Tags: Bernanke | bank | liquidity | tools

Bernanke Gives Valedictory Speech — Part III

By    |   Thursday, 09 Jan 2014 06:52 AM

Outgoing Federal Reserve Chairman Ben Bernanke spoke to the annual meeting of the American Economic Association on Jan. 3 in Philadelphia and spoke at length on the theme of "The Federal Reserve: Looking Back, Looking Forward," in which he discussed the Fed's accomplishments and tasks remaining to be completed.

The second subject Bernanke covered in his speech, after his efforts to improve Fed transparency, was the measures the Fed has adopted to promote financial stability and to reform financial regulation in accordance with the Dodd-Frank Act. Management of financial stability has effectively been added to controlling inflation and maximum employment as the third mandate to the Fed.

While others, including Yale economist William Nordhaus, who served as moderator for the speech, have praised Bernanke's inventiveness in devising new tools to employ to manage the 2008 episode of the ongoing financial crisis, Bernanke himself said that these tools were analogous to crisis responses that have been developed over two centuries of trying to manage financial panics. Among these tools are the provision of liquidity, liability guarantees, recapitalization and reassuring the public.

All of these tools imply issues that Bernanke did not address, and a common denominator of these issues is moral hazard. If liquidity is provided in support of toxic financial products, this validates those products and reinforces incentives for financial institutions to keep issuing those products and to devise new ones.

In the debate over legislation that is supposed to reform housing finance, the industry insists that the government guarantee that liquidity will be available to all segments of the market at all times. The problem with this is that withdrawal of liquidity is one of the market signals that indicate trouble. By disabling these signals, regulators like the Fed reward the issuers of these products and compound the crisis exponentially.

Similar effects can be caused by guaranteeing the liabilities of creditors who might otherwise have an incentive to contribute to market discipline. Once the government assures investors that it stands behind the largest financial institutions, investors no longer care, and this attitude has contributed to a succession of crisis in the savings and loan industry, Fannie Mae and Freddie Mac and money center commercial and investment banks. Assurances to the public and provisions of information calculated to reassure the public have the same effect, lulling market participants into a sense of complacency if they believe what the authorities are saying.

Bernanke cited the admonition of the legendary Walter Bagehot as to how central bankers should respond to a financial crisis: "Lend early and freely to solvent institutions." The implication is that the "too big to fail" institutions that received massive support from the Fed and Treasury were solvent.

Readers will recall the elaborate scene that was staged in which the bankers were summoned to Washington and forced to accept this assistance as a service to the nation. What if this was all a charade, and what should the authorities do next after they have led so freely?

(Archived video can be found here; text of the speech can be found here.)

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Robert-Feinberg
Outgoing Federal Reserve Chairman Ben Bernanke spoke to the annual meeting of the American Economic Association on Jan. 3 in Philadelphia and spoke at length on the theme of "The Federal Reserve: Looking Back, Looking Forward."
Bernanke,bank,liquidity,tools
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2014-52-09
Thursday, 09 Jan 2014 06:52 AM
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