QUESTION AND ANSWER SESSION WITH BEN BERNANKE, CHAIRMAN OF THE FEDERAL RESERVE AT THE ECONOMIC CLUB OF NEW YORK CITY QUESTIONERS: MARTIN FELDSTEIN, PROFESSOR OF ECONOMICS AT HARVARD UNIVERSITY; HENRY KAUFMAN, PRESIDENT OF HENRY KAUFMAN AND COMPANY LOCATION: NEW YORK CITY, NEW YORK TIME: 12:44 P.M. EDT DATE: WEDNESDAY, OCTOBER 15, 2008
MODERATOR: Thank you very much, Mr. Chairman, for those remarks. As is the club's tradition, we'll have questions for the chairman from two club members. The first set of questions or first question will come from Martin Feldstein, who is George F. Baker professor of economics at Harvard, former chairman of the Council of Economic Advisers. Henry Kaufman will also be asking questions of the chairman, president of Henry Kaufman and Company and treasurer of this organization.
Marty, the first question is from you.
MR. FELDSTEIN: Thanks. Thanks very much.
Ben, I know that before you came to the Federal Reserve, you were a student of the experience of the depression years. So I want to ask you two questions related to that and our current experience. Do you think that the current, very severe downturn can be solved without a major fiscal initiative? And second, in the new Treasury plan announced -- if the new Treasury plan that was announced earlier this week had been tried in the 1930s, might it have brought the depression to an earlier end?
MR. BERNANKE: Well, I have worked a great deal on the Great Depression and learned a great deal from those studies. My assessment of the '30s was that there were two primary forces that caused the depression and whose correction led to recovery.
Those were, first of all, inappropriate monetary policy. The monetary policy of '30s led to a deflation of about 10 percent a year, so it was extraordinarily tight monetary policy, which created, among other things, the greatly increased value of debts, which therefore led to more defaults and bankruptcies.
The second element of the Depression that was critical was the collapse of our financial system, again, that the government allowed to happen, that went on for three and a half years without any significant action. The banks failed. The stock market crashed. Other credit markets stopped functioning. Foreign exchange markets stopped functioning. And that collapse of the financial system, together with the deflation in monetary policy, was the basic why the Depression was as severe as it was.
Franklin Roosevelt did two things when he became president that I think were the most important things that helped bring the economy back.
First of all, he relieved the pressure that the U.S. faced from the constraints of the gold standard, which allowed monetary policy to reflate, and prices began to rise and begin to normalize the price level and to return back towards the levels that had been sustained earlier in the '30s.
Secondly, he declared a bank holiday, and during that period banks were evaluated and were only opened -- at least this was the official line -- when they were shown to be sound. But in any case, whether they were sound or not, the subsequent experience, followed by the 1934 introduction of deposit insurance, stabilized the banking system and brought back the credit system.
So in reference to the current example, which, I emphasize, is not remotely like the experience of the '30s, we didn't make either of those mistakes. First of all, monetary policy has been proactive and aggressive. We moved quickly, early to try to stabilize the system and to offset the pressures being created by the credit markets. And secondly, we didn't wait for three and a half years, as the financial market collapsed, to take action and strong action to stabilize the financial system. And the -- as I discussed in my remarks, the actions I've taken this week, together with all the efforts that have been ongoing with provision of liquidity and other things over the last year, are powerful steps to try to stabilize the financial system. So I think we've avoided both of those critical errors that accounted for the 1930s.
On fiscal policy, let me make -- just make a -- I'm sure I'll have a chance to talk about contemporary fiscal policy later on, but just on the case of the '30s, I think contemporary scholarship argues that at least in the case of the United States, that fiscal policy was not the critical element in recovery unless you count World War II, which obviously mobilized the entire economy. Again, I would have focused on monetary policy and monetary stability and financial stability as being the critical elements that brought the economy back in the '30s.
MODERATOR: Henry?
MR. KAUFMAN: Mr. Chairman, what are the lessons of the last few years in the -- from the economy and from the financial markets for the conduct of monetary policy?
MR. BERNANKE: Well, I think we're going to be learning and thinking about those lessons for some time. The Federal Reserve, of course, has a dual mandate to promote price stability and maximum sustainable growth in employment.
