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Bernanke Feared a Second Great Depression – WSJ.com

Posted by WARREN MOSLER on July 27th, 2009


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The great depression was the last US gold standard depression.

A gold standard is fixed exchange rate policy characterized by a continuous constraint on the supply side of the currency.

Interest rates are endogenous, and even the treasury must first borrow before it can deficit spend, and in doing so compete with other borrowers for funds from potential lenders who have the option to convert their currency into gold. Therefore interest rates always represent indifference rates between holding securities and holding the gold.

With non convertible currency the central bank is left to set interest rates as holders of the currency no longer have the option to convert the currency into gold. Without conversion rights, there are no supply side constraints on credit expansion, and government can therefore offer the credible deposit insurance necessary to sustain the functioning of the payments system.
Bernanke failed to recognize this and therefore saw systemic risks that weren’t there, and also failed to act in line with the tools available to the Fed that would not have been available under the previous gold standard. The most obvious is unsecured lending to member banks, as I have been proposing for a number of years.

With today’s non convertible currency and floating exchange rate policy the fiscal ‘automatic stabilizers’ functioned as they always have during previous recessions, and as the deficit got above 5% of GDP at year end it was enough to reverse the downward spiral and turn things around.

This could not have happened under a gold standard. Before the deficit got anywhere near that large it would have driven up interest rates at an accelerating pace and the gold while the national gold reserves were being rapidly depleted.

We’ve seen this happen most recently with Argentina in 2001 and Russia in 1998 where similar fixed exchange rate regimes had similar outcomes.

We’ve also seen failures of logic regarding how the FDIC handled banking system stresses. The FDIC can simply ‘take over’ any bank it deems insolvent, and then decide whether to continue operations, sell off the assets, replace management, etc. This can be done and has been done in an orderly manner without ‘business interruption.’

The alternative in this cycle- having the treasury ‘add capital’- in my opinion was a major error for a variety of reasons.

When a bank loses capital, there is then less private capital left to lose before the FDIC starts taking losses. When the treasury buys capital in the banks, the amount of private capital remains the same. All that changes is that should subsequent losses exceed the remaining private capital, the treasury rather than the FDIC takes the loss. For all practical purposes both are government agencies, so for all practical purposes this changes nothing regarding risk to government. The FDIC could have just as easily accomplished the same thing by allowing the banks in question to continue to operate but under the same terms and conditions set by the treasury (not that those would have been my terms and conditions).

Instead, substantial political capital was burned and numerous accounting issues and interagency issues confused and distorted including ‘adding to the federal deficit’ when there was nothing that altered aggregate demand.

We have paid a high price for financial leaders being completely out of paradigm and in this way over their heads.

Bernanke Feared a Second Great Depression

By Sudeep Reddy

July 27 (WSJ) — Federal Reserve Chairman Ben Bernanke on Sunday said he engineered the central bank’s controversial actions over the past year because “I was not going to be the Federal Reserve chairman who presided over the second Great Depression.”

Speaking directly to Americans in a forum to be shown on public television this week, Mr. Bernanke pushed back against Kansas City area residents who suggested he and other government officials were too eager to help big financial institutions before small businesses and common Americans.

“Why don’t we just let the behemoths lay down and then make room for the small businesses?” asked Janelle Sjue, who identified herself as a Kansas City mother.

“It wasn’t to help the big firms that we intervened,” Mr. Bernanke said, diving into a discourse on the damage to the overall economy that can result when financial firms that are “too big to fail” collapse.

“When the elephant falls down, all the grass gets crushed as well,” Mr. Bernanke said. He described himself as “disgusted” with the circumstances that led him to rescue a couple of large firms, and called for new laws that would allow financial firms other than banks to fail without going into bankruptcy.

Mr. Bernanke appeared stoic at times as he sought to explain his actions during the financial crisis at the town-hall-style meeting with 190 people at the Federal Reserve Bank of Kansas City hosted by the NewsHour’s Jim Lehrer. But he also joked with the crowd, saying “economic forecasting makes weather forecasting look like physics.” He quipped that he could face malpractice charges if he offered investment advice — although he then recommended that a questioner practice diversification and avoid trying to time the stock market.

