Bloomberg schools us on regulating derivatives

Half of the Big 5's trading earnings come from unregulated derivatives. The Bloomberg article below is the essential outline of regulation efforts at this point.

The AIG bailout was the government backstopping CDS's, but they're still not regulated. Even if regulated, they are a speculative tool with hundreds of trillions in notional value. The Administration and Treasury Secretary Geithner seem to be ready to standardize them and put them onto exchanges, but this does not eliminate the government's implicit guarantee. It may make it more explicit.

Beyond this, Geithner has decried efforts to ban "naked" CDS's, whose value is simply as a gaming tool.

Derivatives and commodity trading, activities of extremely questionable value to the society, are now the center of Wall Street's profits.

Wall Street Stealth Lobby Defends $35 Billion Derivatives Haul
Bloomberg, August 31, 2009
By Christine Harper, Matthew Leising and Shannon Harrington

Wall Street is suiting up for a battle to protect one of its richest fiefdoms, the $592 trillion over-the-counter derivatives market that is facing the biggest overhaul since its creation 30 years ago.

Five U.S. commercial banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp., are on track to earn more than $35 billion this year trading unregulated derivatives contracts. At stake is how much of that business they and other dealers will be able to keep.

“Business models of the larger dealers have such a paucity of opportunities for profit that they have to defend the last great frontier for double-digit, even triple-digit returns,”

said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics, which analyzes banks for investors.

The Washington fight, conducted mostly behind closed doors, has been overshadowed by the noisy debate over health care. That’s fine with investment bankers, who for years quietly wielded their financial and lobbying clout on Capitol Hill to kill efforts to regulate derivatives. This time could be different. The reason: widespread public and Congressional anger over the role derivatives such as credit-default swaps played in the worst financial crisis since the Great Depression.

“Public sentiment isn’t very much in their favor,” said Richard Lindsey, a former director of market regulation at the U.S. Securities and Exchange Commission who worked at Bear Stearns Cos. from 1999 to 2006, referring to Wall Street firms. “In some places, they’re not going to have anybody who wants to listen to them.”

Bad Omen

In a bad omen for the industry, the Obama administration kept the details and timing of its plan to regulate the derivatives markets under wraps before making it public earlier this month.

Robert Pickel, head of the International Swaps and Derivatives Association, and Scott DeFife, chief lobbyist for the Securities Industry and Financial Markets Association, were meeting with Deputy Treasury Secretary Neal Wolin on Aug. 11, when Wolin mentioned that the proposals would be sent to Congress in 60 minutes, according to a person familiar with the meeting. The sudden notice was not what they were used to.

“The administration is desirous of maintaining control and the initiative on this,” said Craig Pirrong, a finance professor at the University of Houston who has testified before Congress about derivatives trading. “They wanted to make sure they could get their vision out there pure and uninfluenced by the industry.”

Big Five

The Obama proposal made public that day is an effort to gain oversight and control of the market for derivatives traded over the counter. The so-called OTC market consists of privately negotiated contracts that enable companies or investors to hedge against or bet on swings in the value of bonds, interest rates, currencies, commodities or stocks. Unlike exchanges, the business is unregulated and prices aren’t public.

The five biggest derivatives dealers in the U.S. -- JPMorgan, Goldman Sachs, Bank of America, Morgan Stanley and Citigroup Inc. -- held 95 percent of the $291 trillion in notional derivatives value of the country’s 25 largest bank holding companies at the end of the first quarter, according to a report by the Office of the Comptroller of the Currency. More than 90 percent of those derivatives were traded over the counter, the OCC data show.

Trading Revenue

In the first six months of 2009, those five banks made $35 billion from trading in both derivatives, including interest- rate and credit-default swaps, and cash instruments such as Treasuries and corporate bonds, according to company reports collected by the Federal Reserve.

About half of JPMorgan’s $31.2 billion in trading revenue from 2006 to 2008 probably came from derivatives, based on a breakdown the firm provided in a presentation in February and revenue figures in regulatory filings those years, according to Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York.

The proportion of trading revenue that comes from derivatives is similar at other top firms, according to people familiar with the banks’ income sources.

Spokespeople for all five companies declined to comment.

The Obama plan would require that the most common, or standardized, OTC derivatives be processed through clearinghouses, whose members would make good on trades in the event any of them default.

Bid-Ask Spread

The $182.5 billion federal rescue of American International Group Inc. underlined the problem of so-called counterparty risk, or the danger that one of the parties to a contract won’t be able to meet its obligations. For years New York-based AIG had run a lucrative business collecting fees by selling banks and other investors credit-default swaps, a form of insurance that would pay out if their pools of mortgage securities defaulted. When the housing market collapsed, AIG found itself unable to meet its promises and the government stepped in with taxpayer money to honor the contracts.

Wall Street expected that the administration would try to mandate clearinghouses. It didn’t anticipate the proposals would go further by requiring standardized trades be listed on exchanges or regulated platforms that entail reporting of trades, according to people familiar with how the legislation developed and who asked not to be named.

That could cost Wall Street a lot of money.

Under the current system, the banks profit from the so- called bid-ask spread, which is the gap between what they charge customers and what they pay to hedge their trades.

Interest-Rate Swaps

When a company or investor wants to enter into a swap, the bank checks internal pricing sources to determine the cost of making the opposite trade with another bank, which would enable it to eliminate any exposure on the trade. Armed with that information, it then offers a higher swap price to the client, allowing the bank to pocket a profit. The prices are measured in basis points, each of which is 0.01 percentage point.

Banks earn one to three basis points on average, each year, by creating an interest-rate swap for a customer, according to a former Deutsche Bank AG trader who asked not to be identified. For example, a bank that charges three basis points for a 10- year swap with the notional value of $100 million will earn about 23 basis points, or $230,000, over the lifetime of the trade when accounting for the present value of money, the former trader said. Banks do thousands of such deals a year.

“Part of the pull and tug is that the banks are trying to prevent more and more of the product from being commoditized in the sense of being exchange-traded,” said Charles Peabody, an analyst at Portales Partners LLC in New York, which provides institutional equity research. “Like anything that starts to get commoditized -- we’ve seen that with Trace on the bond side -- it’s obviously going to pressure margins.”

Margin Squeeze

Trace, shorthand for the Trade Reporting and Compliance Engine, was created in 2002 to post prices on all registered corporate bonds 15 minutes after trades occur. The public disclosure meant bond dealers no longer had better price data than clients, and profit margins in the business shrank by more than 50 percent, according to a Bloomberg News review of trades and a study published by the Rochester, New York-based Journal of Financial Economics.

Sanford C. Bernstein & Co. analyst Brad Hintz estimates that Wall Street revenue from trading fixed-income, commodities and currency swaps in the over-the-counter market may be reduced by 15 percent just by a move to clearinghouses. Forcing trades onto exchanges would cut revenue further.

Reducing Secrecy

Obama’s plan deals another blow to banks. It aims to discourage them and their customers from using non-standard, or customized, derivatives that can’t be processed by a clearinghouse or traded on an exchange by requiring that parties to such trades hold more capital to protect themselves against losses. The plan would also require they put up more money, known as margin, to insure they make good on the trades. Both changes would impose added costs on banks and some customers.

Regulators would get to see all of the trades in the market and the positions held by each of the participants, while the public would get data on trading volumes and open positions for the market as a whole, helping to reduce secrecy. The plan also seeks to limit sales of derivatives to individuals and small municipalities to make sure unsophisticated investors don’t get talked into contracts they don’t understand.

While the proposed Obama legislation goes further than some banks expected, it was derived from a broader plan released in June that the industry had already helped influence, said Lauren Teigland-Hunt, managing partner of Teigland-Hunt LLP, a New York law firm that represents hedge funds and institutional investors in the derivatives market.

