The quotes state the *opinions* of an economist, Milton Friedman. From any two economists, I can get five opinions.
The “shadow banking system” - those who have created, sold, bought and traded derivatives against debt instruments held by banks - have effectively created a secondary currency and obligations in that currency which is out of any control of the Treasury or the Fed. In light of this, your quote from Friedman’s is actually somewhat ironic: it was the instruments that were out of sight, accounting, control and regulation of the central banks that have brought this crisis to this point.
I agree with you that Bernanke and Paulson are doing an exceedingly poor job here. One reason why they are is that they have been hide-bound by “free market” dogma against taking ownership in banks in return for providing liquidity. This is why the Fed has frittered away over a trillion dollars of liquidity, swapping treasuries for illiquid debt instruments, without any conditions. The bidders on these auctions (eg, TAF, PDCF, et al) are getting a truly sweet ride. They get to give the Fed (ie, the taxpayers) some piece of illiquid paper of dubious credit value in exchange for a US Treasury. The only terms and conditions apply to the duration and interest rate of the loan. There are no other conditions. What a sweet, sweet deal for the bidders on these auctions.
The Paulson’ plan of buying illiquid debt isn’t being received with any conviction by the debt markets because it isn’t much better.
Compare the results of the Fed/Treasury, who are trying to cajole the large banks and players to do the right thing with the FDIC, who has the power to swoop down upon a bank that is about to fail and *force* it to surrender - they can force the executives out of their jobs, they can seize the deposits and hand them over to another bank, possibly a competitor, who is still functional. The interests of the depositors come first, not the whims and wishes of the bankers. The FDIC is having significantly better results and is doing more in their sphere to add stability than the Fed and Treasury are doing.
The SEC comes in for harsh culpability, because they allowed i-banks to go from 12:1 leverage to 40:1 leverage. The SEC failed to enforce applicable regulations they had, the SEC removed the uptick rule (and still, stubbornly refuses to reinstate same) in a display of dogmatic academic truculence. The uptick rule was a regulation installed after the crash of ‘29, when we went through a stock market crash where we had just day after day of free-fall downdrafts. It worked pretty well for years. So that’s another point against the free market dogmatists. We now have a stock market where it is as free as possible to short a company out of existence. The naked short rule isn’t being enforced. The uptick rule is gone. I don’t know about you, but I’d like a little regulation here just now.
The powers granted to the Fed are not sufficient to manage the problem. The Fed had no (and likely still has no) true idea of the size/scope/entanglement of CDS contracts. The Fed is operating off only what they know when one party in these contracts fails, and what they don’t know and are having trouble learning is causing this system to blow up. I’d wager that the Fed now wishes that they had not allowed Lehman to go belly up. The size of the counterparty exposure has been very destabilizing and has significantly accelerated this crisis. There’s $400B of notational value swaps from Lehman’s portfolio that are going to be resolved tomorrow. By Monday, another large bank might be toast as a result of what will happen tomorrow: open bidding in a nice, unregulated, ad-hoc market of unregulated instruments.
What is needed is direct government intervention in the banking system to force the banks to function. They might not function as well as free market dogmatists would like, but the important point that such people miss is that right now, the banks are not functional at all. We don’t have a top-level banking system just now - we have a bottomless black hole into which we’re throwing money without result.
The government might very well have to declare that the CDS contracts are simply null and void. Purists of tort law will likely howl like ruptured ducks - but they can do so at their leisure, because these people don’t have a better idea how to keep the US economy from following the failing banking system down a black hole.
Bankers, left to their own devices, can, do and will bring these problems down upon the population, once per generation. There are only two ways to avoid this: a) regulate banks to prevent them from chasing marginal returns at geometrically increasing risks, and b) eliminate fractional reserve fiat currency banking and return to a hard metal standard and a very limited limited fractional reserve system.
Since there isn’t enough gold to handle the US economy, we’re left with choice (a).