The Federal Reserve and the Financial Crisis

Ben S. Bernanke

 

A preeminent academic economist and chairman of the U.S. Federal Reserve from 2006 to 2014, Ben Bernanke delivered a series of speeches at George Washington University in 2012. This came at a time when the Federal Reserve sought to both improve its public relations and increase transparency to the financial and capital markets. Although not an academic paper or book, these reprinted speeches nonetheless provide insight into the thought process and workings of the Federal Reserve and other government agencies before, during, and after the Great Recession. He also gave a mainstream overview of central banking in general as well as the experiences of the Federal Reserve throughout the 20^th century. It is important to note that Bernanke is an economic positivist and monetarist. He is a proponent of monetary policy as a means to economic and financial stability and prosperity.

 

“Origins and Mission of the Federal Reserve”

A central bank is a centerpiece of nearly all countries. Central banks have two primary overriding functions: 1. Achievement and maintenance of macroeconomic stability 2. Achievement and maintenance of financial stability. To achieve macroeconomic stability central banks can employ monetary policy. The Fed can trade, via OMO, to adjust short-term interest rates. This transmission mechanism, when functioning properly, lowers a broad range of other rates and thereby promotes economic and investment activity. The reverse, raising the federal funds rate, raises the cost of borrowing and thereby slows the economy. To achieve financial stability, central banks can provide liquidity. This lender of last resort activity is much less understood by the general public. Financial panics are typically caused by asset-liability mismatches: longer term illiquid assets financed by short-term liabilities. Discount window operations were pioneered by Walter Bagehot who taught, “as long as they have collateral, give them money. Central banks need to have collateral to make sure they get their money back, and that collateral has to be good or it has to be discounted.” According to Bernanke, a major impetus for the creation of the Federal Reserve was magnanimous concern by wealthy bankers to stop runs on illiquid but solvent financial institutions. He never addresses the following concerns: Why doesn’t the manipulation of interest rates to some level other than what would otherwise have been arrived at in an unhampered loanable funds market cause financial dislocations and malinvestments? Does the lowering of interest rates induce investment or economic activity in unsustainable areas? Does it gave an accurate signal of potential future consumption levels?

Bernanke begins a lengthy discussion of the gold standard, an alternative to central banks proffered by critics of central banking. The gold standard is characterized by currency fixed in term of gold or other metals. To the chagrin of central banking apologists, “there is not much scope for the central bank to use monetary policy to stabilize the economy.” Others believe depriving a central bank of monetary policy discretion is an advantage of a metallic standard. According to Bernanke, “there was more year-to-year volatility in the economy under the gold standard,” than in more recent times. However, the two most severe and protracted financial crises in American history occurred under the management of the Federal Reserve. Lastly, currency stability under a gold standard holds over long periods. Regarding the Great Depression, monetarists like Bernanke, under the tutelage of Friedman and other Chicagoites, claim that the Federal Reserve failed in both of its charges. It wasn’t proactive enough in easing monetary policy in the midst of an economic downturn. This resulted in a drastic shrinkage of the money supply and a fall in prices that devastated farmers.

 

“The Federal Reserve after World War II”

The two functions of a central bank are the maintenance of macroeconomic stability through the use of monetary policy (manipulation of interest rates) and the maintenance of financial stability through the lender of last resort function. An important note that is often missed in the general public is that wars are financed through borrowing. The Fed, by keeping interest rates low, made it substantially cheaper to finance WWII. I am not sure if this is a credit to central banking or a detraction. It seems that if you are anti-war, you are well recommended to be opposed to central banking. In 1951, the Fed ostensibly put forth its intention to remain operationally independent in the Fed-Treasury Accord. In the post war period, the Fed was concerned largely with macroeconomic stability. The Fed adopted a “lean against the wind policy”, which means, according to Bernanke, “that when the economy is growing quickly (or too quickly), the Fed tightens to try to restrain overheating, and when the economy is growing more slowly, the Fed lowers interest rates and creates some expansionary stimulus in order to avoid recession.” In other words, the Federal Reserve seeks to engineer the economy.  Orthodox macroeconomic theory in the 1950s and 1960s held the existence of the Phillips Curve or tradeoff between inflation and employment. The resulting stagflation of the 1970s crippled this theory and brought monetarism of the Friedman variety into the spotlight. In response to rising prices, Nixon imposed famous wage and price controls. Excessive across the board aggregate demand is only made possible by excessive monetary ease. According to Friedman, “Inflation is always and everywhere a monetary phenomenon”. Wage and price controls do not address the fundamental issue and merely cause shortages and other deadweight costs. In 1979, Volcker did an about face on the monetary policy front and sharply raised interest rates to fight inflation. These high rates caused a sharp recession. However, this decision by the Volcker and Greenspan Fed led to a significant reduction in volatility and the so called Great Moderation. Monetary policy played a role in this development. However, structural changes also occurred that reduced inflation and output volatility.

