Page 1 of 3 CREDIT BUBBLE BULLETIN Bernanke's comment
Commentary and weekly watch by Doug Noland
Somehow the US Federal Reserve has succeeded in making unstable global markets even more so. I read with keen interest chairman Ben Bernanke's paper "The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future", presented last Wednesday to the National Bureau of Economic Research:
In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen, the Federal Reserve was established to "provide a means by
which periodic panics which shake the American Republic and do it enormous injury shall be stopped". In short, the original goal of the Great Experiment that was the founding of the Fed was the preservation of financial stability.
At the time, the standard view of panics was that they were triggered when the needs of business and agriculture for liquid funds outstripped the available supply - as when seasonal plantings or shipments of crops had to be financed, for example - and that panics were further exacerbated by the incentives of banks and private individuals to hoard liquidity during such times. The new institution was intended to relieve such strains by providing an "elastic" currency - that is, by providing liquidity as needed to individual member banks through the discount window; commercial banks, in turn, would then be able to accommodate their customers.
Bernanke is renowned as a preeminent expert on the causes of the Great Depression. We share the view that understanding this historic downturn is indeed "the Holy Grail of economics". Bernanke's views of monetary policy "mistakes" made early in the 1930s profoundly shaped the Fed's monetary policy doctrine following the post-tech bubble downturn and then even more so during this extended post-mortgage finance bubble period.
I take strong exception with what has over decades become a distorted revisionist view of the 1920s and 1930s periods. For starters, I'll take issue with the general context of how Bernanke explains the objectives of the new Federal Reserve back at its inception in 1913.
The US economy and banking system had suffered through decades of destabilizing boom and bust cycles. While having a central bank to help manage systemic liquidity issues during crisis periods was advantageous, the critical role for the Federal Reserve was to more effectively regulate credit - to try to avoid crises. There was a clear appreciation at the time that credit and speculative excesses were the bane of financial stability.
It is worth noting that Bernanke and others' historical accounts of the 1920s basically disregard a crucial fact: the Federal Reserve patently failed in its responsibilities to safeguard financial stability during that period. It basically accommodated a runaway boom. By intervening to limit downturns and backstop system liquidity, the Fed nurtured historic financial and economic bubbles. It failed in regulating credit and it failed in dealing with historic financial excess. Its policies were instrumental in what evolved into epic economic maladjustment and imbalances on a globalized basis.
Bernanke and others gloss over these failures, preferring instead their ideological focus on activist central bank post-bubble "mopping up" stimulus and market interventions. When Milton Friedman in the early-1960s canonized the 1920s as the "Golden Age of Capitalism", this seemingly brought to an end the critical evaluation of one of the most relevant periods in financial, economic and policy history. The focus shifted to post-bubble policy activism.
The Friedmanite view holds that the Fed committed a dereliction of duties by not dramatically loosening policy and printing money early in the 1930s' downturn. From Bernanke:
The Great Depression was the Federal Reserve's most difficult test. Tragically, the Fed failed to meet its mandate to maintain financial stability.
I would argue that mistakes are indeed commonplace in the fog and confusion associated with bursting bubbles (look no further than contemporary Europe). Post-bubble landscapes are fraught with financial, economic, political and social upheaval and discontinuities - and this is a critical reason why central banks should place money, credit and bubble analysis prominently in policy doctrines.
I strongly believe that the Fed's fateful dereliction of responsibilities was committed during the 1920s' accommodation of destabilizing credit and speculative excesses, especially late in the decade. While they may very well remain latent throughout a protracted bubble period, the reality is that the foundation of financial stability is compromised during the boom. Moreover, the greatest risks to systemic stability manifest during the boom's late-cycle period, often as authorities move to aggressive interventions in an attempt to stave off the collapse of increasingly vulnerable credit and speculative bubbles.
This is a most relevant topic, as I believe the Bernanke Fed is now repeating errors similar to those committed by the Benjamin Strong Federal Reserve during the late-'20s period.
Benjamin Strong, first head of the Federal Reserve Bank of New York (1914-1928), is a controversial figure. He was the dominant leader at the Fed during the 1920s - the Alan Greenspan or Bernanke of that era. And based on one's historical/ideological perspective, he was either the central bank genius whose death in 1928 left a fateful leadership void at the Fed - or a dominating activist central banker much too eager to intervene in the marketplace and accommodate a historic bubble.
