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Central Banking after the Great Recession
Lessons Learned, Challenges Ahead
By David Wessel
Brookings Institution PressCopyright © 2014 THE BROOKINGS INSTITUTION
All rights reserved.
The January 2014 inaugural event of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution focused on lessons that the Federal Reserve and other central banks have—or should have—learned from the most severe financial crisis the world economy has weathered in seventy-five years. The session was an encouraging beginning toward our goals of increasing public understanding of fiscal and monetary policy and improving the quality and efficacy of those policies. As Brookings President Strobe Talbott said in his introductory remarks:
Monetary and fiscal policies are the purview of different parts of the federal government, but they have in common two goals: easing our economic woes, particularly the persistence of high unemployment, while at the same time ensuring that decisions that we make today on spending, taxes, interest rates, and financial regulation lay the foundations for a better life for our children and grandchildren.
That means fiscal and monetary policies need to be consistent and compatible if we are to accelerate our recovery from the recent crisis and ensure a healthy economic future. This is a classic challenge to the Brookings mission, which is contributing to the improvement of our system of governance. It's an opportunity to apply the Brookings method which is to convene the best experts; pose the right questions; marshal relevant facts; generate innovative, pragmatic, actionable ideas; debate their merits in a civil, constructive, nonpartisan fashion; engage the public, the private sector, and the policy community, and then advocate for sound policy.
Glenn Hutchins, whose family foundation provided the gift that created the Hutchins Center, added,
At Brookings we are uncompromising in our zeal to protect and promote the independence of our scholars. This is because we are committed to producing only the very highest quality, most data-driven, most rigorous research humanly possible. And we fundamentally believe that can only be accomplished when our scholars are absolutely free to pursue their research to its logical conclusion without ideological or financial fear or favor.
In that spirit, we asked John Williams, president of the Federal Reserve Bank of San Francisco, to reflect on lessons he has gleaned from the past five years of extraordinary, unconventional monetary policy.
He said central bankers should not assume, as they once did, that episodes in which short-term interest rates fall to zero will be infrequent or short-lived. In his view, the Fed's experiments with "forward guidance"—promising to keep rates low for a long time—and with large-scale purchases of bonds and mortgages ("quantitative easing") have been successful, although he acknowledged that quantifying their efficacy has proved difficult. He highlighted three unresolved issues:
—Should central banks shift from inflation targets to price-level or nominal GDP-level targets?
—Should large-scale asset purchases be a standard tool of monetary policy, and if so, how should they be implemented?
—Is the 2 percent inflation target in common use by central banks high enough?
We then turned to an occasional critic of the Fed, Martin Feldstein of Harvard University. He broadened the discussion to inadequacy of fiscal policy, which, he said, put too much burden on the Fed during and immediately following the crisis. We invited Paul Tucker, now at Harvard University after serving as deputy governor for financial stability of the Bank of England, to identify where postcrisis reforms for the financial system have gone far enough—and where they haven't. He had praise for the strengthened regulation of banks but warned that too little has been done to address risks posed by financial markets. He outlined the new approach being followed in the United States and elsewhere to protect taxpayers from paying for future bank bailouts while preserving financial stability in the face of failure. That approach essentially requires the bank-holding companies to hold enough equity and debt to absorb any losses at their subsidiaries and be reconstituted immediately as going concerns. That approach essentially requires the bank-holding companies issue enough equity and long-term debt so that the parent company—as opposed to taxpayers—can absorb any banking losses. Rodgin Cohen of Sullivan & Cromwell, one of the leading banking lawyers, was concerned about the international complications involved in resolving global institutions, and he offered a few modifications to Paul Tucker's proposal.
We also asked our colleague Donald Kohn, a former Federal Reserve vice chairman, to assess the risks to the Fed's independence in the wake of the crisis. In his view, the risks are substantial and unwelcome because politically independent central banks have been proven to be an essential bulwark against inflation. In responding, Christina Romer of the University of California at Berkeley argued that the main reason to shield central banks from political interference is not to resist inflation, but because monetary policy made by experts is better than policy made by politicians. The biggest threat to that independence, she said, comes from bad monetary policy decisions. Kenneth Rogoff of Harvard University was more sympathetic to Kohn's view and expressed concern that today's environment is one in which central bank independence could prove very difficult to preserve.