A key development in the lead up to the 2008 financial crisis was a big increase in home prices (nearly 130%). Underwriting and lending standards were deteriorating which increased demand. Prior to the recession, significant down payments and financial disclosures were needed to obtain a mortgage. As housing prices rose, nonprime mortgages gained traction. Mortgage lenders became willing to move down the credit spectrum. The decline in housing prices in the 2008 recession had a much greater deleterious effect on investor, business, and consumer sentiment than the dot com crash of the early 2000s. Bernanke maintains that, “it is important to make a distinction between triggers and vulnerabilities”. Below are some of the defects in the financial system that contributed to the severity of the recession and its lingering effects:

1.     Excessive private sector debt

2.     Insufficient risk management

3.     Heavily reliance on short term funding by the major financial firms

4.     Outdated and captured financial regulations

Of crucial interest to me as a financial market participant and investor, the Fed’s role in economic management is a source of future posts. Per Bernanke, “When the economy got very weak and there was very slow job growth in 2001 and subsequently, and when inflation fell very low, the Fed cut interest rates. In 2003, the federal funds rate got down to 1 percent. There are people who argue that this was one of the reasons that house prices went up as much as they did. And it is true that one of the purposes of low interest rates that the monetary policy achieves is to increase the demand for housing and thereby to strengthen the economy.” (emphasis added) Indeed, some free market schools of thought emphasis monetary influences on the capital structure of production as being the predominant source of economic fluctuations. I will have more posts with these views later. Essentially, artificial changes in the rate of interest to some level other than that arrived at in an uncontrolled loanable funds market induce malinvestments in orders of production that are not ultimately in line with consumer preferences. Indeed, consumers actually haven’t given up current for future consumption (i.e. saved). Rather, the Fed expanded credit, cut rates, and expanded the money supply. However, according to Bernanke, “the evidence that I have seen suggests that monetary policy did not play an important role in raising house prices during the upswing”. Isn’t that interesting? Right before this assertion, Bernanke explicitly states that the intention and result of low interest rates as monetary policy is to increase the demand for housing and strengthen the economy. However, a second later he claims that the evidence he has seen suggests that monetary policy did not play an important role in raising house prices. Is this a case of our monetary authorities wanting their cake and eating it too? Unless Bernanke believes increasing demand for housing in no way raised housing prices in the ramp up to 2008……………………..

I digress. According to Bernanke, cross national developments casts doubt on the role of monetary policy in the housing bubble. Also, a relatively small change in rates cannot explain much of the massive run up in prices.

 

“The Federal Reserve’s Response to the Financial Crisis”

The two focuses of the Federal Reserve is financial and economic stability accomplished by lender of last resort and monetary policy, respectively. Financial crises occur when financial firms have an asset-liability mismatch. On September 7, 2008, the Treasury was authorized to guarantee Freddie and Fannie mortgage obligations. On September 16^th, the Fed provided liquidity assistance to AIG during the unwinding of its CDS contracts. According to Bernanke, the lessons from the Great Depression was that the Fed was too hesitant to stabilize the banking system or prevent deflation and the contraction of the money supply. During the financial crisis of 2008, overnight interbank rates spiked well above “normal”. The Fed mobilized to provide emergency funding at the discount window while securing collateral along the Bagehot principle.

“The Aftermath of the Crisis”

According to Bernanke, during the financial crisis of 2008 the Federal Reserve acted in line with the historic and intended role of central banks. The two basic tools of central banks are lender of last resort policy and monetary policy. As said by Bernanke, “By raising and lowering the short-term interest rate, the Fed can influence a broader range of interest rates. That, in turn, affects consumer spending, purchases of homes, capital investment by firms, and the like, and that provides demand for the output of the economy and can help stimulate a return to growth”. Ironically, this does not at all contribute to a housing boom or create malinvestments among businesses…… To Bernanke and other central bank apologists, it’s all positive and no negative with regard to the intentions and efficacy of central bank endeavors. In 2009, conventional monetary easing was exhausted as rates were at the zero bound. LSAPs were started. In addition to the short term federal funds rate, the Fed undertook large scale purchases of Treasuries and mortgage securities. QE1 started in March 2009 at the trough of the equity markets and another round of QE2 stated in November 2010. All together, these programs bloated the Fed’s balance sheet in excess of two trillion dollars in increasingly longer maturity assets. The intention and effect of these policies is to lower the interest rate of longer term Treasuries and GES securities as well as other downstream credit instruments for firms and individuals. Lower rates stimulate the economy. These securities were paid for with increase of commercial bank reserve balances at the Fed.

The Fed has implemented new policies in the aftermath. The first is a numerical target of two percent inflation and increased public exposure of the Fed and its policies.