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The Federal Reserve and the Financial Crisis
on 25 November 2013
Some years ago, during the heart of the most recent international financial crisis, when AIG threatened to bring the world as we know it to a halt, appeared the following line in the Financial Times attributed to Honoré de Balzac: "Show me a fortune and I'll show you a crime". Recently, I looked it up in his 'Le Père Goriot', where it actually reads: "Le secret des grandes fortunes sans cause apparente est un crime oublié, parce qu'il a été proprement fait". This translates roughly into: "The secret of a great fortune for which you are at a loss to account is a crime that has never been found out, because it was properly executed." I prefer the FT quote, as it more succinctly and elegantly captures the intended idea.
Similarly, in 'The Federal Reserve and the Financial Crisis', the Chairman of the Board of Governors of the Federal Reserve System, Ben S. Bernanke has captured in a short book the role of the Fed, the origins of the financial crisis, the Fed's role in it, and finally, the aftermath. Delivered originally as a set of lectures at George Washington University, Bernanke first clearly and concisely educates the reader on the role of the central bank, its tools to achieve desired results, its limitations. Then, in a measured and even tone, recites the how the financial crisis began and how the Fed had to respond to it.
From his elevated perch, Bernanke is well-situated to survey the landscape in order to analyze exactly how this particular debacle unfolded. The Fed keeps a daily, almost hourly, watch on various actors in the financial system though it is not the regulator of record for any of them. In the course of his examination, Bernanke makes this concession: the Fed should have allowed Bear Stearns to fail in March 2008 instead of pushing it into a shotgun marriage with JPMorgan. How would it have done so? As Bernanke explains, the Fed has two main tools to achieve its goals, the first is setting monetary policy (e.g., interest rates) and the second, liquidity, that is, short-term loans to financial institutions to cover a short-fall. In effect, Bernanke is saying that such support should not have been extended to JP Morgan for the Bear Stearns deal. His explanation of why Lehman Brothers was not so assisted in contrast: someone had to take a hit in light of the revelations. Bernanke states:
"Finally, let me say a few words about the consequences of the crisis. We did stop the meltdown. We avoided what would have been, I think, a collapse of the global financial system. But one thing that I was always sure of and the Federal Reserve was always sure of was that a collapse of some of these big financial firms was going to have very serious collateral consequences."
In the `Aftermath of the Crisis' chapter, Bernanke adds:
"One of the conclusions we can now draw, having looked at the history, is that rather than being some ad hoc and unprecedented set of actions, the Fed's response was very much in keeping with the historic role of the central banks, which is to provide lender of last resort facilities in order to calm panic. What was different was different about this crisis was that the institutional structure was different. It was not the banks and depositors; it was broker-dealers and repo markets, money market funds and commercial paper. What Bagheot invisioned when he wrote Lombard Street in 1873."
(Here Bernanke is referring to Bagehot's dictum that in times of financial crisis banks should lend freely but only to solvent firms and only against good collateral and at interest rates that are high enough to dissuade those borrowers that are not genuinely in need.)
Reading books by central bankers is not necessarily a cure for lethargy. But Bernanke's style of writing - using simple words and few statistics - helps the former professor of economics at Princeton make difficult ideas easier to understand. In The Federal Reserve and the Financial Crisis, Bernanke provides an intelligent and readable account of what central banks do, what the Fed's role is in a financial crisis and how it acted in the most recent one. Interestingly, at the end of each chapter there is a colloquy between students and the author in which answers refine or amplify points made during the lecture. This is an excellent work which should be read first before any other for an understanding of the global financial crisis and the Fed's role in it. There are questions Bernanke does not address in this book: why didn't the Fed see this problem coming when whistle-blowers had previously alerted the authorities of the mortgage-finance bubble, what exactly was Bernanke's role in the AIG bailout, and why did he overrule his staff who recommended AIG be allowed to fail. But if the reader wants to gain a solid understanding of this subject, this book is the best place to start.
Saamir K. Nizam
Scottish Parliamentary Review
25 November 2013