if any, financial capital to run their business, instead relying on their partners' intellectual capital to make money. This business model - reminiscent of how Wall Street used to operate - is in vogue again.

The revised bailout bill merely flicks at the problem of Wall Street compensation by attempting to limit the "incentives for senior executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution" and by seeking to recover "any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate." That's better than nothing. But the bill is silent on what is really needed: a major reform of the way the Wall Street army gets paid, since it is this throng that ultimately generates the revenue that has caused so many of the financial problems in the past 20 years. That's an idea that Friedman might just appreciate at a time like this.

William D Cohan, a former senior Wall Street banker, is the author of The Last Tycoons: The Secret History of Lazard Frères & Co, which won the 2007 FT/Goldman Sachs Business Book of the Year. He is currently writing House of Cards: The Fall of Bear Stearns and the End of the Second Gilded Age, to be published in 2009.