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Bernanke and the financial crisis

October 14, 2013

As Janet Yellen was nominated by President Obama to replace Ben Bernanke at the head of the Federal Reserve after January 2014 (see recent NYT article), we thought of Mr Bernanke’s legacy and read his book on The Federal Reserve and the Financial Crisis (Princeton UP, 2013). He explains the guiding principles behind the Fed’s actions, always in his clear style, not without reminding first the history of the Central Bank – he was trained as an economic historian, after all. In his view, the action of the Fed during the crisis was consistent with a long history of regulation and intervention, and the extraordinary steps taken helped avoid a worse outcome for the economy. He also draws some lessons from the crisis.

How Central Banking started. Between 1879 and 1914, there were six major banking panics in the US: close to 500 banks were closed at the worst of them in 1893. Earlier examples of Central Banks include Sweden (1668) and England (1694). The Federal Reserve was founded in 1914, with the aim of preserving financial stability. In the US, prior to the creation of the Fed, the New York Clearing House – an entity jointly managed by banks – was an interesting precedent to create a lender of last resort. The Fed’s mandate is dual: achieve macro stability and maintain financial stability. The FOMC is where monetary policy is defined (by seven members of the Board and five of the 12 Reserve Banks). Its tools include monetary policy (fixing rates, quantitative easing) and the function of lender of last resort. Until the 1930s, the gold standard, which in effect prevented discretionary monetary policy and fixed parities between currencies provided a stable environment. The Great Depression was the Fed’s first challenge. For Bernanke, the Fed then failed on both of its missions: monetary policy and financial stability. Between 1929 and 1932, stocks went down 85% from their peak, GDP contracted by almost one third in 1930-33, and unemployment approached 25%. The creation of the FDIC in 1934 was a particularly effective policy. Bernanke quotes repeatedly the ideas of Walter Bagehot: during panics, Central Banks should lend freely to whoever comes to their door as long as they have collateral. In other words, a bank could be illiquid but still solvent.

The Fed after WWII: towards independence and stability. 1951 was a turning point for the institution as the Treasury acknowledged the independence of the Fed. The 50s and 60s saw the definition of a “lean against the wind” policy that successfully controlled inflation (“inflation is a thief in the night” for William McChesney Martin, Chairman between 1951-70). The prevalent economic theory then thought that there was a trade off between unemployment and inflation, a view that would be criticized by Friedman (“inflation is always and everywhere a monetary phenomenon”). Following the Vietnam War and the Great Society, inflation started to rise, a trend Paul Volcker (1979-87) fought with energy. He was followed by Alan Greenspan (1987-2006) and a phase of great moderation.

2006 saw some signs of the crisis to come, especially in the housing market. In 2006, 1/3 of originated mortgages were non prime (with a lower down-payment, less qualified borrowers, less or no documentation). The collapse in house prices during the crisis had significant consequences: a lot of owners lost their equity. 20-25% of all mortgages (12-13 million) were underwater as of 2012. In 2009, almost 10% of mortgages were delinquent. Other problems that exacerbated the crisis included excessive consumer leverage, weak risk management systems at banks, short term funding at banks, the extensive use of derivatives (which were meant to spreads risks, but did not), and inadequate regulations (supervisors had no authority over companies such as AIG). Bernanke highlights some of the Fed’s mistakes: the body did not press enough on the issue of measuring risk at the banks and it did poorly in consumer protection.

The Feds response to the crisis. In extraordinary times, the role as lender of last resort gets full attention. If 2008-09 was a classic financial panic (liquidity mismatch), it was also becoming evident that more and more people were delinquent on their loans (solvency crisis). This brought interbank funding markets to a halt: banks did not want to lend to each other. 2008 saw an impressive succession of failures and forced mergers. In March 2008, Bear Stearns was sold. On September 7, Fannie and Freddie were insolvent and the Treasury got authorization from Congress to guarantee all of their obligations. On September 15, Lehman filed for bankruptcy, while Bank of America acquired Merrill Lynch. Those events raised the question of “too big to fail” banks, which would eventually have to be rescued by public authorities. Several times in the book, Bernanke answers the criticism that the Fed should have let those firms fail. To him, as distasteful as a rescue was, the consequences of a failure of a company such as AIG would have been disastrous. With its action, the Fed avoided a meltdown of the financial system. The US economy nevertheless experienced a 5% GDP contraction, 8.5 million lost their jobs and unemployment rose to 10%.

The aftermath of the crisis. The Dodd Frank Act (Wall Street Reform and Consumer Protection Act) was the most ambitious attempt to reform the banking system. Regulators acknowledged the need to pay attention to the broad stability of the system and not just to some parts. The Act sets up the FSOC (Financial Stability Oversight Council) to better coordinate various supervisory bodies and close gaps. It also imposes annual stress tests to banks; since 2009, they have raised a lot of capital to strengthen their balance sheets. The Act gives an orderly liquidation authority to the FDIC and stresses the need for international cooperation: companies that were deemed “too big to fail” will be allowed to fail in the future. The Act also creates the Consumer Financial Protection Bureau.

Finally, Bernanke draws some lessons from the crisis. As of December 2008, the fed funds rate had been reduced to zero – conventional monetary policy had been exhausted and the Fed resorted to quantitative easing (another form of monetary policy). With QE, the Fed spent $2 trillion in Treasury and GSEs securities. While the Fed is not printing money (purchased assets are funded through reserves held by the banks), QE increases the monetary base and expands the balance sheet of the Fed (now around 20% of the US GDP). Buying these securities reduces their yield, with the aim of stimulating the economy. Bernanke wonders about the exit from those extraordinary measures, an exit that could take longer to play out considering the views of his likely successor Mrs Yellen and the observation that things are not back to normal (the current recovery has been slower than during previous crises). He notes that monetary policy alone cannot solve everything. With the past financial crisis the Fed increased its role in financial stability, following decades of focus on monetary policy. Interestingly, this is a return to where the Fed came from in the beginning when it was created in 1914.

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