As a financial consultant and blogger who has been closely following the economic crisis since 2007, I nodded my head in agreement when I heard U.S. Chairman of the Federal Reserve was named Time Magazine’s 2009 Person of the Year
Ben Bernarke should be the Time Person of the Year. Not because he saved the United States from a second Great Depression, but because he created a new economic order and enshrined moral hazard for the most powerful financial institutions in the nation.
In the past, only commercial banks enjoyed the backing of the federal government (vis a vis the FDIC) because they were closely regulated and had to put aside capital reserves to cover potential losses.
Under his guidance as chairman, the Federal Reserve actively intervened to decide which industries and companies would live or die. Before the crisis, investment banks and industrial credit companies like GMAC were not backed by the government precisely because they didn’t submit to supervision.
As the credit bubble collapsed and money became harder to come by, the Fed decided to provide liquidity to every financial institution it deemed “too big to fail.” Bernarke directed the Fed to purchase toxic assets from banks. The Fed is now the largest holder of mortgage-backed securities in the nation. In other words, he shifted the burden of selling illiquid assets of unknown value to the taxpayer.
He helped create and enforce the notion that some financial institutions are “too big to fail”. Instead of breaking up the banks, as Paul Volcker suggested, he encouraged them to merge. JP Morgan Chase took over Bear Stearns. Bank of America swallowed Countrywide and Merrill Lynch. Wells Fargo absorbed Wachovia. Their bigness and hence their ability to cause systemic failure has increased exponentially.
The flip side of the coin is that many financial institutions are considered “too small to save.” These are community banks and credit unions that supply much of the lending to small businesses and individuals. They are also the most affected by high unemployment and mortgage foreclosures. As of November 2009, over 120 banks have failed a five-fold increase over 2008. Unlike the “too big to fail” banks, the smaller banks could not trade off the Fed’s explicit guarantee of losses in order to raise funds to replenish their capital.
By keeping interest rates near zero and providing unlimited liquidity rather than insisting on solvency, Ben Bernarke made it easier for companies such as Goldman Sachs to speculate overseas with cheap money. In the meanwhile, credit has tightened for small business and individuals.
But Ben Bernarke’s crowning achievement was that he enforced moral hazard. Moral hazard is when you encourage risky lending because those that take the risk know they will be insulated from their losses. After the Fed’s extensive interventions, there is no doubt that the United States will not allow these “too big to fail” institutions to fail. For them, there is no downside. They take the profits, the taxpayer takes the losses.
It may be conventional wisdom on Wall Street that Zero Ben saved the economy, but on Main Street, which is considered “too small to save”, things are not so upbeat. The economic crisis was not a natural part of a business cycle. It was man-made, the result of a credit bubble collapse stoked by esoteric financial engineering and leverage to the tune of 100 to 1.
The big banks were amply rewarded; first on the upside, and now come January 2010 bonus time, on the downside.
Yesterday in front of Congress Ben Bernarke said there was no evidence of inflation because “the United States economy was operating so far beneath its potential that inflation was unlikely to become a problem.” This is a statement that can only warm the hearts of stockholders. For everyone else, it implies overcapacity and more unemployment.
In any case, his assertion is belied by the Producer Price Index, which registered a surprising spike in prices (excluding food and energy) on Tuesday.
He also said that he saw no sign of a bubble in the stock market. But stock prices have gone up over 60% since February. The stock index in China is up more than 75% this year and the stock in Brazil are up even more. Oil prices have rebounded to over $70 a barrel from the low $40 range in February.
In his 1999 Princeton economics professor days, Ben Bernarke argued that the Fed should get out of the way of bubbles because 1) it wasn't possible to determine when they occurred and 2) if the Fed intervened it would cause more problems. Obviously keeping out of the housing bubble was a serious error. If he is confirmed on Thursday, perhaps the bubble he doesn’t see is the one that will blow up in our faces.