Over the weekend, the Wall Street Journal published an enlightening interview with economist Anna J. Schwartz, of the National Bureau of Economic Research.
In it, Dr. Schwartz makes the important point that the current situation is not a liquidity crisis, as it is often described in the media.
"The Fed," she says, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem."
It's not that lenders do not have enough liquidity to lend -- it is that they do not have enough confidence in the balance sheets of institutions that want to borrow. The basic problem, she says in the interview, is uncertainty "that the balance sheets of financial firms are credible."
To her credit, Dr. Schwartz had seen the same thing long before the chaos of the past month, and her insights then were published in an interview in a Research Report dated May 18, 2008 from the American Institute for Economic Research.
In that interview, she stated, "liquidity is not the same thing as solvency, which is concerned with a company's balance sheet: Do its assets exceed liabilities? [. . .] Liquidity is not the answer to the solvency problem."
Going further, in that interview she argued that "If the credit market had accurate information on the health of each financial institution, credit paralysis would end."
To that end, she suggested that "One way of dealing with the problem is for a special examination of the portfolios of financial companies that the Fed should require, assigning examiners from the regulating agencies who have been specially trained in assessing the value of exotic collateralized investments that the credit markets have created."
She noted that sending in examiners to inspect the books has a historical precedent of success: "It was used by J.P. Morgan in 1907, when he deputized Benjamin Strong to examine the books of New York City banks to determine which ones merited rescue and which did not. It was used in 1933 after the national Bank Holiday to determine which banks were fit to be licensed by the secretary of the Treasury to reopen and which were to be unlicensed, and then suspended, merged or liquidated. It was used by JPMorgan Chase in 2008 [with Bear Stearns, in March]."
We agree with Dr. Schwartz that the situation calls for an army of accountants to descend upon the books of financial institutions and provide the clarity that the credit markets require in order to unlock the flow of lending.
If Anna Schwartz is correct, and we believe there are excellent reasons to agree with her, then "credit paralysis would end."
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