What were the consequences of the crisis? The economic consequences were severe. Figure 18 shows a measure of financial stress. It is just an index that combines a variety of financial indicators that indicate that the financial system is under great stress. And you can see what happened in 2008 and 2009: a sharp increase in financial stress in the financial markets. Figure 19 shows that the stock market plunged. The first decline, in 2000 and the 2001 recession, was a very large decline in tech stocks, but notice that the decline in the stock market in the more recent recession was even bigger than the one in 2000 and 2001. Figure 20 shows home construction. You can see the very sharp decline there. Home construction fell before the recession; of course, it was a trigger of the crisis. But looking to the right, you can see that it still has not really begun to recover. And then finally, figure 21 shows that unemployment rose very sharply, peaked around 10 percent, and has currently fallen to about 8.3 percent.
Figure 18. Financial Stress
Index, 1994-2012
Source: St. Louis Federal Reserve Bank Financial Stress Index
Figure 19. S&P 500 Composite Index, 1992–2012
Source: Bloomberg
STUDENT: In the previous lecture, you discussed that in the Depression, it seemed that policy was tightened too early and that led to a double dip. And then today, we were discussing that policy in the 1970s was too slow to tighten. How do we know when the right time is? And is there a right time or does it vary all the time?
CHAIRMAN BERNANKE: It is challenging, and that is certainly one of the reasons that the Fed has so many economists and models and everything to try to figure out what the appropriate moment is to tighten or to ease policy. Forecasting is not very accurate, and so we have to keep looking at what is happening and make adjustments as we go along. The 1970s was particularly difficult because at that time inflation expectations were not at all tied down. If gas prices went up, then people began to expect higher inflation and then to demand higher wages to compensate for the higher prices. And then, of course, higher wages would feed into higher prices, and so on. That was a result of the fact that everybody expected inflation to go up; nobody had any confidence that the Fed or the government in general would keep inflation low and stable. We have a very different situation now, fortunately—and this owes a lot to Chairman Volcker and to Chairman Greenspan as well. After a long period of low inflation, most people are pretty comfortable that inflation will stay reasonably low despite the fact that there are ups and downs with gas prices and so on. That helps a lot because, with inflation staying low, the Fed has more leeway. If policy is easy for a period, that is not necessarily going to feed into a wage-price spiral that would create a much bigger inflation problem down the road. So, keeping inflation expectations low and stable is one of the great accomplishments of Chairman Volcker and Chairman Greenspan, and it is an important objective of central banks around the world.
Figure 20. Single-Family Housing Starts, 1992-2012
Source: Census Bureau
Figure 21. Unemployment Rate, 1992-2012
Note: Value for the first quarter of 2012 is the February reading.
Source: Bureau of Labor Statistics
STUDENT: I have a question about the low interest rate monetary policy in the early 2000s and your view, with all the different research that was conducted, that it did not spark the housing bubble. If you had been Fed chairman in 2001, would you have kept rates that low? Do you think it was the correct thing to do?
CHAIRMAN BERNANKE: I was on the Fed Board during that time and the very first speech I wrote when I became a governor in 2002 was about bubbles and financial supervision and regulation. The theme of my speech was “Use the right tool for the job.” The problem with tying interest rate policy to perceived bubbles and asset prices is that it is like using a sledgehammer to kill a mosquito. The problem is that housing is only one part of the economy, whereas interest rates are dedicated to achieving overall economic stability. So we estimate that in order to stop the increase in house prices, interest rates would have had to be raised very dramatically in a period when the economy was very weak. Unemployment was still above normal. Inflation was falling toward zero. And generally speaking, the right way to use monetary policy is to achieve overall macroeconomic stability. Now that does not mean you should ignore financial imbalances. I think the Federal Reserve could have been more aggressive on the supervisory and regulatory side to make sure, for example, that the mortgages being originated were of better quality, that firms were appropriately monitoring their risk, and so on. So I think the first line of defense should be regulation and supervision. One of the lessons I talked about today was not to be too sure of anything, to be humble. For that reason, I think we should never rule out the possibility that, if all of our regulatory and other types of interventions do not achieve the stability and the financial system we want, monetary policy might, as a last resort, be modified to some extent to deal with that problem. But again, because monetary policy is such a blunt tool, which affects all asset prices and affects the entire economy, if you can get a laser-focused type of tool, that is going to be much better for everybody.