The hourlong session was the latest unusual forum where the Fed chairman has explained his actions in recent months, including bailouts and massive lending. Mr. Bernanke appeared before the National Press Club in February, agreed to an interview with CBS’s “60 Minutes” in March and took questions on camera from Morehouse College students in April.

Sunday’s setting offered the former Princeton economics professor a chance to speak outside of congressional testimony and speeches to economists, as his tenure leading the central bank faces increasing scrutiny. With just six months left in his term as chairman, Mr. Bernanke will learn in the coming months whether President Barack Obama will reappoint him to another four-year term or replace him.

Mr. Bernanke repeatedly used the frustrations voiced by people in the room to show his limited options during the crisis and reiterate the need for a regulatory overhaul.

David Huston, who called himself a third-generation small-business owner, said he was “very frustrated” to see “billions and billions of dollars” sent to large financial firms and called the government approach “too big to fail, too small to save.”

“Small businesses represent the lifeblood of small cities, large cities and our American economy,” he said, and they are “getting shortchanged by the Federal Reserve, the Treasury Department and Congress.”

Mr. Bernanke responded that “nothing made me more frustrated, more angry, than having to intervene” when firms were “taking wild bets that had forced these companies close to bankruptcy.”

More than 20 people asked questions of the Fed chairman, on topics ranging from bailouts to mortgage-regulation practices to the Fed’s independence, a topic that drew the most forceful tone from the Fed chairman. Mr. Bernanke suggested that a movement by lawmakers to open the Fed’s monetary-policy operations to audits by the Government Accountability Office is misunderstood by the public.

Congress already can look at the Fed’s books and loans that could be at risk for taxpayers, he said. Under the proposed law, the GAO would also be able to subpoena information from Fed officials and make judgments about interest-rate decisions based on requests from Congress.

“I don’t think that’s consistent with independence,” he said. “I don’t think people want Congress making monetary policy.”

After appearing before lawmakers three times last week, Mr. Bernanke broke little new ground in explaining the state of the economy. He said the Fed’s expected economic growth rate of 1% in the second half of the year would fall short of what is needed to bring down unemployment, which he sees peaking sometime next year.

“The Federal Reserve has been putting the pedal to the metal,” he says. “We hope that’s going to get us going next year sometime.”


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33 Responses to “Bernanke Feared a Second Great Depression – WSJ.com”

  1. Dave Begotka Says:

    Interest rates are endogenous, and even the treasury must first borrow before it can deficit spend,

    But, the government can just print money? Right? Who do they barrow from?

    Reply

    Mike S Reply:

    The government does not need to borrow money. For example, from whom did they borrow the first U.S. dollar? There was not a dollar yet to borrow, so they had to first either spend it or give it away.

    Spend first, borrow to set interest rates.

    Reply

    Who spent the first union dollar Reply:

    You are very confused Mike S. My great great great grandfather didn’t want to set his slaves free or take union currency. He liked his confederate cash. The first union dollar came into my ancestors store to buy some food for union soldiers.

    The union soldier shot him for not taking that union dollar. As he lay dying bleeding to death, he didn’t know who the union or the confederates borrowed dollars from or how they spent dollars into existance, all he knew was he was about to die because he would not accept the first union dollar that was about to be spent. If you come into my store today, and I won’t take what currency you want to spend with me, I bet some smartazz will call the IRS and get me in trouble. I am already encountering places internationally that will not take my US dollars, who do I call to get a military soldier to go shoot them for shunning my currency I am trying to spend? We shot our own americans for not taking union dollars, why not shoot foreigners for the same transgression?

    Reply

    Dissenting Comments Encouraged Reply:

    First union dollar – you are a Fool! What do you think Iraq was all about, we had to send the military in to shoot people that would not take our dollars. All peaceful civilization rests on the cruelty of a thug with a gun to blow your brains out.

