Give Bernanke Credit—For Chutzpah

by Liberty and Power

In my mind’s eye, I envision a street fair—one of those happy community gatherings at which sellers of handcrafted ceramics, funky clothing, herbal remedies, fresh vegetables, and edible delicacies congregate to display their wares for the strolling customers, who chat amiably with the stall-keepers and with one another. Suddenly, amid horrified shrieks and the roar of a giant engine, a truck plows through this placid setting, scattering twisted debris and broken bodies in its wake. Finally, after wreaking a hundred-yard swath of death and devastation, the truck stops, and the driver, Ben Bernanke, climbs down from the cab.

“People, people,” he exhorts them in a calm, world-weary voice, “do not panic. I am here to assess the damage and make recommendations for reforms that will prevent a recurrence of this unfortunate and wholly unforeseen act of God.” Whereupon he proceeds to lay out his assessment and recommendations, always speaking in the same quiet, unemotional voice. The stunned and wounded survivors gaze at him in astonishment. “He’s a madman,” one cries out.

Undismayed by the swelling chorus of curses and the groans of the injured, the truck driver addresses the gathering crowd of stunned onlookers. “We must have a strategy that regulates the street-fair system as a whole . . . not just its individual components.” He then methodically lays out a series of recommendations for strengthening the construction materials of stalls and regulating their placement along the street, for ensuring that each transient merchant have an adequate capital cushion against such crises, for monitoring fruitmongers and hippy artists deemed “too big to fail,” to keep them from taking excessive risk. He proposes that the city council consider new ordinances to require that wooden crafts such a birdhouses be made sturdier and to establish a “limited system of insurance” to protect against customer runs on the most daring drug-paraphernalia sellers.

“Moreover,” he continues, “street fairs are too important to be left for each town to regulate on an ad hoc basis.” He proposes that the rules be harmonized among the mayors of all the world’s great cities and that a global street-fair authority be created to monitor street-fair risks and protect the people from accidents such as the one that has just occurred. Listeners look on in amazement, their mouths agape.

With that walk on the imaginary side as a warmup, I invite you to consider the speech Bernanke gave to the Council on Foreign Relations today, March 10, 2009. In this address, he proposes a sweeping overhaul of the regulation of “the financial system as a whole . . . not just its individual components.” According to the Associated Press report,

Bernanke offered new details on how to bolster mutual funds and a program that insures bank deposits. He also stressed the need for regulators to make sure financial companies have a sufficient capital cushion against potential losses.
. . .

To guide the regulatory overhaul, Bernanke laid out four key elements. One is for Congress to enact legislation so the failure of a huge financial institution can be handled in such a way to minimize fallout to the national economy—similar to how the Federal Deposit Insurance Corp. deals with bank failures. Such “too big to fail” companies must be subject to more rigorous supervision to prevent them from taking excessive risk, he said.
. . . Policymakers also should consider ways to bolsterimoney market mutual funds that are susceptible to runs by investors, Bernanke said. That could be done by imposing tighter restrictions on the financial instruments that money markets can invest in or through a limited system of insurance for certain funds. Bernanke also called for a review of regulatory policies and accounting rules, suggesting a larger financial buffer for the FDIC’s insurance program for bank deposits that could be used when conditions worsen. Capital regulations for banks and other financial institutions also must be “appropriately forward-looking” to ensure sufficient money is set aside against potential losses.

These proposals certainly answer the question, How do you make a byzantine regulatory system more byzantine by an order of magnitude? At the same time, they show how you display a conviction that if only you tinker with the apparatus long enough, you can make monetary central planning work, even though central planning has always and everywhere produced economic calamity.

All of this second-order handwaving might be dismissed as touchingly naive or as workaday establishment obtuseness, were it not such transparent grasping for power in the fashion that crisis always brings to the fore in a world entranced by the ideology of salvation by the grace of government. Bernanke concludes that “the government should consider creating an authority specifically responsible for monitoring financial risks and protecting the country from crises like the current one.” And who, pray tell, might fill these mighty shoes? Well, of course, none other than the Federal Reserve System, over which Ben Bernanke presides with such placid and self-confident mien.

In view of the Fed’s fundamental, if wholly unacknowledged, role in bringing about the world’s present economic debacle – by spewing forth the ample fuel that allowed the recent ill-fated mania in real estate and related financial dealings to flame so high ― the question that Bernanke’s current proposals immediately raise could not be more obvious: Quis custodiet ipsos custodes? Until someone can provide a compelling answer to this insistent question, we will be well advised to ignore, or even to denounce, the proposals advanced by this lunatic truck driver.

