"The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."
So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."
How did we get into this mess in the first place? "The basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object."
Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."
So what does she suggest? The Fed and Treasury should be focusing on reducing the uncertainties that are blocking lending decisions, by letting banks fail, and by applying consistent policies when doing so. It would also help if the government can resolve the valuation problem of "toxic" securities, as Paulson is trying to do with his plan to buy these securities via auctions.
I would add that since the Fed caused this problem with too-easy money, then easing money even more is probably not a good thing to do. This could result in more inflation and more uncertainty going forward. Better to have confidence in the currency than to have too much currency.
I wish she had some magic solutions to the crisis which have been overlooked, but she doesn't, unfortunately. At least she is not afraid to tell us that the (Fed) Emperor has no clothes, and that throwing money at this crisis is not necessarily going to solve it.
(HT to Marc Denny)