  2. jcmccutcheon Says:

    Interest rates are endogenous, and even the treasury must first borrow before it can deficit spend,

    But, the government can just print money? Right? Who do they barrow from?>

    He is stating this in the context of a gold standard/fixed currency monetary system which is not applicable today.

    Reply

  3. jcmccutcheon Says:

    If the government “prints” to much money in a gold standard system, it may default ( Warren has said it happened in 1933 I think)

    Reply

  4. Curious Says:

    “We’ve seen this happen most recently with Argentina in 2001 and Russia in 1998 where similar fixed exchange rate regimes had similar outcomes.”

    Argentina’s and Russia’s currencies were pegged to $. People borrowed in $, but their income was in local currency. When exchange rates moved against them, they didn’t have enough to repay, causing the crisis, no?

    How is that similar to gold standard?

    Reply

    warren mosler Reply:

    when the govt tried to borrow they were competing with the right to convert into the reserve currency (dollars in this case)

    The higher the rates the govt tries to pay to sell its securities, the worse they are because the govt has to pay all that interest in convertible currency as well. rates spike and then it all collapses as there are no buyers at any rate.

    Reply

  5. knapp Says:

    What about countries that have a floating rate non-convertible fx regime but where the private sector – either households, banks or industry- have built up huge non-domestic liabilities? (i’m thinking here of Hungary, Switz., and Russia) This is not technically a fixed-rate problem but doesn’t it force additional constraints on the sovereign currency as the govt feels compelled to support the private sector for systemic or national interests. I guess the other option is debt repudiation.

    Reply

  6. zanon Says:

    CURIOS: It is similar because the Govt took on a liability in a specie that it does not have any ability to produce.

    KNAPP: Not sure what a Sovereign can do if it can only make rubles and it’s company needs dollars. Debt repudiation, forcible debt conversion, etc. All the usual stuff you get in a bankruptcy situation I suppose.

    Reply

  7. knapp Says:

    Zanon

    Yes but in that case it’s almost a defacto fixed exchange system with all the risk of discontinuity and debt defaults.

    Maybe some of these smaller countries should put limits on private sector non-domestic currency liabilities as a way to safeguard their financial system.

    Reply

    warren mosler Reply:

    if the private sector agents get strung out on external debt let them default, go bankrupt, and let the creditors get their share of the proceeds and move on.

    Reply

    zanon Reply:

    Yup. It’s called bankruptcy.

    KNAPP: Your suggestion of putting a limit on private sector’s non-domestic currency liability is interesting. Certainly, many SE Asian countries were burned by hot money flows in and out in the Rouble crash of 1998.

    Their response, of course, was for the Govt to start hoarding dollars! Govt can be close to industry in that part of the world (seems to work out OK too).

    Reply

  8. Dissenting Comments Encouraged Says:

    “Without conversion rights, there are no supply side constraints on credit expansion,”

    There is FEAR that people won’t take your currency anymore. And like the union/confederate issue above – if they won’t take your currency, then you have to send in troops to enforce your will. So let me take the meme further, our credit expansion is limited by our military might. In many previous empires, the domestic military grew as much as possible, and they had to supplement with mercenary soldiers. But once that supply ran out, these empires began to fade. Notice USA is hiring many foriegn workers/security folks to do USA military operations. So I would think credit expansion is ultimately limited by your ability to feed your domestic and mercenary army. The last days of rome there was amazing accounting and tax records to make sure each food producing landowner took as little resources as possible for himself and all the rest went to the roman military and the harrison bergeron populace for bread and circuses.

    “All that changes is that should subsequent losses exceed the remaining private capital, the treasury rather than the FDIC takes the loss. For all practical purposes both are government agencies, so for all practical purposes this changes nothing regarding risk to government.”

