The Courage to Act by Ben Bernanke
I really enjoyed this book from Ben Bernanke. It's a story told by Ben Bernanke who was the Chairman of the Federal Reserve during the greatest financial crisis since the Great Depression. His decision to print a lot of money prevented our economy from living another great depression and Ben discuses his thought process behind a lot of his decisions and what led to the crisis. He also discuses other big topics surrounding the crisis like the big bonuses paid to AIG despite their imprudent actions leading up to the crisis.
People tend to think low inflation is a good thing, because it means that they can afford to buy more. But very low inflation – if sustained – also comes with slow growth in wages and incomes, negating any benefit of lower prices. In fact, inflation that is low can be just as bad for the economy as inflation that is too high, as Japan’s experience illustrated.
Bear wasn’t too big to fail. It was too interconnected to fail. Bear had nearly 400 subsidiaries, 5,000 trading counter-parties, and 750,000 open derivative contracts… A bankruptcy proceeding would lock up the cash for many other creditors, potentially for years.
In making the decisions we made in March 2008, we could not know all that would transpire. But even in hindsight, I remain comfortable with our intervention. The enormously disruptive effect of Lehman’s failure in September, I believe, confirmed our judgment in March that the collapse of a major investment bank – far from being the nonevent that some thought it might be – would severely damage both the financial system and the broader economy. Our intervention with Bear gave the financial system and the economy a nearly six-month respite, at a relatively modest cost. Unfortunately, the respite wasn’t enough to repair the damage already done to the economy or to prevent panic from breaking out again in the fall.
“Capitalism without bankruptcy is like Christianity without hell.”
- Frank Borman, former astronaut who became came CEO of Eastern Airlines
[Ben Bernanke's justifying the major theory of the housing crisis by using a simple analogy], “You have a neighbor, who smokes in bed… Suppose he sets fire to his house. You might say to yourself… I’m not gonna call the fire department. Let his house burn down. It’s fine with me. But then of, of course, what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood?” The editorial writers of the Financial Times and the Wall Street Journal in September 2008 would, presumably, have argued for letting the fire burn. Saving the sleepy smoker would only encourage others to smoke in bed. But a much better course is to put out the fire, then punish the smoker, and, if necessary, make and enforce new rules to promote fire safety.
The Fed and the Treasury did not choose to let Lehman fail. Lehman was not saved because the methods we used in other rescues weren’t available. We had no buyer for Lehman, as we’d had for Bear Stearns – no stable firm that could guarantee Lehman’s liabilities and assure markets of its ultimate viability. The Treasury had no congressionally approved funds to inject, as they’d had in the case of Fannie and Freddie. Unlike AIG, which had sufficient collateral to back a large loan from the Fed, Lehman had neither a plausible plan to stabilize itself nor sufficient collateral to back a loan of the size needed to prevent its collapse. And Lehman’s condition was probably worse than reported at the time, according to the bankruptcy examiner’s report in 2010. As we would learn, the company used dubious accounting transactions to inflate its reported ratio of capital to assets.
During the last 4 months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.
I agree that more should have been done to help homeowners, although devising effective policies to do that was more difficult than many appreciate.
In September 2007, once it seemed clear that Wall Street’s financial turmoil could threaten Main Street, we started cutting the target for the federal funds rate. We continued until we reduced the target to near zero and could go no further. From there, we would venture into unchartered waters by finding ways to push down longer-term interest rates, beginning with the announcement of large-scale purchases of mortgage-backed securities. The journey was nerve-racking, but most of my colleagues and I were determined not to repeat the blunder the Federal Reserve had committed in the 1930's when it refused to deploy its monetary tools to avoid the sharp deflation that substantially worsened the Great Depression.
Since Adam Smith, economists have generally believed in the capacity of free markets to allocate resources efficiently. But most of my colleagues and I recognized that, in a financial panic, fear and risk aversion prevent financial markets from serving their critical functions.
The bonuses [to AIG employees] had been promised, before the bailout, to retain key employees, most of whom had nothing to do with the controversial actions that brought the company to the brink. Many had specialized expertise that was needed to safely unwind AIG’s complex positions and, thus, to protect the taxpayers’ investment in the company. That said, I certainly understood why an unemployed worker or a homeowner facing foreclosure would be outraged. Paying bonuses to employees of a company that had been bailed out by the taxpayers was an injustice that anybody could understand. No wonder people were angry.
This new European crisis was entirely homegrown. Fundamentally it arose because of a mismatch in European monetary and fiscal arrangements. 16 countries, in 2010, shared a common currency, the euro, but each – within ill-enforced limits – pursued separate tax and spending policies.
There was virtually zero risk that our policies would lead to significant inflation or “currency debasement”. That idea was linked to a perception that the Fed paid for securities by printing wheelbarrows of money. But contrary to what is sometimes said, our policies did not involve printing money – neither literally, when referring to cash, nor even metaphorically, when referring to other forms of money such as checking accounts. The amount of currency in circulation is determined by how much cash people want to hold (the demand goes up around Christmas shopping time, for example) and is not affected by the Fed’s securities purchases. Instead, the Fed pays for securities by creating reserves in the banking system. In a weak economy, like the one we were experiencing, those reserves simply lie fallow and they don’t serve as “money” in the commend sense of the word. As the economy strengthened, banks would begin to loan out their reserves, which would ultimately lead to the expansion of money and credit. Up to a point, that was exactly what we wanted to see. If growth in money and credit became excessive, it would eventually result in inflation, but we could avoid that by unwinding our easy-money policies at the appropriate time.
The debt limit is not about spending and taxing decisions themselves, however; rather, it is about whether the government will pay the bills for spending that has already occurred. Refusing to raise the debt limit is not analogous, as is sometimes claimed, to a family cutting up its credit cards. It is like a family running up large credit card bill and then refusing to pay. One of the governments key commitments is paying interest on the national debt. Failure to make those payments on time would constitute default on U.S. Treasury securities – the world’s most widely held and traded financial asset. At the time, about $10 trillion in U.S. government debt was held by individuals and institutions around the world. Even a short-lived default would likely have catastrophic financial consequences, while permanently damaging the credibility and creditworthiness of the U.S. government. A failure to make other government payments – to retirees, soldiers, hospitals, or contractors, for example – also would constitute an important breach of faint with serious financial and economic effects. Refusing to raise the debt limit takes the economic well-being of the county hostage.
Future financial shocks are inevitable – unless we are prepared to regulate risk taking out of existence and suffer the consequent decline in economic dynamism and growth. The most important post-crisis reforms seek not to eliminate shocks entirely but to increase the financial system’s ability to withstand them. These reforms include increased capital and liquidity requirements, especially at the largest banks; elimination of regulatory gaps that left major institutions like AIG effectively unsupervised; more transparent and safer derivatives trading; improved consumer protection; and new authorities that will allow the government to close failing financial firms with less risk to the financial system.