The Federal Reserve and the Financial Crisis

by Ben S. Bernanke

  There are many other aspects of the Dodd-Frank Act. Another vulnerability I discussed was the exotic financial instruments, derivatives and so on, that concentrated risk. There is a whole set of new rules that require more transparency about derivatives positions, standardization of derivatives, and trading of derivatives through third parties called central counterparties. The idea here is to take derivatives and those transactions out of the shadows, to make them available and visible to both the regulators and the markets to avoid a situation like we saw during the crisis.

  The Federal Reserve did not do as good a job as it should have in protecting consumers on the mortgage front. So the Dodd-Frank Act creates a new agency, called the Consumer Financial Protection Bureau, which is meant to protect consumers in their financial dealings, and that would include things like protections on the terms of mortgages, for example.

  So there is quite a variety of aspects of Dodd-Frank. It is a large and complex bill, and there has been a lot of complaining about the fact that it is large and complex. The regulators are doing their best to implement these rules in a way that will be effective and, at the same time, minimize the cost to the industry and to the economy. That is difficult, but it is an ongoing process. We do that through an extensive process of putting out proposed rules, gathering comments from the public, looking at those comments, making changes to the rules, and so on. It is an iterative process through which we put in place these regulatory standards. And again, it is still very much under way.

  Let me conclude by saying a couple of things about the future. Central banks, not just in the United States but around the world, have been through a very difficult and dramatic period, which has required a lot of rethinking about how we manage policy and how we manage our responsibilities with respect to the financial system. In particular, during much of the World War II period, because things were relatively stable, because financial crises were things that happened in emerging markets and not in developed countries, many central banks began to view financial stability policy as a junior partner to monetary policy. It was not considered as important. It was something to which they paid attention, but it was not something to which they devoted many resources.

  Obviously, based on what happened during the crisis and the effects we are still feeling, it is now clear that maintaining financial stability is just as important a responsibility as maintaining monetary and economic stability. And indeed, this is a return to where the Fed came from in the beginning. Remember that the reason that Fed was created was to try to reduce the incidence of financial panics; financial stability was the original goal in creating the Fed. So now we have come full circle.

  Financial crises will always be with us. That is probably unavoidable. We have had financial crises for six hundred years in the Western world. Periodically, there are going to be bubbles or other instabilities in the financial system. But given what the potential for damage is now, as we have seen, it is really important for central banks and other regulators to do what we can, first, to anticipate or prevent a crisis, but also, if a crisis happens, to mitigate it and to make sure the system is strong enough to make it through the crisis intact.

  Again, we began by noting the two principle tools of central banks, serving as lender of last resort to prevent or mitigate financial crises, and using monetary policy to enhance economic stability. In the Great Depression, as I described, those tools were not used appropriately. But in the recent episode, the Fed and other central banks used these tools actively. I should also say that there has been a great convergence, that other major central banks have followed policies very similar to that of the Fed. And in any case, I believe that by using these tools actively, we avoided much worse outcomes in terms of both the financial crisis and the depth and severity of the resulting recession. A new regulatory framework will be helpful. But again, it is not going to solve the problem. The only solution in the end is for us regulators and our successors to continue to monitor the entire financial system and to try to identify problems and to respond to them using the tools that we have.

  STUDENT: In the first lecture, you touched on the Main Street versus Wall Street divide, and this has been in the back of my mind throughout the lecture series. You have talked about the importance of educating the public on monetary policy. And although this lecture series has definitely demystified the Fed for me, I think it has really been Wall Street, not Main Street, that has been tuning in. So, given how unpopular bank bailouts were among many Americans struggling to pay their mortgages who don’t really understand the importance of financial stability, do you ever see Americans reconciling these differences?

  CHAIRMAN BERNANKE: You’re right. Some of the same conflicts that we saw in the nineteenth century, we see echoes of them today as well. I do not have a simple answer to that question. As you know, the Fed has done more outreach—the press conferences and other kinds of tools—to try to explain what we did and what we are doing. Clearly, the Fed is very accountable. We testify frequently, not just myself but other members of the Board or Reserve Bank presidents. We give speeches. We appear at various events and so on.

  It is inherently difficult because the Fed is a complicated institution. And as you have seen in these four lectures, these are not simple issues. But all we can do, I think, is to do our best and hope that our educators, our media, and so on will begin to carry the story and help people understand better. It is a difficult challenge and it does reflect a tension in American feelings about central banks ever since the beginning.

  STUDENT: Earlier you mentioned that the Fed had several ways to unwind the large-scale asset purchases, including selling them back into the market. What guarantees that investors will be willing to buy them back in the future?

  CHAIRMAN BERNANKE: We have essentially three separate types of tools that we can use, any one of which by itself would allow us to unwind our policies. But taken together, they give us a lot of comfort.