    But Warren, if you could have any job, CFTC director, FDIC director, Treasury director, president, secretary of state, or the jester clown of washington because every kingdom needs a laugh – which would you choose? There is already intense political bickering for POWER, STATUS, and RECOGNITION. You can’t just say well FDIC this and Treasury that and put it all under the govermnet umbrella. Sure in your academic fantasy land models it shouldn’t matter, but in the real world governments are populated with real people that are needy, emotional, fallable, EVIL and you never address this – you wipe it all away saying they are just ignorant and it doesn’t progress the reality of our world with your broad dismissal of very real issues.

    Reply

    warren mosler Reply:

    i’ve never heard of troops going in to make someone accept your currency.

    to get sellers of real goods and services in exchange for your non convertible currency you need taxing authority and enforcement.

    Reply

    Dissenting Comments Encouraged Reply:

    “i’ve never heard of troops going in to make someone accept your currency.”

    “Accepting currency” can be swapped out with accepting your government and it’s taxing authority. Certainly you have heard of that millions of times. Reference the american war for indpendence from britain, and the civil war – 2 very clear examples right here in the USA.

    “to get sellers of real goods and services in exchange for your non convertible currency you need taxing authority and enforcement.”

    Bingo! All these people that are starting to feel like the founding fathers, or like the confederate states in the civil war. Or the roman landowners of 2000 years ago. They are tired of their government and it’s taxes – reference the link I already posted about Alaska and every single state congressman and palin and all the other political people voting unanimously to basically get out of the Union.

    Also oil states stopping to use the US dollar as the middleman trading mechanism.

    You move to hurricane alley in the USVI to escape all that taxation yourself and get 4% rates and then claim ignorance about all the other times in history people wanted freedom from thier governments oppression – quit being the hypocrite!

    Reply

    Warren Mosler Reply:

    never seen us send in troops to then tax anyone either

  9. JKH Says:

    Interesting point on capital.

    Treasury capital is like first loss protection for FDIC – economically meaningless for the consolidated government entity.

    Reply

    winterspeak Reply:

    That is correct. The entire notion of “taxpayers making a profit” is nonsensical. A lot of gold standard thinking preventing good Governance. Plenty of other barriers to good Governance too, of course.

    Reply

    warren mosler Reply:

    and the tarp net net has removed capital from the banks to the tune of the govt’s ‘profits’ and to some extent by the interest it’s received on the fed’s portfolio.

    did i say the obama admin is in this way over its head?

    Reply

    Dissenting Comments Encouraged Reply:

    You say it is “ignorance” again Warren. But I watched the paulson hearings, and some congresswoman asked him why did goldman sachs and warren buffet get such great terms for their loans, much better than any of the other participants. Paulson started to choke and he was very visibly distressed at this question more than any other during the whole hearing.

    If they were so ignorant, how did they know to snow the congressmen with thousands of pages of legislation that they only had a few hours to read before it was time to vote on it?

    I think the proof is in the pudding, paulson and friends are worth billions and have huge political power from the government positions they have held, you do not have billions or that kind of political power Warren, so who are you to call bazooka hank and friends ignorant? I bet if you even THOUGHT of the actions that paulson and friends actually DID, you would be in jail yesterday while they walk free laughing at suckers like you.

    Dissenting Comments Encouraged Reply:

    PS a good banker makes sure that if he is ruined, everyone else is ruined too. It was political genius getting everyone hyped and scared to death not to pass that legislation to “save america” before chicken little blew the nuke on us. So much pork and favors got passed through that rushed legislation, what a great job our congressmen and bazooka hank did to save the american people! Obama promised at LEAST 5 days open public review of ANY new stuff, HE LIED!

    winterspeak Reply:

    Hah! True.

    What’s even funnier is that monetarists, like Scott Sumner (who don’t understand money, and recommend *taxing reserves*) are getting traction while PK remains on the fringe.

    Surely a failure of something.

