By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side
As the end of Bernanke’s tenure as Fed Chairman approaches, observers will offer appraisals of his performance. However appraising or grading any Fed Chairman, or perhaps more accurately the Fed during a Chairmanship, is fraught with difficulties.
Model-based evaluations cannot serve as an objective means for assigning a grade. Macro-economic model-based grading is either a comparison of the realized outcome to a model-based hypothetical and/or a comparison of hypothetical outcomes. The results are largely determined by the choice of models. Different models and/or different parameters give rise to different results and are reflections of judgments/assumptions made by the person specifying the model or parameters to be employed. The choice of model will largely determine the grade. Furthermore, model-based evaluations omit dimensions of Fed performance, e.g., financial regulation.
There is a solution that removes biases inherent in the choice of a model. The Bernanke Fed can be graded based on a comparison of Bernanke’s expressed understanding of, and goals set for, Fed policy and the economy on the one hand, and the actual evolution of the economy and Fed policy on the other. The understanding and goals to be employed are those that Bernanke set out for the Fed in a speech in November of 2002, near the end of his first year on the Board of Governors.
The speech, titled “Deflation: Making Sure It Doesn’t Happen Here,” was prompted by concerns that the US might experience a Japan-style “lost decade.” While the title highlighted deflation, Bernanke made clear that the ultimate concern of policymakers was the real economy:
…this concern…is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation–a decline in consumer prices of about 1 percent per year–has been associated with years of painfully slow growth, rising joblessness…
In the speech, Bernanke expressed confidence that the US would not experience a prolonged Japan-like bout of economic ill health and provided a number of reasons why. From the introductory paragraphs:
So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons.
The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow… A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored.
The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself…I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.”
These introductory paragraphs provide the yardstick:
1. Did the Bernanke Fed succeed in achieving the goals he set out for it?
2. Did Bernanke correctly assess the underlying health and resiliency of both the financial system and the real economy as well the robustness of the regulatory system?
3. Did Bernanke accurately estimate the effectiveness of monetary policy?
Unfortunately, while the Fed’s monetary policy hit its chosen intermediate target (price stability), it failed to secure the ultimate targets, i.e., trend growth with full employment, and to insure financial stability. Deflation was avoided, but all the other ills that have beset Japan have been and/or are present in the US economy: a financial crisis, a recession, sluggish growth, and prolonged elevated rates of unemployment.
Why/how could this have occurred? Bernanke assured listeners in 2002 that a serious financial crisis would not happen:
…the Fed should take most seriously–as of course it does–its responsibility to ensure financial stability in the economy… 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.
However, both the opening paragraphs of the speech and the surprise Bernanke expressed in 2007 at the financial crisis and recession imply that he misread the health of the financial and household sectors as well the robustness of the financial regulatory system.
One would think that the Fed, who’s Chairman believed that it would take its responsibility to ensure financial stability seriously, would have at least periodically reviewed the robustness of the financial and regulatory systems. However, the Fed never made the effort required to determine the true state of the financial and regulatory systems. This view is supported by the Fed’s use of the self-serving “no one saw it coming” defense, when despite their responsibilities they failed to see it coming.
Unfortunately, the financial system was becoming progressively more fragile in the years before the crisis. During this period, unsustainably high prices for real estate and financial assets were supported by historically high levels of leverage and maturity mismatches as the players in the asset markets reached for yield. These developments reflected both the low-for-long interest rate policy stance as well the failure of regulators to exercise their responsibilities.
This sin of omission on the part of the Fed and financial regulators reflected an implicit decision to ignore lessons learned about regulation and financial stability in the then recent past. In 1997, the FDIC held a symposium/postmortem on the crises and bank failures of the 1980s and early 1990s. The papers and presentations were published under the title “History of the Eighties – Lessons for the Future.”
In a presentation titled “Lessons of the 1980s: What Does the Evidence Show?” in Volume II of the “History,” William Seidman drew the following lessons:
“First, every major developed nation learned that it is possible to have serious banking problems despite a great variety of regulatory structures, deposit insurance systems and banking organizations… No magic formula for supervision or financed system can be identified from the difficulties of the last decade.
