Arnold Kling  

Central Bankers and History

Bailout Watch... Are We in a Liquidity Trap Aft...

Brad DeLong writes,

The current financial crisis has its roots in Greenspan's decision to keep interest rates very low in 2002 and 2003 to head off the danger of a deflation-induced double-dip recession, and his subsequent decision that the costs of cleaning up after a housing bubble were likely to be less than the costs of the high unemployment that would be generated by a preemptive attempt to pop a housing-speculation bubble. Two years ago, I would have said that Greenspan's judgment here was correct. Six months ago, I would have said that his judgment was probably correct. Today -- in the middle of the largest nationalizations in history -- I can no longer state that Greenspan made the right calls with respect to the level of interest rates and the housing bubble in the 2000s.

Given that Ben Bernanke was appointed in 2005, it should be noted that the worst of the housing bubble took place under Ben Bernanke'.s watch. It should also be noted that Brad DeLong hates Greenspan and adores Bernanke.

Until just a few weeks ago, all of macroeconomic theory suggested that inflation targeting was sufficient for monetary policy. In The Economics of the Great Depression, Randall E. Parker interviews the top modern macroeconomists on their view of the 1930's. Ben Bernanke, in his interview, says (p. 65)

A price target that avoided deflation would have de facto forced abandonment of the gold standard and would have eliminated a major channel of depression...So I do agree that stabilizing prices is the ultimate lesson of the Great Depression and also of the 1970s. There really is nothing more a central bank can do for domestic economic stability than make sure that inflation remains low and stable over long periods.

Re-read that last sentence. Ben Bernanke, the Depression expert, or "technocrat-prince," as DeLong hails him, says nothing about the Fed needing to pop financial bubbles or to give Treasury Secretary Mussolini power to buy hundreds of billions of dollars of mortgage assets and then use that power to partially nationalize banks, insurance companies, auto companies, or anyone else of his choosing.

My view of history is rather different from Brad's. I think that the current financial crisis was not the product of Alan Greenspan. I think it was a phenomenon that emerged from a number of subtle factors, the most important of which was the anomaly in capital requirements. See my fantasy testimony and written remarks.

The central bank does not control the risk premium, which is perhaps the most important financial variable in the economy. Had there been no housing bubble, it is possible that the general drop in the risk premium that took place from approximately 2001 through 2007 would have created a crisis elsewhere. Perhaps it indeed did create a crisis in the debts of the so-called emerging-market countries.

I do not believe that we should be happy that Ben Bernanke and Henry Paulson have as much power as they do. Neither of them has the knowledge that is commensurate with that power.

I do not believe that "rescues" of insolvent firms will be necessary or sufficient to prevent an economic downturn. Instead, I believe we will find that the economy will be paralyzed for a long time by the uncertainty created by keeping failing firms in business and directing so much of the nation's investment from Washington.

[UPDATE: A commenter correctly points out that in that same interview, two questions later Bernanke does say that "the financial industry is a special industry...[we] have a particular obligation to make sure that financial stability is preserved, that banks and other financial instutions are well capitalized..."

Another commenter points to Andrew Lahde's letter. Lahde was a hedge fund manager who evidently did not share David Brooks' high opinion of the elite and made a fortune shorting their stocks.]

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COMMENTS (14 to date)
MattYoung writes:

"..inflation remains low and stable over long periods.."

Here is Ben's error, in my opinion. Long periods are finite, the monetary standard can only hold for some time and eventually external shocks require a new monetary standard.

Any monetary standard is defined around the current structure of the supply chain, and as the supply chains starts accumulating changes to reflect real, physical changes, then eventually these changes move restructuring upward and into the banking system.

Ultimately, the reserves concept is based on a differentially adjusted flow of goods through a stable supply chain. But, supply chains continually adjust and accumulate errors in the reserve concept, until the bankers accept a new restructuring.

An example is the collapse of the American consumer whose flow of consumption provided the stable set of transactions on which the world monetary standard rested.

Chaz Miller writes:

Think back to the 1980's, when the reek left by the rampant inflation of the prior decade was still hanging in the air. Some brilliant minds decided that by utilizing some tomfoolery, inflation would be less of a looming specter in the future if they reduced wage demands by taking housing price inflation out of the inflation calculation, and voila! - we got the CPI. But if we're going to measure the impact of rising prices on the consumer, why exclude the single largest purchase, with respect to earnings, that consumers make?

