Bailouts and Ben Bernanke

There has been a lot of commentary in newspapers and on the Internet about the actions taken this year by the Fed and the U.S. Treasury to prevent the bankruptcy of various financial institutions. I would characterize the general tenor of the discussion as puritanical. 

People seem to think that Bear Stearns, Fannie Mae, Freddie Mac, and AIG were “bailed out”, rescued by the Federal government despite their having committed one of the seven deadly sins: greed. These corporations are now seen to have been imprudent because their balance sheets were highly  leveraged. A good portion of the assets on their balance sheets are regarded now as “toxic waste”, mortgage-backed securities which have become highly illiquid. Commentators tell us that these institutions had no business being so highly levered to finance assets of such dubious quality. 

There is another theme which runs through this commentary. It is that the federal regulators who are responsible for oversight of these institutions are “letting them get away with murder” by “bailing them out”. Worse, by bailing out these institutions the federal government is supposedly encouraging such reckless behavior in the future. 

Finally, most of these commentators think that the financial crisis of 2008 was entirely foreseeable by regulators and therefore could have been prevented. They claim we are confronted by a clear case of regulatory misfeasance. Indeed, some argue that it is actual malfeasance resulting from financial benefits congressmen have received from these corporations. 

I believe the views I have just characterized are terribly misguided. They ignore the history of financial crises and the well developed body of practical wisdom which is now guiding Bernanke’s and Paulson’s response to the current crisis. 

Every financial institution is in the business of lending long term and financing these assets by borrowing short term. Most of the time this mismatch between the durations of assets and liabilities causes no problem. But if for some reason it becomes difficult to borrow short term against the value of these long term assets a so-called debt-deflation spiral can begin. Virtually all financial crises are examples of this phenomenon. If short term financing becomes tight or unavailable, financial institutions must sell long term assets. This depresses the price of long term assets and thus reduces the value of these assets as collateral for short term financing. This in turn makes it even more difficult to borrow short term to finance holding long term assets. This self-accelerating process will inevitably lead to severe drop in the value of long term assets and a long lasting economic depression if allowed to continue unchecked. 

Depressions caused by debt-deflation spirals have happened in the past. The panics of 1857, 1873, and 1893 were the principal examples of the 19^th century. Within the past 100 years the U.S. has seen debt-deflation depressions which began with stock market panics in 1907 and 1929. This last was especially devastating. The banking panics of 1931 and 1933 helped extend an economic depression which lasted until 1940. The Federal Reserve had refused to act as a lender of last resort to prevent these banking panics.

People seem to have forgotten that the Federal Reserve was created in 1913 precisely to be a lender of last resort. Congress believed then that the reason for the frequent panics and depressions in the U.S. prior to that time was the absence in the U.S. of a central bank which would act as such a last resort lender. In times of financial crisis, the job of the lender of last resort is to prevent a debt-deflation spiral which would result in an economic depression. It does this by lending short term to financial institutions which cannot otherwise obtain financing. By doing so it prevents the wholesale liquidation of long term assets which would seriously impair the economy’s capital base and ability to finance future investments. Once the crisis has passed these short term loans made by the lender of last resort are expected to be repaid and the long term assets financed in the normal way. 

It seems to me that Bernanke and Paulson are fulfilling their responsibilities as lenders of last resort. The actions they have taken are only what is necessary to prevent a catastrophic debt-deflation spiral, not just in the U.S. but in the rest of the world too. Once the smoke has cleared and people have the opportunity to reflect upon these events, I predict that both men will be seen as heroes. In fact I think because of his actions during the Crisis of ’08  Bernanke’s reputation as a central banker will eclipse the Great Greenspan’s. 

Let me say something about the term “bailout”. Many people seem to believe that the bailouts we have seen pose a serious moral hazard problem to the economy by encouraging reckless behavior by financial institutions. But I do not believe this fear withstands closer scrutiny. The first thing to keep in mind is that the stock holders in these institutions have lost most or all of the value of their shareholding. The bondholders come out somewhat better, but will still show the scars of this event. The top executives in these corporations have lost not only their jobs but a substantial part of their net worth as the share price dropped close to zero. It defies belief that these stakeholders in the troubled institutions are indifferent to these consequences. To the contrary, I think they are being severely punished for whatever bad decisions they may have made. So I think this aspect of the moral hazard problem is difficult to take seriously. 

There is a second moral hazard consideration which escapes the calculus of individual choice. Hyman Minsky (1919-1996) made his considerable reputation as an economist by developing a theory of financial crises. I think his books can and should be profitably read today. In his book of essays, Can “It” Happen Again? (1982), Minsky predicted that financial crises would become more frequent. Because the Fed was now willing to act as the lender of last resort he believed the cost of averting crises would be paid in persistently increasing inflation rates. This was the macroeconomic, moral hazard associated with the so-called “Fed put” which financial institutions may think prevents them from taking serious losses on long-dated assets.

But Minsky’s prediction was only half right. Yes, financial crises have continued to recur periodically and the Fed did act as lender of last resort. After Minsky’s book we saw crises in 1987, 1990, 1998, 2000-2002, and now 2008. In each instance the Fed acted to provide enough liquidity to prevent a debt-deflation spiral. But the upward spiral of inflation which Minsky predicted did not happen. In fact, just the opposite occurred. From 13.5% in 1980 the rate of inflation dropped to 1.6% in 2002 before rebounding slightly during the past six years. Thus an inflationary spiral is not a necessary  consequence of the Fed’s actions as lender of last resort.

Let me close this short essay with a few remarks about the often heard assertion that better regulation would eliminate the need for these so-called bailouts by the Fed. In a word, this is nonsense. Does anyone really think that a bureaucrat in Washington can foresee the risks associated with a financial asset better that the firms which create them and hold them on their balance sheets? 

Hindsight is always 20-20, but it is foresight that is needed to prevent financial crises. Sadly, foresight is in short supply and for good reason. To understand this we can look to Minsky's theory.

Minsky believed that financial innovations play a central role in creating financial crises. New assets are created and new portfolio strategies implemented to exploit profitable niches for financial intermediation. But these innovations, precisely because they are new elements in an evolving financial structure, will interact with the economy’s balance sheet in ways nobody can anticipate. Regulators are necessarily behind the curve when it comes to innovative financial products. So if Minsky is right, and I think he is, it is hopeless to expect that new layers of regulation can or will prevent the next financial crisis. No one, let alone a government bureaucrat, can foresee the future well enough to do this properly. 

I think we all should be grateful that public servants like Bernanke and Paulson have taken their responsibilities seriously. In doing so they show the courage to endure the misguided criticisms of people who see their actions as either immoral, as benefiting only “the rich”, or as "bankrupting" the U.S. and its taxpayers. These men are saving us from an economic depression whose consequences would be terrible to contemplate.