<blockquote>"
In December 1929, as what we now know to have been the Great Depression loomed, Mellon outlined his formula for fighting recession, which had worked well in the previous episode of 1920-21. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.’’ Mellon then foolishly remained at Treasury until 1932, a powerless spectator of the opposite approach taken by President Hoover, tarnishing his reputation for the rest of his lifetime and beyond.
There are a couple of points in Mellon’s prognosis that have resonance today. “Purging the rottenness out of the system” is precisely what’s required to sort out the banking mess, while “leading a more moral life” is fairly clearly also required after the over-consumption and excess of the bubble period. “High costs of living and high living will come down” is, however, directly contrary to the Keynesian majority view, which holds that deflation is the most serious possibility to fear, and that restoring consumption through government spending is a prime objective.
Had Mellon been Treasury secretary throughout the 2000s, as he was throughout the 1920s, he would not have needed to sort out this mess because we would not have been in it. Mellon had a keen appreciation of the dangers of bubbles, based on his decades of market experience as chairman of Mellon Bank and founder of Alcoa and Gulf Oil. Thus, he would have opposed the Bush stimulus proposals of 2001 and the Federal Reserve’s interest-rate cuts of that year, which between them prevented the full purging of the “rottenness” of the late 1990s tech bubble. Equally, he was an extraordinarily successful budget cutter, halving federal spending over the eight years of the Harding and Coolidge administrations. Thus, a Mellon-run economy would have entered 2009 in good shape, possibly in a recession, but without either banking system excesses or past fiscal profligacy complicating matters.
...
Without Mellon, we will have a budget deficit of 10% of GDP in both fiscal years 2009 and 2010, borrowing by the federal government that crowds out the private sector, rapidly increasing inflation as a result of Fed money printing, a housing market that remains artificially supported at excessive prices, state and local governments that remain profligate, a CDS system that remains a danger to the global economy and several huge value-destroying banks. It is also doubtful whether our moral values will have been adjusted, or less competent people weeded out of high positions.
The Mellon approach would have given us a pretty terrifying fourth quarter of 2008, but in the long run it would have been worth it."</blockquote>
The Liquidationist AlternativeBy Martin Hutchinson
February 16, 2009
SourceAs the Obama stimulus plan passes and Treasury Secretary Tim Geithner unveils the outline of a $1.5 trillion bank rescue package, the die has been definitively cast in favor of the Keynesian stimulus approach to the ongoing unpleasantness. That has been conventional wisdom since the Great Depression, but it’s still worth looking at what might have happened had policymakers followed an alternative route, the liquidationist approach favored by 1920s Treasury Secretary Andrew Mellon.
In December 1929, as what we now know to have been the Great Depression loomed, Mellon outlined his formula for fighting recession, which had worked well in the previous episode of 1920-21. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. … It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.’’ Mellon then foolishly remained at Treasury until 1932, a powerless spectator of the opposite approach taken by President Hoover, tarnishing his reputation for the rest of his lifetime and beyond.
There are a couple of points in Mellon’s prognosis that have resonance today. “Purging the rottenness out of the system” is precisely what’s required to sort out the banking mess, while “leading a more moral life” is fairly clearly also required after the over-consumption and excess of the bubble period. “High costs of living and high living will come down” is, however, directly contrary to the Keynesian majority view, which holds that deflation is the most serious possibility to fear, and that restoring consumption through government spending is a prime objective.
Had Mellon been Treasury secretary throughout the 2000s, as he was throughout the 1920s, he would not have needed to sort out this mess because we would not have been in it. Mellon had a keen appreciation of the dangers of bubbles, based on his decades of market experience as chairman of Mellon Bank and founder of Alcoa and Gulf Oil. Thus, he would have opposed the Bush stimulus proposals of 2001 and the Federal Reserve’s interest-rate cuts of that year, which between them prevented the full purging of the “rottenness” of the late 1990s tech bubble. Equally, he was an extraordinarily successful budget cutter, halving federal spending over the eight years of the Harding and Coolidge administrations. Thus, a Mellon-run economy would have entered 2009 in good shape, possibly in a recession, but without either banking system excesses or past fiscal profligacy complicating matters.
