Requiem for a Bernank

Ben BernankeBen Bernanke´s tenure as, arguably, the most powerful man in the world came to an end on 3 February, 2014. For the past eight years, “the Bernank” as he affectionately came to be called, steered the world´s largest economy through its most turbulent crisis since the Great Depression.

Consider the following statistics comparing the beginning and ending of his reign.

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Bernanke has been responsible for a 200% increase in the Fed’s holdings of U.S. Treasury bills. When one accounts for the nearly $2 trillion of mortgage-backed securities and federal agency debt that the central bank now owns, total assets have ballooned by almost 400% over the past eight years.

Most of these asset purchases, which now happen under the guise of Quantitative Easing, have resulted in a drastic increase in excess reserves held by private banks. While banks are flush with reserves, little funding has made its way to main street. Since banks are remunerated by the Fed for holding reserves, they are quite content to passively hold them and earn interest instead of placing them at risk in the loans market.

If the Fed were a private bank, it started the Bernanke regime with a fairly normal equity ratio of 3.5%.

This means that, in 2006, if the Fed suffered a loss of 3.5% on its assets it would have been balance sheet insolvent. Not too high by any measure, but about on par with the private banking system. Today the Fed’s same ratio stands a hair over 1%. Bernanke has continued leveraging the Fed, and the broader economy, to the point where a 1% loss on its assets will endanger the solvency of the world’s premier central bank.

Such a loss is not inconceivable. After all, the Fed holds $1.5 trillion of mortgage-backed securities representing some of the toxic debt that private banks did not want to hold on to. As the Fed makes its plans to reverse its current Quantitative Easing program, it will almost certainly take a loss on these assets imperiling its solvency. (While I would welcome the Fed’s insolvency if it meant it disappeared forever, I am sure Congress would have other plans as it pursues the largest bailout it has ever attempted.)

Of course, Ben Bernanke does not shy from criticizing himself. He admits to making one major error during his eight years at the head of the Fed. That error lay in underestimating the role that declining housing prices would play in propagating a larger downturn.

However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression.

In this succinct admission Bernanke shows two significant misunderstandings about how financial prices trigger changes in the broader economy. First, his belief that the dot-com bust was followed by only a mild recession would prove as a roadmap for the housing collapse of 2008. Second, that the bursting of the housing bubble was what triggered the subsequent recession.

Years of credit expansion at the hands of the Fed and the fractional-reserve banking system caused multiple discoordinations in the economy. Most notably, these occurred as credit inflated paper wealth (as in the cases of the dot-com stock boom and the housing boom), and caused Americans to consume more than would otherwise be the case. This is what Ludwig von Mises called “overconsumption”, and is one of the hallmarks of the Austrian business cycle.

The eventual collapse of equity and housing prices were necessary signals to inform investors and savers that they are not as wealthy as they once thought, and that consumption patterns should be restructured accordingly. Rather than triggering the subsequent recession, the decline in these prices only exposed the previous over-valuations fostered by a loose credit environment.

In thinking that the recession following the housing collapse would be similar in magnitude to the dot-com collapse, Bernanke erroneously believed that the two events were unrelated. Of all the mistakes Bernanke made during his eight-year tenure, this might be the largest. It is also the one which is also somewhat excusable.

Following the dot-com collapse in 2000-01, Alan Greenspan flooded the market with liquidity. Between 2003 and 2004, the Federal Funds Rate was held at 1%. By the time Greenspan left office on Jan. 31, 2006 the rate was still a low 4.5%, and when adjusted for inflation was close to zero. This ample liquidity in the aftermath of the dot-com bust levitated markets and resulted in the reflation of stock prices, as well as an increase in housing prices.

By the time housing prices started collapsing, Bernanke was caught off guard with little understanding that the reflation under the previous Greenspan Fed was culpable. With little understanding that the then-present collapse was the result of prior easy credit conditions, he was left with few theoretical arguments as to why reflating the housing collapse would not be a good idea.

The only difficulty for Bernanke was that the housing collapse proved much more difficult to relfate than the prior dot-com bust. This makes sense, if one understands that imbalances that existed in the very early 2000s were not liquidated because of Greenspan, and that these imbalances had since grown into the crisis that Bernanke faced. The increases in monetary stimulus that the Bernanke Fed enacted were a response to an attempt to reflate the overhang still existing from the Greenspan era, as well as the ones he was able to create during the early years of his tenure.

Ben Bernanke didn’t exactly get dealt the best hand of cards when he took over the Fed eight years ago, but he hasn’t done much to improve the situation. The mass imbalances that a decade of low interest rates created still exist. Financial prices are inflated to the extent that they no longer give an accurate forecast of the health of the general economy. (Indeed, stocks now react positively to bad economic news as it means further inflationary stimulus from the central bank.) The reserves that the private banking system holds earn interest that gets paid by the Fed, and which ultimately comes from the taxpayer. Last year this interest payment amounted to $4 billion.

And what does Bernanke have to show for it? The unemployment rate on the day he took the helm of the Fed stood at 4.8%; today it is 6.6%. This statistic doesn’t even account for the discouraged workers who have given up looking for work over the crisis and sluggish recovery. The labor force participation rate – a measure that illustrates what percentage of eligible workers have a job – today stands at only 63%, 3% less than eight years ago. General government debt has almost doubled, and now stands at more than 100% of GDP.

I wish this requiem could be more cheery, but the past eight years were an unmitigated disaster. More than that, though, is that the policies that the Bernanke Fed implemented actually worsened the downturn by delaying the liquidation of bad investments.

I will end on a positive note. Several years from now when I review Janet Yellen’s achievements as head of the Fed, I am optimistic that the story will be much improved. After all, the situation today is so dysfunctional and unbalanced that there may only be one way to go – up. Let’s hope so.

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One Response to “Requiem for a Bernank”

  1. flow5 says:

    Bernanke caused the Great-Recession. I.e., the Fed determines the price level. Those assets that served as loan-collateral were principally effected (housing).

    Rates-of-change in monetary flows (our means-of-payment money times its transactions rate-of-turnover), equal roc's in all transactions (nominal-gDp is a proxy). (1) Bernanke drained legal reserves (which are based on transaction accounts 30 days prior), for 29 consecutive months. (2) The trajectory for MVt in December 2007 forecast a recession for the 4th qtr of 2008 (without policy easing). (3) As the economy collapsed, Bernanke introduced the payment of interest on excess reserve balances thereby inducing dis-intermediation among the non-banks.

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