Book Review: 'The Federal Reserve and the Financial Crisis," by Ben S. Bernanke (Princeton University Press: 2013)
Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System, gave four lectures at George Washington University in March 2012 about "the Federal Reserve and the 2008 financial crisis." This was an unprecedented act for no other Federal Reserve Chairman ever exposed himself to such an extended act of "transparency" to the public.
Mr. Bernanke, as he writes, is an economic historian (page 1). Therefore, his story must be placed within an historical setting. The four lectures cover the history of the Federal Reserve beginning with Lecture 1, the Origins and Mission of the Federal Reserve; Lecture 2, the Federal Reserve after World War II; Lecture 3, the Federal Reserve's Response to the Financial Crisis; and Lecture 4, the Aftermath of the Crisis.
The interesting thing is that in terms of the history, I really did not find anything particularly new. But, I have been following events pretty closely over the past five years or so and this includes speeches by Mr. Bernanke and other Federal Reserve officials as well many, many current interpretations of the financial crisis.
What I did find interesting is the insight Mr. Bernanke gives us about how he views the Federal Reserve and the workings of the economy. This is the first time I have seen his worldview laid out so simply and plainly.
More than once, Mr. Bernanke states what he believes is the mission of a central bank ... the mission of the Federal Reserve. And, there are two aspects of the mission. First, to "achieve macroeconomic stability," second is to "maintain financial stability."
To achieve macroeconomic stability means that the Federal Reserve needs to promote "stable economic growth, avoiding big swings - recessions and the like - and keeping inflation low and stable." (page 3)
To maintain financial stability means that the Federal Reserve needs to "keep the financial system working normally and, in particular, they try to either prevent or mitigate financial panics or financial crises." (page 3)
A central bank, the Federal Reserve, has two sets of tools. The first, monetary policy is to achieve economic stability. Monetary policy consists of raising or lowering short-term interest rates. (page 3) "The main tool of central banks for dealing with financial panics or financial crises is ... the provision of liquidity." (page 4) "There is a third tool that most central banks have, which is financial regulation and supervision." (page 4).
Following this introduction, Mr. Bernanke talks about financial panics…more specifically bank runs…and how the use of the "liquidity" tool comes into play to put a stop to these events. This is covered in pages 5 through 8.
Not only does this set the stage for a historical discussion of "bank runs" but it provides the context for the discussion Mr. Bernanke has later in the book that relates to "modern" bank runs, like the ones seen in 2008 and 2009. The latter "bank runs" included more financial organizations (investment banks and money market funds) than just those that hold demand deposits. A discussion of these latter-day bank runs comes on pages 75 through 88.
Perhaps the most interesting discussion for me was the section on "lessons from the Great Depression" found on page 74. There are two lessons: first, "the central bank has to lend freely to halt runs and to try to stabilize the financial system; and second, "the Fed did not do enough to prevent deflation and contraction of the money supply in the 1930s…"
So, what did the Federal Reserve do to achieve financial stability in the recent crisis? When the financial collapse of 2008 started the Federal Reserve opened up the discount window. In doing this, the Fed responded to the possibility of the financial markets falling apart by serving as the "lender of last resort," the classical response to a "liquidity" crisis. So far, so good.
But, the financial crisis did not stop just with the commercial banks. Here we get into the situation mentioned above where the bank "run" spilled over into alternative financial institutions, investment banks and money market funds. The Fed could not legally lend to these organizations through the discount window. So, it had to craft new ways to provide a "discount window" where the Fed could lend to these organizations, using good collateral, and stop the 21st century "bank" run that included financial institutions which offered customers more than just demand deposits.
What about achieving macroeconomic stability? The most helpful thing about Mr. Bernanke's presentation is the insight it gives me on where he is coming from. He is much more of a died-in-the-wool Keynesian than I had believed him to be. The transmission mechanism for monetary policy seems to be solely through interest rates. Bernanke discusses this mechanism over and over again throughout the book. Monetary policy lowers interest rates so as to spur on the economy. For an example discussion see page 104.
In Lecture 4, Mr. Bernanke discusses the growth of the Federal Reserve balance sheet but discussing quantities, like reserves, the monetary base, and so on, seem almost an afterthought for him. The crucial thing to him is the Fed's ability to determine the nominal rate of interest.
But, what about the fact that there seems to be a floor below which short-term interest rates cannot fall? Here Mr. Bernanke talks as if there is a (Keynesian) liquidity trap although he never calls it that. But, after 2008, the Fed kept putting all the reserves it could into the banking system and the interest rates couldn't go any lower. And, if interest rates could not go any lower…well then, investment in physical capital could not take place and economic growth could not increase. This sure sounds like the Keynesian liquidity trap to me.
What does a central bank do when it faces a liquidity trap? The solution seems to be that the central bank needs to keep pumping more and more and more reserves into the banking system until the banks start lending again for capital investment and the economy starts to pick up. Hence, the first round of quantitative easing…which began in March 2009.
The result? The economy started its recovery in July 2009, but the expansion proved to be very sluggish. And then inflation began falling in the fall of 2010. Now it was time for Mr. Bernanke to remember the second lesson from the Great Depression: "the Fed did not do enough to prevent deflation and contraction of the money supply in the 1930s…." Consequently, in November 2010 the second round of quantitative easing began.
What is Mr. Bernanke's summary of the actions of the Federal Reserve during this time of financial crisis? "We did stop the meltdown." (page 86) Whew!
But, we have not yet achieved macroeconomic stability.
My take away concerning macroeconomic stability is that I better understand where Mr. Bernanke is coming from in terms of his policy position. Monetary policy works solely through interest rates. To stimulate the economy the central bank must lower interest rates so that businesses will investment more in physical capital and families will purchase homes. If the central bank faces a liquidity trap where interest rates can go no lower the central bank must flood the market with liquidity to assure that deflation doesn't occur. Mr. Bernanke is fundamentally a Keynesian.