    JKH Reply:

    Partial enlightenment at the New York Fed:

    “Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.”

    http://newyorkfed.org/newsevents/speeches/2009/dud090729.html

    Scott Fullwiler Reply:

    Saw that too, JKH. I was focused on the following part, and putting the quote you had and this one together, I’m trying to figure out if he was just repeating the excess reserve tax argument and then knocking it down, or if he believed the er tax would work. As I was reading it the first time, I was troubled, but then didn’t know what to make of it once I got to the part JKH quoted. Interested in hearing others’ interpretations of Dudley’s intentions here.

    Dudley writes just before the part that JKH quoted:

    “The sharp rise in excess reserves has caused the monetary base, which is simply the sum of currency plus total reserves, to expand significantly. The increases in excess reserves and in the monetary base generated by the Fed’s balance-sheet growth have led some observers to worry that this expansion will ultimately prove inflationary. Proponents of this view say that the monetary base, the broad monetary aggregates, total credit outstanding and inflation have historically tended to move together, at least over longer time periods. Thus, if the monetary base is growing rapidly, as it has been over the past year, the view is that this growth will ultimately lead to inflation.”

    “Is this concern well founded? The answer is that in a world where banks could not be paid interest on excess reserves, these persistent high reserve balances would indeed have the potential to prove inflationary.2 In that world, the excess reserves are likely to lead ultimately to an overly accommodative monetary policy. The story goes like this: If banks are earning no interest on their excess reserve holdings, they will be willing to lend those reserves out to any creditworthy borrowers as long as the interest rate is positive after adjusting for risk. The borrowers would then spend these monies, thereby boosting economic activity. The funds would not disappear, but instead would flow back into the banking system as they were deposited by those who had received the income generated by the increase in spending, thus replenishing the reserves that had been lent out in the first round of lending. This would result in a new stock of excess reserves that would then lead to a second round of credit creation and a further increase in economic activity. This cycling of excess reserves into credit creation, and the corresponding increase in economic activity, would continue until the excess reserves were fully absorbed by an increase in currency outstanding and/or an increase in required reserves associated with the rise in the amount of banking deposits. Inflation would rise as the excessive credit creation generated by the excess reserves led to an overheated economy and a rise in inflation expectations.”

    “But that is not the world in which we now live. Because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess reserves from leading to excessive credit creation. Because the Federal Reserve is the safest of counterparties, the IOER rate effectively becomes the risk-free rate.3 By raising that rate, the Federal Reserve raises the cost of credit more generally because banks will not lend at rates below the IOER rate when they can instead hold their excess reserves on deposit with the Fed. Because banks no longer seek to lend out their excess reserves, there is no increase in the amount of credit outstanding, no redeposit of the excess reserves, no increase in economic activity and no risk that excessive credit creation will fuel an inflationary spiral.”

    “For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability. If demand for credit exceeds what is appropriate, the Federal Reserve raises the IOER rate to reduce demand. If the demand for credit is insufficient to push the economy to full employment, then the Federal Reserve reduces the IOER rate, recognizing that the IOER rate cannot fall below zero. This does not differ much from how the Federal Reserve has behaved historically—set the fed funds rate at a level consistent with the desired level of economic activity and inflation over time.”

    JKH Reply:

    Scott,

    Coincidentally, I left on comment on Sumner’s blog this morning to the effect it would be interesting to hear directly from the Fed what they think of the reserve tax argument.

    This speech here is fairly standard relative to what the Fed has been saying for some time, I think. I believe their intention has always been to use excess reserves as a funding mechanism for the Fed balance sheet – and not as a signal for the commercial banking system to expand its balance merely due to a “backlog” of available excess reserves. Paying interest on reserves discourages any such interpretation and corresponding action by the banks.

    The speech is structured to include the counterfactual of not paying interest on reserves. In this sense, it anticipates the same kind of bank behaviour than the reserve tax would be intended to motivate, although in this more benign case of no interest on reserves, as opposed to charging interest on reserves.

