Bernanke Tries to Defend the Fed

In a sign that the Federal Reserve is circling the wagons, chairman Ben Bernanke has an op-ed in the Washington Post that attempts to defend the central bank’s role. What is interesting is how much the tables have turned. The Obama effort to make the Fed into the uber bank regulator has become a rout, with decent odds that the Fed will have its powers reduced, and an increasing possibility that Bernanke might not be reconfirmed (which is frankly the right outcome, no CEO who presided over a similar disaster would still be in charge).

This piece has so many artful finesses that I must limit myself to the most salient points. From Bernanke:

As a nation, our challenge is to design a system of financial oversight that will embody the lessons of the past two years and provide a robust framework for preventing future crises and the economic damage they cause.

Yves here. He’s only one paragraph into the article and he is already discrediting himself. If he is looking only to last two years for lessons, he is looking in the wrong place. This crisis was at a minimum a decade in the making, and I’d say more like 30 years. Where are the post-mortems? There is absolutely no evidence that the Fed sees its own policies, namely the Greenspan and then Bernanke puts, and the extreme laissez-faire attitude towards bank regulation, as major culprits.

For instance, the Fed was the architect of the “let a thousand flowers bloom” policy towards derivatives, and made inadequate (one might say no) effort to understand new financial technology. Bernanke himself rationalized burgeoning consumer debt, claiming that consumer balance sheets were in good shape. Hun? This is Japan circa 1989 thinking. The measure of whether a borrower can handle his debt load is primarily his debt coverage ratios (income versus debt service costs). And by those measures, consumer creditworthiness had been deteriorating (admittedly, the data series aren’t great here, but merely looking at zero consumer saving rates would tell anyone with an operating brain cell that things were out of whack). And why do we want to encourage consumer borrowing? Unlike businesses, consumers are not funding in productive investments (and before you offer student loans as an example, one reader has done an analysis and had concluded the returns are lousy). Balance sheets are relevant only in a distress or liquidation scenario. If you need to revert to a conversation about balance sheets to defend debt levels, it should be obvious you are on shaky ground.

Similarly, I had a chat with a Fed official in the early stages of the subprime crisis, and the Fed was absolutely unwilling to see the banks as having any culpability for the disaster.

This is hardly a complete list of pre-crisis failures; I’m sure readers can make numerous additions. Back to Bernanke:

I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation.

Yves here. Notice how Bernanke invokes a “global consensus,” which is wonderfully vague and ignores the fact that the pre-crisis “global consensus” of minimally regulated markets and financial institutions, is precisely what caused the crisis. Moreover, even if the Fed’s mandate in theory was appropriate, its governance structure is not. The Bank of England and the ECB are not peculiar largely private institutions, accountable to almost no one, as the Fed now is. The Fed’s insistence on secrecy regarding many of its emergency operations is unwarranted and deeply troubling. And “the Fed played a major role in arresting the crisis” ignores the fact that the Fed played a major role in creating it, namely, via negative real interest rates for a protracted period. And he is declaring the Fed’s policies to be successful when the jury is still out.

Back to Bernanke:

The proposed measures are at least in part the product of public anger over the financial crisis and the government’s response, particularly the rescues of some individual financial firms. The government’s actions to avoid financial collapse last fall — as distasteful and unfair as some undoubtedly were — were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Yves here. This is actually very arrogant once you translate it: “What we did was correct, but the public is on a witch hunt and is incorrectly taking it out on the Fed. And I do know better because I am an expert on the Depression.” First, if we are going to get into dueling experts, Anna Schwartz has been enormously critical of the Fed’s conduct, both pre-crisis and in seeing providing liquidity as the primary solution. She also warned explicitly against drawing comparisons between the gold standard era Depression and now. Second, Bernanke’s reading of the Depression (which is pretty conventional, that the Fed blew it by not providing more liquidity) is contradicted by other evidence. As Paul Krugman has pointed out repeatedly, the monetary base, which is what the Fed controls, grew in 1930. But the money supply collapsed. Third, the vast majority of economists tend to look for single factor explanations of why the Depression ended, and within those, tend to focus on the ones that are the easiest policy levers, namely monetary or fiscal stimulus. But the Depression also saw considerable institutional reform, as well as a protracted period of debt reduction, via restructuring (via the Home Owners Loan Corporation) and defaults. Drawing simple conclusions from a complex phenomenon strikes me as misleading and misguided.

Back to Bernanke:

Moreover, looking to the future, we strongly support measures — including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system — to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is “too big to fail” — while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

Yves here. This is way oversold. First, financial firms decay catastrophically, as we saw with Bear and Lehman. No one has a template for how to resolve a big capital markets trading firm, save a subsidized gunshot wedding. This is like pretending you know how to build a nuclear weapon in 1935. What do you do about counterparty exposures? No one wants to be at risk of having his positions frozen. And if you have the government backstop a firm while it continues trading, you get into another huge can of worms. And layer the political problems, that to resolve a big financial firm, you need a very large check. Congress is not about to cede that kind of spending authority to the Treasury, and there do not appear to be any proposals on the table to come up with emergency approval processes (as in some pre-set frameworks and ground rules). But even so, there are massive thorny issues that Bernanke is pretending are solved, when they have not even been addressed. What do you do with Citibank’s $500 billion of foreign deposits, for instance, a fair chunk of which are presumably uninsured? How do you justify having US taxpayers bail out foreign depositors? What responsibility (if any) does the US have for trading operations in other countries? This is thorny because trading books are passed across time zones, again putting operational issues in conflict with legal jurisdiction. And it isn’t clear that a US desire for a resolution regime will dovetail well, or at all, with the bankruptcy regimes in various countries (bankruptcy is handled where the legal entities are domiciled, the Fed’s fond wishes for a US-driven process to the contrary). I have not seen anything to indicate that anyone in authority has grappled with the complexity of the issues, which means statements like this are mere empty sloganeering.

Back to Bernanke:

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

Huh? Toughening oversight? We’ve seen the reverse, massive regulatory forbearance. Yes, I am told the Fed is now making all the banks disclose their derivatives positions to them, but the Fed lacks the analytical capacity to do much with this information (and I am further told the Fed staff understands that too). So that does not fit my notion of “tougher oversight.” And the rest is just empty promises. Back to the op-ed:

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

Yves here. The worst is the folks at the Fed clearly believe the bogus stress tests were a meaningful exercise. That alone should disqualify them from getting a bigger role in bank supervision. And if you read their pronouncements, they plan to continue to use them, and have the process run by….monetary economists! Pray tell, what do they know about bank operations? Help me! And some of the help the Fed has enlisted in the stress test exercise includes the consulting firm McKinsey, which has the biggest banking practice in the consulting industry. Think McKinsey is going to devise anything that might be rough on its biggest meal tickets? Bernanke also conveniently ignores the fact that the rally might also have a wee bit to do with the fact that he threw a bit over $1 trillion at the markets, as announced in mid-March.

I could go on, but you get the picture. The Fed seems to believe its own PR.