However, that’s not a terribly enlightening speculation. The really interesting question is: what would Andrew Mellon have done if appointed Treasury secretary in, say, June 2008, with the bubble already burst, oil at $147 per barrel, house prices declining rapidly and Bear Stearns already “rescued.” At that point, he would have been parachuted into a crisis situation, even if the full dimensions of that crisis were not yet fully apparent.
Being sophisticated about financial markets, Mellon might well have picked up the negative whirlpool that was sucking down Lehman Brothers once Bear Stearns had been forcibly “rescued.” It’s doubtful, however, whether he could have done much with that knowledge; there were simply too few private sector rescuers available for Lehman.
Mellon would certainly have made no attempt to rescue AIG, or to prop up the credit default swap (CDS) market once the AIG bankruptcy had produced losses for all its counterparts that were “long” CDSs. He would have recognized that CDSs were a deeply flawed product, whose settlement was completely arbitrary, and would thus have rejoiced in the destruction to the CDS market inflicted by AIG’s bankruptcy. There would have been no need for legislation to ban CDSs; the market would have been killed or at least greatly reduced in size by the losses to counterparties from that bankruptcy. What’s more, U.S. taxpayers would have been $150 billion better off. Most losses from CDSs that suddenly proved worthless would have been borne by the hedge fund community, although there would doubtless also have been losses to the more aggressive banks and investment banks, some of which were doomed anyway.
Mellon would not have rescued Fannie Mae and Freddie Mac. Had he been in office since 2001, he would have shut down those two useless distorters of the housing finance market several years ago. Coming to office in June 2008, he would merely have welcomed their collapse. The result would have been the closing of the market for agency-backed mortgage-backed securities (MBSs), and the return of the home mortgage market to banks and other institutions financing directly, without a government guarantee. Essentially all housing loans would have become “jumbo.”
Home mortgages would have been extremely difficult to get for a few months, and would have been made somewhat more expensive for a year or two – the current cost of a “jumbo” mortgage is 7.08% compared to the artificial 5.26% of a “conforming” mortgage now effectively guaranteed through Fannie or Freddie by the federal government. However, the differential between the two rates of 1.82% is already significantly below the early January differential of 2.5%, and if the artificial “conforming” mortgage category were removed, jumbo mortgage costs would decline still further. Mortgage costs, expressed as a premium over Treasury yields, were lower in the 1970s when made primarily by local banks than in the securitized markets of 2000-06.
Mellon would not have believed the Troubled Asset Relief Program (TARP) rescue of the U.S. banking system either necessary or desirable. Indeed, had such a bailout been suggested by the banking industry or by Congress, he would have worked hard to defeat it. The short-term consequences of this would have been grim. Merrill Lynch, instead of being bought by Bank of America, would have been bankrupt within days once Lehman went. Citigroup, instead of being rescued by a second capital infusion and enormous asset guarantee in November, would also have gone. Since funding would not have been available for Wells Fargo’s high-risk takeover of Wachovia, that bank, too, would probably have failed, although being sound except for its extraordinarily foolish $24 billion 2006 takeover of Golden West Financial, it might have been rescued by a consortium of its peers with backing from major investment institutions. JP Morgan Chase would presumably have felt its emergency acquisition of the housing lender Washington Mutual (WaMu) was a deal too far, although it appears not yet to have led to huge further losses. National City Bank, with no PNC Financial Services bailout possible, would probably also have gone.
For other banks, the lack of a TARP would have made little difference. Bank of America, relieved of the need to buy the struggling Merrill Lynch, would have had only modest losses in 2008’s fourth quarter and would continue its current battle against the problems from its foolish January, 2008, acquisition of the mortgage lender Countrywide. Wells Fargo, relieved of Wachovia, would have survived easily, as would JP Morgan Chase, whether or not relieved of WaMu.
