Emerging from the Crisis: Where Do We Stand?

Chairman Ben S. Bernanke

November 19, 2010

The last time I was here at the European Central Bank (ECB), almost exactly two years ago, I sat on a distinguished panel much like this one to help mark the 10th anniversary of the euro. Even as we celebrated the remarkable achievements of the founders of the common currency, however, the global economy stood near the precipice. Financial markets were volatile and illiquid, and the viability of some of the world’s leading financial institutions had been called into question. With asset prices falling and the flow of credit to the nonfinancial sector constricted, most of the world’s economies had entered what would prove to be a sharp and protracted economic downturn.

By the time of that meeting, the world’s central banks had already taken significant steps to stabilize financial markets and to mitigate the worst effects of the recession, and they would go on to do much more. Very broadly, the responses of central banks to the crisis fell into two classes. First, central banks undertook a range of initiatives to restore normal functioning to financial markets and to strengthen the banking system. They expanded existing lending facilities and created new facilities to provide liquidity to the financial sector. Key examples include the ECB’s one-year long-term refinancing operations, the Federal Reserve’s auctions of discount window credit (via the Term Auction Facility), and the Bank of Japan’s more recent extension of its liquidity supply operations.

He still doesn’t understand that the obvious move is to lend unsecured to member banks in unlimited quantities. The liability side of banking is not the place for market discipline; it’s the asset/capital side.

To help satisfy banks’ funding needs in multiple currencies, central banks established liquidity swap lines that allowed them to draw each other’s currencies and lend those funds to financial institutions in their jurisdictions; the Federal Reserve ultimately established swap lines with 14 other central banks.

He still doesn’t realize what the fed did was to lend approx $600 billion unsecured to foreign governments, for the sole purpose of bringing down LIBOR settings, and that there are far more sensible ways to bring down LIBOR settings. Nor has he realized the public purpose behind prohibiting us banks from using LIBOR in the first place.

Central banks also worked to stabilize financial markets that were important conduits of credit to the nonfinancial sector. For example, the Federal Reserve launched facilities to help stabilize the commercial paper market and the market for asset-backed securities, through which flow much of the funding for student, auto, credit card, and small business loans as well as for commercial mortgages.

Nor has the fed understood how to utilize its member banks, which are public private partnerships, to further public purpose. Rather than buy the collateral in question for its own portfolio, the Fed could have empowered its member banks to do it by such means as, for example, allowing them to put that specific collateral in segregated accounts where the fed would cover losses. This is functionally identical to the fed buying for its own account, but without the costly need for the fed itself to establish trading desks, back office operations, and other associated support structure.

In addition, the Federal Reserve, the ECB, the Bank of England, the Swiss National Bank, and other central banks played important roles in stabilizing and strengthening their respective banking systems. In particular, central banks helped develop and oversee stress tests that assessed banks’ vulnerabilities and capital needs. These tests proved instrumental in reducing investors’ uncertainty about banks’ assets and prospective losses, bolstering confidence in the banking system, and facilitating banks’ raising of private capital.

They did this entirely because they were concerned about the banks’ ability to fund themselves, which again misses the point of the liability side of banking not being the place for market discipline. Again, the right move was to lend fed funds to the banks in unlimited quantities on an unsecured basis.

Central banks are also playing an important ongoing role in the development of new international capital and liquidity standards for the banking system that will help protect against future crises.

Again, misses the purpose of capital requirements, which is the pricing of risk. Risk itself is controlled by regulation and supervision.

Second, beyond necessary measures to stabilize financial markets and banking systems, central banks moved proactively to ease monetary policy to help support their economies. Initially, monetary policy was eased through the conventional means of cuts in short-term policy rates, including a coordinated rate cut in October 2008 by the Federal Reserve, the ECB, and other leading central banks. However, as policy rates approached the zero lower bound, central banks eased policy by additional means. For example, some central banks, including the Federal Reserve, sought to reduce longer-term interest rates by communicating that policy rates were likely to remain low for some time. A prominent example of the use of central bank communication to further ease policy was the Bank of Canada’s conditional commitment to keep rates near zero until the end of the second quarter of 2010.1 To provide additional monetary accommodation, several central banks–among them the Federal Reserve, the Bank of England, the ECB, and the Bank of Japan–purchased significant quantities of financial assets, including government debt, mortgage-backed securities, or covered bonds, depending on the central bank. Asset purchases seem to have been effective in easing financial conditions; for example, the evidence suggests that such purchases significantly lowered longer-term interest rates in both the United States and the United Kingdom.2

Yes, with little or no econometric evidence that lower rates added to aggregate demand. Nor is there any discussion of this controversy.

