Bernanke is Fighting the Last War

A Defense of the Federal Reserve’s Monetary Policy by Monte Malhtra

Already considered the worst financial crisis since the Great Depression, America's current economic predicament has many experts agreeing that this recession may end up as the worst in modern history.  While I concur with Anna Schwartz's assertion that this crisis is different than the Depression, I strongly disagree with her criticisms of the Federal Reserve's handling of the situation. Over the past months, the Fed's actions have addressed the disaster in three ways.  First, it has necessarily injected massive liquidity through quantitative easing in order to keep the money supply constant and prevent deflation.  Second, for the purposes of cleaning balance sheets and lowering counterparty lending risks, the Fed has decided to save banks on an individual basis rather than use a system-wide bailout.  Finally, the Federal Reserve has implemented a myriad of wide reaching policies to address the inherent problems that catalyzed the crisis in the first place.  Considering Ms. Schwartz's disapproval of each of the aforementioned actions, I would posit that all of the measures on the part of the Fed are not only justified, but crucial in the planned recovery of the American economy.

The Federal Reserve has initiated a policy of quantitative easing and injected massive liquidity into the financial system to combat a threat of deflation.  Ms. Schwartz criticizes the Federal Reserve, “The Fed has gone about as this is a shortage of liquidity. That’s not what’s going on in the market right now. Today, the banks have a problem on the asset side of their ledgers.[i]” While Ms. Schwartz correctly notes a second problem in this crisis is that the Fed needs to help banks recapitalize and deal with ‘toxic’ assets on their balance sheet, she has misinterpreted the policy decision to provide enormous liquidity to the financial system. 

Many leading economist have recognized the need for aggressive monetary policy to preemptively prevent deflation.[ii]  In Chairman of the Federal Reserve Ben Bernanke’s speech at the National Economists Club in 2002, he commented on causes of and monetary responses to deflation. Ben Bernanke cites a passage by Irving Fisher, an economist who conceptualized the impact of severe financial crisis on the economy, “Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. [iii]” He continues with a monetary response, “As suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates[iv]. By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation.[v]”

There have been three main shocks to the economy which justify the quantitative easing.  First, shocks to the financial system have crippled its ability to provide for functioning capital markets, and banks have been forced to fire sale assets on their balance sheets to raise capital.  Second, on a consumer level, housing prices according to the S&P/Case-Shiller price index have dropped 17.4% nationally from a year earlier.[vi]  Housing values are a large component of how individual’s value wealth, and since prices have declined, people are effectively poorer.  Reduced aggregate demand and falling home asset prices both contribute to a deflationary environment. Third, inflation has declined; CPI, a measure of the average price of consumer goods and services purchased by households, decreased 1.0% in October after being unchanged in September. [vii]  A decline in the CPI is early evidence that deflation has already set in.  The Fed has justifiably lowered the federal funds rate quickly and decisively to 1.0% to stem a crippling deflation. 

Second, the Fed has decided to save banks on an individual basis through equity stakes for the purposes of cleaning the balance sheet, recapitalizing banks, and lowering counterparty lending risks.  At the heart of Ms. Schwartz’s criticisms, she argues the Treasury Department’s original plan to buy assets from troubled institutions was the right plan.  By implementing this solution, firms would be able to recapitalize by removing these assets from their balance sheets, and firms that made wrong decisions would fail. Other firms that would be adversely affected by a company’s bankruptcy should suffer from improperly evaluating counterparty risk.  By keeping otherwise insolvent banks afloat, the government is only prolonging the crisis.[viii]

Ms. Schwartz is correct that banks are not lending because banks lack faith in the ability of borrowers to repay their debts. However, her solution of recapitalizing banks would either be inefficient or further devastate the banking system. For the Treasury’s original plan to succeed, a determining factor is what price the Treasury will pay for the bank’s toxic assets. Stanford economics Professor Michael Boskin noted in his class, Public Finance and Fiscal Policy, there exists a paradox in buying assets from banks with taxpayer money.  There is public pressure to buy these assets at rock-bottom prices so losses are minimized and returns to the government are maximized. However, in order for banks to benefit, these assets need to be bought at a premium to fair value; otherwise, banks receive no excess capital to better their balance sheets.[ix]  Moreover, there is a cascading effect from these actions.  Because current accounting regulations force banks to value these assets at current market prices, purchasing at too low of prices could unfairly force banks to take write-downs on these assets inducing possible bankruptcies and market turbulence. 

Buying equity stakes in banks is a cleaner solution to recapitalize banks. Banks can be given enough capital to take forced write-downs on these toxic assets, which is equivalent to removing these assets from banks’ balance sheets.  If the banks value these assets at zero and still have enough capital, then banks can use extra capital they may have to lend profitably.  The government also benefits from this because they gain from the equity stakes of owning the banks and will participate in future profit-sharing.  Furthermore, because banks are again properly capitalized, there is no longer apprehension to lend among banks for fear of their insolvency and potential bankruptcy.  This restoration of lending is essential to easing the credit crisis. 

While a fundamental tenant of capitalism is letting the free markets punish firms that made bad decisions, the devastation to the financial system would be too great to let this happen.  For example, Lehman Brothers’ bankruptcy had cascading effects that forced the Fed and the Treasury to react to further needs for bailouts. Subsequent runs on money market accounts forced some prominent money market funds to “break the buck” or trade below a Net Asset Value of $1, causing massive redemptions, increased fear and panic, and further bankruptcies among financial firms.  Moreover, as Ms. Schwartz correctly notes, the markets had expected the government to bailout Lehman under the theory that firms too big fail would devastate the financial markets if they filed for bankruptcy.  When the government declined to save Lehman Brothers, as it had saved other similar firms, the markets suffered huge losses and didn’t know how to react to the inconsistencies of the authorities and the large systemic risk Lehman Brothers posed to the markets.  This example shows why a clear policy is necessary that all major institutions will receive capital injections from the government. Firms are too interconnected to allow any one firm to go bankrupt.  Giving all firms the opportunity to once again become profitable eliminates any uncertainty as to which institutions are “problem” firms, and is the only way to restore confidence and reduce counter-party risk so banks once again to lend to each other. 

Finally, the Federal Reserve has implemented many policies to solve the problems at the root of the crisis.  First, the Federal Reserve has created a program to buy Freddie Mac and Fannie Mae mortgage-backed securities, which will reduce interest rates on mortgages.  The Fed has also considered buying 10-year Treasury Notes to lower their yields and reduce long-term borrowing rates.  Through these programs, the Fed can lower rates over the maturity spectrum of public and private securities which should strengthen aggregate demand, and thus help stem deflation.[x] The Fed also lowers the cost of borrowing to help homeowners refinance their mortgages.  If homeowners can refinance into lower rates instead of being foreclosed upon, these toxic mortgage assets on banks’ balance sheet aren’t as toxic, and an increase in the value of those assets limits write-downs banks must take. Second, the Federal Reserve has become a lender in the commercial paper market for corporations, so short-term liquidity is available for corporations in this credit freeze.  If corporations didn’t have access to this market, they would be unable to finance critical short-term operations.  This would force corporations into a crisis cash saving mode, which would lead to increased layoffs. Higher unemployment would lead to a deeper recession and increased foreclosure rates which would devastate the economy.  These two programs, although not comprehensive, are examples of how the Fed is directly targeting the initial causes of the crisis.