That mandate is an appropriate mandate and one we'll continue to follow.
The basic structure in which we will address that mandate is one in which the Federal Reserve responds to economic shocks as they occur, within the context of maintaining price stability and well- anchored inflation expectations in the intermediate term.
That basic structure, which is now shared essentially by all central banks in the world, I think, will survive this experience and will continue to serve us well in the future.
There are some lessons, I think, that I could think of here on -- of the recent experience. One, related to what I just said to Marty, I do think that early intervention, preemptive intervention, moving quickly was important. We did so. We moved early this year.
The -- at the time, there was a lot of concern and skepticism that our actions might lead us into a stagflation or an inflation. I think that and moreover that there was also skepticism that the situation was all that serious. I think the evidence is now in that the inflation problems are moderating. We look to be returning to price stability at a reasonable pace.
At the same time, our guess that there was a significant tail risk, that there was a significant downside risk, from the financial stresses on the economy which was, I think, one of the main lessons I learned from my own research and study, which is that the financial system really does matter for the economy. I think that is -- has confirmed our strategy.
A second lesson I would take though is that monetary policy also has its limits. We have -- the Federal Reserve, as you know, acted very aggressively both on the side of monetary policy and the side of providing liquidity and using all the tools we have to try to maintain stability and support economic growth.
We reached a point though where the situation required additional firepower. And at that point, we -- the administration with the Federal Reserve's support went to the Congress to ask for financial, fiscal resources to address the problem in a way it had to be addressed.
So I think that's the second lesson, that monetary policy ultimately cannot always solve the problems, that sometimes you do need some fiscal or financial intervention. And we're getting that currently.
A third lesson I would mention again thinking through the recent experience, you know, last week, we had a coordinated rate cut with five other central banks. A coordinated rate cut is extremely unusual. But it couldn't have happened if we hadn't had ongoing coordination, discussions, consultation with all the other major central banks in the world.
I understand that President Trichet spoke here yesterday. I got a call from him on the way in this morning. We have continual conversations, discussions. And we work very closely together as well as with Mervyn King of the Bank of England, Masaaki Shirakawa of the Bank of Japan. And that close international operation, which we're now seeing also in the sphere of the financial rescue, I think, is very important.
Henry, I think, implicit in your question is probably the very vexed question of asset bubbles and what to do about those.
That -- obviously the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there's no doubt that as we emerge from the current crisis, that we're all going to look very hard at that issue and what can be done about it.
I don't think that this is -- I have the time or the -- or that this is the right place to try to go through other nuances and the difficult questions that that raises. I'll just make one point here, which is, I think that one of the key issues that's going to be debated as we look at the problem of bubbles in the future is, what should be the leading approach? Should it be monetary policy, or should it be supervisory and regulatory policy? I do believe that the latter does have a significant role to play in constraining excessive leverage, excessive risk-taking and the other elements that lead to bubbles. And I believe that one of the elements of our reform as we go forward and look at the financial system as a whole will be to think about a more macro-oriented or more macroprudential regulatory system that takes into account the broader issues of financial stability as well as the issues related to the safety and soundness of individual institutions.
MODERATOR: Marty?
MR. FELDSTEIN: I think we now recognize that a principal cause of the current financial problem was the bursting of the bubble of house prices. Experts say that house prices still have another 10 to 15 percent to fall to get back to the pre-bubble conditions.
I think there's a danger of a downward spiral of house prices beyond that, though, not stopping at just 10 or 15 percent further, that would be generated by defaults of homeowners with negative equity, defaulting, leading to foreclosures and increasing the supply of homes.
So that brings me to this question. Do you think that this financial crisis can be stopped without preventing the downward spiral in house prices?
MR. BERNANKE: Well, Marty, I recognize some of your own thoughts and policy suggestions in that question. (Laughter.)
MR. FELDSTEIN: If not here, where? (Laughter.)
MR. BERNANKE: (Chuckles.) And I'm very sympathetic. I'm very sympathetic to your perspective. I think, as I said earlier in my remarks, the housing bubble or the burst of the bubble was the triggering event of the crisis. It's played a central role both in decline in the real economy, as wealth has been affected, as construction has been affected, but also in the financial sector as mortgage assets, residential mortgages have been at the center -- not the only form -- I should say not the only type of asset that's been problematic, but certainly one of the central and largest classes of assets that have been a problem.
