The New York Times http://www.nytimes.com/2013/07/19/business/economy/when-bernanke-got-it-wrong.html
July 18, 2013 When Bernanke Got It Wrong By FLOYD NORRIS It is amazing that a lot of criticism of the Federal Reserve today focuses on what it clearly got right — the response to the debt crisis in 2008 and thereafter, a response that may well have prevented Great Depression II — and not on what it got wrong: policies that allowed the dangerous imbalances to grow and bring on the crisis. You could see that this week when Ben S. Bernanke, the Fed chairman, made his semiannual pilgrimage to Capitol Hill to discuss the state of the economy. Lawmakers voiced concern about possibly excessive regulation of banks, but not about the clearly inadequate capital the big banks — and many small ones — had before the crisis. Some of them seemed to be upset that the Fed’s policies had caused stock prices to rise. Jeb Hensarling, the Texas Republican who is chairman of the House Financial Services Committee, seemed to think that all current economic problems could be traced to President Obama’s excessive spending and was upset that the “Federal Reserve has regrettably, in many ways, enabled this failed economic policy through a program of risky and unprecedented asset purchases.” Mr. Bernanke, who is probably nearing the end of his tenure running the Fed, seemed to have had such criticisms in mind last week when he assessed “the first 100 years of the Federal Reserve” at a conference in Cambridge, Mass. In analyzing the Fed’s failures during the Depression, he seemed to be taking clear aim at some of his current critics — and perhaps at other central banks that were far less aggressive after the credit crisis. First, he appeared to address the idea, popular in some circles, that we need a new gold standard. “The degree to which the gold standard actually constrained U.S. monetary policy during the early 1930s is debated,” he said, “but the gold standard philosophy clearly did not encourage the sort of highly expansionary policies that were needed.” He said policy makers, following flawed economic theories, concluded “on the basis of low nominal interest rates and low borrowings from the Fed that monetary policy was appropriately supportive and that further actions would be fruitless.” Was that a criticism of the European Central Bank under Jean-Claude Trichet, which lowered interest rates but did little else as the euro zone crisis grew? It certainly helped to explain why Mr. Bernanke felt the need to embark on quantitative easing and to focus on longer-term interest rates as well as short-term ones. Then Mr. Bernanke pointed to “another counterproductive doctrine: the so-called liquidationist view, that depressions perform a necessary cleansing function.” That was the view pushed in the early 1930s by Andrew Mellon, the Treasury secretary, to such an extent that it angered even President Herbert Hoover, who did not, however, seem to think he could overrule the secretary. Now the comments could be read as a reproach to those, in the United States and Europe, who push for austerity above all else. “It may be that the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of an intellectual framework for understanding what was happening and what needed to be done,” Mr. Bernanke concluded. It seems to me that something similar could be said for the Fed before the debt crisis erupted. The intellectual framework it used simply could not cope with the idea that financial stability can itself become a destabilizing factor, as investors and bankers conclude that it is safe to take on more and more risk. For a time, the period before the collapse was known as the “Great Moderation,” a term that Mr. Bernanke helped to publicize in a 2004 speech. Low levels of inflation, long periods of economic growth and low levels of employment volatility were viewed as unquestioned proof of success. And what brought on that success? In 2004, Mr. Bernanke, then a Fed governor, conceded good luck might have helped, but his view was that “improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation.” In 2005, three Fed economists, Karen E. Dynan, Douglas W. Elmendorf and Daniel E. Sichel, proposed an additional explanation for the Great Moderation: the success of financial innovation. “Improved assessment and pricing of risk, expanded lending to households without strong collateral, more widespread securitization of loans, and the development of markets for riskier corporate debt have enhanced the ability of households and businesses to borrow funds,” they wrote. “Greater use of credit could foster a reduction in economic volatility by lessening the sensitivity of household and business spending to downturns in income and cash flow.” At least Mr. Bernanke’s hubris was not as great as that of Robert E. Lucas Jr., the Nobel Prize-winning University of Chicago economist. In 2003, he began his presidential address to the American Economic Association by proclaiming that macroeconomics “has succeeded: Its central problem of depression prevention has been solved.” In his speech last week, Mr. Bernanke cited several assessments of the Great Moderation, including the one by the Fed economists. None questioned that it was wonderful. The Fed chairman conceded that “one cannot look back at the Great Moderation today without asking whether the sustained economic stability of the period somehow promoted the excessive risk-taking that followed. The idea that this long period of calm lulled investors, financial firms and financial regulators into paying insufficient attention to building risks must have some truth in it.” One economist who would have expected that development was Hyman Minsky. In 1995, the year before Minsky died, Steve Keen, an Australian economist, used his ideas to set forth a possibility that now seems prescient. It was published in The Journal of Post Keynesian Economics. He suggested that lending standards would be gradually reduced, and asset prices would rise, as confidence grew that “the future is assured, and therefore that most investments will succeed.” Eventually, the income-earning ability of an asset would seem less important than the expected capital gains. Buyers would pay high prices and finance their purchases with ever-rising amounts of debt. When something went wrong, an immediate need for liquidity would cause financiers to try to sell assets immediately. “The asset market becomes flooded,” Mr. Keen wrote, “and the euphoria becomes a panic, the boom becomes a slump.” Minsky argued that could end without disaster, if inflation bailed everyone out. But if it happened in a period of low inflation, it could feed upon itself and lead to depression. “The chaotic dynamics explored in this paper,” Mr. Keen concluded, “should warn us against accepting a period of relative tranquillity in a capitalist economy as anything other than a lull before the storm.” When I talked to Mr. Keen this week, he called my attention to the fact that Mr. Bernanke, in his 2000 book “Essays on the Great Depression,” briefly mentioned, and dismissed, both Minsky and Charles Kindleberger, author of the classic “Manias, Panics and Crashes.” They had, Mr. Bernanke wrote, “argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behavior.” In a footnote, he added, “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.” It seems to me that he had both Minsky and Kindleberger wrong. Their insight was that behavior that seems perfectly rational at the time can turn out to be destructive. As Robert J. Barbera, now the co-director of the Center for Financial Economics at Johns Hopkins University, wrote in his 2009 book, “The Cost of Capitalism,” “One of Minsky’s great insights was his anticipation of the ‘Paradox of Goldilocks.’ Because rising conviction about a benign future, in turn, evokes rising commitment to risk, the system becomes increasingly vulnerable to retrenchment, notwithstanding the fact that consensus expectations remain reasonable relative to recent history.” I asked Mr. Barbera for his evaluation of Mr. Bernanke’s tenure. “He missed on the way in, big time,” Mr. Barbera said, referring to the debt crisis, “but he appreciated what was happening, and very aggressively responded. It was not in the standard tool kit. But he did it. He did it aggressively, and he did it to good effect.” If Mr. Bernanke’s successor, whoever he or she is, will take to heart the lesson that Mr. Bernanke missed during the good times — that stability itself eventually becomes destabilizing — the chances of a Great Recession II will be greatly reduced. -- Jim Devine / "Reality is that which, when you stop believing in it, doesn't go away." -- Philip K. Dick _______________________________________________ pen-l mailing list [email protected] https://lists.csuchico.edu/mailman/listinfo/pen-l
