By Paul Amery
In fairness to Bernanke, nowhere in his remarks does he make such a grandiloquent claim, unlike British Prime Minister Brown, who did just that last December in the U.K. parliament.
However, underlying Bernanke’s narrative of events is the U.S. central bank’s conviction that the panic that hit global markets last fall was a kind of act of God, a phenomenon that was “collectively irrational”, and which the Fed contained by its policy of “lending freely against sound collateral.”
Is this fair, or does Bernanke’s speech signify that U.S. policymakers have understood nothing and learned nothing?
For a start, Bernanke’s attempt to portray the events of last September and October as completely unexpected stretches his listeners’ and readers’ credulity. “When we met last year [in late August 2008] … ,” Bernanke writes, “there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts.”
Here’s a chart of the average credit default swap spread on the 14 key financial institutions active in the over-the-counter derivatives market, as calculated by Credit Derivatives Research LLC, from the beginning of 2007 to the eve of Bernanke’s speech on 22 August last year.
click to enlarge
Although Bernanke is correct to say that in August 2008, counterparty risk levels had not yet breached the March peak reached when Bear Stearns nearly failed (although they did very soon afterwards), it’s pretty evident to anyone, looking at this chart, that financial market strains had been on a general uptrend since the beginning of 2007. Indeed, the average credit default swap spread on these dealer banks was 13 times higher in August 2008 than it had been in January 2007.
Has the Fed lent “freely against good collateral”? Hardly. Here’s Econbrowser’s pictorial representation of the Fed’s balance sheet from a few months ago, showing a dramatic shift from holdings concentrated in US Treasuries to a mish-mash of mortgage-backed and asset-backed debt, taken on from Bear Stearns and AIG, on which it has already suffered losses of up to US$5 billion.
Most worryingly, it’s difficult to believe that Bernanke’s speech hardly mentions the word debt, given that most people accept that we have passed through a historic bubble in the credit markets. Isn’t it the vast global superstructure of debt based on limited underlying economic activity that is causing our current problems?
Bernanke asserts in the final paragraph of his speech that “we have avoided the worst”. He may be right, but I wouldn’t bet on it. I’m more inclined to agree with Willem Buiter, who wrote recently in the Financial Times that “[t]he US Treasury, the Congress, the Fed and the other financial regulators have, through their behaviour since August 2007, confirmed and re-inforced the incentives for excessive risk taking by crossborder banks and any other financial institution deemed too systemically important to fail. The groundwork for the next financial boom and bust cycle, worse than what we are just emerging from, has been put in place.”