‘Starting Point’

“They did their homework, they didn’t want to roll out something stupid,” Teigland-Hunt said of the administration. “Once they did that, they said, ‘We’re going to do this legislation. We’re not going to have it written for us.’”

The new, more detailed proposals are “a starting point,” she said. “The industry will have an opportunity to weigh in here, and will weigh in here.”

The Obama proposals don’t go as far as some people have urged. Hedge fund billionaire George Soros and Berkshire Hathaway Inc. Vice Chairman Charles Munger are among investors who have called for limits on the use of credit-default swaps. Soros wrote in a March 24 Wall Street Journal column that regulators should ban so-called naked swaps, in which the buyer isn’t protecting an existing investment.

Two days later Treasury Secretary Timothy Geithner dismissed such an idea before the House Financial Services Committee, telling members that “my own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally.”

‘Overrated and Overpriced’

Janet Tavakoli, founder and president of Tavakoli Structured Finance Inc. in Chicago, said in an interview that derivatives have allowed banks to camouflage risk.

“There has been massive widespread abuse of over-the-counter derivatives, which have contributed to transactions that people knew or should have known were overrated and overpriced at the time they came to market,” said Tavakoli, who traded, structured and sold derivatives over more than two decades in the financial industry.

Wall Street is accustomed to getting its way with derivatives legislation. The last major congressional action, in 2000, was designed to exempt over-the-counter derivatives from government oversight.

Commodity Futures Act

Lawyers for Wall Street’s largest banks initiated and shepherded the 2000 Commodity Futures Modernization Act through Congress because they were concerned the business was in jeopardy from reforms proposed by Brooksley Born, then chairman of the Commodity Futures Trading Commission, according to two lawyers involved in the process who asked not to be identified.

The market has swelled more than sixfold since then, according to industry data.

“The Street does make money on this, so it tends to be pretty important to them,” said Lindsey, the former Bear Stearns executive who now works as an adviser to hedge funds and institutional investors at New York-based Callcott Group LLC.

Analysts can only estimate how much revenue the big banks make from over-the-counter derivatives because the banks provide little disclosure in their quarterly 10-Q and 10-K filings, said Portales Partners’ Peabody.

“I’ve been in the business for 30 years, and I read these 10-Qs and 10-Ks, and I still walk away not understanding how they’re conducting their business, how profitable it is."

Wall Street Campaign

In recent months, Wall Street firms have embarked on a lobbying campaign to influence the media and legislators.

Goldman Sachs held an off-the-record seminar for reporters in April to explain how credit-default swaps work. Deutsche Bank has offered to put clients in touch with media to discuss concerns about increased capital and margin requirements.

JPMorgan has mobilized some corporate clients, advising them that the proposed changes could hurt their ability to hedge against losses, according to a person familiar with the matter.

The banks “are saying everyone thinks we’re biased, so you have to go out there and talk about it,” said Paul Zubulake, a senior analyst at Boston-based research and consulting firm Aite Group LLC.

While banks say the need for customized contracts stems from customer demand, it’s often the case that Wall Street pushes the products on their clients, said Lindsey, the former Bear Stearns executive.

“Some customers want bespoke derivatives, but often these products are sold, not bought.”

Derivatives 101

On Aug. 24, while lawmakers were on recess, the U.S. Chamber of Commerce organized a briefing for congressional staffers aimed at explaining how companies use derivatives to manage risk. The session, called “Derivatives 101,” featured speakers from Cargill Inc. and Devon Energy Corp., so-called end-users that don’t represent banks, said Jason Matthews, who leads the group’s lobbying efforts on financial-services issues.

The organization called the briefing because “some proposals would make it very difficult for many companies, including manufacturers, energy companies and commercial real estate owners and developers to use over-the-counter derivatives to manage the risks of their day-to-day business,” Matthews said in his e-mail invitation to the staffers.

Wall Street firms and trade associations have held a series of meetings with staff members of the House Financial Services Committee to discuss derivatives trading, said Cory Strupp, who ran government relations for JPMorgan before joining SIFMA, the securities-industry group, last year.

Defining ‘Standardized’

“There’s been a big learning curve, and members and staff have gone a long way along that curve,” said Strupp, a key lobbyist on derivatives. Strupp was on the team at JPMorgan a decade ago when the industry persuaded Congress to repeal the depression-era Glass-Steagall law that separated deposit-taking companies from investment banks.

While the Obama proposals will have “a lot of influence,” they won’t necessarily serve as a “base text” for legislation, Strupp said.

Wall Street firms stand to benefit from staving off efforts for reform. One senior executive at a top-five derivatives firm, who declined to comment publicly, said that while he expects Congress will adopt some form of legislation, he thinks it will be a long time coming and that the degree of reform is in doubt.

One key issue is how the government and regulators define the word “standardized,” which will determine what contracts need to be handled by clearinghouses and can be traded on exchanges.

“The legislation would say that all standardized contracts need to be cleared, which begs the question what is standardized?” said Geoffrey Goldman, a partner who focuses on derivatives and structured products at law firm Shearman & Sterling in New York. “The bill doesn’t answer that question.”

Schapiro, Gensler

That question, which will determine how much change there is in the way the contracts are traded, may fall to regulators, including SEC chairman Mary Schapiro and Gary Gensler, chairman of the Commodity Futures Trading Commission, Goldman said.

In interviews last week, both Schapiro and Gensler said there was a need to make the OTC derivatives market more transparent and less risky by moving more trading onto exchanges and clearinghouses.

“I feel passionately that we must bring the over-the-counter derivatives marketplace under regulation,” said Gensler, a former Goldman Sachs banker who opposed giving the CFTC oversight of over-the-counter derivatives when he worked at the Treasury Department from 1997 to 2001. “Looking back, there’s no doubt that I think all of us should have done more to protect the American public knowing what we know now.”

ICE, CME

Another debate is over which clearing platforms or exchanges should be used. JPMorgan, Goldman Sachs, Bank of America, Citigroup, Morgan Stanley and other banks will begin sharing profits next year from the credit-default swap clearinghouse ICE US Trust LLC.

While the banks have an interest in supporting that initiative, they’re expected to lobby to remove any requirements that the contracts be executed on exchanges because that would cut them out of making a profit on the trades, according to lawyers working for the banks.

“The broker-dealers are happy to clear as much as they can because they do have a vested interest in the clearing companies that they’re clearing these products through,” said Aite Group’s Zubulake.

Chicago-based CME Group Inc., the world’s largest futures exchange, would be a logical place to clear interest-rate swaps because it already clears Eurodollar futures, which are often used as a hedge for rate swaps, Zubulake said. He doubts that will happen though.

“They don’t want to clear an interest-rate swap through the CME because they don’t own the CME."

Delaying Reform

Paul Gulberg, a colleague of Peabody’s at Portales Partners, said the most likely outcome is legislation requiring that trades be reported and, in some cases, cleared. He said it’s “not very likely” the law will force derivatives onto an exchange or an electronic facility.

Health-care reform may make it unlikely any derivatives legislation will be enacted in the near future, Peabody said.

For Wall Street, the longer it takes to get legislation passed the better. As stock market values and the economy improve, anger at banks is likely to subside.

“If we don’t pass it by early 2010, we get into the congressional election period where this is just too controversial an issue,” Peabody said. “You’ve got too many different financial interests with opposing views that Congress just isn’t going to go out on a limb and pass it and put their re-election in jeopardy. We don’t think we’re going to see legislation until 2011.”