Thus, by not funding TARP, Mellon would have caused up to five additional major financial institutions to go under between September and December 2008. The remainder of the banking system would have been as solid as it is in the current reality, provided that the additional bankruptcies did not themselves cause a crisis of confidence in U.S. banks sufficient to set off a general default. However, the Fed would have continued to supply lavish credit to the system, as it did in reality, and the surviving banks would have worked together under Mellon’s guidance to contain the payment and loss problems caused by Citigroup and Wachovia’s demise, as the New York banks did under J.P. Morgan’s guidance in 1907. We cannot know whether the crisis of September-December 2008 would have been worse under a Mellon solution (though the real-world widening of credit spreads after TARP was announced indicates that it might not have been). But by now, the worst of the banking system’s problems would be behind us.
Had Mellon been appointed in June 2008, he would presumably have left office with the change of administration in January 2009, leaving us with the likelihood of an Obama-led stimulus package, but no great risk of Geithner’s new $1.5 trillion bailout scheme, since the credit markets would already be recovering, minus several banks but without the necessity of a TARP. Fannie Mae, Freddie Mac and the credit default swap market would have been euthanized, to the enormous benefit of the U.S. and global economies going forward.
Alternatively, had Mellon, in a moment of bipartisanship gone mad, instead been appointed Treasury secretary last month by the incoming Obama, he would have concluded from the Congressional Budget Office’s January forecast of a 2009 budget deficit of $1.19 trillion that the appropriate size for a stimulus package was approximately MINUS $800 billion. Spending cuts would be front-loaded as much as possible to relieve the strain on the debt markets and allow the private sector to resume raising finance. Going through the federal budget, he would have found plenty of items to cut, indeed several Cabinet departments to abolish, though he could also have bribed the Congressional left by closing down much of the United States’ international defense activity.
Probably, an Obama-backed Mellon would not have succeeded in cutting $800 billion from the federal budget deficit, but only perhaps $500 billion, equally split between fiscal 2009 and 2010. That would have reduced the fiscal 2009 deficit from 8.3% of GDP to 6.6% of GDP and the 2010 deficit from 5% of GDP to 3.3% of GDP. (Had he, in an extraordinary display of bipartisanship, been Treasury secretary in both administrations since last June, the costs of TARP, Fannie Mae Freddie Mac and various minor Congressional stimuli would also have been avoided, and the 2009 deficit would be only $447 billion, 3.1% of GDP.)
The temporary disruption of the home mortgage market, the additional banking bankruptcies and the lack of Keynesian stimulus might well have increased the initial decline in U.S. Gross Domestic Product. Perhaps the fourth quarter 2008 decline, initially estimated at an annual rate of 3.8%, would have been a negative 8% instead, followed by further declines at annual rates of 6% and 4% in the first and second quarters of 2009, for a total GDP decline of 4.5% from 2008’s third quarter.
However, the economic position from the middle of 2009 would be far superior. The housing market would have reached a solid bottom, and would start to recover. The federal budget deficit would be modest, so there would be ample financing available for the private sector. Interest rates would be higher, and the U.S. savings rate would have recovered fully to its long-term average around 8%. The U.S. trade deficit would have substantially diminished, so the risk of protectionism globally would be much less. In short, from the third quarter of 2009, the United States would lead the world into a strong economic recovery, its banking and housing rottenness purged, its high living reduced by the increased savings rate, and its business morality improved by the removal of Wall Street excesses and the “free lunch” shenanigans of the securitized housing market.
Without Mellon, we will have a budget deficit of 10% of GDP in both fiscal years 2009 and 2010, borrowing by the federal government that crowds out the private sector, rapidly increasing inflation as a result of Fed money printing, a housing market that remains artificially supported at excessive prices, state and local governments that remain profligate, a CDS system that remains a danger to the global economy and several huge value-destroying banks. It is also doubtful whether our moral values will have been adjusted, or less competent people weeded out of high positions.
The Mellon approach would have given us a pretty terrifying fourth quarter of 2008, but in the long run it would have been worth it.