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Grading Bernanke: A Symposium

Thursday, March 27, 2008

At a time of severe anxiety in the financial world, has the Fed acted wisely? Five experts share their thoughts.

Amid widespread financial turmoil and talk of recession, we asked five experts at the American Enterprise Institute to grade and assess the Federal Reserve’s recent policy decisions. Here are their responses.

JOHN L. CHAPMAN

I would give the Federal Reserve an A for intentions but a C- for execution. 

With the recent “forced sale” of Bear Stearns, on top of an over-leveraged economy and credit crunch largely of the Fed’s own making, systemic monetary reform should again be put on the agenda. Here’s why.

Milton Friedman’s empirical investigations into monetary history led him to declare that inflation was always and everywhere a monetary phenomenon. A corollary of this axiom is that all durable recessions are the result of errant monetary policy; that is to say, every boom contains the seed of its own bust. This is not because of any inherent instability in a capitalist economy, but because an excessively loose monetary policy generates falsified low interest rates, which generate malinvestment in capital goods sectors such as housing. Because this capital investment is not backed by real savings, consumer time preferences are distorted and there is no effective demand (that is, consumer preferences backed by requisite buying power) for much of the resulting output. Cancelled projects, misallocated resources, bankruptcies, and lay-offs must, therefore, ensue. 

Between December 2000 and June 2004, the fed funds rate was reduced from 6.5 percent to 1 percent, and for at least three years real interest rates were negative. From June 2004 to September 2007, the fed funds rate rose back to 5.25 percent, ending the boom and revealing significant capital malinvestment. The economic slowdown we have entered is a necessary consequence of this stop-go monetary policy, which has also hurt the U.S. dollar and guarantees higher inflation and interest rates in the future.

With respect to the Fed’s steering of Bear Stearns into JPMorgan Chase’s arms, the Bank of England’s nationalization of Northern Rock PLC is a distinction with little difference. This was an unprecedented act of government intervention, and it opened a new era in U.S. financial history. A Bear Stearns bankruptcy would have been painful to the firm’s clients, owners, employees, and trading counterparties. Other bank balance sheets would have collapsed in cascading fashion, causing a recession. But at least capital assets could have been repriced and credit unlocked. Instead, moral hazard, already inherent in financial markets due to the very existence of the Fed as a lender of last resort, has now been fully actualized and taken to a new level, with the Fed as a “buyer of first resort.” Very painful failures lie ahead, and we can expect a much longer recession.

Indeed, we have entered an era of unpleasant choices, with a fiat currency run by a monopoly issuer undergirding an extremely leveraged fractional reserve banking system. Worse, since the dollar is the de facto international reserve currency, we have long “exported” inflation abroad as the Fed accommodated the fiscal demands of the U.S. political system. Dollar stability, low inflation, and investment-led growth will now be sacrificed in the coming unavoidable reversal.

Rather than provide a framework for monetary stability, the Fed has been an engine of instability in recent years, in terms of policy and regulatory execution. The sure result is slower economic growth.

John L. Chapman is an NRI fellow at the American Enterprise Institute.

DESMOND LACHMAN

The Federal Reserve should be highly commended for its bold and innovative measures aimed at stabilizing financial markets. I would give it a grade of A-.

After vacillating for far too long in the second half of 2007, the Fed is now demonstrating that it fully grasps the risks posed by the housing bust and the associated credit crunch. The Fed is now signaling that it will do whatever it takes to avert a financial market meltdown, which is welcome news.

Since the start of this year, the Fed has slashed interest rates by a full 2 percentage points, and it has indicated that it stands ready to cut interest rates further as needed. These measures must be applauded, since the U.S. economy shows every sign of having entered a recession (and possibly a severe one). Faced with the prospect of a Japanese-style crisis developing, the Fed is correct to be paying more attention to the risk of recession than to the risk of stoking inflation.

The Fed has been highly innovative in responding to the financial market strains. By introducing Term Auction Facilities and by opening the Fed’s discount window to all primary dealers, the Fed has provided the market with much needed liquidity at a time of unusual stress. By engineering the takeover of Bear Sterns, the Fed has also averted what might have been a financial market collapse.

Looking forward, it is far from clear that the Fed can avert a nasty recession by itself. The current situation calls for greater policy coordination between the Fed and the U.S. Treasury to arrest the housing market’s downward spiral, which has been the main source of the credit crisis.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

ALLAN H. MELTZER

I would give the Federal Reserve either a C or C-, reflecting an average of one good grade and one poor grade.

The Fed has two responsibilities. Monetary policy should be conducted to maintain economic and price stability. That calls for well-timed changes in short-term interest rates. Credit or lender-of-last-resort actions should maintain the payment and settlement system. This requires the Fed to lend reserves to the market when it lacks liquid assets that can be used to settle claims.