Jeffrey Sachs and the year since Lehman Brothers

Jeffrey Sachs capsule history of the year since Lehman Brothers and AIG

The Financial Crisis One Year After
by Jeffrey D. Sachs
Project Syndicate
August 30, 2009

NEW YORK – It is now almost a year since the world economy teetered on the edge of calamity. In the span of three days, September 15-17, 2008, Lehman Brothers filed for bankruptcy, the mega-insurance company AIG was taken over by the United States government, and the failing Wall Street icon Merrill Lynch was absorbed by Bank of America in a deal brokered and financed by the US government. Panic ensued and credit stopped circulating. Non-financial companies could not get working capital, much less funding for long-term investments. A depression seemed possible.

Today, the storm has broken. Months of emergency action by the world’s leading central banks prevented financial markets from crashing. When banks stopped providing short-term liquidity to other banks and industrial companies, central banks filled the gap. As a result, the major economies avoided a collapse of credit and production. The sense of panic has subsided. Banks are once again lending to each other.

Although the worst was avoided, much pain remains. The crisis culminated in a collapse of asset prices at the end of 2008. Middle-class and wealthy households around the world felt poorer and therefore cut their spending sharply. Sky-high oil and food prices added to the pain, and thus to the downturn. Enterprises could not sell their output, leading to production cuts and layoffs. Rising unemployment compounded the loss of household wealth, throwing families into deep economic peril and leading to further cutbacks in consumer spending.

The big problem now is that unemployment continues to rise in the US and Europe, because growth is too slow to create enough new jobs. Dislocations are still being felt around the world.

A huge debate has ensued around the so-called “stimulus spending” in the US, Europe, and China. Stimulus spending aims to use higher government outlays or tax incentives to offset the decline in household consumption and business investment. In the US, for example, roughly one-third of the $800-billion two-year stimulus package comprises tax cuts (to stimulate consumer spending); one-third is public outlays on roads, schools, power, and other infrastructure; and one-third takes the forms of federal transfers to state and local governments for health care, unemployment insurance, school salaries, and the like.

Stimulus packages are controversial, because they increase budget deficits, and thus imply the need to cut spending or raise taxes sometime in the near future. The question is whether they successfully boost output and jobs in the short term, and, if so, whether they do enough to compensate for the inevitable budget problems down the road.

The true effectiveness of these packages is not clear. Suppose that the government gives a tax cut in order to increase consumers’ take-home pay. If consumers expect that their taxes will rise in the future, they may decide to save the tax cut rather than boost consumption. In that case, the stimulus will have little positive effect on household spending, but will worsen the budget deficit.

An early assessment of the stimulus packages suggests that China’s program has worked well. The sharp fall in China’s exports to the US has been compensated by a sharp rise in the Chinese government’s spending on infrastructure – say, on subway construction in China’s biggest cities.

In the US, the verdict is less clear. The tax cut has probably been saved rather than spent. The infrastructure component has not yet been spent because of long lags in turning the US stimulus package into real construction projects. The third part – the transfer to state and local governments – almost surely has been successful in maintaining spending on schools, health, and the unemployed.

In short, the US stimulus effects on spending have probably been positive but small, and without a decisive effect on the economy. Moreover, concerns about the enormous US budget deficit, now running at $1.8 trillion (12% of GNP) per year, are bound to increase, not only creating enormous uncertainties in politics and financial markets, but also dimming consumer confidence as households focus their attention on potential future budget cuts and tax increases. The US has reached the practical limits of reliance on short-term stimulus spending, and will need to start cutting the budget deficit and fostering alternative pathways to growth.

When the crisis deepened a year ago, Barack Obama introduced into the presidential campaign the theme of a “green recovery,” based on a surge of investment in renewable energies, new electric vehicles, environmentally efficient “green” buildings, and ecologically sound agriculture. In the heat of the battle against financial panic, policy attention turned away from that green recovery. Now the US needs to return to this important idea.

Debt-burdened consumers in the US and Europe will limit their spending for years to come as they rebuild their wealth and pension assets. But the resulting economic slack gives us the historic opportunity – and need – to compensate for low consumer spending with increased investment spending on sustainable technologies.

Government policies in the US and other rich countries should stimulate those investments through special incentives. These include a cap-and-trade system for greenhouse-gas emissions, subsidies for research and development on sustainable technologies, feed-in tariffs and regulatory incentives for renewable energy, consumer subsidies and other inducements for the uptake of new “green” technologies, and implementation of “green” infrastructure programs, such as mass transit.

The rich world should also provide the poorest countries with grants and low-interest loans to buy sustainable energy technologies, such as solar and geothermal power. Doing so would add to the global recovery, improve long-term environmental sustainability, and accelerate economic development.

The crisis can yet be an opportunity to turn from a path of financial bubbles and excessive consumption to a path of sustainable development. In fact, seizing this opportunity is the only recipe for genuine growth that we have left.

Bernanke back in ... Oy! Plus the 70-30 labor-capital split means other than you think

Today on the podcast, it is baffled Ben Bernanke in for a second term -- What does that mean for the economy, the financial crises, and the competence of the Obama team going forward?

Also. You've heard that consumption is falling from its peak of over 70 percent. There is another, more stable 70 percent figure. The allocation of national income to workers. The 70-30 split of labor to capital has held for a good long time. What does it mean, for your retirement, investments, job prospects?

And finally today, the history note with Hyman Minsky. Nobody saw it coming. Hoo couldda node? If we keep listening to the people who have been wrong, we're not going to get out of confusion, and we just re-upped the king of denial. But Minsky's analysis predicted instability and increasing instability as financing moved to more speculative forms.

First. The six or eight readers of the blog noticed last week that I filed the reappointment of Ben Bernanke under the heading, What a disaster.

Many have applauded. Paul Krugman, fellow Princetonian, comes to mind. Least surprising was the virtually unanimous approval of the Wall Street Chamber of Commerce. On the transcript of today's podcast, far below, is a single-ply roll of the comments.

We did not applaud. We were dismayed and disgusted. Obama put one of hte architects of the disaster back in as head of the rebuilding team. That means as much about the chances of a new approach to financial markets as it does about the competence of the president's brain trust. Fed Chair is THE most powerful seat in government that is not elected. To ratify the status quo of the past thirty years is really, really, really dumb.

We've said our forecast is dependent on policy choices from the administration. This reappointment signals that the progressive policies we anticipated from the new president will not be forthcoming. Shift the scenario to the right to pessimistic.

Maybe we were naive .... No maybe about it. If not progressive, we expected at least pragmatic. If one thing doesn't work, try something else. Well, it didn't work. But the results on Main Street don't matter. Apparently saving the big banks has been translated to meaning we have saved the financial function and saving the financial function of the economy is an essential first step.

The translation is being skewed by the financiers. It didn't work. Low interest rates and easy terms for banks have meant weird stock markets and a new commodity bubble. Credit is not flowing to business or consumers. Bernanke has critically compromised the Fed's balance sheet in the process of creating huge new backstops for speculative finance.

The entire financial sector collapse and market meltdown is a clear defeat for the corporate-run markets. Alan Greenspan's naive expectation that market forces would provide discipline even in the presence of implicit government bailouts fell apart. How much less will Bernanke's ever more elaborate protections for the financial cowboys work?

And to be clear, the choice was not between saving the institutions who caused the mess and doing nothing. A whole range of banking institutions who had not screwed up could have been capitalized and enabled. The banks themselves could have been cut up. As it is, the big banks are subsisting on their toxic securities -- which are still on the balance sheets -- and on the spreads between zero interest from the Fed and the usury they charge retail borrowers. The more successful ones are playing market games with the cheap chips they get from the Fed. None of this comes under the category of the financial system leading the real economy into recovery.