STUDENT: At the end of the lecture you mentioned the role that global imbalances played in creating the housing bubble. Doesn’t the current U.S. monetary and fiscal policy, which focuses on boosting consumption through borrowing more—-doesn’t that lead us down the same road of overconsumption through borrowing that got us into the crisis in the first place?
CHAIRMAN BERNANKE: First, we would like to get a better balance in general, so monetary policy stimulates capital formation as well. It also tends to promote exports. So we would like to get a better balance of consumption, investment, and exports, as well as government spending—those are the main components of demand. So current monetary policy is consistent with a better balance. That being said, consumer demand is now far below where it was before the crisis. Consumer spending has not recovered. It is still quite weak relative to where it was before the crisis. Private debt has come down quite a bit. And you mentioned global imbalances, so we are talking about the current account imbalance, or the trade deficit, that the United States has. It has come down quite significantly. So all those things have moved, if anything too far in the short run because we lack a source of demand to keep the economy growing. I agree that every country needs to have an appropriate balance of consumption, capital formation, exports, and government spending, and that is an important task for us. But right now, debt and consumption and so on are still quite low relative to the pattern before the crisis.
STUDENT: The latter part of your lecture was about monetary policy in the 2000s after the dot-com bubble and how interest rates were kept low. You argued that that was not a trigger to the increase in house prices. But to look at it from another point of view, what is your take on the argument that the low interest rates caused private investors and banks to make riskier trades, and that could have been a trigger to the crisis?
CHAIRMAN BERNANKE: That is a good question. I think there is some effect of low interest rates on risk taking. But, once again, it is an issue of getting the right balance. During a recession, generally speaking, on most dimensions, investors become very cautious. That is certainly where they have been for much of the recent past. You want to achieve an appropriate balance between the amount of risk being taken—not too much, not too little—and once again, this is yet another reason why financial supervision and regulation needs to be playing a role. Particularly with large institutions—banks—we need to be looking directly at those firms and making sure that they are managing their risks appropriately. So, again, it is a question of the right tool for the job.
STUDENT: The graphs on the housing bubble show how, clearly, one thing led to another, like rising prices and then eventually a fall. When you were observing the economy in the 2000s, what did you think would happen to the rising house prices in the housing bubble? Did you think that it would eventually lead to a r
ecession? There is a book called The Big Short about some investors who were very prescient in shorting the market. What is your take on that?
CHAIRMAN BERNANKE: As I tried to argue, the decline in house prices by itself was not obviously a major threat. In 2005, when I was the chairman of the Council of Economic Advisers for President George W. Bush, we did an analysis for him on what would happen if house prices came down. We concluded that we would have a recession, but we did not anticipate that the decline of house prices would have such a broad-based effect on the stability of the financial system. When I became chairman of the Federal Reserve in 2006, house prices were already declining. In the first two weeks after I became chairman, I gave testimony in which I said: house prices are falling; that is going to have negative impacts on the economy and we are not sure of all the consequences. So we were always aware of the possibility that house prices might come down. The really hard thing to anticipate fully was that the effects of the decline in house prices would be so much more severe than the effects of the somewhat similar decline in dot-com stocks. And again, the reason is the way in which the decline in house prices affected mortgages, which affected the soundness of the financial system and created a panic, which in turn led to the instability of the financial system. So the whole chain of events was critical. It was not just the decline in house prices; it was the whole chain.
STUDENT: Amid the dispersion of cheap credit in the years preceding the housing crisis, there was a bipartisan push for American homeownership, originally spearheaded by President Bill Clinton and later carried on by President George W. Bush. To what degree could it be argued that that aggressive government policy supporting increased lending during this period contributed to the eventual erosion of credit standards on behalf of the mortgage originators?