  First, we have the ability to pay interest on the reserves that banks hold with us. So, when the time comes for the Fed to raise interest rates, we can do so by raising the rate of interest we pay to banks on those reserves. Banks are not going to lend out the reserves at a rate lower than they can earn at the Fed. And so that will lock up those reserves, raise interest rates, and serve to tighten monetary policy. So, that one tool by itself, even if our balance sheets stayed large, could tighten monetary policy.

  The second tool we have is what are called draining tools. Basically, we have various ways that we can drain the reserves from the banking system and replace them with other kinds of liabilities even as the total amount of assets on our balance sheet remains unchanged.

  The third and final option is either to let the assets run off as they mature or to sell them. These are Treasury securities and government-guaranteed securities. It is certainly possible that the prevailing interest rate when we sell those securities will be higher than it is today. In other words, we will have to pay a higher interest rate in order to make investors willing to acquire them. But actually, that will be part of the process. That will be a time when we are trying to raise interest rates. It will be the reverse of what we did when we bought them. At that point, we will be trying to raise interest rates in order to exit from the easy policy to a policy that will allow the economy to grow in a low-inflationary way.

  So, I do not think there is any danger that investors will not buy the assets. They will certainly buy them at a higher interest rate, and that would be part of the objective of reducing the balance sheet to tighten financial conditions, so as to avoid inflation concerns in the future.

  STUDENT: I read an article that laid out a plan to allow homeowners who have been on time with their mortgage payments to refinance at the current lower rates as a way to protect them from their housing prices dropping. I was wondering whether you have heard of plans like that and what sort of involvement the Fed would have or whether that would fall to the Consumer Financial Protection Bur
eau.

  CHAIRMAN BERNANKE: There are some programs like that, one in particular is called the HARP program, which is run by the GSEs, Fannie and Freddie, and by their regulator, the Federal Housing Finance Agency. In this program, if you are underwater in your mortgage—in other words, if you owe more on your mortgage than your house is worth—you still may be able, under this program, if your mortgage is held by Fannie or Freddie, to refinance at a lower interest rate, which will reduce your payments. That program is under way and being expanded. It does not necessarily work if your mortgage is being held by a bank because they are not part of this program, but they may choose voluntarily to do it. But you might be out of luck if your mortgage is not held by Fannie or Freddie.

  So, there are programs like that. The Fed is not involved in them. Our job has been to keep mortgage rates low and hope that we can help homeowners. But programs like that, which allow people to get lower payments, obviously are going to be helpful to those people because they will face less financial stress, and there would be a smaller chance that they will end up being delinquent on their mortgages.

  STUDENT: You mentioned in your lecture the dangers of deflation from the Great Depression and more recently in Japan. And one of the arguments for maintaining a target inflation rate above zero is to provide a cushion against the possibility of deflation. Yet in the last two recessions in the United States, there has been a significant fear of deflation, causing the Fed to keep monetary policy very accommodative in the beginning of the last decade and even more so at this point. Do you think that 2 percent is enough of a cushion to prevent deflation? And have you considered higher inflation target rates?

  CHAIRMAN BERNANKE: That is a great question, and there has been a lot of research on it. It seems that the international consensus is around 2 percent. Almost all central banks that have a target have either a 2 percent target or a 1–3 percent target or something similar. And there is a trade-off here, because, on the one hand, you want to have it above zero, as you say, in order to avoid or reduce deflation risk. But on the other hand, if inflation is too high, it is going to create problems for markets. It is going to make the economy less efficient. And so there is a trade-off in which one level of inflation gives you at least some reasonable buffer against deflation, but it is not so high that it makes markets work less well. And so again, the international consensus has been around 2 percent, and that is where the Fed has been informally for quite a while. So that is what we announced, and for the foreseeable future that is where we plan to stay. But obviously researchers will continue to look at this issue, trying to pinpoint exactly where the optimal trade-off is.

  STUDENT: You mentioned that one of the biggest lessons you learned from the recent financial crisis is that monetary policy is powerful but it cannot solve all the problems, especially structural problems. What are the effective tools that can be used to solve these structural problems in housing and financial and credit markets?

  CHAIRMAN BERNANKE: It depends on the particular set of problems. In the case of housing, the Federal Reserve staff wrote a white paper that analyzed a number of the issues, not just foreclosures, but also what to do with vacant houses, how to get more appropriate mortgage origination conditions, and issues of that sort. We did not come out with a list of actual recommendations because that is really up to Congress and to other agencies to determine. But we did go through a whole list of possible approaches.

  But housing is a very complex problem, and there are many different things that could be done to try to make it work better. And indeed, looking forward, given the problems with Fannie and Freddie, we have some very big decisions to make as a country about what our housing finance system is going to look like in the longer term.

  In Europe, for example, there has been a very complex problem. We have been in close discussions with our European colleagues. They have taken a number of steps. Right now they are talking about a so-called firewall, how much money they are going to contribute to provide protection against the possibility of contagion if some country defaults or fails to pay its bills.