Any semblance of the conservative's free market is a memory in the current disaster. The remnants of that market is trying to regroup on the fringes while the government carries the mail. But if you listen to the business media, as I do, you hear cries of exit strategies, tax cuts and government withdrawal. Basically, their message is "Put out the fire, rebuild the broken parts, and let us play again, because we know what we're doing."

The conservatives and market fundamentalists promised explicitly a rose garden with deregulation, low taxes and trust. The roses have bloomed, been cut, carried off to the Hamptons, and we have the thorns to live in.

We may sound redundant, but we don't see that the point is realized. The markets crashed. The economic system went into crisis. Not because of any government or outside problem, but because of the internal contradictions and the running wild of the capital markets themselves. Rather than give our future into the hands of a hoocouldanode, perhaps we might check out those whose theories and analysis predicted problems.

Continuity in confusion and error is not the kind of continuity that is required.

Others have been less hysterical than Demand Side.

James K. Galbraith wrote in a couple of places recently. Galbraith's The Predator State is competing with Stiglitz' Making Globalization Work as the best economics book of the milenium, so far.

Writing under the head, "Resist False Optimism," Galbraith says.

Ben Bernanke came to the Federal Reserve imbued with academic notions. One of these was that central banks should concentrate on “inflation targeting.” Another was that we were living in a Great Moderation, that efficient financial markets would provide for stable economic growth evermore. ... Mr. Bernanke had to chew and swallow [these ideas]. His merit is that he did so, quickly, when the time came.

In the crisis, he cut interest rates to zero, nationalized the commercial paper market, lent with abandon here and abroad –- and kept the financial system afloat. He deserves credit for this. But President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen.

One challenge will be to overcome fixed ideas on deficits -– ideas sadly shared in Washington.

Keeping big banks alive is not the same as restoring credit flows. Credit will not recover until the housing crisis subsides. Right now, with record inventories, collapsed cure-rates, and a flood of foreclosures we’re far from that. The jobs picture remains grim. Low interest rates alone can’t fix these problems, nor can “quantitative easing.” Mr. Bernanke’s first challenge, going forward, will be to recognize these facts — and his own limited power.

His second challenge will be to overcome fixed ideas on deficits -– ideas sadly shared throughout Washington. Fiscal expansion remains necessary. More is needed, especially to sustain state and local public services. This is no moment for people who are made nervous by a big government debt. With the private sector still flat, the public sector has to grow, or the economy will not.

A third challenge will be to resist deceptive optimism. In July, 2007, Mr. Bernanke was still testifying that our housing problems could be managed. I don’t believe that he didn’t see the impending collapse. But he didn’t want to precipitate it — understandable, but bad policy. He should now beware of cheerleading for a recovery that may, at best, leave millions behind.

Ben Bernanke is smart and capable, honorable and honest. Yet his renomination signals continuity in policy from the late Bush era, through this year and onward. President Obama passed up a chance to reorganize his economic team. When the moment comes that the policy has to change, the task will not be easier, because of this.

Simon Johnson offered this:

Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. But which Bernanke are we getting? There are at least three.

1. The Bernanke who led the charge to rescue the US (and world’s) financial system after the Lehman-AIG collapse. If you accept that the choice from late September was “Collapse or Rescue,” this Bernanke did a great job.
2. The Bernanke who argued for keeping interest rates low as the housing bubble developed. This Bernanke was part of the Greenspan Illusion – the Fed should ignore bubbles and “just clean up afterwards.” Is that still Bernanke’s view? Surely, he has learned from that experience.
3. Then there is Bernanke-the-reformer. Given #1 and #2 above, shouldn’t he be pushing hard for tough re-regulation of the financial system – particularly those dodgy parts where markets meet banking? But is there any sign of such an agenda, even with regard to recently trampled consumers – let alone “too big to fail” financial institutions?

Most likely, we’re in for another bubble.

Mark Auerback's header was "Woe and Behold" It began

Obama’s decision, announced yesterday, to reappoint Ben Bernanke to a second term as chairman of the Federal Reserve confirms what we already know and fear: This administration’s determination to save the big banks guarantees that we will emerge from this slump with an unreformed financial sector in the hands of the same people who produced the disaster in the first place.

Let’s be honest.It wasn’t Bernanke’s “bold” creative decisions that stemmed the onset of “Great Depression 2.0?; automatic fiscal stabilizers did the actual heavy lifting to stave off the depression — as they always have done since the onset of the New Deal.

Expanding lending to his member banks by progressively accepting more and more collateral helped but the liquidity crisis was caused by the Fed never having understood that requiring any collateral from member banks is both redundant and disruptive in the first place. Bernanke has yet to recognize this, as per his current discussions and policies.

The complete version of the Auerback piece was put up yesterday in cybertime. This and the rest, most of them more positive, again appear at the bottom of the transcript of today's podcast on the blog.

But in case you missed it, our take on this is

What a disaster. Ben Bernanke to be reappointed Fed Chairman

This reveals very deep problems in the Obama program.

Bernanke was chief economist to George W. Bush, from which position he rose to Fed chairman. It is often remarked that we are so lucky to have an expert on the Great Depression in charge when the second Great Depression came knocking.

Bernanke was put in charge not because he is an expert on the Great Depression, but because he values the big banks above all else. He is deep in the pockets of Wall Street. His theory of the Depression is that it could have been avoided if we'd just saved the institutions that caused it. Witness the hundreds of billions of dollars in transfer from the taxpayer to the big banks, the free too-big-to-fail insurance, the many missed calls and predictions, the absence to this day of real help for mortgage holders when their main asset goes down.

Wow.

The Monetarists are alarmed at the unprecedented direct loans and guarantees to specific Wall Street firms. Why? It's just socializing the risk.

But by far the worst element is what it says about the Obama team and Obama's understanding of what is wrong. Sixty years of New Deal protections worked, but there is no inkling to go back to them. Market discipline is out the window when banks are too big to fail, but no move to break them up, only to backstop them. The Fed has arrogated new powers to itself, but apparently with the consent of the Treasury and Administration.

The policy adjustments we had hoped for are clearly not in the cards if this is the preferred path. Boomers look out. You saw your wages stagnate for thirty years. Now you can retire in the Great Recession.

It is no fun saying "I told you so." Half the responses are, "You did? I don't remember." The other half are silent gestures. This post is for the first half.



We went on so long, we're going to abbreviate our discussion of the 70% rule. Not to be confused with the Rule of 8 we presented last week.

One of the more celebrated statistics of the past year has been the fall in the percentage of GDP going to consumption. It had risen to 70 or 71 percent in the debt-fuled consumption boom that corresponded to the boom in housing. Now it is dropping. This, of course, reflects the rising savings rate, or the rising savings rate reflects the reduction in borrowing and consumption from borrowing. (And we've beat the funeral drum for the consumer several times here on Demand Side.)

But below this consumption number is a much more stable statistic -- the returns to labor.

briefly quoting from a newsletter out of the Federal Reserve Bank of St. Louis

The allocation of national income between workers and the owners of capital is considered one of the more remarkably stable relationships in the U.S. economy. As a general rule of thumb, economists often cite labor’s share of income to be about two-thirds of national income—although the exact figure is sensitive to the specific data used to calculate the ratio. Over time, this ratio has shown no clear tendency to rise or fall.

Wage and salary income as a fraction of national income shows a declining trend in recent decades. Having reached a peak of 58 percent in 1970, wages and salaries have declined to only 52 percent of national income in 2003. However, if we consider total compensation—including employer social insurance contributions and benefits—labor’s share has shown very little variation. By this measure, labor’s share of national income has averaged 70.5 percent over the past 50 years and has remained within a narrow range of that average.


... a long-run perspective suggests that it would indeed be unusual for labor’s share to deviate far from its historic value.