CHAIRMAN BERNANKE: That is a very good question, and another controversial one. Certainly, there was some pressure to increase homeownership. There was the American dream aspect of owning a home and so on. Homeownership rose during this period. But to put all the responsibility on the government is probably wrong in this case. Most of the worst loans were made by private-sector lenders and then sold for private-sector securitization, that is, they did not touch Fannie Mae and Freddie Mac. For example, they went directly to investors. Fannie and Freddie did acquire some subprime mortgages, but actually that was a little bit later in the process rather than at the beginning of the process. But clearly the private sector, without any encouragement from the government, was a big player in the decline in mortgage underwriting standards and in the selling of bundled mortgages to private investors.
STUDENT: I think one of the hallmarks of the Fed under your leadership has been your commitment to transparency. All of us in this room are beneficiaries of that policy. But I wonder whether you think too much transparency could actually damage the central bank’s credibility, if it gets things wrong.
CHAIRMAN BERNANKE: Generally, I agree that transparency is very important for at least a couple of reasons. I talked already about the importance of a central bank being independent. So there is one linkage there. But if a central bank is independent and making important decisions that affect everybody, then it has to be accountable. People have to understand what it is doing, why it is doing it, and on what basis it makes its decisions. So for democratic accountability, I think it is important for the central bank to be transparent. I testify all the time, I give speeches, I have town hall meetings and other kinds of meetings like this, I give press conferences, and I think it is very important for me to explain what the Fed is doing and why it is doing it. The other reason for transparency is that, over time, there has been increased understanding that most of the time, transparency can make monetary policy work better. So, for example, if the Federal Reserve communicates that its future actions will be X or Y and conveys that information to the markets, the markets may respond by building those expectations into interest rates, which may have a more powerful effect in the economy. So communication also reduces uncertainty and helps increase the impact of monetary policy in financial markets.
STUDENT: My question concerns price stability and inflation expectations. You mentioned the importance of macroeconomic stability and long-run economic growth. Given the massive amount of liquidity that has been pumped into the market recently, how has the Fed been able to keep inflation expectations so low?
CHAIRMAN BERNANKE: I think we owe something to my predecessors—Chairman Volcker, in particular, and also Chairman Greenspan—who got inflation down low and kept it there. People get used to what they see. And in a world in which inflation remains low year after year, people become more and more confident that the central bank—the Fed or whoever—will meet its mandate of keeping inflation low. It has been very striking that, even though we have had movements in oil prices and other shocks to the economy, deep recession and financial crisis, throughout most of the period inflation expectations have been very well tied down to about the 2 percent range that the Fed is trying to hit.
3 I say “nonprime” instead of “subprime.” Subprime mortgages were the lowest-quality mortgages in terms of the credit of the borrowers, but there were other mortgages that were below the quality of prime mortgages: so-called Alt-A and other types of mortgages. They were also not up to the traditional standards of credit underwriting. So I say “nonprime.”
4 If you want to explore this more, here are a few references on the role of monetary policy in the housing bubble. Ben S. Bernanke,“Monetary Policy and the Housing Bubble,” speech delivered at the Annual Meeting of the American Economic Association, Atlanta, January 3, 2010, posted at www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm, summarizes some of the evidence. My speech is based very heavily on Jane Dokko and others, “Monetary Policy and the Housing Bubble,” Economic Policy 26 (April 2011): 237–287, which presents the results of all the internal Federal Reserve research. Carmen Reinhart and Vincent Reinhart, “Pride Goes before a Fall: Federal Reserve Policy and Asset Markets,”NBER Working Paper Series 16815, National Bureau of Economic Research, February 2011, makes the point that interest rates did not move enough to move house prices and also makes the point about capital inflows. Kenneth Kuttner, “Low Interest Rates and Housing Bubbles: Still No Smoking Gun,” in Douglas Evanoff, ed., The Role of Central Banks in Financial Stability: How Has It Changed? (Hackensack, NJ: World Scientific, forthcoming), concludes that there was no connection between interest rates and the housing bubble. But I emphasize that this question continues to be debated.