So what we have seen is a -- what we use -- in wonk-speak is called the adverse feedback loop, the phenomenon whereby declining house prices weaken the economy, lead to higher delinquencies and defaults. That feeds into the financial system, which then becomes weakened because of losses, which then becomes less willing to extend credit, which causes the economy to weaken, and you get this very adverse vicious circle.
And so I think I would agree with you that the key to the solution here is to break that cycle. And I think housing is an important place to work, but I think this also can be broken at different points.
On housing, let me again address that. And I think there have been a number of aggressive steps to address the housing issue. First, you know, the stabilization of Fannie and Freddie, which I mentioned before, together with their increased purchases of mortgage- backed securities, increased purchase of mortgage-backed securities by the Treasury, is supporting the mortgage market, and at least that portion of the mortgage market, I believe, that as -- particularly as the current crisis dies down, will be there to support homeownership and construction, residential development.
Secondly, your concern about foreclosures is absolutely on the mark. That has been part of this adverse dynamic. People who are more prone to default when they are either, of course, unemployed or if their house value is declining have been creating losses for banks which in turn creates, again, this cyclical adverse dynamic.
There have been a number of steps to try to address foreclosures and those include work with servicers where the Federal Reserve has supported Treasury's work on the so-called HOPE NOW initiative. Federal Reserve has done its own work, also, on a voluntary basis working with servicers and communities around the country trying to address foreclosures. The Congress recently passed the HOPE for Homeowners bill, which creates a $300 billion fund to help homeowners refinance their mortgages after a principal write-down into the FHA. The Federal Reserve is on the board of that and we are involved in that as well.
There are other steps as well, but I think strengthening the economy in general and strengthening the financial system in general helps to break that feedback loop. And so I think that, for example, the capitalization of the banks, to restore credit to the economy and strengthen it, will also feed back onto people's ability and willingness to buy homes and into the prices of homes. So that cycle can be broken in a number of different areas.
I am -- I want to be very clear -- I am sympathetic to policies that attempt to address the problem at the level of housing. A number of things have been tried. The difficulty is that the U.S. housing market is enormous and affecting it directly is difficult. It's very difficult. We should continue to work in that direction, though, and suggestions made by Marty and others, I think, deserve serious attention as we try to -- as we try to create a floor or at least some stabilization going forward in prices, which will be a critical element, I think, of the stabilization of the financial system and then the recovery of the economy.
MR. KAUFMAN: Mr. Chairman, financial concentration has increased significantly in the last few decades and certainly has accelerated in this current crisis. How should monetary policy and policy in general deal with the risk that this financial concentration poses to the effective functioning of financial markets?
MR. BERNANKE: So there has been -- not just recently, but for a number of a years -- a great deal of consolidation, for example, in the banking system and greater concentration, greater size in financial institutions. We continue to have, in this country, thousands of smaller institutions, community banks and regional banks. So we have a very diverse credit system, including banks, non-banks and other markets.
And I think that's very important to maintain. I don't want to see this country go to the point where we have six large banks and that's basically the credit market. We need to have that diversity. We need to have the information capital, the local knowledge that is incorporated in local lending, local community banking and a diversity of different types of credit institutions. So that's an important policy consideration in the long run.
Excessive market concentration is also a concern. There are two ways to look at it. You can look at the share of markets that the large institutions have. And some of them are now becoming very, very big in the overall markets.
On the other hand, as the Federal Reserve evaluates mergers and acquisitions, we also look at local markets. Because it's in the local city or the local county where the competition for deposits and for credit goes on. And there, what we found is that, because these banks are nationally diversified, that we can still maintain generally speaking, in most local communities, good competition among credit providers.
The -- but to get to, I think, the heart of your question once again, Henry, I think the real concern that we have is that we have got and developed, in this country, a very serious Too Big to Fail problem. And that problem -- we've just recognized now in the current situation how severe it is.
There are too many firms that are, that are in some sense systemically critical. And that creates problems both for the system itself, because if one fails, it creates tremendous problems. But it also creates distortions in that market discipline will break down if everyone believes that Firm X, you know, is not going to be allowed to fail.