—Michael R. Pakko

This clearly does not mean workers wages and compensation has gone up with the rise in total output over the years. Clearly it has not, by the individual. The median wage has more or less stagnated since the 1970s.

The 70 percent has on one hand been divided by a larger and larger workforce, and on the other the division has become more and more unequal.

The implications are not so difficult. If you sat in 1970 and remarked about the stabke 70-30, you might have said, the 30 percent is the most important, because it is investment in capital that is going to finance my retirement. Just as the wage part of the pie is being divided between a larger workforce, when I and the other boomers retire, we will be dividing the capital portion among a big retired population.

You might have predicted that an expectation of rising asset values in such a circumstance might be frustrated, and that an extension of work past normal retirement might be in the cards.

And you would have been right.

Briefly, what would the 70-30 split tell you about the future. That relatively speaking working people will do better. That asset prices will likely not recover and may trend downward. That a bigger pie is better for everyone. If we grow the wage portion, we will grow the capital portion. That retirement plans based on transfers of income from the working to the retired are not so dumb after all, and less dumb than everybody putting their faith in capital assets.

I am not trying to tell you why the 70 percent number is so stable, notice. Because I really do not know. I don't even have a plausible guess. This has been an exercise in accepting it as fact and seeing what it would mean as other, more flexible parameters -- like demographics and consumption -- come up against it.

There is a lot to think about there, but let's move on to the history note, with Hyman Minsky. Minsky's book Stabilizing an Unstable Economy is in my bag nowadays. It is not particularly well written or organized, and the editing is terrible, but Keynes' General Theory is one of the most influential books of all time in spite of its shortcomings. You might think I have fallen in love just because Jamie Galbraith sent me a note, but it is more that I looked again at his Predator State. It is not a polemic against the corporate oligarchy, at least as much as the title suggests, but a very well-rounded expose of economics, both laying bare the real dynamics and exposing much of the conventional wisdom as vacuous and many of the sacred tenets as demonstrably wrong.

But here is Minsky.

The policy of using monetary constraint to control inflation was not a great success in 1969-70. The policy-makers assumed that constraint upon the rate of growth of the money supply would lead to a smooth decrease in business and household spending and that this would remove some of the excess demand that contributed to inflation. In the world in which we live, however, monetary policy does not directly affect demand. It first affects financing and refinancing conditions and the prices of instruments traded in financial markets. Consequently, monetary constraint leads to financial market disruption even though income, employment, and prices continue to increase; before demand is finally lowered, a financial crisis is induced.

...

And here

Every time the Federal Reserve protects a financial instrument it legitimizes the use of this instrument to finance activity. This means that not only does the Federal Reserve action abort an incipient crisis, but it sets the stage for a resumption in the process of increasing indebtedness -- and makes possible the intrudction of new instruments. In effect, the Federal Reserve prepares the way for the restoration of the type of financing that is a necessary, but not a sufficient condition, for an investment boom that is brought to hald by a financial crisis.

...

What we seem to have is a system that sustains instability even as it prevents the deep depressions of the past. Instead of a financial crisis and a deep depression being separated by decades, threats of crisis and deep depression occur every few years. Instead of realizing a deep depression, we now have chronic inflation. In terms of preventing deep depressions, we have done better than in earlier epochs. This is not a trivial gain. But the instability and the deteriorating performance mean that we need to search for something better.

Indeed.

And in terms of quote legitimizing the use of this instrument, I think we have legitimized the use of the credit default swap in all its grotesque applications.

Hang on.













POSTSCRIPT

Brad DeLong said on Project syndicate:

It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers.

Why the Senate Should Confirm Bernanke But Make the Fed More Accountable, Too

http://robertreich.blogspot.com/2009/08/why-senate-should-confirm-bernanke-but.html

from Robert Reich's Blog by Robert Reich

The President did the right thing in renominating Ben Bernanke to be Fed Chair, but the Senate should couple its vote to confirm him with new legislation requiring the Fed to be far more open about its doings.

If you'd have asked me three months ago whether Bernanke would be confirmed, I'd have said no. Congress (and much of the public) is still furious about the bank bailouts, as well they should be. TARP saved the Wall Street but Wall Street still hasn't saved Main Street, which was the publicly-stated purpose of the bailouts. The only clear outcome of the taxpayers' $600 billion rescue package is a return to giant salaries and bonuses on the Street.

But Bernanke at least deserves credit for lowering interest rates, swamping the nation with money, and pushing the Fed to become the nation's banker of last resort. With the big banks sitting it out, the Fed is buying a huge number of mortgage-backed securities (keeping many homeowners afloat, via the intermediaries of Frannie and Freddie); buying securities in which car loans, educational loans, and other consumer loans are bundled; and -- importantly -- signaling its willingness to do more, if necessary. It's become the U.S. Bank.

To the extent the U.S. economy is showing signs of "bottoming out" -- or, more likely, coming to a slow landing on swampy tarmac rather than crashing -- it's partly due to Bernanke's U.S. Bank. Congress knows this, or at least knows whatever Bernanke has been doing seems to be working. Hence, the Senate will confirm.

Yet much of what Bernanke has been doing has been cloaked in secrecy. No one knows exactly what the Fed has bought, from whom, and why. The secrecy is unnecessary. If the Fed is going to continue to be the U.S. Bank, it has to be publicly accountable. This is no argument for direct political control of the Fed. It's an argument for transparency. Congress and the public need to know what the Fed, with the ever-creative Bernanke at its lead, are up to. Never underestimate the power of public knowledge and opinion. Even our least democratic branch -- the federal judiciary -- is not immune to it. And don't underestimate the importance to our economy of knowing who and what is getting Fed assistance, and in what form.

So the Senate should confirm Bernanke, but link the confirmation vote to new legislation that makes the Fed more transparent.


Resist False Optimism
James K. Galbraith

James K. Galbraith, an economist at the L.B.J. School of Public Affairs at the University of Texas at Austin, is the author of “The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too.”

Odds are, Mr. Bernanke’s second term will not be as interesting as his first.

Ben Bernanke came to the Federal Reserve imbued with academic notions. One of these was that central banks should concentrate on “inflation targeting.” Another was that we were living in a Great Moderation, that efficient financial markets would provide for stable economic growth evermore. Ha, and ha-ha-ha. Both of these ideas, Mr. Bernanke had to chew and swallow. His merit is that he did so, quickly, when the time came.

In the crisis, he cut interest rates to zero, nationalized the commercial paper market, lent with abandon here and abroad –- and kept the financial system afloat. He deserves credit for this. But President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen.

One challenge will be to overcome fixed ideas on deficits -– ideas sadly shared in Washington.

Keeping big banks alive is not the same as restoring credit flows. Credit will not recover until the housing crisis subsides. Right now, with record inventories, collapsed cure-rates, and a flood of foreclosures we’re far from that. The jobs picture remains grim. Low interest rates alone can’t fix these problems, nor can “quantitative easing.” Mr. Bernanke’s first challenge, going forward, will be to recognize these facts — and his own limited power.

His second challenge will be to overcome fixed ideas on deficits -– ideas sadly shared throughout Washington. Fiscal expansion remains necessary. More is needed, especially to sustain state and local public services. This is no moment for people who are made nervous by a big government debt. With the private sector still flat, the public sector has to grow, or the economy will not.

A third challenge will be to resist deceptive optimism. In July, 2007, Mr. Bernanke was still testifying that our housing problems could be managed. I don’t believe that he didn’t see the impending collapse. But he didn’t want to precipitate it — understandable, but bad policy. He should now beware of cheerleading for a recovery that may, at best, leave millions behind.

