Bernanke's Speech on September 18

I have written a speech for Chairman Ben to record on his home video camcorder and then post on YouTube on the morning of September 18, which is the date of the next scheduled meeting of the Federal Open Market Committee. He may use it free of charge. It is my gift to him.

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As you will no doubt read in the financial press, the Federal Open Market Committee has voted to reduce the target interest rate for the Federal Funds market to 4.75%, half a percentage point lower than the prevailing 5.25%. I voted against this decision. I want to explain why.

Throughout my entire academic career, I have operated on the assumption that a free market is incapable of providing monetary and price stability. Like most economists and all Federal Reserve Chairmen, I was convinced that in affairs of money and banking, it would be economically suicidal to rely on the self-interested decisions of bankers who operate as agents of the depositors. As I and my peers said, “Money is too important to be left to the bankers.”

They agreed with us. They long ago figured out that the banking system offers lots of advantages to bankers, but with these advantages come risks. So, they have long called for the creation of restraints on trade, namely, for the creation of state licensing. This keeps out competitors. There is nothing like a legal license to print money. That’s what fractional reserve banking is. If you haven’t heard about how fractional reserve banking allows commercial banks to expand the money supply and collect interest by lending the newly created money, you need to re-read the section on banking in your college textbook in economics.

Second, they called for the creation of a government-licensed monopoly called the Federal Reserve System, whose primary goal has always been to protect overextended banks from runs by their depositors. They all have seen “It’s a Wonderful Life,” and all of them were terrified by the scene where the depositors wanted to withdraw their money at the same time. America’s bankers decided decades ago that they were not about to dole out their honeymoon money to soothe depositors’ fears. Also, they knew that all the other depositors would line up the next morning. Frank Capra neglected to put that scene in.

So, whenever we economists have praised the efficiency of the free market and the inefficiency of government-created restraints on trade, we always had an exception: the banking system. Here, we have all assured the public, the free market cannot be trusted.

I believed this myself until mid-August of this year. I believed that the Federal Open Market Committee could safely raise the target rate of interest for the money that banks lend overnight to each other. This rate had been set by the FOMC under my predecessor, Alan Greenspan, at 1%, in 2003. Then the Committee started raising the rate. When he resigned in late January, 2006, to return to the private sector, the target rate was 4.5%. Under my leadership, the Committee raised it to 5.25% in three moves, where it sat since June 29.

For over a year, I looked at the data supplied to me by my staff. I concluded that an increase of this interest rate by almost six-fold would have no adverse economic consequences. The only economists who said that it would surely create a capital crunch are members of the Austrian School, and they do not believe in the legitimacy of central banking, so no one pays any attention to them, especially at the Federal Reserve System.

On March 28, I reassured the Joint Economic Committee that things were going well, despite a few problems in the subprime mortgage market.

Although the turmoil in the subprime mortgage market has created severe financial problems for many individuals and families, the implications of these developments for the housing market as a whole are less clear. The ongoing tightening of lending standards, although an appropriate market response, will reduce somewhat the effective demand for housing, and foreclosed properties will add to the inventories of unsold homes. At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency. We will continue to monitor this situation closely.

Notice that I did what any academic economist would do. I said the topic deserved further study. Thus, Senators and Congressmen could rest assured that we at the Federal Reserve were monitoring things closely, and there was no problem. Anyway, no big problem. Hardly any problem to speak of. The problem was contained. Anyway, this was likely, other things being equal. More or less.

On June 5, in a speech in South Africa, I again surveyed the fall in America’s residential real estate markets, the rise in delinquencies, and the increase in foreclosures. I offered this assessment:

We will follow developments in the subprime market closely. However, fundamental factors — including solid growth in incomes and relatively low mortgage rates — should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.

I ended my speech with these uplifting words:

Together with other regulators and the Congress, we have much to do and many issues to consider. We undertake that effort with utmost seriousness because our collective success will have significant implications for the financial well-being, access to credit, and opportunities for homeownership of many of our fellow citizens.

Admittedly, I seemed to have said the exact opposite two weeks before at the May 17 meeting of the Federal Reserve Bank of Chicago.

Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit.

I have been quoted out of context regarding the inability of regulation to match the free market’s system of profit and loss. My very next paragraph, which closed my speech, reasserted my commitment to active regulation.

We at the Federal Reserve will do all that we can to prevent fraud and abusive lending and to ensure that lenders employ sound underwriting practices and make effective disclosures to consumers. At the same time, we must be careful not to inadvertently suppress responsible lending or eliminate refinancing opportunities for subprime borrowers. Together with other regulators and the Congress, our success in balancing these objectives will have significant implications for the financial well-being, access to credit, and opportunities for homeownership of many of our fellow citizens.

I was careful to focus on fraud, not basic monetary policy. What I did not see coming then was, first, by 2007 the horse was not only out of the barn, the barn was on fire. Second, the problem of fraud was far deeper than the ethics of mortgage brokers. You may have noticed that I have always talked about fraud in general, not specific fraud. I never, ever talk about specific fraud. The worldwide subprime market started coming unglued in August. So, either there was fraud on a massive scale or else the fraud had to do with prior monetary policy, which led directly to the subprime mortgage crisis.

I have been careful always to speak of the long run whenever talking about good results, and to speak of the short run whenever confronting results that are perceived as bad by the financial press in general, but especially Jim Cramer. I just did not understand in June and July how short the short run was.