All this provided substantial fodder for thinking and rethinking the recent past and offered an agenda for future research and policy. That alone would have been fruitful, but we concluded with an illuminating interview with Ben Bernanke, then in his final weeks as chairman of the Federal Reserve, by Liaquat Ahamed, a Brookings trustee and author of the Pulitzer Prize–winning Lords of Finance: The Bankers Who Broke the World.
Perhaps the most telling moment came when Ahamed recalled that then-Treasury Secretary Tim Geithner once referred to Ben Bernanke as the "Buddha of central bankers"—and asked if Bernanke had suffered any sleepless nights during the crisis. Bernanke said he had, adding, "It was kind of like if you're in a car wreck. You're mostly involved in trying to avoid going off the bridge, and then later on you say, 'Oh, my God...."
This volume includes a lightly edited transcript of that conversation as well as the reflections of Williams, Tucker, and Kohn and the wide-ranging discussion with the panelists and the audience that followed. You can keep track of the evolution of the Hutchins Center on Fiscal and Monetary Policy on the website: www.brookings.edu/hutchinscenter.CHAPTER 2
A CONVERSATION WITH BEN BERNANKE
Liaquat Ahamed and Ben Bernanke
Two weeks before the end of his eight-year term as chairman of the Federal Reserve, Ben Bernanke was interviewed by Liaquat Ahamed, a Brookings trustee and author of the Pulitzer Prize–winning Lords of Finance: The Bankers Who Broke the World. As Glenn Hutchins noted in introducing the conversation, Ahamed's book was about the mistakes that central bankers made during the Great Depression. The story of Ben Bernanke's tenure is about the steps the Federal Reserve took to avoid another Great Depression. An edited transcript of the conversation follows.
AHAMED: The way you handled the financial crisis in 2008 will clearly go down as one of your signature achievements. You've said somewhere that the playbook that you relied on was essentially given by a British economist in the 1860s, Walter Bagehot. His dictum was that in a financial crisis, the central bank should lend unlimited amounts to solvent institutions against good collateral at a penalty rate. How useful in practice was that rule in guiding you?
BERNANKE: It was excellent advice. This was the advice that's been used by central banks going back to at least the 1700s. When you have a market or a financial system that is short of liquidity and there's a lack of confidence, a panic, then the central bank is the lender of last resort. It's the institution that can provide the cash liquidity to calm the panic and to make sure that depositors and other short-term lenders are able to get their money.
In the context of the crisis of 2008, the main difference was that the financial system that we have today obviously looked very different in its details, if not in its conceptual structure, from what Walter Bagehot saw in the nineteenth century. And so the challenge for us at the Fed was to adapt Bagehot's advice to the context of a modern financial system. So, for example, instead of having retail depositors standing in line outside the doors, as was the case in the 1907 panic, in the United States we had runs by wholesale short-term lenders like repo lenders or commercial-paper lenders, and we had to find ways to essentially provide liquidity to stop those runs.
So it was a different institutional context, but very much an approach that was entirely consistent, I think, with Bagehot's recommendations.
AHAMED: Now in addition to lending to institutions, you intervened in markets. Is there a sort of similarly pithy dictum, a Bernanke rule that you can come up with about when the Fed should intervene in markets and when it shouldn't?
BERNANKE: If we're talking about the crisis period, I would say that all the interventions we did fit under the Bagehot heading. For example, the commercial-paper facility that we set up was essentially designed to prevent a run on this particular form of financing. It was a different institutional structure, but it was, again, essentially the same Bagehot rule being applied in a different institutional context. So while the analogies between what we did and the run on the savings and loan in It's a Wonderful Life are not always obvious, there was, in fact, a very close parallel.
Now we have done other interventions, with our asset purchase program, for example, but that I would call those the monetary policy part of our response.
AHAMED: The crisis began in August of 2007, when there was a problem with a fund run by a French bank. And if you trace through it, it actually continued until the spring of 2009. So that was a long time. And despite major intervention after Lehman, despite the Troubled Asset Repurchase Program (TARP), you still had a run on Citibank, you still had a run on Bank of America. Why did it take so long to get it under control?
BERNANKE: It was not a continuous crisis of equal intensity for the entire period that you described. In the fall of 2007, we were seeing obviously a lot of stress in markets, but at that point, it was not obvious whether this was going to be the start of something bigger or whether it was something more comparable, say, to some of the disruptions we had seen in the 1990s, for example, around the Russian debt crisis.