Ben Bernanke is smart and capable, honorable and honest. Yet his renomination signals continuity in policy from the late Bush era, through this year and onward. President Obama passed up a chance to reorganize his economic team. When the moment comes that the policy has to change, the task will not be easier, because of this.

Getting the Recovery Right
Tyler Cowen

Tyler Cowen is a professor of economics at George Mason University. His blog, Marginal Revolution, covers economic affairs.

I was glad to see Mr. Bernanke reappointed but he faces a daunting task. Basically the Fed pumped a lot of liquidity into the economy to sustain the banking system. So far all that new money has not caused inflation because banks have sat on much of it rather than lending it out and stimulating expenditures.

His biggest challenge will come when the economy starts to recover and the new money starts to be translated into inflationary pressure on prices. What will he do?

Will growth fade away once the stimulus money is spent? That will be a hard call to make.

Most likely he will try to withdraw a lot of that new money from the system, so as to keep inflation within a manageable range. That is indeed the right plan but it’s an open question as to whether the Fed gets the timing right. If they withdraw money too quickly, we could see a “double dip” recession. If they wait too long, inflation may rise to unacceptable levels and then the subsequent required monetary tightening could cause a double dip recession as well.

Running the fiscal stimulus makes good prediction much harder. As more of the stimulus spending comes on-line, measured G.D.P. is very likely to rise because there will be more economic activity. But does that change in the numbers represent true sustainable recovery? Or is it a temporary blip that will fade away once the stimulus money is spent? That will be a hard call to make.

Successful execution requires the Fed to have a good sense of exactly when the recovery is coming. Even though the Fed has an excellent staff they’ve been wrong in the past. I don’t give them any more than a 50 percent chance of getting it right.

It is possible that Mr. Bernanke will face an even bigger challenge if our high and rising debt leads to a run on the U.S. dollar. As we’ve seen with our banking sector, such “attacks” can come with very little warning and that probably would lead to a second Great Depression. I don’t think the Obama administration is worried enough about this problem. But Mr. Bernanke is not the one who can solve it, what we need is more fiscal discipline from Congress, most of all on health care costs.

Why Obama Needs Bernanke
Brad DeLong

Brad DeLong is a professor of economics at University of California, Berkeley, and blogs at Grasping Reality with Both Hands.

Ben Bernanke has already guided the Federal Reserve through two very tumultuous years with only one major mistake (although that mistake, Lehman Brothers, really was a beauty). His knowledge of the Great Depression and of crises is exactly what we need, and he’s intelligent, honest, clear-sighted in his vision of the economy and pragmatic. Even if he weren’t the incumbent he would be at the top of the list of candidates. Here’s why.

Since the reworking of the Federal Reserve’s decision-making structure in the Great Depression, on only two occasions — Reagan in 1987 with Paul Volcker, and President Carter in 1978 with Arthur Burns — have presidents failed to renominate a Federal Reserve Chair of the other political party who seeks reappointment. Presidents have renominated chairmen of the opposite party six times — William McChesney Martin twice, Paul Volcker once, Alan Greenspan twice, and now Ben Bernanke.

Financial markets lose confidence if they think the Fed chairman is too much under the thumb of the president to fight inflation.

The reason, I think, that presidents are so willing to reappoint chairmen from the other political party is closely linked to one of the two things that a president seeks from the chairman: the confidence of financial markets.

If financial markets lose that confidence — if they conclude that the Fed chairman is too much under the thumb of the president to wage the good fight to control inflation, or if they conclude that the chairman does not wish to control inflation — then the economic news is almost certain to be bad.

Capital flight, interest rate spikes, falls in private investment spending as businesses find lenders demanding extra insurance in the interest rate against future inflation, a collapsing value of the dollar — all of these are likely should financial markets lose confidence in the Fed chairman.

And if these events should come to pass, the likelihood of an economy strong enough to give a president the running room to accomplish anything is very low.

A Voice for More Regulation
Mark Thoma

Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View.

One important challenge Mr. Bernanke will face is to keep the financial sector recovery on track by not raising interest rates too soon, while avoiding inflation by not raising interest rates too late. It will be a difficult balancing act, particularly with the complications that a large budget deficit adds. I’m quite confident Mr. Bernanke is up to the task.

But the most important challenge is how to restructure the financial sector to reduce its vulnerability to a collapse like the one we just experienced. That’s a task that will require both institutional and regulatory change.

The Fed needs the authority to dismantle “too big to fail” financial firms, authority it lacked but very much needed during the crisis.

Some of this the Fed can do on its own, but other parts require Congressional approval. As the financial sector has started to show signs of life, we are already hearing protests against regulation. The most prominent objection is that regulation will stifle new financial innovation (never mind that it was this innovation that helped to cause the predicament we are in).

My worry is that as time passes, we’ll forget how bad things were and the desire to impose necessary new regulation will fade. Here’s where I think Mr. Bernanke’s experience will be crucial. He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress.

For example, the Fed needs the authority to dismantle “too big to fail” financial firms, authority it lacked but very much needed during the crisis. Mr. Bernanke knows first hand how hard it was to manage the crisis without this authority. He’s also seen the consequences of an unregulated shadow banking sector, and he knows how bad incentives and poor market structures created problems that could have been avoided.

There are two other factors working in Mr. Bernanke’s favor. If the financial recovery goes as I expect, his reputation will grow, giving him the authority he needs to persuade Congress to make needed regulatory changes. And just as important, unlike some past Fed chairmen, he’s been able to articulate complex ideas in ways that legislators seem to understand.

Surprises in Store
Vincent R. Reinhart

Vincent R. Reinhart, a senior fellow at the American Enterprise Institute, is a former director of the Federal Reserve Board’s division of monetary affairs.

President Obama’s decision to reappoint Federal Reserve Chairman Ben Bernanke was a welcome surprise. The news was not in the choice. Chairman Bernanke has done a good job at shepherding monetary policy over the past three and one half years. He got the big decisions right, easing quickly and acting creatively with the Fed’s balance sheet. He also moved incrementally to provide more information about policy makers’ outlook.

The blots on his record relate to decision in crisis management, which were fitful and inconsistent in 2008. But the Fed chairman was part of a team, and it is difficult and probably unfair to apportion responsibility.

The surprise comes from the timing of the announcement, five months before the Fed chairman’s term is up. Leaving the incumbent twisting a while in the wind was probably tempting. A Fed chairman not sure of his job prospects might be less likely to ease his foot off the monetary accelerator, which has been pedal-to-the-metal for some time. Instead, the White House pulled a page from the Robert Rubin playbook of trying to calm the anxieties of financial market participants.

But two more surprises are in store.

First, the White House will likely learn that a Fed chaired by Ben Bernanke will follow a policy uncomfortably tight as the 2012 election looms into sight. Bernanke has espoused a commitment to low inflation over his entire career. He also is a democratic and consultative chairman, so the voices of monetary conservatives among Fed officials will be heard loudly and frequently.

Second, Chairman Bernanke’s surprise will be that the validation of a second term, while no doubt personally rewarding, will not be worth much in the ongoing bureaucratic battle over regulatory powers and the structure of the Fed. The Congress has justifiable concerns about giving the institution more authority, and the competition among the agencies will be fierce.


Calculated Risk

As Fed Governor Bernanke supported the flawed policies of Alan Greenspan - he never recognized the housing bubble or the lack of oversight - and there is no question, as Fed Chairman, Bernanke was slow to understand the credit and housing problems. And I'd prefer someone with better forecasting skills.

However once Bernanke started to understand the problem, he was very effective at providing liquidity for the markets. The financial system faced both a liquidity and a solvency crisis, and it is the Fed's role to provide appropriate liquidity. Bernanke met that challenge, and I think he is a solid choice for a 2nd term (not my first choice, but solid).

