“It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States.” Ben Bernanke

“Attached below, you will find excerpts from Chairman Bernanke’s opening remarks to the FCIC. Simply stated, he argues that macroeconomic factors led to increased risk-taking (and unsustainable asset bubbles) and the financial crisis. In these remarks, Mr. Bernanke offered three hypotheses for this increased risk-taking by consumers, businesses, lenders, and investors: 1) the Fed and other government policies in the 1980s and 1990s fostered a relatively strong economic environment, with few business cycles. Essentially, everyone became overconfident. (I believe smaller business cycles are essential for credit discipline to occur.) 2) U.S. foreign trade deficits led to huge foreign investment in U.S. financial assets (in particular U.S. Treasury and other “AAA” debt securities like Fannie, Freddie, Ginnie, and private MBS). And 3) Fed monetary policy during the 2003 – 2005 timeframe; low rates caused investors to chase higher-yielding, but riskier assets. Mr. Bernanke says he believes it was foreign trade and investment imbalances that caused the increased risk-taking and he downplays the Fed’s role in causing the crisis. I believe it was ‘all of the above’, plus many other factors. For example, Raghuram Rajan (who is now India’s central bank head), whose book on the crisis I have reviewed on this blog, has posited that the credit bubble was also a consequence of income inequality. In his telling, stagnating incomes led middle and lower-income families to borrow excessively. In hindsight, I agree.  And we haven’t even mentioned or discussed the distortive economic effects of the government’s well-intended housing policies: everything from the tax deductibility of mortgage interest, to Fannie, Freddie, and Ginnie’s massive distorting presence, to the Clinton-era $500,000 tax- free capital gain on the sale of a primary residence (In hindsight, I believe this tax change alone, created tens of thousands of hidden housing speculators.), to government guaranteed no/low-down payment mortgages (that bled over into the private mortgage market over many decades), to CRA and fair lending policies, to various state foreclosure rules that allowed borrowers to walk away from their mortgage debt without any liability (if the mortgage exceeded the home’s value), to a prohibition on prepayment penalties by federal mortgage agencies (increasing interest rate risk of fixed-rate mortgages). And we haven’t even talked about the government’s well-intended, but hugely distortive role in banking and finance: bank regulation that creates largely a homogenous rather than safer heterogeneous banking system, ‘too big to fail banks’ (whose role creates an unfair playing field; resulting in greater risk of failure for smaller banks), federal deposit insurance, anointment of an incompetent oligopoly of National Statistical Rating Agencies into all debt investment decisions (by embedding these ratings into bank and insurance capital requirements), bank and Basel risk-based capital rules that central bankers knew were inadequate to protect banks from failure in a major financial crisis (Greenspan made this point in his paper, ‘The Crisis’). It is disturbing, that despite all of the evidence that free and fair housing, mortgage finance, and banking markets were massively distorted (rationale economic decisions were distorted) by well-intended government and central bank policies and practices, that the mainstream view today is that the private markets failed and that more government intervention is therefore needed. That just defies any logic or common sense.” Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpt from Chairman Ben Bernanke’s Opening Remarks, Closed Session, Financial Crisis Inquiry Commission, November 17, 2009:

“One general area you’re going to want to look at is the macroeconomic context, the macroeconomic background that led to the risk-taking and soon of the crisis. So let me just identify some hypotheses which you’ll want to look into.

So why did risk-taking increase?

One hypothesis is the so-called great moderation. In a way, this suggests that monetary and fiscal policy were too successful during the eighties and nineties in creating a very stable environment, low inflation. And that it was that sense of excessive security that led to risk-taking. That’s one hypothesis.

A second hypothesis, which I have advocated in a number of speeches, which has greatly expanded and worked by Martin Wolf, the journalist, and others, is what’s called the global savings glut. And the idea here basically is that after the Asian crisis in the nineties, many developing emerging-market economies became capital exporters rather than capital importers. That was because either they had large savings and investment differentials, as in China, for example; or they had lots of revenue from commodities, like the oil producers; or they were acquiring large amounts of foreign exchange reserves, which was a less of the nineties, that that was supposedly a way to protect themselves against exchange-rate problems. All those things created large capital inflows into Western industrial countries, notably the United States. It’s a common observation in the context of emerging-market financial crises that they’re often preceded by large capital inflows from abroad and that the problem is that the local banking system can’t handle the massive inflow of capital. So by analogy, sort of a similar story may have happened in the United States. A particular feature of that is that what may have mattered under this story is not just the net inflows, but the gross inflows. People like Ricardo Caballero of MIT, have argued that the emerging markets were looking for high-quality, safe assets, like Treasuries, for example. So there were huge amounts of inflows that were only partly offset by U.S. investment abroad. And that, indeed, once there became a sort of shortage of Treasuries, that there was strong incentives to U.S. financial institutions to create, quote, ‘safe assets’. And that’s where the securitized AAA credit assets came from. By the way, the savings glut idea doesn’t necessarily mean that there was a lot of extra saving, per se, but, rather, that savings and investment were out of balance. So part of the reason for the savings glut….by this story….was that investment in the emerging markets’ dropped after the crisis, and that was part of the imbalance.

A third explanation, which I am sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for reasons having to do with both the slow recovery from the recession and because of concerns about deflation at that time. Some have argued…and I’m sure you’ll look at that….that those low rates contributed to risk-taking…I think there are a lot of different components of this issue…if I could just sort of illustrate why there are a number of different questions to be looked at…The first question is, was, in fact, this policy the cause or a major cause? And as I said, there are some alternative hypotheses, like the savings glut and some other things. A second question is, if it was a cause, you know, was it a knowable problem? Was the Fed doing the best it could given the information it had, or was it neglecting information it should have used? And that’s the second question. And related to that is the general issue, which has become very hot in monetary policy circles, which is, should monetary policy be used to try to knock down bubbles or not? Just for the record, my view is that it can be a backup, but the first line of defense ought to be supervision/regulation.”

Posted on November 11, 2013, in Postings. Bookmark the permalink. Leave a comment.

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