There was a critical point in March of 2008 with the Bear Stearns episode, and that was a period of very intense stress in the repo markets and in some other parts of the financial markets. After Bear Stearns, financial conditions calmed fairly notably for a while. Obviously we remained very alert. The Federal Reserve was beginning to supervise the investment banks together with the Securities and Exchange Commission over the summer. So we were not complacent about the crisis being over, but conditions were certainly more stable after Bear Stearns for a number of months. And there was, you know, at least some hope—given that, for example, the Bush administration was undertaking a fiscal expansionary policy—that things might calm. But, again, we were very attentive.
The real intense phase, I think everyone would agree, began with the takeover, the putting into conservatorship of Fannie Mae and Freddie Mac in early September of 2008. And that was followed by this very intense period of Lehman and AIG, the TARP, and so on. So the very intense period from, say, September 1 until the latter part of the year, that was the period of greatest stress and greatest risk.
And the combination of our lending programs and the injection of government capital, the fiscal aspect of that, brought the crisis down considerably by the end of the year. Of course, into the next year we were still working to stabilize the system with our stress testing, addressing some concerns of specific institutions with our monetary policy and the like, but I don't think it's fair to characterize the crisis as being something that was continuous for a year and a half. Rather, there were periods of ebbs and flows.
And in the most intense period in September and October, I think we actually got that under control reasonably quickly with the combination of the Fed's liquidity provision, the TARP, the fiscal injections, plus actions by the FDIC [Federal Deposit Insurance Corporation] and other agencies as well.
AHAMED: Hank Paulson describes having sleepless nights at that time, you know, agonizing that he would go down in history as the Herbert Hoover of this episode. And I think Tim Geithner once described you as the Buddha of central banks, which implies a certain level of enlightened detachment. Now, did you have sleepless nights?
BERNANKE: Oh, sure, absolutely. But it's my nature, I think, to kind of focus on the problem, and I was so absorbed in what was happening and trying to find a response to it that I wasn't really in that kind of reflective mode. It was kind of like if you're in a car wreck. You're mostly involved in trying to avoid going off the bridge; and then later on you say, "Oh, my God...."
AHAMED: Your partnership with Secretary Paulson and then Secretary Geithner was clearly central to solving the crisis. To an outsider it's remarkable what a united front you presented, but you did have different backgrounds, different personalities, and represented different arms of government. And so to some degree there's a natural tension. The central bank does liquidity. The Treasury does solvency. But the distinction is not always very clear. Were there any big disagreements?
MR. BERNANKE: You're absolutely right that we had a very strong partnership: Hank Paulson, Tim Geithner, and me. We are different people, different backgrounds. And I think we were actually quite complementary in various ways. And we certainly all recognized the seriousness of the situation and the need for cooperation among the Treasury, the Fed, and other agencies. And that was the overwhelming imperative: to work together to try to solve the problem.
There were certainly points where we were trying to address the financial condition of AIG or some other politically very difficult problem, and there was a little bit of discussion about whether or not the Fed or the Treasury should take the lead on that particular area. But in the end, Paulson, in particular, who during the heat of the 2008 crisis, was the person who was most exposed to the political winds, because as secretary of the Treasury, he represented the administration and he had to go to Congress and so on. In the end, he always did what had to be done.
And I think that was the reason that we worked together: the combination of our complementary backgrounds and skills and the fact that we shared a common purpose. There were many people in the world, economists among them, who thought that it's perfectly safe to let the financial companies go down. We heard that even at Jackson Hole a few days before the crisis intensified in September of 2008. The three of us were all very much in agreement that that was not a wise thing to do, and we were committed to not doing that.
Let me just also say, though, that while the interventions with large failing firms are the part of the story that gets the most attention, and are the most controversial, much of the good work that was done was a little bit more under the radar and had to do with our actions to try to stabilize key financial markets like the money market funds, the commercial-paper market, the asset-backed securities market; to strengthen the commercial banking system and so on; and to work with our partners to do currency swaps with fourteen other central banks. There was a whole range of things that we did that didn't involve firm interventions, which were less visible, but probably occupied a much greater portion of our time and were at least as important if not more important in terms of stabilizing the system.
Excerpted from Central Banking after the Great Recession by David Wessel. Copyright © 2014 THE BROOKINGS INSTITUTION. Excerpted by permission of Brookings Institution Press.
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