    The key point in the description of that counterfactual, in my view, is the statement:

    “The story goes like this: If banks are earning no interest on their excess reserve holdings, they will be willing to lend those reserves out to any creditworthy borrowers as long as the interest rate is positive AFTER ADJUSTING FOR RISK.” (My capitals)

    This is the critical point that is missing as an explicit technical component in Sumner’s proposal, and I’ve told him so a number of times. He backs into it by suggesting that “at least” banks would go out and buy treasury bills. But the larger point is that, complementing the idea that banks do not need reserves to lend, they DO need capital, at least as it pertains to any lending where risk weighting is an issue – which means most lending. So the reserve tax proposal, such as it is, and however one views it, is incomplete without being married to the capital adequacy issue, which is at least one major constraint on it. Of course there are others.

    At least the Fed has acknowledged the issue of risk as it affects the more benign counterfactual of not paying interest on reserves.

    So I think the message from the Fed here is that this is their rationale and justification for paying interest on reserves as opposed to not paying interest on reserves. Still it would be interesting to hear from them directly on the extreme idea now floated of charging interest on reserves.

    Finally, the one element in all of this that took me by surprise when I first saw it was the Fed’s concern over the issue of the effect of excess reserves on non-risk weighted capital ratios – i.e. nominal balance sheet capital ratios. Of course, this just reflects the unfortunate labyrinth of capital adequacy measures that banks have to deal with. There is obviously no true capital adequacy issue associated with a bank holding excess reserves at the Fed. But the system has to deal with the optics of a balance sheet that has been expanded by $ 800 billion, and people that look at such ratios as equity to total balance sheet size. That part of it is a mess.

    JKH Reply:

    Here’s another paper from the New York Fed on excess reserves, just out:

    http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    Warren Mosler Reply:

    right, the tarp has net removed capital to the tune of the ‘profits’

    Reply

    Scott Fullwiler Reply:

    Thanks for the link. It’s as if they’ve been reading everything I’ve ever published . . . too bad, as usual, no attribution. A critique of Sumner, to boot. McAndrews has published a lot in this area and knows how banks work, or at least his research has suggested as much.

    Reply

    Scott Fullwiler Reply:

    Just read it all the way through . . . seems like they think the money multiplier would “work” if the remuneration rate were below the target rate … they still don’t seem to get that holding ER, whether they earn interest or not, doesn’t make a bank lower its lending standards.

    Reply

  10. Dissenting Comments Encouraged Says:

    Diary farmers have just come on CNBC and saying they have to slaughter their herds, their is not enough demand for cow milk! Good lord, all the starving kids all over the world, certainly they could find the demand.

    On another note, Mosler can your supercar take algae fuel? What will our saudi friends do if we don’t buy thier oil?

    http://science.slashdot.org/story/09/07/27/1747237/Company-Claims-Potential-Magnification-In-Bio-Fuel-Production

    A company called Joule Biotech claims to have a breakthrough in biofuel production. Their process can create 20,000 gallons of fuel per acre per year at a cost of about $50 per barrel. ‘Algae-based biofuels come closest to Joule’s technology, with potential yields of 2,000 to 6,000 gallons per acre; yet even so, the new process would represent an order of magnitude improvement.

    Reply

    Matt Franko Reply:

    Dissent,
    A friend of mine in the industry says there about 500,000 too many dairy cows in US,(out of total approx 12M). Price of milk is below current production costs, and Govt price supports are activated. They are goint to have to go to slaughter.

    I guess the Chinese think USD reserves and Treasury Bonds are more valuable than calcium and whey proteins.

    Resp,

    Reply

    Dissenting Comments Encouraged Reply:

    So many container ships come from china full of stuff, and go back to china empty. Certainly they could ship our milk back over to thier kids and not get all those toxic chemicals like melamine in it no? What stupidity. Look it points to the same meme over and over – the tower of babel has grown too high. The 500 congresmen in washington are too powerful and too detached from the rest of us. All that central government control and power needs to be dispersed – as arnold kling said. The 800lb gorilla is not as efficient as 800 1b monkeys perhaps.

    Reply

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