LECTURE 3
* * *
The Federal Reserve’s Response to the Financial Crisis
Today I want to talk about the Federal Reserve’s response to the financial crisis. In the last couple of lectures I mentioned a key theme, the two main responsibilities of central banks—financial stability and economic stability. Let me turn it around and talk about the two main tools. For financial stability, the main tool the central banks have is lender of last resort powers by providing short-term liquidity to financial institutions, replacing lost funding. Central banks, as they have for a number of centuries, can help calm a financial panic. For economic stability, the principal tool is monetary policy; in normal times, that involves adjusting short-term interest rates.
Today I will discuss the intense phase of the financial crisis in 2008 and 2009, and so I will focus primarily on the lender of last resort function of the central bank. I will come back to monetary policy in the final lecture when we talk about the aftermath and recovery.
Last time I talked about some of the vulnerabilities in the financial system that transformed into a crisis the decline in housing prices, which by itself seemed no more threatening than the decline in dot-com stock prices. Because of these vulnerabilities, the decline in housing prices led to a very severe crisis. The vulnerabilities I talked about last time were private-sector vulnerabilities, including the excessive debt taken on perhaps because of the period of the Great Moderation; very
important, the banks’ inability to monitor their own risks; excessive reliance on short-term funding (which, as a nineteenth-century bank would tell you, makes it vulnerable to a run as short-term funding is pulled away); and increased use of exotic financial instruments such as credit default swaps and others that concentrated risk in particular companies or in particular markets. Those were the vulnerabilities in the private sector.
The public sector had its own vulnerabilities, including gaps in the regulatory structure. Important firms and markets did not have adequate oversight. Where there was adequate oversight, at least by law, sometimes the supervisors and regulators did not do a good enough job. For example, not enough attention was paid to forcing banks to do a better job of monitoring and managing their risks. And finally, an important gap we have really begun to look at since the crisis is that, with individual agencies looking at different parts of the system, not enough attention was being paid to the stability of the financial system as a whole.
Let me talk for a moment about another important public-sector vulnerability, the so-called government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are nominally private corporations (they have shareholders and a board) but they were established by Congress in support of the housing industry. Fannie and Freddie, as they are called, do not make mortgages. You cannot go to Fannie’s headquarters and get a mortgage. Instead, they are the middleman between the originator of the mortgage and the ultimate holder of the mortgage. If you are a bank and you make a mortgage loan, if you like you can sell the mortgage to Fannie or Freddie. They will, in turn, take all the mortgages they purchase and put them together into mortgage-backed securities (MBSs) to sell to investors. A mortgage-backed security is just a security that is a combination of hundreds or thousands of underlying mortgages. That process is called securitization. Fannie and Freddie pioneered this basic approach to getting funding from mortgages. In particular, when the GSEs, Fannie and Freddie, sell their mortgage-backed securities, they provide guarantees against credit loss. So if the underlying mortgages in those MBSs go bad, Fannie and Freddie make the investor whole. Now, Fannie and Freddie were permitted to operate with inadequate capital. So they were particularly at risk in a situation with a lot of mortgage losses. They did not have enough capital to make good on their guarantees. Although many aspects of the financial crisis were not anticipated, this one was. Going back for at least a decade before the crisis, the Fed and many other people said that Fannie and Freddie just did not have enough capital and that they were a danger to the stability of the financial system. What made the situation even worse was that Fannie and Freddie, besides selling mortgage-backed securities to investors, also purchased on their own account large amounts of mortgage-backed securities, both their own and some that were issued by the private sector. They made profits from holding those mortgages but, to the extent that those mortgages were not insured or protected, Fannie and Freddie were vulnerable to losses and, without adequate capital, they were at risk.
The Federal Reserve and the Financial Crisis Page 6