Therefore why should we, you know, why should we monitor this form? Why should we care about what they do with the money we lend them? Because we know we're going to get it back. So that Too Big to Fail problem is a very serious problem. And I do believe it's going to be an important thing to address as we go forward.
In some speeches I've given earlier this summer, one at the FDIC, I've talked about some ways to address this. Let me just mention a few possibilities.
One is clearly to the extent that you have firms where market discipline is weakened, that needs to be compensated for by strong regulatory and supervisory oversight.
We need to make sure that the large firms, if they do seem to have that Too Big to Fail status, are not taking advantage of it to take excessive risks, excessive leverage.
Second, a second way to address the problem is to strengthen the financial infrastructure. We've seen for example that some of the firms that have been critical to the system and which have proved systemic risks had for example provided large amounts of credit insurance to banks and other institutions, using credit default swaps and other vehicles.
Now, credit default swaps are not traded on in exchange. They're not traded through a central counterparty, which means that if one of these firms failed, among the consequences would be that the banks and others who had purchased credit insurance would be forced to write down tens of billions of dollars, of value, because of the loss of the counterparty, which would no longer be able to make good on their credit guarantees.
So we need to strengthen the infrastructure. We need to work, as Tim Geithner here at the New York Fed is doing, to create central counterparties, exchanges, other mechanisms to reduce the instability that arises when the failure of one large counterparty permeates the entire system through over-the-counter derivatives, CDS and other types of instruments.
That's a very important thing as well.
A third element which I also think is very important is we need a way to resolve large failing institutions in a safe and sound manner, if you will. In the case of banks, we have a system. It's called FDICIA. It's a law passed in 1991 which was recently applied in the Wachovia case whereby there's a set of rules and expectations that can be met by the FDIC in resolving any bank and doing it in a way that, generally speaking, will be at least cost to the depositors. However, there are provisions in that law which say that if there's a systemic risk problem associated with the failure of an institution then there's an exception made and the FDIC can use extraordinary powers if necessary to protect and guarantee the creditors of that institution and avoid the systemic implications that might arise if that institution was simply allowed to fail.
Outside the banking system -- and in Bear Stearns and in AIG and Lehman and all the other things we've dealt with -- there is no such system. There's no resolution system. There's no set of rules. There's no funding. There's no authorizations. So everything that was done with all those non-bank firms had to be done in a very ad hoc way.
I think -- as I say, for the time being now, the funding of the TARP will provide an important backstop to allow us to address these things in a more orderly situation, which I hope will not occur in the future. But I think in a longer term we need something analogous to the FDICIA law for banks for broader financial institutions to make them less systemically critical.
So if we take these steps, if we have oversight, if we strengthen the system so that it's -- that it's less prone to be damaged by the failure of one firm and if we develop a resolution regime, I think we will at least get our hands around the too-big-to-fail problem, which, again, I believe is a very serious problem today in our financial system.
MODERATOR: Okay. Marty?
MR. FELDSTEIN: Ben, many market participants I talk with think that the way the -- Lehman was allowed to fail caused substantial damage to confidence and to the access to credit of other financial institutions. Do you think that criticism has some merit? And if so, how might it have been done differently? And could it be done differently if there were a similar situation under the TARP?
MR. BERNANKE: So, Lehman was not allowed to fail in the sense there was some choice being made. There was no mechanism, there was no option, there was no set of rules, there was no funding to allow us to address that situation. The Federal Reserve's ability to lend, which was used in the Bear Stearns case, for example, requires that adequate collateral be posted so that we are not taking credit risk; we are lending against collateral. In this case, that was impossible. There simply wasn't enough collateral to support the lending. From the Treasury's perspective, unlike the FDIC, a deposit insurance fund, there were no funds. There was no option.
We worked very hard over one of those famous weekends with not only some potential acquirers of Lehman but also with -- we called together many of the leading CEOs of the private sector in New York to try to come to a solution.
We didn't find one and therefore we were unable to do what we wanted very much to do, which was to prevent the failure of the company.