By Phil Izzo

Economists, lawmakers, bloggers and others weigh in on President Obama’s decision to reappoint Fed Chairman Ben Bernanke.

* While I have had serious differences with the Federal Reserve over the past few years, I think reappointing Chairman Bernanke is probably the right choice. Chairman Bernanke was too slow to act during the early stages of the foreclosure crisis, but he ultimately demonstrated effective leadership and his reappointment sends the right signal to the markets. –Sen. Chris Dodd, (D., Conn.), Chairman Senate Banking Committee

* The experience that Bernanke has acquired will be invaluable. I don’t mean this to sound like a back-handed compliment, but Bernanke is not the same person today as the one who made the decisions that his critics object to. –Louis Crandall, Wrightson ICAP

* I think it’s good news for the Federal Reserve. It’s good news for the country. It’s a great choice. Chairman Bernanke has done a terrific job in bringing openness to the Fed. He has been bold and creative in dealing with the financial crisis… It was not clear to most people that the crisis was going to be as broad-based, and that the excesses in the financial markets and in lending were as broadly based as they turned out to be. Even at the start, he was willing to consider all options to deal with what appeared to be more a liquidity than a solvency crisis. As it began to become more clear that it was a crisis of solvency and leverage and a classic credit crunch, he didn’t flinch in bringing enormous creativity to bear in mitigating the problem –Richard Berner, Morgan Stanley

* Having a new chairman come in at this late date would put the Fed engineered solution to both the recovery and the exit strategy at risk. The Federal Reserve made a hasty exit from easy money stimulus in the 1930s and we know how that worked out… Mistakes have been made at many regulatory institutions during this crisis, but all the Fed’s mistakes would have been made by any man according to the prudent man rule. Bernanke is a true prudent man who calls them as he sees them, and knows the ins and outs of policymaking… If he can pull off this recovery that still needs nurturing, he could well go down as one of the greatest Fed Chairmen in history. –Christopher Rupkey, an economist with Bank of Tokyo-Mitsubishi

* History shows that uncertainty is the enemy of markets. Much speculation about Bernanke and a possible Summers succession has swirled in market analysis circles. That is over… We wish the reappointed chairman success. Meanwhile we remain vigilant and recognize that, in a globally linked world, financial integration means that no single central bank and no one chairman of it has ultimate and dominant power. Bernanke needs to find a path for coordinated action when the time to remove the stimulus is at hand. –David R. Kotok, Cumberland Advisors

* While America’s head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s. It is as if a doctor guilty of malpractice is being given credit for inventing a miracle cure. Maybe the patient needs a new doctor. –Stephen Roach, chairman, Morgan Stanley Asia at FT.com

* As Fed Governor Bernanke supported the flawed policies of Alan Greenspan — he never recognized the housing bubble or the lack of oversight — and there is no question, as Fed Chairman, Bernanke was slow to understand the credit and housing problems. And I’d prefer someone with better forecasting skills. However once Bernanke started to understand the problem, he was very effective at providing liquidity for the markets. The financial system faced both a liquidity and a solvency crisis, and it is the Fed’s role to provide appropriate liquidity. Bernanke met that challenge, and I think he is a solid choice for a 2nd term (not my first choice, but solid). –Calculated Risk

* I am extremely pleased to learn that Ben Bernanke has been nominated for a second term as chairman of the Federal Reserve. We have had an excellent and very close working relationship during the current episode of exceptional challenges for the world economy. The Federal Reserve and the European Central Bank have, together with other central banks, initiated an unprecedented level of close cooperation, which has been key in coping with the present situation. –European Central Bank President Jean-Claude Trichet

* I am delighted to learn of Ben Bernanke’s renomination as Chairman of the Federal Reserve. Since he became Chairman, we have worked closely together, in conjunction with other central banks, and I look forward to continuing that relationship. Ben brings strong leadership to the Federal Reserve at this vital time. It is a long time since we had adjoining offices at MIT. But that experience has stood us in good stead in dealing with the crisis over the past two years.–Bank of England Governor Mervyn King

* Maybe Obama realizes that the really hard part is only just beginning. Unwinding the vast expansion of the Fed’s balance sheet and figuring out how to tighten the screws on the money supply without plunging the country into an another economic contraction will be a tremendous challenge. Why saddle that grief on some up-and-coming Democratic economist? It’s Bernanke’s mess. Let him clean it up. –Andrew Leonard, Salon.com

* [A] benefit of continuity is that it buys you room to maneuver. During the last several months, the Fed has massively expanded its role in the economy to keep credit flowing and prevent the financial system from seizing up. This is unquestionably a good thing… But one side effect has been to create a vocal reaction among bond traders (and their economist-sympathizers), who fear the moves will be inflationary and are constantly pressuring Bernanke to unwind these policies as soon as possible. Alas, doing so while the economy and financial system are so weak would be a horrible, self-defeating mistake–something Bernanke understands. But without Bernanke’s track record and credibility, a new chairman might have to start unwinding the Fed’s balance sheet much sooner to establish his/her anti-inflation bona fides. (Or, put differently, bond investors might actually start bidding up interest rates rather than just kvetching about inflation unless a new chairman sent a hawkish signal out of the gate.) Suffice it to say, the White House has very good reasons for wanting to avoid this outcome. –Noam Scheiber, The New Republic

* Excellent decision. P.S. Don’t let this good news distract you from the much-less-good economic news on Tuesday: CBO and OMB are releasing new budget projections that will show trillions upon trillions of coming deficits. –Donald Marron

* Game theory would have it this is the safe pick, the one that you cannot get into trouble for, even if things go bad later. A new Fed Chair, in the event something went awry down the road would lead bame back to the White House. –Barry Ritholtz, Fusion IQ

Which Bernanke? Whose Bubble?
Simon Johnson
with 33 comments

Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. But which Bernanke are we getting? There are at least three.

1. The Bernanke who led the charge to rescue the US (and world’s) financial system after the Lehman-AIG collapse. If you accept that the choice from late September was “Collapse or Rescue,” this Bernanke did a great job.

2. The Bernanke who argued for keeping interest rates low as the housing bubble developed. This Bernanke was part of the Greenspan Illusion – the Fed should ignore bubbles and “just clean up afterwards.” Is that still Bernanke’s view? Surely, he has learned from that experience.

3. Then there is Bernanke-the-reformer. Given #1 and #2 above, shouldn’t he be pushing hard for tough re-regulation of the financial system – particularly those dodgy parts where markets meet banking? But is there any sign of such an agenda, even with regard to recently trampled consumers – let alone “too big to fail” financial institutions?

Most likely, we’re in for another bubble.

The Fed will keep interest rates low for the foreseeable future. This will make sense given continued high rates of unemployment in the US economy. But unemployment indicates average economic outcomes – high unemployment is completely consistent with some parts of the financial sector expanding at record rates: this is part of the two-track story.

The big banks have access to large amounts of Fed-provided funding at very low rates. We’ll see this reflected in speculative market activities (think oil).

We’ll also see this in global capital flows (i.e., gross flows, perhaps also net flows – but the new global imbalances may not be so obvious in the pattern of current account surpluses/deficits around the world). The US is increasingly a cheap funding environment, if you are a big player (definition: anyone regarded as an important client by Goldman). Rates now begin to rise in emerging markets, as their economies turn around. The Asia story will be compelling fundamentals and a great carry trade (borrow cheaply in dollars, lend at higher rates in Asian currencies) - and the exchange rate risk is for appreciation against the dollar.

Everyone involved knows this is unsustainable, but also that it can last for a while – and they can get out before everyone else. Or, alternatively, that – as major financial players – they can’t afford to sit on the sidelines (talk to Chuck Prince: what has changed, in ideology, policies, and people at the top since his day?).

