Ben Bernanke On Why Things Were Different This Time Around: New Understandings For Monetary Policy?

by: John M. Mason

Former Fed Chair Ben Bernanke has just published some new analysis on what took place in the Great Recession and subsequent recovery.

Mr. Bernanke's major finding is that macroeconomic analysis did not take credit markets sufficiently into account when trying to forecast the economic downturn.

Fortunately, Mr. Bernanke contends that the changes in credit markets were taken into account in planning for the recovery and helped to account for the success of the recovery.

Well, former Federal Reserve Chairman, Ben Bernanke, has done sufficient homework to publish his latest thoughts on the financial crisis and the subsequent economic recovery.

The title of his effort is 'The Real Effects of the Financial Crisis', and it is published in the Brookings Papers of Economic Activity. His 93-page paper can be found at this site.

I will just concentrate on his summary of the work in this article and the details can be discussed later.

Mr. Bernanke writes in the Abstract for the paper that in reviewing the research produced since the crisis, he has come up with this conclusion “that credit-market developments deserve greater attention from macroeconomists, not only for analyzing the economic effects of financial crises but in the study of ordinary business cycles as well.”

In addition, Mr. Bernanke provides “new evidence on the channels by which the recent financial crisis depressed economic activity in the United States. Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, I find that the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disrupted the supply of credit.”

Mr. Bernanke uses this finding to support the behavior of the Federal Reserve during the subsequent recovery. He writes “This finding helps to justify the government’s extraordinary efforts to stem the panic in order to avoid greater damage to the real economy.”

Mr. Bernanke’s first comment, cited above confirms what a lot of economists, myself included, have been saying for a long time. Some call what happened over the last forty years of the 20th century leading into the first decade of the 21st century “the financialization of America.”

Basically, since the early 1960s, finance has been playing a bigger and bigger role in the United States economy as more risk-taking increased, financial leverage increased, and financial innovation grew and grew and grew.

Relatively, more and more people went into the finance industries during this time period, and more and more of the national income went to people connected with financial institutions of any kind.

Furthermore, it was a period in which the federal government attempted to provide high levels of employment, almost on a continuous basis, and housing for the middle classes, and other social services that would make a lot of people better off. In order to accomplish these objectives, the federal government created an environment of what I have called “credit inflation” to continuously support deficit spending, consumer debt creation for mortgages and cars, and rising incomes.

This environment created opportunities for smart, sophisticated investors to take advantage of the programs and become extremely wealthy and resulting in a major skewing of income/wealth inequality.

One of the problems of this new era was that this “credit inflation” went more and more into assets and not into the production of goods.

The result was a period of time which economists have labeled “the Great Moderation,” This was a time when the volatility connected with real economic activity dropped significantly and when the major price indices showed a substantial and relatively tame decline in growth. That is inflation moderated along with the reduction in the variability of the economy.

However, beginning in the 1990s, asset bubbles became more of a concern as the expansion of money and credit went more and more into the financial circuit of the economy and not into the industrial circuit. Financial engineering became relatively more important than did physical engineering. In Mr. Bernanke’s words, macroeconomists needed to pay more attention to the financialization of the economy.

Mr. Bernanke’s second point is also very relevant. In order to pull the economy out of the Great Recession and get the economy growing again, Mr. Bernanke and the Fed expanded the money stock measures faster than ever before. The idea was to avoid the Great Recession from getting any worse than it already was. Then, Mr. Bernanke and the Fed followed up this effort with three rounds of quantitative easing, buying securities in the open market at a rate never seen before.

Mr. Bernanke refers to this effort as the Fed’s attempt to “stem the panic.” The Fed had to overcome what was going on in the “funding and securitization markets,” which had disrupted “the supply of credit” and “avoid greater damage to the real economy.”

Throughout this period, the emphasis was always to err on the side of too much ease.

But, what didn’t happen at this time?

Because of the Fed’s largesse at this time, many economists offered up the dire prediction that such actions were going to create massive amounts of inflation… even hyperinflation. During the first four to five years of the economic recovery, at least one group of economists believed that the United States was going right from the Great Recession to the Great Inflation!

But, inflation never picked up, even though monetary ease and monetary growth had never been so great in any period previous to the current one.

The conclusion, as is being presented by Mr. Bernanke, is that things changed over the past fifty to sixty years. Mr. Bernanke’s research seems to confirm that the most important change that took place for the conduct of monetary policy, specifically, and for the conduct of economic policy, in general, was the financialization of the economy.

Macroeconomists had not given sufficient attention to “credit market developments” and, consequently, they did not produce policy models that captured the behavior of credit market behavior adequately. Therefore, these macroeconomists and policymakers did not have as full an understanding of the economy as they thought they had.

Mr. Bernanke and the Fed were able to compensate for this as they dealt with this during the Great Recession and the following recovery. However, this whole episode points to the need for economists, and other analysts, to pay more attention to what is happening in the credit markets, and what is happening to asset prices, in trying to understand how the world is working.

Can you imagine a chairman of the Federal Reserve, today, as happened in the 1990s, not accepting that asset bubbles might exist?

There still is a long way to go in building understanding and building economic analysis up to the point where we can have adequately build economic models that sufficiently include the capital markets. At least we are more aware of the current shortcoming and hopefully can build it into our current analysis and policymaking.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.