Delaying the crash
By Scott Sumner
I am gradually working my way through Bernanke’s recent memoir, and so far I am greatly enjoying the book. It does an outstanding job of explaining how things looked from the inside, and is full of fascinating tidbits. For instance, like me, Bernanke is a big fan of Frederic Mishkin. He was sad to see Mishkin leave the Board after the August 2008 meeting. He doesn’t say so, but Mishkin’s final meeting contained a highly prophetic warning to the rest of the Board.
I’ve often remarked on the fact that the rest of the government doesn’t realize just how important, and how difficult, it is to get monetary policy right (especially at the zero bound). People with no expertise on monetary policy are put onto the Board. We clearly need two boards at the Fed, one for monetary policy experts and another for banking regulation experts (or better yet, give the banking duties to another agency). Another example of the cluelessness of the government is that Mishkin had to leave because of a potential “conflict of interest” in his upcoming work revising his best-selling textbook on money and banking. This seems completely insane to me–we were just shooting ourselves in the foot. (Mishkin wasn’t replaced by anyone for several years, by which time it was too late.)
I do occasionally have differences with Bernanke, and one example is the Bear Stearns bailout, which occurred in March 2008. To set the stage, let me remind you how the recession played out, conveniently in nice three-month segments:
December 2007: Recession begins, and is mild for the first 6 months
March 2008: Bear Stearns is rescued (too big to fail)
June 2008: Severe phase of the recession begins, and lasts for 6 months
September 2008: Lehman fails, is not bailed out
December 2008: Severe phase of recession ends, Rates hit zero
March 2009: QE1 announced
June 2009: Recession ends
1. The bailout of Bear Stearns was justified.
2. The consequences flowing from the failure of Lehman show why the Fed was concerned about Bear Stearns.
3. Bernanke wished the Fed could have arranged the sort of takeover of Lehman that they arranged for Bear Stearns, but were unable to find a partner.
4. The Fed thus had no ability to rescue Lehman.
5. Yes, the rescue of Bear Stearns did not in the end prevent a financial crisis, but at least it delayed it for 6 months (which Bernanke regarded as a good thing–he calls it “a nearly six-month respite.”)
I’m not an expert on banking, so I won’t try to second-guess the bulk of his argument. But I would like to suggest that even in retrospect the 6-month delay in the crisis was not a good thing, but instead very likely a bad thing. First let’s review the history of “too big to fail” (TBTF):
In May 1984 the government bailed out all depositors at Continental Illinois, which at the time was the largest bank failure in US history. At smaller banks, depositors were only protected up to $100,000.
In 1994, Mexico’s creditors were saved by a large US loan to Mexico during the peso crisis.
In 1998, a rescue of LTCM by big banks was organized by the Fed.
In March 2008, Bear Stearns’ creditors were rescued.
Put aside the Mexico case, which might have foreign policy implications. I’d like to suggest that the other three bailouts were a mistake even if in retrospect it would have been wise to bailout Lehman.
Bailouts clearly create moral hazard, and Bernanke acknowledges that this aspect of a rescue is undesirable. Bernanke argues, however, that in some cases the threat to the broader economy justifies the action. (“There are no atheists in foxholes and no ideologues in financial crises.”) Let’s say that’s correct. Then when would bailouts be most justified and when would they be least justified? When would monetary policy be able to prevent a failure of a large firm, and tighter credit conditions, from driving the economy into a deep recession?
In May 1984 the economy was in the midst of a powerful boom. NGDP rose at an 11% annual rate in 1983 and the first half of 1984, and RGDP grew by 7.7%. Interest rates were still very high—there was no zero bound problem. Even if a failure of Continental Illinois had represented a sizable negative AD shock, it hard to imagine the Fed could not have offset the impact with a suitably large monetary stimulus (perhaps combined with the Bagehot policy of lending freely to other banks with sound balance sheets.) To quote General Turgidson:
. . . but an occasional crisis would do wonders putting the fear of God into large bank creditors.
In 1998, the US was again in the midst of a powerful economic boom, with interest rates far above zero. The tech boom would last until 2000. If LTCM had failed, and the economy was somewhat weaker in 1998-2000, but then stronger in 2001-03, would that have been so bad? Then perhaps during the subsequent housing boom the big banks like Lehman would have been a bit less reckless, realizing the need for lots of capital in a crisis.
The argument for Bear Stearns is somewhat weaker, but still applies. Obviously the economy was far weaker than in 1984 or 1998, and interest rates were lower. But notice that in March 2008 the economy was still much stronger than in September 2008, and interest rates were modestly higher (3% instead of 2%). I make two claims:
1. If the severe banking crisis occurred in March rather than September, and was equally bad (itself a doubtful assumption, as the economy, and bank balance sheets–were stronger in March), then the Fed would have had more room to cushion the blow, and the subsequent severe phase of the recession would have been milder.
2. It created even more moral hazard, making Lehman creditors (and Dick Fuld) more confident than they would otherwise have been.
3. Even if I’m wrong, and the Fed would have been unable to cushion the impact of the consequences of a Bear Stearns failure anymore than the subsequent Lehman failure, the recession might have been 6 months shorter if the post Lehman policies began 6 months earlier.
Here is Mishkin from an earlier meeting, in December 2007, (implicitly) making my point:
When you look at all of this, I get very nervous. The bottom line is that my modal forecast is certainly down, very much along the lines of what the staff has suggested. But I think there is a significant probability that things will go south. You don’t like to use the R word, but the probability of recession is, I think, nearing 50 percent, and that really worries me very much. I also think that there’s even a possibility that a recession could be reasonably severe, though not a disaster. Luckily all of this has happened with an economy that was pretty strong and with banks having good balance sheets; otherwise it could really be a potential disaster. I don’t see that, but I do see that there is substantial risk that the economy could have a severely negative hit to it that would be very, very problematic. [Emphasis added]
By September 2008 the economy was far from “pretty strong” and the bank balance sheets were almost an order of magnitude worse.
I conclude that Bernanke’s defense of delaying the crisis for 6 months is unproven, and that the weight of evidence suggests that if Lehman had to fail, it would have been better to have had the crisis (and TARP bailout) in March. As an analogy, if you have to do some emergency steering of a car, it’s better to do it while in dry pavement, than wait until you are on a patch of ice. The Fed delayed the crisis until a period when the economy was in free fall and interest rates were approaching the zero bound.
And even then they failed to act, refusing to cut interest rates from 2% at the meeting right after Lehman failed. I’ll have more to say about that later.
I also believe that previous examples of TBTF policies were unwise in retrospect. Even if it is true that those bailouts helped the economy during the year in which they occurred, the resulting moral hazard created bigger crises down the road. It’s like getting a flu shot. It hurts a bit at the time, but helps inoculate you against a much more painful flu episode later on.
On the other hand, this post does not in anyway refute Bernanke’s claim that saving Lehman (an by implication all big banks) would have been wise. The real argument here is that you don’t want to store up hazard in boom periods and then surprise markets by abandoning TBTF in a recession. Of course this is all Monday morning quarterbacking, and government officials (with very limited powers) can’t be expected to get this exactly right—it’s better to build a banking system that is less prone to crisis, like the Canadian system. In this regard I suspect that I would agree with many of Bernanke’s ideas. For instance, both Bernanke and I were very worried about the GSEs, long before the crisis. And like Bernanke, I did not recognize just how fragile the US banking system was before the crisis.
PS. The Fed should have NGDP/person grow at a constant rate, forever. So the moral hazard argument obviously doesn’t apply to monetary policy.