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Bill Woolsey - 3/17/2009

Perhaps I misuderstand some of the "technical" lingo. I understand "momentum" traders to be people who observe rising prices and then buy so that they can make money like everyone else already has. If momentum traders are supposed to be people who only look at the last tick, then I guess I am thinking of a broader group.

People who try to determine whether or not it is now the late stages of a bull market are technical, greater fool, traders. Well, if they intend to use that information to sell before the peak.

That the Federal Reserve would make an error in adjusting the market rate to the natural interest rate should be no surprise. However, it is just the other side of the coin of adjusting the quantity of base money to meet its demand. That isn't any easier. Regardless, in hindsight we can see that the Fed made an error. That is why spending in the economy fell off rapidly last fall and winter. Consumption fell 10% and investment fell 20%. And why it rose extra fast in 2002 and 2003.

Chinese saving turns into American saving if there is a net capital inflow (like there was.) With perfectly integrated capital markets there is a single world natural interest rate. A net capital inflow would be how the domestic natural interest rate falls to the world natural interest rate if domestic conditions would result in saving less than investment at the world rate. Under current conditions, it might be better to see the net capital inflow as being a factor that reduces the domestic natural interest rate.

If we imagine that, somehow, the quantity of money adjusts to meet the demand, so that there is no monetary disquilibrium, then the flow of funds from China to the U.S. either inovles them directly purchasing assets, and so raises the prices and lowers the yields of the assets, or else they accumulate money balances, and by assumption, those are accomodated by an increase in the quantity of money. But the banking system accumulates assets, then, raising the prices and lowering the yields.

Without monetary disequilibrium, the market interest rate adjusts to the natural interest rate through purchases and sales of financial assets. (Or through pruchases of capital goods.)

If the quantity of money doesn't accomodate the increased demand, then if the foreign savings goes to accumulate monetary assets directly, or else, those who sell assets to the foreigners hold increased monetary assets, then this creates a shortage of money. The market interest rate fails to fall to meet the new, lower natural interest rate. Prices and nominal incomes fall so that the real supply of money rises to meet the demand. As the real supply of money rises, some of those who are wealthier purchase assets, bringing down the market interest rate. To the degree some of this is outside money, there may be a pigou effect so that consumption rises independent of the impact of the lower interest rates. In that situation, the natural interest rate rises as well as the market interest rate falls.

Anyway, to the degree Greenspan really meant that the central bank cannot impact mortgate rates, he was incorrect. It is just that long term interest rates mostly depend on what short term interest rates will be doing in the future. Only a fool looks at the current target for the Federal Funds rate and assumes that it will last forever. But that doesn't mean that the lower interest rates now don't impact longer term interest rates at all--interest rates for the next few months are part of future interest rates.

Finally, credit isn't the same thing as money. While large ratios of debt to GDP may tell us something about willingness to borrow and lend, it tells us next to nothing about what happened to monetary policy.

If we imagine that all lending is done by banks and that banks fund all the lending by issuing debt instruments that can be used as money, then lending equals money creation.

But that isn't the real world. Most lending is outside of banks and banks fund most of their lending using things other than debt instruments that can be used as money.

Further, aggregate saving puts no limit on credit creation.

Suppose that there is zero "personal" saving. Half of the households save 50% of their income and half the houseolds consume 150% of their income. The savers lend to the dissavers. Aggregate saving is zero. But the debts of the dissavers are 25% of total income. This continues for 4 years, with the dissavers getting more and more in debt to the savers. Now, total debt is 100% of income,

So, now we have a huge amount of debt. There was no saving to fund any of this debt. Must have been money creation? Well, no. (This can all be unwound as planned, with the former savers now consuming more than income as their assets decrease and debts are repaid. The fomer dissavers must now consume much less of their income. If there is a default, then the former dissavers don't have to cut consumpiton as much and the former savers don't get to increase consumption as much.)

Suppose that profitable firms retain earnings and buy capital goods. This is both saving and investment. There is no debt. Suppose that instead, some of the profitable firms purchase stock in other firms and those other firms issue new shares and not only buy capital goods with their own retained earnings, but with the funds raised from selling the stock. Saving, investment, and no debt. Now, suppose the firms buy corporate bonds rather than stock with retained earnings. Saving, investment, but debt. People point to the firms that have financed their expansion through debt and point out that they are too leveraged. People can even look at the aggregate figures and point out that total leverage is now "too high." Still, all of the investment was funded by the saving (retained earnings.) The growing debt had nothing to do with money creation.