Thus, lesson number one must be that there is no “magic bullet” system that will ensure banking safety and soundness…
As Adam Smith recognized, banking is different. Thus, lesson number two must be that financial systems are not, and probably never will be totally free market systems….Bank regulation can limit the scope and cost of bank failures but is unlikely to prevent failures that have systemic causes. The rise in the number of bank failures in the1980s had many causes that were beyond the regulators power to influence or offset. These included broad economic and financial market changes, ill-considered government policy actions, and structural weaknesses. However, if significant new structural weaknesses or serious economic problems are allowed to develop in the future, bank regulation alone will not be able to prevent a major increase in the number of bank failures….
… But more than anything else, real estate lending became the fashion, the “new” banking idea of the times…
Everywhere from Finland to Sweden to England to the United States to Japan to Australia, excessive real estate loans created the core of the banking problem. Some have maintained that government subsidies such as deposit insurance created a moral hazard, which caused institutions to behave in a non-market manner and therefore to take risks that they would not have taken without government subsidy. However, in looking around the world, the risks were taken without regard to whether the deposit insurance system was comprehensive as in the United States, minimal as in the UK, moderate as in Japan, or essentially nonexistent as in New Zealand…
The critical catalyst causing the institutional disruption around the world can be almost uniformly described by three words: real estate loans.
Chapter 1 in Volume I of the “History” is titled “Crises of the 1980s and Early 1990s.” Among the conclusions presented in this chapter are:
…bank failures were partly shaped by their own distinct circumstances…certain common elements were present:
1. Each followed a period of rapid expansion; in most cases, cyclical forces were accentuated by external factors. (Ed.: the savings glut in Asia?)
2. In all four recessions, speculative activity was evident…Expert opinion often gave support to overly optimistic expectations.
3. In all four cases there were wide swings in real estate activity.
Chapter 3 of Volume I of the “History” was titled “Commercial Real Estate and the Banking Crisis of the 1980s.” The final paragraphs of this chapter included a summary of the causes for this crisis:
… Generally, bank underwriting standards were loosened, often unchecked either by the real estate appraisal system or by supervisory restraints. In addition, overly optimistic appraisals, together with the relaxation of debt coverage, the reduction in the maximum loan-to-value ratios, and the loosening of other underwriting constraints, often meant that borrowers frequently had little or no equity at stake and in some cases lenders bore most or all of the risk.
Chapter 4 of Volume I of the “History” was titled: The Savings and Loan Crisis. The lessons for future regulators were summarized as:
The regulatory lessons of the S&L disaster are many. First and foremost is the need for strong and effective supervision of insured depository institutions, particularly if they are given new or expanded powers or are experiencing rapid growth. Second, this can be accomplished only if the industry does not have too much influence over its regulators… In this regard, the bank regulatory agencies need to remain politically independent.
Volcker was also a participant in the symposium presented in Volume II of the History. He focused on the dynamic nature of the financial system and the need for the regulatory system to evolve along with it:
What strikes me in reading the material for the 1980s is how much has changed in the 1990s and is in the process of change. I have no doubt that if we had these papers somehow available at the beginnings of the 1980s – that if we could have absorbed the lessons of the 1980s before the 1980s took place – we would not have many of the problems of the 1980s. But I’m not sure I could say the same thing about the 1990s because so much has change. Would the same lessons be adequate for, say, 2007.
A comparison of the views expressed in the FDIC review of 1997 on the one hand and the reaction of policymakers to Rajan’s speech in Jackson Hole in 2005, as well as to Shiller and others who reported risks and imbalances in the financial system and real economies is enlightening. It implies that in a just a few years the policymakers had forgotten the important, painful, and costly lessons of the 1980s and 90s. It also highlights the failure to update the regulatory system in light of the changes in the economic and interest rate climate and the evolution of financial institutions, markets and instruments. Lessons forgotten included:
1. The possibility of a real estate-based speculative bubble in the housing market was dismissed even though real estate bubbles had existed in the US and abroad in the recent past and the US had experienced the NASDQ bubble of 1996-2001.