From "Benjamin Strong, the Federal Reserve, and the Limits to Interwar American Nationalism ... ," Priscilla Roberts, Federal Reserve Bank of Richmond Economic Quarterly, Spring 2000):
The most notorious episode of monetary ease, however, occurred in July and August 1927, when Strong, though alarmed by the American market's speculative and inflationary tendencies, nonetheless forced through the Federal Reserve System a decrease in the discount rate from 4 to 3 percent. This move relieved the excessive pressures to which the initial level of American interest rates was subjecting the dangerously shaky [British] pound.
In July 1927 the central bankers of Great Britain, the United State, France, and Germany had met on Long Island in the United States to discuss means of strengthening Britain's gold reserves and the general European currency situation. Strong's reduction of discount rates ... appears to have been the direct result of this conference. Indeed, according to Charles Rist, one of the French central bankers who attended, Strong said that the American authorities would reduce discount rates as "un petit coup de whisky for the stock exchange". Strong pushed this reduction through the Federal Reserve System despite strong opposition ...
Throughout the Roaring Twenties, US-based credit became an increasingly dominant source of finance internationally. Some have criticized Strong for being too close to Wall Street. He was definitely an avid proponent for the US taking an active internationalist approach with policymaking. Strong came to recognize the powerful new tools available for the Fed to lower market yields, bolster system liquidity and backstop the financial markets (at home and abroad).
The Fed in general believed the proliferation of productivity-enhancing technologies and low (and falling) inflation provided an opportune backdrop for implementing accommodative monetary policy. There was definitely a New Era/New Paradigm mentality that took root at the Federal Reserve, in Wall Street and throughout segments of the real economy. Enlightened policymaking ensured a "permanent plateau" in US prosperity - or so leading economic thinkers believed heading into 1929.
The great credit inflation/bubble that set the stage for the Great Depression generally commenced with the outbreak of World War I. There are myriad disconcerting parallels between that period and today's ongoing credit bubble - including extraordinary technological innovation, US dominance of global finance, major destabilizing financial innovations, expanding use of leverage in financial speculation, and expanding domestic and international financial and economic imbalances.
In both periods, I would argue, central banking policy doctrine was ill-prepared for the major evolutions in the functioning of economies and financial systems. In the '20s, central bankers were confused by how new technologies and a global credit boom had altered inflation dynamics, while failing to appreciate the latent financial and economic fragilities associated with a long period of rampant credit growth and leveraged speculation. They unwittingly accommodated bubble excess - and then systemically tried to sustain the boom when bubble fragilities became acute risks to global financial and economic systems.
I'm sticking to my view that Fed chairman Bernanke moved forward last summer with open-ended quantitative easing (QE) primarily because of worsening global fragilities. Tying "money printing" to the unemployment rate was politically expedient - yet deeply flawed policy for an economy suffering from major structural issues.
US stocks are up better than 20% from last August's lows, in the face of slowing US growth and a rapidly deteriorating global economic backdrop. Bernanke, similar to Strong, could not resist the ("coup de whisky") stimulus expedient a surge in securities prices might provide to vulnerable financial and economic systems. Both were willing to accommodate dangerous divergences between deteriorating economic fundamentals and highly speculative financial bubbles.
Chairman Bernanke committed another major policy blunder last week. The media focused on his "highly accommodative monetary policy for the foreseeable future is what's needed" comment. While important, I would argue the following statement was more impactful: "If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that." It was this statement, I believe, that had such a dramatic impact on global markets - the dollar, currencies, the emerging markets, bonds and record US stock prices.
The Fed needs to begin extracting itself from the aggressive market backstop and intervention business. Such a role, as should be abundantly clear by now, only feeds speculative excess and serial bubbles. The Fed's $85 billion monthly QE has been fueling speculation and exacerbating global financial instabilities - with marginal (at best) benefits. To be sure, injecting enormous amounts of liquidity into a highly speculative marketplace and generally unstable backdrop carries huge risks. The Fed needed to begin winding down this program - a process Bernanke signaled several weeks back. Our central bank should not have been surprised by market reactions.