Finally, the Fed could target housing prices. It might not be possible to use the Federal Funds rate as an operating target, though I am not sure why not. But, more fundamentally, the Fed would just expand base money when housing prices are "too low." The nominal value of houses could go up at whatever rate the Fed wants. Trying to maintain production of new houses at a target level would be much more difficult. It is that sort of "target" that is behind much of the Austrian Business Cycle theory. Futile efforts to use money creation to maintain unsustainable levels of production in a sector must eventually end.

RickC - 3/17/2009

H. Skip Robinson,

Nice comments. One thing that came immediately to mind was Thomas Sowell's 1992 book, "Inside American Education." Dr. Sowell rarely pulls any punches. Still relevant and timely almost 17 years later.

William Stepp - 3/14/2009

Bubbles result from momentum traders and technical, "greater fool" traders.

Asset bubbles do not result from momemtum traders. On the contrary, they are famously late to bull markets, and are notorious for buying at the top of markets, when value investors are selling. By definition, they are not concerned with fundamentals, just the last quoted price of an asset. Value investors are generally the ones buying in the early stages of bull markets. They buy undervalued assets and sell them when they become overvalued.
To use an analogy, they are like a passerby who throws gasoline on an already burning fire. They are not like an arsonist who starts a fire. The Fed was run by the economic equivalent of an arsonist.
The ECBureaucrats were also arsonists; when the euro started trading in 1998, they tried to make euro-denominated interest rates lower than rates tied to the national currencies they replaced, in order to make sure everyone was on board with their program, and also to fend off anticipated political blowback from nationalist types.

The second failure of the Fed has been its failure to meet the demand for money in the aftermath of the crisis. An alternative way to describe this is a failure to keep market interest rates equal to a natural interest rate that has fallen because of pessimistic expecations.

As George Selgin points out in his _The Theory of Free Banking_, interest rate target is a fool's errand fit for socialists. In his discussion of interest rate pegging by central banks, he concludes that this can only result in monetary equilibrium by "an incredible, and short-lived, stroke of luck (p. 105)." It's not happening on the Helicopter Pilot's watch, nor under that of any of his successsors. Ever.
Or, put it this way: it will happen when the average Cuban is richer than the average American--and Cuba still has socialism.

The Fed could target the prices of houses and keep them rising at a rapid pace. Anyone who invested in housing on the assumption that such was the Fed's poilcy was a fool. And while I do think there was some foolish investing in real estate, I don't think that was the cause of the foolishness. Nor do I think that a myopic projection of a 1% federal funds rate forever was the cause of the problem either.

I don't see how the Fed could target the price of houses, or of any other asset class, such as stocks. After all, its policy tool here is the Fed funds rate, over which it has sway, but nothing like perfect control.
If the Fed targets interest rates and runs an expansionary monetary policy, this will inevitably spill over into different asset classes, not just houses (for example). Indeed, in the 2001-2007 credit expansion, virtually all asset classes were inflating in price--real estate, mortgages, stocks, bonds, derivatives, commodities, private equity, and art. Americans also went on a credit card and consumption binge. The Fed can't confine the effects of its depradations to one group of assets.
I think the evidence against the Fed is overwhelming. Easy Al defended his sorry record in the Wall Street Journal last Wednesday, "The Fed Didn't Cause the Housing Bubble."
He confined the essay to the housing bubble, (deliberately?) overlooking
the massive bubble in other assets.
He claimed that the "correlation between home prices and mortgage rates rates was highly significant, and a far better indication of rising home prices than the fed-funds rate."
But correlation is not causation, and the lowering of the Fed funds rate put downward pressure on the entire term structure of rates, including 15-and 30-year mortgage rates.
Presumably he thinks the Fed can run an expansionary (or contractionary) monetary policy under the "right" circumstances. If so, he has to admit that interest rates and asset prices would be affected across the spectrum of markets. When the Fed tried to boost the economy, it doessn't say, gee, let's increase home prices and employment in Houston, which has been depressed lately.

He also blames the increase in global savings from developing countries, such as China, for the drop in interest rates. There was no savings glut among Americans.

He quotes Milton Friedman's 2006 defense of his record, also in the Wall Street Journal. He should have quoted Marc Faber's Feb. 18 Wall Street Journal piece, "Synchonized Boom, Synchronized Bust":
"total credit increased in the U.S. from an annual growth rate of 7% in the June 2004 quarter to over 16% in early 2007. It grew five times faster than nominal GDP between 2001 and 2007."

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H. Skip Robinson - 3/14/2009

There are at least 17 major policy issues that I can see that caused the current financial meltdown. Robert Higgs is aware of elementary economics. It appears to me that he is making fun of Bernanke and his fellow social engineers of the monoplistic central bank whose focus is to stabalize runs on banks and large cyclical swings in economic activity, that has done just the opposite over the last 100 years. A fact that you appear to have missed. Just wait till you experience the results of their actions over the next several years.