Part of the problem was, I think, though -- is that, is that Lehman was a, it was not just a cause; it was also a symptom. Because throughout this period, we have seen one large company after another. And I can list them all for you but I don't -- I think you all know five, six, seven, eight companies that have come under increasing pressure, with the pattern that as the weakest falls or is taken care of, then the pressure just goes to the next one.
And there was a lot of, a lot of concern among the CEOs, at the meetings over the weekend there, that okay, you know, even if we all pool lots of money and somehow or another patch this together and keep Lehman afloat, well, there's another company right down the road, you know, right down the list that's going to be, going to be next.
So it was clear at that point, to me, that this was simply beyond the capacity of our existing authorities, and that it was necessary for us to go to Congress and say, the only way to fix this is through a systemic, comprehensive approach; we can no longer deal with the situation in an ad hoc manner. And so we went to Congress.
We received the authorization, the $700 billion authorization, which comes by the way with quite a bit of flexibility in the way it can be used. And that has already, I think, preemptively as the money, the capital that's gone into banks, even the banks that were -- didn't receive capital, we've seen already their credit default swap spreads come down; the default risk come down.
I think that's the approach that's going to stabilize the financial system. And I'm very glad the Congress was able to give us this, so that we can address it.
If another situation like that arises, I think, the Lehman-type situation, I think, the TARP would in fact, because of the fiscal resources there, would in fact provide some additional options which would be very valuable. And we recognize notwithstanding the Too Big to Fail problem, which I discussed before, that systemic risk is a very serious matter.
We've never felt otherwise. We've never been deluded into thinking that allowing systemically critical firms to fail was in any way going to be anything other than a very serious problem. I do believe we now have some better tools to address it.
In the longer term once again we need to have resolution authorities that will allow us, in a systematic and congressionally approved manner, address the resolution of large non-bank critically -- systemically critical firms.
MODERATOR: Henry, the last question is yours.
MR. KAUFMAN: Okay. Thank you.
Mr. Chairman, now that we have TARP and with its proposed reverse auction, designed to create price discovery, don't you think that this process will not lead to a significant lifting of mortgages, out of private institutions, considering the complexity of the problem? And therefore the volume that will be put aside is going to be relatively small.
MR. BERNANKE: Well, one of the key issues, in this crisis -- I was saying earlier, there are a lot of similarities and general themes that -- between this crisis and earlier ones. But this crisis also has a number of unique characteristics. And one that I mentioned, in my remarks, is the opacity and complexity of the financial instruments that many banks and other institutions hold.
It's a problem that those assets do not trade. There is no liquidity. There's no price discovery. Nobody knows what they're worth. They're marked down based on distress sale prices.
That in turn causes markdowns in capital. So part of the solution, if we can do it, would be to try to restore some liquidity and price discovery to these -- to these markets. And that was one of the objectives of the TARP, to create a set of mechanisms that would create market-based price discovery by buying assets from institutions.
Now, you're absolutely right. The amount of -- for example, the amount of mortgage credit outstanding if you include both residential and commercial is on the order of $14 trillion. So 700 billion (dollars) is only 5 percent of that. So it's obvious that -- and now we've committed some of the money to the capital injections. So it's obvious that the TARP funding will not be sufficient by itself to take, you know, all the questionable credit or the hard-to-value assets off of bank balance sheets. That's not really the goal.
The goal of that part of the program is to create some liquidity in the market, to create some price discovery. If that happens then we would hope to see some trading begin and see some of these situations resolved through the private sector. So it's meant to be a stimulus, not a complete solution.
Now, as I've described, we are -- you know, we are involved now in the capital injection program. One of the great virtues of the TARP is that it is flexible and can be used in different ways, as required. And so we will be thinking, going forward -- and I should say -- I say "we" -- I mention myself only in the context of being a member of the oversight board. The Treasury, of course, is the lead, while the Federal Reserve is providing as much technical assistance as possible -- that going forward, you know, we will have to adapt to developments in the financial system and try to use this money in a way that will give us the biggest bang for the buck and will help restore the economy and the financial system as quickly as possible.
Thank you. (Applause.)
MODERATOR: Thank you very much, Mr. Chairman, for those remarks. Thank you, Marty and Henry as well. This podium is always here for you whenever you want it.
The lunch will now be served. Thank you.