At my June 10 speech at the Federal Reserve Bank of Atlanta, I commented on the credit supply. I had no clue that within two months, this issue would move from theory to reality.

Like banks, nonbank lenders have to raise funds in order to lend, and the cost at which they raise those funds will depend on their financial condition — their net worth, their leverage, and their liquidity, for example. Thus, nonbank lenders also face an external finance premium that presumably can be influenced by economic developments or monetary policy. The level of the premium they pay will in turn affect the rates that they can offer borrowers. Thus, the ideas underlying the bank-lending channel might reasonably extend to all private providers of credit. Further investigation of this possibility would be quite worthwhile.

When I said that “Further investigation of this possibility would be quite worthwhile,” I did not have in mind the opportunity to study, first-hand, the worldwide collapse in mid-August of the credit markets for subprime mortgage loans and other collateral-backed obligations. I just meant research by academic economists, who never are asked to put their money where their mouths are, let alone reveal their investment track record. You know — people just like I was throughout my entire academic career.

I did not think then that nine weeks later, on August 17, the Federal Open Market Committee would be forced by events to release this statement to the press:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I did not think that we would be forced that day to reduce the interest rate at the discount window from 6.25% to 5.75%, and then accept otherwise unmarketable mortgages as collateral for the loans. I did not think the four largest banks in the United States would borrow $500 million each on August 22.

Because of the collapse of the secondary markets for subprime debt, and because of the volatility of the American stock market, the Federal Reserve System believes that it has an obligation to be perceived as not being asleep at the wheel. This makes things difficult because of what I and other Federal Reserve officials said regarding the containment of spillover effects from the subprime credit markets. It surely looks as though we were all asleep at the wheel.

Here is the inescapable reality: the only things we have in our toolbox are monetary inflation, obfuscation, and blarney. Obfuscation ceases to work when markets collapse. This leaves monetary inflation and blarney.

The difficulty is as follows. The Federal Reserve spends any newly created money into circulation. Normally, this money goes to the U.S. Treasury. The FED buys U.S. government debt. The other option is to lend short-term money directly to banks based on collateral. We do this through the so-called repo market, which sounds suspiciously like an unpleasant aspect of the used car market. But it is actually the opposite of repo’s in that market. Ever since August 17, we have advanced money to lenders based on collateral that is about to turn into the equivalent of the used car repo market. Prior to August 17, we advanced money based on much better collateral. That was then. This is now.

The problem with our mode of creating new funds to supply liquidity is that this liquidity, meaning newly created money, does not go to the companies that really need it. It goes to companies that qualify for our loans, which means the largest banks in the country. This money serves as legal reserves for banks to make loans. So, the banks then lend money. But they lend it to borrowers who look nothing like the holders of all those subprime mortgages.

There are two possible exceptions: Fannie Mae and Freddie Mac, the mortgage conglomerates. They are loaded with mortgages, and if these two institutions ever look as though they are about to go bankrupt, we will buy anything they offer to sell us.

The problem is, it takes new money to bail out bad collateral. That means a lot of new money unless banks start lending to high-risk markets. But our new, improved regulatory policies have clamped down on this.

This means the end of my program to reduce the rate of inflation in the country. I have talked of little else from the day I took over in February 1, 2006. So did my predecessor. So did his predecessor, and so on, all the way back to 1938.

So, basically, I have given up. We can bail out the mortgage market or we can pursue monetary stability. We cannot do both at the same time. I think fighting price inflation is the most important thing that the Federal Reserve System can do, not protect overextended banks. This is why I voted against the new official federal funds target rate. The only way we can attain this rate is to put a lot of fiat money into the economy. Our repo rate is going to go through the roof. We have to lend directly to banks, not the U.S. Treasury. The free market federal funds rate has been pushing against 5.25% for months. To supply funds to push it to 4.75% will take a lot of fiat money.

So, late in my career, I have come to a new conclusion. The best policy that a central bank can pursue is to target nothing except the rate of increase of central bank credit. This rate of increase should not exceed zero percent per annum. The Federal Reserve System should cease issuing new money or buying new assets. So should all other central banks.

In short, it is time for every central bank to stop doing anything. It is time for a free market to allocate credit, just as it allocates capital in the equity markets.

Will the rate of interest rise? There is more than one rate of interest. Short-term rates will rise until recession hits. Then they will fall. Long-term rates will fall immediately. Why? Because stable money will produce price deflation. This will lower long-term rates. The inflation premium in long-term loans will disappear. It will eventually go negative.

So, to Jim Cramer, George Bush, and the U.S. Congress, I say this:

“We need a return to the free market. No more central bank follies in trying to set an appropriate interest rate — any interest rate. Let borrowers and lenders work this out among themselves. Why should anyone trust a group of academic economists with tenured positions in a government-created monopoly? I can’t think of a good reason.”

This represents a major change of opinion for me. I used to believe all the hype I wrote about the positive results of regulation and wise central bank monetary policy. Folks, it was all a crock. It was subprime economic theory, which led to subprime economic policy.

I intend to keep on saying this for the remainder of my tenure as Chairman.

And if Jim Cramer doesn’t like it, who cares?

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Somehow, I do not expect to see this video. But YouTube is surely the best place to get wide distribution.

September12, 2007

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 19-volume series, An Economic Commentary on the Bible.

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