Ben Bernanke's 2007 Summary of His Views

a speech he gave in June

A commenter asks,

My question is why the Fed DIDNT just buy something else when inflation AND employment were below target? Isn't that what Bernanke's own research suggested should be done?

Greg Ip leads me to a speech Ben Bernanke gave in June of 2007. I recommend reading the whole speech in order to appreciate his thinking. Bernanke talked about a second channel by which financial conditions affect the economy (I wrote about the first channel—bank relationships—after the announcement of the Nobel Prize).

The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers.  In general, the availability of collateral facilitates credit extension.  The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender.  However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments.  Borrowers' cash flows and liquidity were also impaired, which likewise increased the risks to lenders.  Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. 

I have to admit that this channel, to which I should have paid more attention, strikes me as a much better fit for the 2008 financial crisis than does the “bank relationship” channel. The major investment banks had been using AAA-rated mortgage securities as “repo” collateral for very short-term loans, and doubts about the value of that collateral drove them into distress.

As Bernanke points out, doubts about the value of collateral can be self-reinforcing. If I do not think that your mortgage securities are worth $10 million as collateral, you may have to sell some of them, which will drive down their value. That is what appeared to be happening in 2008.

In his recent article, Ip makes it sound like Bernanke saw all this coming in 2008. But back when he covered the speech, Ip wrote,

Mr. Bernanke doesn't say it, but the current crisis in the subprime mortgage market may be a perfect illustration of the financial accelerator at work today. Many subprime borrowers are facing bankruptcy because their net worth has collapsed and they can't get new credit. Similarly, numerous subprime lenders have gone bankrupt because they could not get financing to continue operations from newly skeptical Wall Street lenders. As yet, there has been little spillover from these developments into consumer spending or the economy overall. But given his historical interest in the subject, Mr. Bernanke will certainly be on the alert.

Ip’s coverage was not truly prescient, either. At the time, it seemed to most observers that the problem was confined to the lower tier of the housing market. The vulnerability of Wall Street and the major banks was not understood.

Within nine months of Bernanke’s speech, the impact of bad mortgage securities on Wall Street was evident. The Fed orchestrated a bailout of Bear Stearns in March of 2008.

Back in the early 1980s, when I worked at the Fed in Washington, a colleague intimated to me that the Fed views the banking system through the eyes of the New York Fed, which in turn views it through the eyes of the so-called primary dealers—large investment banks like Bear Stearns. In my colleague’s cynical view, as long as the primary dealers are doing ok, the Fed does not care how unemployment and inflation are doing.

My point is that even without Bernanke as chairman, the Fed was going to be very disturbed by problems on Wall Street. But was bailing out Bear Stearns good for the economy? David Skeel wrote,

The decision to bail out Bear Stearns set expectations for everything that followed.  This, in my view, was the key moment in 2008.  Because Lehman was unprepared for a bankruptcy filing, its bankruptcy was much more disorderly than it otherwise would have been.

The Lehman bankruptcy caused problems for Reserve Primary, a leading money market fund, because it had wrongly invested heavily in Lehman’s debt, effectively treating Lehman’s debt as riskless because of the Bear Stearns precedent.

After the Lehman fiasco, the thinking in Washington and at the New York Fed was that no other large financial institution could be allowed to fail. And none did. But the economy as a whole suffered from a deep and long recession. Mr. Bernanke and his defenders insist that without the bailouts the recession would have been longer and deeper.

But did Bernanke’s speech justify bank bailouts? In fact, the main point of his speech was to argue that monetary policy, by which he meant conventional monetary policy, can be more powerful than you might otherwise think. A monetary expansion not only increases the incentive of firms and households to borrow and spend: it also makes credit markets function more effectively, in the case of the “second channel” by strengthening the value of collateral and reducing the perceived risk of lending.

Bernanke says in his conclusion,

Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel).

By implication, he was saying that, used judiciously, monetary policy (meaning buying or selling securities, not bailouts out banks) is a powerful tool to stabilize the economy. If he was correct, then conventional monetary policy should be able to prevent a long, deep recession such as the one that occurred. The commenter’s question is very much on point.

Bernanke’s speech also raises another question. If the credit channel amplifies a downturn, is there a reason to be concerned about too much credit expansion during a boom? You can easily find non-academic cranks who point to ratios of both private and public debt to GDP and warn that a crash is coming. Academic economists have never been fond of such doom-mongering, but the theory of the credit channel seems to connect economic theory with the cranks’ warnings. Research into this question might lead mainstream economists to be more skeptical about financial innovations that promote the expansion of credit.