Adair Turner's account of financial markets is insightful but misunderstands the role of the state in creating financial crises.
How one might think about the biggest SIFI of them all.
Ben Bernanke’s 2012 lectures on central banking as he has studied and practiced it, now published as The Federal Reserve and the Financial Crisis, make a short (129 pages), direct and instructive discussion of what is the world’s most potent financial institution, for better and for worse. In the wake of the 21st century’s financial crises, there has been a lot of regulatory agonizing about “SIFIs,” or “systemically important financial institutions.” The Federal Reserve itself is the biggest SIFI of them all.
One can debate whether this has resulted in “The Global Curse of the Federal Reserve,” as is argued by Brendan Brown, but it is certain that the Federal Reserve is unsurpassed in its ability to create systemic risk for everybody else through its unlimited command of the principal global fiat money.
Mr. Bernanke’s chairmanship of the Federal Reserve Board, which will run from 2006 to 2014 (it appears), will without doubt go down in financial history as highly memorable for remarkable emergency actions and a vast expansion of central banking. When financial histories are written in the future, they will want to cite this book.
How future histories characterize the author will reflect something they will know, which we cannot: what the outcome of the Bernanke Fed’s massive manipulation of the government debt and mortgage markets will have been. This is something that we, and the Federal Reserve itself, now can only guess about. We do know that this has taken the Bernanke Fed’s assets to $3.5 trillion, including $1.2 trillion of real estate mortgages. The then-dominant personality in the Fed, Benjamin Strong, famously decided in 1927 to give the stock market a “little coup de whiskey.” Ben Bernanke decided to give the bond market a barrel or so of whiskey, in a way which would have astonished previous generations of Federal Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act. The ultimate outcome of this manipulation will probably render Chairman Bernanke in future histories as either a great hero or a great bum. An intriguing personal gamble.
If only the Chairman, the Governors, the Presidents and the scores of Ph.D. economists of the Federal Reserve could know the future! Then they could carry out their mandates without the many mistakes, deflationary and inflationary (including both goods price inflations and asset price inflations), which have marked the history of the Fed. These mistakes should not surprise us. Bernanke quotes Arthur Burns, the Federal Reserve Chairman in the 1970s and author of the Great Inflation of those days: “In a rapidly changing world, the opportunities for making mistakes are legion”—“which is certainly true,” Bernanke honestly adds. [p. 34]
Bernanke reflects on the fact that economists of the 1960s, before the Great Inflation, foolishly came to believe in what they called “fine tuning”—“the notion that the Fed and fiscal policy and other government policies could keep the economy more or less perfectly on course.” [p.34] Surprising as it may seem, this was actually believed by intelligent and well-educated economists. Some of them held a conference in 1967, for example, to discuss “Is the Business Cycle Obsolete?” It wasn’t.
This notion of fine tuning “turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s,” Bernanke writes. “So one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.” [p.35] A charming and very true statement.
The record of the Federal Reserve at economic and financial forecasting, including missing the extent of the Housing Bubble and the huge impact of its collapse, and failing to forecast the ensuing sharp recession, strengthens this wise case for humility on the Federal Reserve’s part. Such humility seems especially appropriate about attempts to predict financial market dynamics. As Bernanke recently said about rapid increases in bond yields, “Well, we were a little puzzled by that.”
In a 1996 speech otherwise famous for raising the question of “irrational exuberance,” then- Federal Reserve Chairman Alan Greenspan sensibly discussed the limits of the Fed’s knowledge. “There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment, and inflation,” he said. “In principle, there may be some unbelievably complex set of equations that does that. But we [the Fed] have not been able to find them, and do not believe anyone else has either.” Indeed, they have not, as subsequent history has amply demonstrated. Moreover, in my view, not even in principle can any model successfully predict the financial and economic future, so the Federal Reserve cannot know what the results of its own actions will be.
However, the 21st century Federal Reserve and its economists again became optimistic, and perhaps hubristic, about their abilities when their Chairman Greenspan had been dubbed “The Maestro” by the media and knighted by the Queen of England (it is now hard to remember the faith he and the Fed then inspired). Of particular pride, they thought they were observing a durable so-called “Great Moderation” of macro-economic behavior, and gave their own policies an important share of the credit. Bernanke insists that the Great Moderation was “very real and striking.” [p. 38] Yet, since it is apparent that the Great Moderation led to the Great Bubble and the Great Collapse, how could it have been so real?
Bernanke does address this puzzle. As the Great Moderation went on, he says, “There were vulnerabilities both in the private sector of our financial system and also in the public sector.” There was “too much debt, too much leverage.” And: “one reason they did that may have been the Great Moderation. With twenty years of relatively calm economic and financial conditions”—here he seems to forget the 900 commercial banks which failed from 1988-1992, as well as the Mexican, Russian and Asian debt crises of the 1990s, but never mind—“people became more confident, willing to take on more debt” [pp. 48-49]—with the results we know about. Central banks also became more confident.