I know, I know... CPI is designed to exclude investment items so we use "rental equivalence" because we need to separate the 'consumption' from the 'investment' when it comes to housing. Fine and dandy when borrowers are putting reasonable amounts down and actually having part of their monthly payments go toward principal. But that ain't what were heading towards. No, we got the spawning of collateralised debt obligations, etc. that allowed *the bankers* to leverage the margin between the real inflation rate and the CPI to become fee-wealthy. And this housing bubble spun off little bubbles in retail spending, financial sector profits and nominal GDP and corporate profits.

Amicus writes:

Greenspan's fault, arguably, was supporting Bush's tax experiment, when Rubin was telling him that he was wrong to do so.

Monetary policy? Not so much.

His fault here seems to be that he became predictable, that the so-called "Greenspan put" got priced ... almost to infinity, to breathtaking levels of risk.

In short, his very liege, the financial system, took advantage of him (and he let them, willingly or otherwise).


Well, they built companies outside his direct purview (Countrywide, hedge-funds) and structured-securities that abused the "monetary help" that he was giving, by levering up the yield-curve spread risk, on their balance-sheet via abject levels of short-term funding and off their balance sheet, in instruments like CDOs, SPVs, and SIVs. They threw in a *huge* dose of credit-risk, too.

Luckily, some of the structures, like synthetic CDOs, can be "unwound" - why the authorities haven't already done this is ... deeply troubling (if it has gone on behind the scenes, no one has reported on it).

Other instruments, like CDS (often linked-into various structures), _appear_ to have created super-large system-linkages that the Fed was not monitoring on a system-wide basis.

dearieme writes:

"Brad DeLong hates Greenspan and adores Bernanke": you make economists sound like a bunch of girls at primary school. Some economists, anyway.

John Turner writes:

At the end of page 65 Mr. Bernanke allows us to glean some insight into his current actions:

the two main lessons which I think have been learned to a large extent, but always can be re-emphasized, are first that a central bank’s primary responsibility is the maintenance of price stability, to provide low and stable inflation in the medium term, to avoid sharp inflations or deflations and particularly to avoid the instability of expectations associated with an unanchored price level. The second lesson is that the financial industry is a special industry in terms of its role in macroeconomic stability. Major upheavals in the financial system can be extremely disruptive to the economy as a whole and therefore the central bank and other government institutions have a particular obligation to make sure that financial stability is preserved, that banks and other financial institutions are well capitalized and well managed and that there exists a mechanism for responding in the event of crisis, such as the discount window or a deposit insurance system or whatever you need to make sure that the financial system will remain whole even under a great deal of stress.

Professor Kling, I recommend Michael Lewis's latest Bloomberg column. Tho partly tongue in cheek, he has some great wit. For instance, he writes:

"If you haven’t figured it out by now, America has hired the wrong Paulson. There are two of them, Hank and John. Hank turned Goldman Sachs from an investment bank into a busload of tourists going to a casino, with borrowed money."

Lewis also alerts me to this beauty of a letter written by Andrew Lahde. After running the table this year shorting banks–his hedge fund reports earnings over 800 percent–Lahde decided to retire in his prime. The best except of his resignation letter:

"I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America."

Sounds like some geeks made some money off the suits.

Mr. Econotarian writes:

Ever since 1928, I've been against Fed attempts to "pop" asset bubbles ;)

The poster that mentioned housing and the CPI has an interesting point, but consider if one segment of the economy has rapidly rising prices, are we really going to "starve" the rest of the economy just to regulate that segment?

I'm not a hard-core monetarist, but I suspect there is something more economy-wide regarding true monetary inflation, and that certain segments may have bubbles that should be left to themselves rather than involve economy-wide macroeconomic policy.

Besides, there is so much else to blame for the housing bubble (tax policy, GSEs, CRA, outright stupidity on lender and borrowers) that may have outweighed macro policy anyway - unless the macro was like the great contraction that lead to, duh duh, the Great Depression. And I don't consider that acceptable.

Barkley Rosser writes:


"Worst of bubble was on Bernanke's watch." Not up to your usual standards, Arnold. The housing bubble peaked in early 2006. According to Shiller and other close observers (such as me) it started around 2000. So, sure, its peak and the most extreme of the exotic mortgages were under Bernanke, but the majority of the runup, and certainly getting well into highly bubblicious territory, was under Greenspan. Tsk, tsk.