The Bernanke Fed needed to demonstrate some courage and resolve. Instead, it almost immediately signaled its limited tolerance for even moderate market tumult. "If financial conditions were to tighten" are code words for the Fed being there as necessary with open-ended QE to backstop US and global markets.
Bernanke's "Comment" came with the dollar at multi-year highs, emboldening the view that he's there to push the dollar lower as necessary to stem global de-risking and de-leveraging. Bernanke's "Comment" emboldened the view he'll backpedal from any move to reduce stimulus at the first sign of market unrest. Bernanke's "Comment" emboldened the view that he and global central bankers will punish sellers of risk assets and reward those that disregard risk and accumulate securities. Bernanke's "Comment" emboldened those leveraging and taking outsized risks with the view that the Fed and global central bankers will ensure robust securities markets. Bernanke's "Comment" further distorted perceptions of risk throughout global markets. Bernanke's "Comment" bolstered the "QE forever" camp and provided a green light to further speculation, especially in the US stock market.
"If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that" - is one for the history books. At this point, the Fed has been accommodating credit and market bubbles for so long that the only way to ensure ongoing loose financial conditions is to perpetuate bubble excess.
I would argue - and I believe recent market behavior supports this view - that various bubbles have inflated to the point of acute vulnerability. This implies fragility to waning liquidity and episodes of risk aversion, hence - and as the speculator community assumes - unrelenting Fed QE activism.
From Bernanke's paper:
The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy. The implication is that a central bank must take into account risks to financial stability if it is to help achieve good macroeconomic performance. Today, the Federal Reserve sees its responsibilities for the maintenance of financial stability as coequal with its responsibilities for the management of monetary policy, and we have made substantial institutional changes in recognition of this change in goals. In a sense, we have come full circle, back to the original goal of the Federal Reserve of preventing financial panics.
How should a central bank enhance financial stability? One means is by assuming the lender-of-last-resort function that Bagehot understood and described 140 years ago, under which the central bank uses its power to provide liquidity to ease market conditions during periods of panic or incipient panic. The Fed's many liquidity programs played a central role in containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also important to foster a financial system that is sufficiently resilient to withstand large financial shocks.
Well, allow me to suggest a few things the Fed shouldn't do if it endeavors to enhance financial stability.
It shouldn't peg short-term interest rates; it shouldn't seek to manipulate long-term market yields (bond prices); it shouldn't seek to promote the stock market or risk assets more generally - as all such interventions work to distort market behavior, mis-price securities and risk, and incentivize destabilizing speculation. Its policy doctrine should not incentivize the issuance of potentially destabilizing marketable debt, at the expense of more stable traditional bank finance.
The Fed should not pre-commit to a future policy course - or provide policymaking "transparency" that works to promote risk-taking and speculation. The Fed should only resort to backstopping market liquidity in the event of dire systemic vulnerability.
Significant Fed balance sheet expansions should be temporary and then reversed as soon as possible. The Fed should refrain from non-crisis asset purchases/liquidity injections - and should limit its open-market activity to Treasury bills. The Fed should not accommodate a doubling of mortgage debt in six years. It shouldn't then accommodate a doubling of federal debt in four. Fed policymaking should not unduly impact system credit and resource allocation - albeit to housing or, more recently, the federal government.
The Fed should avoid the slippery slope of intervening in the markets in the name of promoting economic growth. Its policies shouldn't distort market risk perceptions or the pricing of finance. This will only fuel asset inflation, credit bubbles and the misallocation of real and financial resources. The Fed should not accommodate persistently large current account deficits. These only promote liquidity excesses and global financial and economic imbalances. The Fed must never set off on an experimental path, but should instead strive toward a stable and conservative rules-based policy regime.
Generally, in what direction should the Fed be going?
When it comes to financial stability, the Fed must be disciplined and preemptive. In this world of unanchored global finance, the Fed finds itself full-circle back to where it began 100 years ago: It's imperative that some type of policy regime or mechanism is constructed to help regulate US and global credit. The Fed must develop a framework for recognizing bubble dynamics and nipping them in the bud before they become too powerful to address.