This is a fine example of Hyman Minsky’s hypothesis that “Stability creates instability.” Financial markets become the most risky by feeling the safest. As both Bernanke and Minsky suggest, in the optimistic phase of debt expansions, risks tend to be underestimated, and catastrophes viewed as remote, if not impossible. “So if in 2006 you asked a bank about the effect if house prices fell 20 per cent, it probably would have greatly underestimated the impact on its balance sheet,” Bernanke writes. [p. 49] He is probably right about that. But was the Federal Reserve asking banks this question in 2006? Nope. Was it asking itself what would happen to the entire financial sector in if U.S. house prices fell 20% on average—let alone the 30% they did fall? Nope.
“We did not anticipate that the decline in house prices would have such a broad-based effect on the stability of the financial system,” Bernanke concedes. [p. 61] “What was missing here was enough attention being paid [note passive voice] to things that could affect the system as a whole.” [ p. 51] But to pay attention is not sufficient: you have to pointedly conceive in confident times how bad things will get. This is hard to do, even for extremely intelligent, extremely well-informed, very highly placed people like Chairman Bernanke. As an old banker told me long ago, “Risk is the price you never thought you would have to pay.” Indeed, well into 2007, the Fed was downplaying the extent of the damage the mortgage collapse which had already begun would entail.
The Federal Reserve will soon celebrate the 100th anniversary of the passage of the Federal Reserve Act, a big event by any standard. What has happened since it appeared on the scene? Well, there was bust and huge boom and again bust in Benjamin Strong’s 1920s; depression, recovery and then new depression in the 1930s; financing the government’s debt for the war in the 1940s; enjoying America’s global hegemony in the 1950s; two severe credit crunches, multiple dollar crises, and the start of high inflation in the 1960s; the run on the U.S. Treasury’s gold and then the Great Inflation of the 1970s; the thrift, oil bubble, Farm Credit, and less-developed country loan crises of the 1980s; the bank commercial real estate bust and then the various international debt crises of the 1990s. As one student of risk wrote, “The 1980s and 1990s were very turbulent times…it seemed that hundred-year floods were occurring at least every five years.” And then of course came the most recent decade of bubbles and collapse.
All this is rather different from the rosy imaginings at the foundation of the Federal Reserve. “The financial disorders which have marked the history of the past generation will pass away forever,” opined the American Banker in 1913. With the creation of the Federal Reserve, said the Comptroller of the Currency in 1914, “financial and commercial crises, or panics…seem to be mathematically impossible.”
This contemporary optimism reflected the idea that the Federal Reserve could provide an “elastic currency” which could be expanded to address panics and crises, as Bernanke discusses. This was and is true. In its emergency actions in 2008-2009, the Federal Reserve has demonstrated that the U.S. currency in its hands is very elastic indeed. “We did stop the meltdown. We avoided what would have been, I think, a collapse of the global financial system,” Bernanke writes. [p. 86] I think this is a fair assessment, given that the panic was already under way in an already hyper-leveraged housing finance sector.
So the primary “elastic currency” goal of the Federal Reserve Act has been fully achieved. We nonetheless keep having financial crises. “Financial crises will always be with us,” Bernanke writes. “That is probably unavoidable. We have had financial crises for six hundred years in the Western world. Periodically, there are going to be bubbles or other instabilities.” [p. 122] This is wise and the prediction is almost certainly true.
Central banks like the Federal Reserve have two essential missions, according to Bernanke. The first is “achieving stable growth in the economy, avoiding big swings…and keeping inflation low and stable.” Note that having perpetual inflation (at a more or less steady rate) is part of macroeconomic stability, as Bernanke, joined by all the other current central bankers, conceives it. The second is “financial stability. Central bankers…try to prevent or mitigate financial panics or financial crises.” [p. 3]
But what if central bankers help to cause panics and crises by promoting debt, leverage, and asset price inflation? Is that not what the Federal Reserve did as the U.S. housing bubble took off in 2001-2004? Just as the inflation of the housing bubble was accelerating, the Federal Reserve was pushing the fed funds rate to 1%, and congratulating itself for creating a “wealth effect” through higher house prices to boost economic growth. Observing this in 2003, Richard Koo called it a “brilliant strategy.” Looking at it now, lots of people, including me, think the Federal Reserve was seriously culpable in promoting the housing and debt boom which was already turning into a bubble.
It seems very important to Bernanke to deny that this was so. “The evidence I have seen suggests that monetary policy did not play an important role in raising house prices,” he writes. [p. 52] In fairness, he adds, “There is no consensus on this…economists continue to debate this issue.” [pp.52, 54] However, it seems to me that most of the briefs for the Federal Reserve’s innocence are self-justifying arguments from the Fed itself.
Overall, Chairman Bernanke gives us a lucid and obviously informed exploration of the difficulty of central banking now, in the past, and in the future. It strikes me that the dream of consistently achieving the two missions he articulates is probably mission impossible. Robert Solow recently claimed that “Central banking is not rocket science.” No: it is a lot harder than rocket science. This is precisely because it is not and cannot be a science at all, because it cannot operate with determinative mathematical laws, because it cannot make reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future. We should have no illusions about the probability of success of such a difficult attempt, no matter how intellectually impressive its practitioners may be.