Monetary policy is too lax at present. The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure. As a result, real short-term interest rates are negative. Borrowers are being paid to borrow. Negative real rates were a cause of the current problem; they are not a cure. The Fed must raise interest rates in order to prevent inflation.

On the other hand, the Fed’s credit policy has been good. It has been alert to problems in the payment and settlement system. Banks and financial institutions are uncertain about the solvency of other institutions, so they prefer to hold cash rather than to lend it. The traditional way to solve problems of this kind is to provide as much cash as the market wants. And indeed, the Fed has invented new ways of pumping reserves and liquid assets (Treasury bills) into the market. This has helped to prevent a genuine market crisis—at least so far. The Fed did not “bail out” Bear Stearns. It arranged a sale that wiped out the equity and replaced the management without closing the firm.

The Fed’s only mistake was to guarantee $30 billion of Bear’s portfolio. This action transferred potential losses from the market to the taxpayers. I do not believe the present system can remain if the bankers make the profits and the taxpayers share the losses.

Allan H. Meltzer is a professor of political economy at Carnegie Mellon University and a visiting scholar at the American Enterprise Institute.

ALEX J. POLLOCK

I give the Fed an A-.

When government financial officers, like Treasury secretaries and Federal Reserve chairmen, stare into the abyss of potential financial chaos, they always decide upon government intervention. And so they should. In the first place, nobody wants to go down in ignominy for doing nothing in the face of financial collapse. Secondly, nobody will or should take the risk of triggering the unnecessary financial and economic destruction of a debt deflation. So they always intervene.

The intervention must take the form of expanding the risk to the government and hence to the taxpayers, which generates arguments against it. The counterargument is that a financial collapse will also extract great cost from the government and the taxpayers. 

In a panic, the desire for return on capital is replaced by the desire for return of capital (as Will Rogers said); uncertainty premiums grow extremely high; and everybody wants a government guarantee. To supply the market with the government guarantees it craves, government debt and government balance sheets must expand, either through loans to finance risky positions or by purchasing risky assets. In this way, the government balance sheets intermediate between the panicky market’s excessive demand for safety and risk assets. Their expansion allows private balance sheets to reduce risk. It should always be temporary and limited to the crisis. 

The Fed was created to perform this function after the Panic of 1907, and since the Panic of 2007 it has been responding to the same fundamental problem. But other government balance sheets are expanding, as well, notably those of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBs). In fact, the Fed’s discount window lending is vastly outweighed by that of the FHLBs, which have lent $99 billion to Citibank, $51 billion to Countrywide, and $44 billion to Washington Mutual, to name three pressed borrowers. Meanwhile, the Federal Housing Administration’s contingent liabilities for credit risk are expanding rapidly. 

All of this recalls Walter Bagehot’s celebrated dictum that to quell a panic you must “lend freely.” The most pointed example is the Fed’s deal to avoid the failure of Bear Stearns. By demonstrating that it had the will to do whatever was necessary, and convincing the market that it will do whatever is necessary—“lending freely,” generously interpreted—the Fed succeeded in stopping what would likely have been other panicked runs on financial firms. 

Of course, one could quibble with the details. The Fed is taking the risk on the ultimate value of $29 billion in illiquid securities, which is effectively a new capital contribution. This should in principle be senior to Bear Stearns’s common stock, $350 million of preferred stock and $1.3 billion of subordinated debt, which should bear losses ahead of any losses to the Fed. But time was short, the situation was complex, events were pressing, the abyss was in view, and action was required. 

It will not be the last action taken as a result of the great housing bubble of the 21st century. 

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

PETER J. WALLISON

I think the Federal Reserve gets an A for “Effort,” a B for “Works Well with Others,” a C for “Oral and Written Expression,” and an F for “Tidiness.” 

The Fed deserves praise for stepping into a dangerous situation with an imaginative solution (thus, an A for “Effort”). There is no question in my mind that a collapse of Bear Stearns at that moment in time would have been a disaster. There were no other policy tools available, but the Fed recognized the gravity of the situation and acted quickly with an unprecedented but seemingly effective move.  

However, the Fed’s role in forcing the management and board of Bear Stearns to accept a low-ball offer from JPMorgan Chase is less praiseworthy (thus, a B for “Works well with others”). At the moment, who exactly brought this pressure is still unclear; but it was unnecessary and did not achieve its purpose. 

Apparently there were some at the Fed who thought and said that paying virtually nothing for Bear Stearns somehow eliminated the shadow of a bailout and moral hazard, but this is an illusion (thus, a C for “Oral and Written Expression”). The creditors of Bear were clearly bailed out, and now all creditors will apply reduced market discipline because they will anticipate similar Fed protection. 

This leaves the regulatory system in a mess (thus, an F for “Tidiness”). The Fed’s actions have summoned the would-be regulators in Congress from the “vasty deep,” and if they succeed in turning securities firms into wards of the government, as the banks have become, we will have a much less innovative, profitable, aggressive, competitive, and successful financial system. 

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

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