In fact, it looks to me like lower rates more likely reduced aggregate demand through the interest income channels, and continues to do so.

Although the efforts of central banks to stabilize the financial system and provide monetary accommodation helped set the stage for recovery, economic growth rates in the advanced economies have been relatively weak. Of course, the economic outlook varies importantly by country and region, and the policy responses to these developments among central banks have differed accordingly. In the United States, we have seen a slowing of the pace of expansion since earlier this year. The unemployment rate has remained close to 10 percent since mid-2009, with a substantial fraction of the unemployed out of work for six months or longer. Moreover, inflation has been declining and is currently quite low, with measures of underlying inflation running close to 1 percent. Although we project that economic growth will pick up and unemployment decline somewhat in the coming year, progress thus far has been disappointingly slow.

Yes, the Fed continues to fail to deliver on both of its dual mandates.

In this environment, the Federal Open Market Committee (FOMC) judged that additional monetary policy accommodation was needed to support the economic recovery and help ensure that inflation, over time, is at desired levels.

That is, they were concerned about falling into deflation.

Accordingly, the FOMC announced earlier this month its intention to purchase an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee also will maintain its current policy of reinvesting principal payments from its securities holdings in longer-term Treasury securities. Financial conditions eased notably in anticipation of the Committee’s announcement, suggesting that this policy will be effective in promoting recovery. As has been the case with more conventional monetary policy in the past, this policy action will be regularly reviewed in light of the evolving economic outlook and the Committee’s assessment of the effects of its policies on the economy.

Note that comments from FOMC members have repeatedly shown they lack a fundamental understanding of actual monetary operations, and are promoting policy accordingly

I draw several lessons from our collective experience in dealing with the crisis. (My list is by no means exhaustive.) The first lesson is that, in a world in which the consequences of financial crises can be devastating, fostering financial stability is a critical part of overall macroeconomic management. Accordingly, central banks and other financial regulators must be vigilant in monitoring financial markets and institutions for threats to systemic stability and diligent in taking steps to address such threats. Supervision of individual financial institutions, macroprudential monitoring, and monetary policy are mutually reinforcing undertakings, with active involvement in one sphere providing crucial information and expertise for the others. Indeed, at the Federal Reserve, we have restructured our financial supervisory functions so that staff members with expertise in a range of areas–including economics, financial markets, and supervision–work closely together in evaluating potential risks.

Systemic liquidity risk comes from the fed not realizing it should always be offering fed funds at its target rate in unlimited quantities.

That limits risks to bank shareholders (and unsecured debt which is functionally part of the capital structure), and to the FDIC/taxpayers where it has failed to adequately regulate and supervise and losses exceed private equity.

Second, the past two years have demonstrated the value of policy flexibility and openness to new approaches. During the crisis, central banks were creative and innovative, developing programs that played a significant role in easing financial stress and supporting economic activity. As the global financial system and national economies become increasingly complex and interdependent, novel policy challenges will continue to require innovative policy responses.

Unfortunately, it also demonstrated the consequences of not understanding monetary operations and bank fundamentals. For example, there was and continues to be a complete failure to recognize that the treasury buying bank capital under tarp was functionally nothing more than regulatory forbearance, and not an ‘expenditure of tax payer money’

Third, as was the focus of my remarks two years ago, in addressing financial crises, international cooperation can be very helpful; indeed, given the global integration of financial markets, such cooperation is essential.

It is not. This is another example of failure to understand banking fundamentals and monetary operations. The US is best served by independent banking law, regulation, and supervision.

Central bankers worked closely together throughout the crisis and continue to do so. Our frequent contact, whether in bilateral discussions or in international meetings, permits us to share our thinking, compare analyses, and stay informed of developments around the world. It also enables us to move quickly when shared problems call for swift joint responses, such as the coordinated rate cuts and the creation of liquidity swap lines during the crisis. These actions and others we’ve taken over the past few years underscore our resolve to work together to address our common economic challenges.

Sadly, it’s the blind leading the blind, and we all continue to pay the price.

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