Bond Guy writes:

I agree with Rosser. I read your blog daily and am interested in your insight on the " credit crunch." I also read DeLong along with others. I am a fixed income manager and believe in a mosaic approach to the causes of this crises. However, in reading DeLong over the years I was always surprised at the reverence he showed Greenspan. When I read your post on "hatred" I was surprised and went to his site to see if I was wrong. I searched his site and found old posts (Dec. 05 and Jan 06) where he basically claimed him to be beyound mortal. Clearly showing excessive (as is his style)respect. So that part of your narative is unfair. By the way, I believe the real problem with Greenspan is that he stayed too long. Everyone has blinders and that gets built into markets. Nobody should have the position for that long.

Lord writes:

Bernanke took office in Jan 2006 just as the bubble reached its peak. No more revisionist history please.

Arnold Kling writes:

January of 2006 was well before the peak. More importantly, Ben Bernanke was a member of the Federal Reserve Board starting in 2002. There is, as far as I know, no record of him suggesting a need to pop the housing bubble during that time.

Look, I'm not knocking Bernanke. I'm just suggesting that any history in which he is a saint and Greenspan is a sinner is not necessarily credible.

parviziyi writes:

Arnold Kling appears to believe there's a solvency crisis in the banking system (for instance he says "the economy will be paralyzed for a long time by the uncertainty created by keeping failing firms in business and directing so much of the nation's investment from Washington"). Based on the currently available loan delinquency rates, I don't believe there's a solvency problem. One can see the historical delinquency rates for the various classes of bank lending going back to the year 1987, and up to Q2 2008 at In the early 1990s the delinquency rate for commercial bank loans secured by real estate peaked at 7.5 percent in Q2 1991. It was above 4.2 percent thoughout the years Q1 1987 through Q4 1993. That puts in comforting perspective the fact that the Q2 2008 rate was 4.2 percent. That's the delinquency rate on home and commercial real estate loans combined. For the home loans taken on their own, the Q2 2008 delinquency rate (4.3%) is higher than the 1990s peak (3.4%), and will almost certainly go higher still. But bear in mind that commercial real estate is equally as big a lending category for the banks as home real estate is. And the banks had extraordinary damage from commercial real estate in the early 1990s without inducing a solvency crisis.

Needless to say the banks have seen a steep rise in real estate delinquencies and defaults in recent quarters and they now extrapolate this, steeply, to higher levels in upcoming quarters. In light of historical experience that extrapolation is sensible enough for a couple of upcoming quarters (Q3 and Q4). But at that point, however, the level of defaults on real estate loans -- residential and commercial combined -- will still not have exceeded the level of the early 1990s recession or in the worst case will have exceeded it only modestly. And it is not sensible right now to extrapolate any further!

Here's a way of putting the upcoming solvency risk in perspective. As I've said, 4.2 percent was the delinquency rate for real estate loans in Q2 2008 and banks endured a delinquency rate of more than 4.2 percent on such loans continuously for the seven whole years 1987 - 1993. Can you imagine that the delinquency level experienced in Q2 2008 could continue every single quarter from now until Q1 2015? I cannot. But if it did happen, the banks' losses would merely be in the vicinity of their 1987 - 1993 losses. That assumes the delinquency rate is a good index for their actual losses. The data link I gave above also links to the bank "charge-off" rate. I believe the delinquency rate is a better index than the "charge-off" rate.

Michael E Sullivan writes:

I don't think you're being entirely fair in suggesting that Brad thinks of Bernanke as a saint. Admittedly, he doesn't really challenge any specific decision BB has made in the way he does Greenspan, but when he refers to the technocrat-prince, I read more of a genuine sense of alarm that so much power has become invested in one person with no obvious good way to change that, than a hailing of Ben Bernanke in particular as deserving of such weighty responsibility.

I disagree that Jan 2006 was well before the peak. I'm sure some markets continued to rise after that, but in my market, we saw about a 10% drop in the first two quarters of 2006, and that corresponds to some other markets I know around the country. The national index did not fall until Q2, but the Q2 peak was barely above the Q1 number (Case-Shiller), while Q1 2006 was more than 10% higher than Q1 2005. By 1/2006, the national market had already gone from boom to flat.
I say the run up was essentially over by January 2006, even if the most dramatic falls didn't come for another 6-12 months. By January 2006 or shortly after, the question was not whether to pop the bubble, but how big and hard the fallback would be.

Barkley Rosser writes:


Your point that Bernanke was on the Fed Board from 2002 until 2005 is well taken, although it is also well known that Greenspan was a very dominating figure on that board. Most of Bernanke's public statements involved fear of deflation, of being like Japan, which may now look silly, although one can argue that he helped aggravate the bubble by supporting the stimulative policy that was carried out then.

OTOH, the Case-Shiller index says that the national average of housing markets peaked in June-July, 2006, not all that long after Bernanke took over.

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