H. Skip Robinson - 3/14/2009

Hey Robert big fan of you and the Independence Institute.
I have recently decided to focus on writing and speaking about the negative ramifications and unintended consequences of the failed various Keynesian/socialistic policies. For instance, there must be at least 10 negative ramifications of our most cherished public education system that most Americans have never heard or read of. It's about time we started using the demonising approach so well used by our advosaries. It would be interesting to see which negative ramifications are the ones that will resonate most through the populas as they start to read and hear them.

BillWoolsey - 3/12/2009

I disagree with the notion that the Fed caused the speculative bubble in housing. My view is that the very low interest rates mostly reflected a low natural interest rate, though, not entirely. While a speculative bubble is more likely when there is a change in fundamentals to give it a start, the Fed's modest error was just one of many such misktakes.

Bubbles result from momentum traders and technical, "greater fool" traders. While soap bubbles actually fill up with air, bubbles in asset prices are not really filling up with money. The notion "where does the money come from for the bubble" is mistaken. It based on the loose usage of the term "money" to mean "wealth."

It is likely that an asset price bubble will raise the demand to hold money. And if money balances are less than desired balances, people will sell something or buy less out of current income. So, monetary factors can play a role in these things, but don't let analogies let you get carried away.

Did I seek to increase my checking account balance because my house increased in value? I don't think so. But, it seems plausible that people would do this. And if they did, then, such people would purchase fewer other assets than they otherwise would or purchase fewer consumer goods for a time, or sell some other assets. So other prices would be lower than otherwise, which would to allow for the higher real balances. And, this would presumably dampen the bubble a bit. A rising money supply accomodates the greater demand for money balances and makes that process "unnecessary."

Momentum traders are being fools. And "greater fool" technical traders are playing a risky game in order to fleece the fools. Lending into a speculative bubble, especially when the asset with pricing bubble is the collateral, is really no different.

If those lending into the speculative bubble all expect to be bailed out by the government, there is no risk. (Or rather, it is a sort of political risk about who gets bailed out how much.) That was a problem before, and, as best I can tell, Bernanke has been supportive of the maximum bailout policies we have seen over the last two years. He is laying the groundwork for future bubbles. His remarks on regulations are "correct" in a sense. If the taxpayers are going to cover all losses of everyone, then their representatives must approve all the lending projects. Because regulators work for politicians and politicians in a rent-seeking society are poor stewards for taxpayers, I think this is a foolish approach.

The better approach, I think, is to let the foolish momentum traders take their losses. And those "greater fool" traders who couldn't find a greater fool and failed to get out, _especially_ should take their losses. And that includes lenders.

The second failure of the Fed has been its failure to meet the demand for money in the aftermath of the crisis. An alternative way to describe this is a failure to keep market interest rates equal to a natural interest rate that has fallen because of pessimistic expecations.

The natural interest rate cannot be observed. But surely it can change. Given the nominal quantity of moeny, the market process that brings market interest rates to the natural interest rate requires changes in prices throughout the economy. It is the same process that brings the real supply of money into equilibrium with demand.

A central bank that changes the quantity of money so that it remains equal to the demand for money, at the same time allows the market interest rate to adjust directly to the natural interest rate. A central bank that sets the market interest rate at the natural interest rate, allows the quantity of money to ajust to the demand for hold money.

It is hard for me to imagine that a central bank could do this perfectly. And so, there will be mistakes. However, the notion that speculative bubbles require thses mistakes is false. And, further, speculative bubbles are not "optimal" responses to the mistakes. It isn't like the market responded optimally to what the Fed was doing, and it was the Fed's error that generated the market response.

Looking at the Fed's target for the Federal Funds rate and imagining that the natural rate is always unchanging, so that each move in the Federal Funds rate is a movement towards or away from the natural interest rate is a mistake.

Similarly, looking at the monetary base (or M2, or any other statstic) and assuming that every incresase is creating an excess supply relative to an unchange demand is also a mistake.

With hindsight, we can see that the Fed creating an excess suppply of money (or, equivalently, set market interest rates below the natural interet rate) given its prefered regime. Even though I don't like the Fed's approach, I don't confuse those failures with it not moving towards what I think is better.

The Fed could target the prices of houses and keep them rising at a rapid pace. Anyone who invested in housing on the assumption that such was the Fed's poilcy was a fool. And while I do think there was some foolish investing in real estate, I don't think that was the cause of the foolishness. Nor do I think that a myopic projection of a 1% federal funds rate forever was the cause of the problem either.