2. The real estate dimension of the financial crisis of 2007, like the crises of the 1980s and 90s, was driven in part by a failure of private regulation as reflected in questionable third-party assessments of the value of underlying assets, declining underwriting standards, higher loan-to-value ratios, greater levels of leverage and larger maturity mismatches. But the Fed, as regulator and implementer of interest rate policy, had acted as if private regulation was sufficient. Kohn dubbed this position on the role of regulation as the “Greenspan Doctrine” at Jackson Hole in 2005.
3. Both optimism and rapid growth were rampant prior to the crisis of 2007. They were concentrated in the latest financial “fashion”, i.e., widespread use of derivatives and new structured products, as well as off-balance sheet entities to increase leverage and the risk profile of financial firms.
4. Price stability was viewed as a magic bullet. Financial stability was viewed as the sole province of regulation and supervision, which was in turn dismissed as sapping efficiency and unnecessary if price stability was achieved.
5. The consensus view as of the early 1990s was that it was better and cheaper to avoid crises and bank failures than to clean up afterwards. This is reflected in the FDIC Improvement Act of 1991. The Act mandated that the regulators pursue “prompt corrective actions” before a depository institution became capital impaired. In contrast, during the run-up to the latest crisis, the Fed publicly hewed to the position that it is better to clean up after a crisis than take action to prevent it, even though at the same time saying it was better to prevent deflation than to have to react to it.
Bernanke also overestimated the effectiveness of monetary policy. In the 2002 speech, Bernanke argued that rapid cuts in interest rates could prevent a Japan-like outcome in the US. He cited model-based policy simulations that indicated that Japan would have avoided the lost decade if policymakers had moved more quickly to provide monetary stimulus. More specifically, the policy simulations indicated that the lost decade could have been avoided if the BOJ had reduced the policy rate another 200 basis points at any point before 1995.
There is no indication that the Fed was constrained from easing as quickly as Bernanke and the FOMC thought desirable when the US housing market rolled over. The Fed funds rate target was reduced from 5.25% to 2.00% in seven moves (two of 75 basis points) between August of 2006 and April of 2008. The target rate was reduced from 2.00% to a range between 0.00% and 0.25% in the fall and early winter of 2008.
However, despite this rapid and presumably unconstrained reduction in the Fed funds target, the FOMC has continued to provide additional “stimulus” in response to the continued existence of a sizable output gap and weakness in the labor market. This resorting to unconventional policy and numerous de novo special facilities and programs suggests that Bernanke was overly optimistic about the effectiveness of monetary policy in 2002 when he said:
…that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments…
In short, Japan’s deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has.
The lingering problems in the labor market and output below potential despite the continuance of unprecedented stimulus imply that Bernanke had read the economy and financial markets as robust when they were in fact fragile, and overestimated the effectiveness of monetary policy. This divergence between the actual state of economic and financial conditions and the assumed states as indicated by Bernanke imply that the chosen policy paths were inappropriate.
It is also interesting to note that in the same speech Bernanke argued that a recovery in Japan required structural reforms:
I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal… As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan’s long-run economic health.
However, he has not suggested any remedies other than counter-cyclical monetary and fiscal policies in the US case, even as he admitted that monetary policy is no panacea.
The grading procedure used in this effort cannot provide a definitive final grade. The near-term path of the economy is in question. Furthermore, the grade assigned must also reflect the relative importance attached by the observer to price stability, deviations from trend growth with full employment, financial stability, etc. Consequently, the grades assigned will vary from observer to observer.
However, any grading methodology should reflect Bernanke’s and the Fed’s performance in achieving the goals set out, as well as those specified in its legal mandate. It would not be proper to grade Bernanke on one criterion, e.g., price stability, alone. Additionally, it would not be proper to grade Bernanke or the Fed’s performance based on a sub-period of his tenure in office, i.e., the response to the crisis.