  Each of these issues has its own approach. In the labor market, we have the problem of people who have been out of work for a long time. Obviously, one of the best ways to deal with that would be some form of training, increasing skills. So you could just go down the list. And basically, anything that makes our economy more productive, more efficient, and deals with some of these long-term issues related to our fiscal problems, those are all things that would help. And the fact that the Fed is doing what we can to try to support the recovery should not mean that no other policies are undertaken. I think it is important that we look across the entire government and ask what kinds of constructive steps can be taken to make our economy stronger and to help the recovery be more sustainable.

  STUDENT: You mentioned that the Fed is doing what it can to sustain the recovery, but with unemployment at 8.3 percent and the housing market very sluggish and the problems in Europe, what other tools does the Fed have to address other issues that might arise in the future—say, if unemployment starts to rise, or the housing recovery gets worse, or Portugal, Spain, and Italy default?

  CHAIRMAN BERNANKE: Oh, my! You will cost me a night’s sleep now. What I described today is basically what the toolkit is for the Federal Reserve and other central banks. We still have lender of last resort authority. It has been modified in some ways by the Dodd-Frank Act—strengthened in some ways and reduced in some ways. So between that and our financial regulatory authority, we want to make sure our financial system is strong. And we have worked particularly hard to make sure that we do everything we can to protect our financial system and our economy from anything that might happen in Europe. So, that whole set of tools is still available and in play should there be any new problems in financial markets.

  On the monetary side, we do not have any completely new monetary tools, but we have our interest-rate policies, and we can continue to use monetary policy as appropriate as the outlook changes to try to achieve the appropriate recovery while still maintaining price stability, which is the other half of the Federal Reserve mandate.

  So we have these two basic sets of tools. We will have to continue to evaluate where the economy is going and use them appropriately. We do not have lots of other tools. And that is why I was saying earlier that we really need an effort across different parts of the government, and indeed the private sector, to do what can be done to get our economy back on its feet.

  STUDENT: You spoke a lot about the economic recovery and that, although it is painfully slow, there is a clear recovery happening. What are the key indicators that you and the Federal Reserve are looking at that would suggest that the private sector has begun self-sustaining this economic recovery and that the Fed may begin to tighten monetary policy?

  CHAIRMAN BERNANKE: That is a great question. First, one set of indicators that has been looking better lately and we have been paying a lot of attention to is developments in the labor market, jobs, unemployment rate, unemployment insurance claims, hours of work, all of those indicators suggest that the labor market is strengthening. And indeed, employment is one of our two objectives. So clearly, that is something we would like to see sustained. We would like to see a continued improvement in the labor market.

  As I discussed in the third lecture, it is much more likely that the improvement in the labor market will be sustained if we also see increases in overall demand and overall growth. So we will continue to look at indicators of consumer spending and consumer sentiment, capital plans, capital expenditures, indicators of optimism on the part of firms, those kinds of things, to see where production and demand are going to go. And then, of course, as always, we have to look at inflation and be comfortable that price stability will be maintained and that inflation will be low and stable. So those are the things we will be looking at, and there is no simple formula. But as the economy strengthens and becomes more self-sustaining, then at some point the need for so mu
ch support from the Fed will begin to diminish.

  5 In United States, legislation is unofficially named after the chairs of the relevant committees. Barney Frank was the chairman of the House Financial Services Committee when the Democrats controlled the House in 2010, and Chris Dodd was the chairman of the Senate Banking Committee.

  Index

  adjustable rate mortgages (ARMs), 66–67

  AIG Financial Products Corporation, 49–50, 70, 71, 73, 85–86, 92, 95, 117, 118, 120

  asset-backed securities, 78

  Bagehot, Walter, 7, 29, 83, 97

  balance sheets, 93–94; Federal Reserve, 102–6

  Bank of America, 73

  Bank of England, 5, 7, 12–13, 25

  Basel 3 capital requirements, 95

  Bear Stearns, 50, 72, 75, 78, 84, 86

  Big Short, The, 61

  Board of Governors of the Federal Reserve, 15, 100–101

  Bryan, William Jennings, 14

  Burns, Arthur, 34

  Bush, George W., 61–62

  businesses: global financial, 85–87; inventories, 40–41; too big to fail, 86, 94, 117–20

  Carter, Jimmy, 35

  central banks, 1, 126; basic missions of, 29–30; creation of American, 910; in different countries, 2–3; financial regulation and supervision by, 4; function of, 3; future of, 121; gold standard and, 10–14; liquidity and, 4; origin of, 5; tools used by, 3–4. See also Federal Reserve

  China, 12

  Civil War, American, 8, 9, 10

  clearing houses, 8–9

  Clinton, Bill, 61

  collateral, 7, 29

  collateralized debt obligation (CDO), 69