Presumably, commodity prices also get dragged up – or perhaps they jump up in anticipation of the Coming Asian Boom? Now this might lead Asian central banks to tighten, but probably not if these economies can continue to keep wage costs under control. And it might lead the Fed to tighten, but probably not as the mantra of focusing on “core inflation” (without food and energy prices) remains intact – however anachronistic it may seem to the rest of us. It’s hard to see Bernanke #2 doing anything different, except perhaps at inconsequential margins.

So then we really bubble – and perhaps we even mistake it for a boom.

When the Big Crash comes, there’ll be another moment of decision: “Collapse or Rescue.” And we know what Bernanke #1 will do. Which is, of course, why this administration is reappointing him – and not seriously reregulating big finance.

By Simon Johnson

The Logic of Reappointing Bernanke
from The Stash by Noam Scheiber

The big news from Martha's Vineyard is that Obama is appointing Ben Bernanke to a second term as Fed chairman. I've explained before why I think this is a good idea--Bernanke has been creative, even highly unorthodox, at precisely the moment when the economy demanded these qualities from the Fed, and when a conservative, by-the-book approach would have likely sent us into a depression. True, Bernanke's Fed didn't exactly distinguish itself on the regulatory side, particularly the consumer regulatory side, during the boom years--the Fed is by statute one of the nation's top consumer financial regulators. But that was the status quo Bernanke inherited from Alan Greenspan in 2006. And there wasn't exactly a ton of time between then and the onset of the financial crisis in 2007 to reorient the institution. (Which isn't to say Bernanke would have if he'd had more time, but still...)

Of course, that doesn't in itself explain why Obama chose to reappoint Bernanke rather than tap a Democratic-leaning economist like Larry Summers, Janet Yellen, or Roger Ferguson--all of whom could have made fine Fed chairmen. To get there, you have to understand the additional importance of continuity at the Fed. It matters in two key ways. First, it just takes a while for financial markets to understand a particular Fed chairman's idiosyncracies and ways of communicating (and, conversely, for a new Fed chairman to settle on the most efficient way of communicating with markets).

The markets have come to trust Bernanke's pronouncements about monetary policy in recent years. But that wasn't always the case. The first several months of his tenure featured a series of misunderstandings--none of them catastrophic, but all less than ideal. The most famous was Bernanke's comment to a congressional committee in April 2006 that the Fed might lay off raising interest rates at some point soon and gauge the state of the economy before resuming. The market interpreted this as a statement of clear intent, when in fact Bernanke meant it literally--he really didn't know whether or not the Fed would take a breather. When Bernanke then inadvertently clarified the statement--through a private, off-hand comment to CNBC's Maria Bartiromo, who subsequently shared it with the world--the markets briefly threw a fit. Not exactly the kind of kinks you want to be working through while trying to recover from the worst financial crisis since the Depression.

The second benefit of continuity is that it buys you room to maneuver. During the last several months, the Fed has massively expanded its role in the economy to keep credit flowing and prevent the financial system from seizing up. This is unquestionably a good thing (see the first paragraph above). But one side effect has been to create a vocal reaction among bond traders (and their economist-sympathizers), who fear the moves will be inflationary and are constantly pressuring Bernanke to unwind these policies as soon as possible. Alas, doing so while the economy and financial system are so weak would be a horrible, self-defeating mistake--something Bernanke understands. But without Bernanke's track record and credibility, a new chairman might have to start unwinding the Fed's balance sheet much sooner to establish his/her anti-inflation bona fides. (Or, put differently, bond investors might actually start bidding up interest rates rather than just kvetching about inflation unless a new chairman sent a hawkish signal out of the gate.) Suffice it to say, the White House has very good reasons for wanting to avoid this outcome.

--Noam Scheiber


The Bernanke Question
Added to cato.org on July 28, 2009
by William Poole

William Poole is Senior Fellow at the Cato Institute and Distinguished Scholar in Residence at the University of Delaware. He retired as President and CEO of the Federal Reserve Bank of St. Louis in March 2008.

Should President Obama reappoint Fed Chairman Bernanke? The case for reappointment is strong in many respects but there is a contrary case that deserves serious attention.

The President and congressional leaders, especially the majority leaders, should logically favor reappointment; the Fed's massive lending relieved the administration and Congress from taking politically difficult steps. The contrary case is that the Fed too readily made expansive use of its powers. Fed lending programs took Congress off the hook and have had the predictable effect of embroiling the Fed in political disputes that compromise its political independence.

Under section 13(3), a 1932 amendment to the Federal Reserve Act, the Fed can make loans to borrowers other than banks "in unusual and exigent circumstances." The Federal Reserve invoked this authority as the legal basis for its emergency loans. The Fed had to decide in a few hours whether to bail out Bear Stearns in March 2008. There was no possibility that Congress could act over a weekend. The Fed confronted the same situation in September 2008, when it decided to bail out AIG. Whether or not these bailouts were wise, they clearly fit the language of section 13(3).

The Fed's other credit programs are different. The Fed also invoked its authority under section 13(3) to justify its Commercial Paper Funding Facility (CPFF). The Fed announced the program on October 7, 2008 and made the first loans about 3 weeks later. Consider also the Fed's buying program for mortgage-backed securities (MBS), which is authorized by section 14 (b) of the Federal Reserve Act. The Fed announced the MBS program November 25, 2008. The first appearance of MBSs on the Fed's balance sheet was in mid-January.

The CPFF and MBS programs should have been authorized by Congress. Congress was not in session in October but could have come back into session right after the election to legislate both programs.

Neither the CPFF nor the MBS program reflected a weekend emergency. The financial crisis called for quick and decisive action, but not immediate action that needed to be decided in a matter of hours. If there was an emergency at all, it was because of congressional unwillingness or inability to act and not because Congress did not have time to act. If Congress were unable to act, because of its concern about the politics of the CPFF program to provide credit to large corporations, should a federal agency make its own decision on what is necessary, committing taxpayer resources amounting to hundreds of billions of dollars? Worse yet, while legislated programs would have been financed by sale of new Treasury securities, the Fed's programs are being financed by monetary expansion — printing money.

The two programs are large. The CPFF reached a peak of $350 billion in mid January, but has declined since. The MBS program is still growing — $545 billion as of July 22, 2009, on its way to an announced $1.25 trillion. All financed, remember, by printing money.

One view is that it is very unfortunate that the Fed found itself in this position, but it did what it had to do given the financial turmoil. A contrary view is that the Fed's responsibility was to make a strong public case that Congress had to act to provide the needed credit. There would have been a public debate about the wisdom of the proposed programs, whereas we know nothing of the internal debates in the Fed.

The Federal Reserve has not explained why assistance to the particular borrowers eligible for the programs — CPFF, MBS and others — are essential to dealing with the financial crisis, whereas loans to other potential borrowers are not essential. To be clear, the Fed's decisions have not been political in a partisan sense, but they do reflect inherently political judgments in the sense that borrower X deserves or needs access to Federal Reserve resources and borrower Y does not. Such issues belong to Congress. The Fed should not have been making these decisions, because doing so would inevitably draw it into political disputes, such as those already seen over disclosure and other matters.

Access to Federal Reserve credit is valuable. It has long been a staple of monetary analysis that monetary policy is a general policy instrument, controlling the aggregate supply of funds in the market through open market operations in government securities. We then rely on private banking and financial markets, and government credit programs authorized by legislation, to make judgments as to which particular borrowers have access to credit and on what terms.

Chairman Bernanke has stretched the emergency authority under Section 13(3) of the Federal Reserve Act beyond recognition and has provided credit to certain non-bank borrowers and not to others. His consultation with Treasury secretaries and congressional leaders is not an adequate substitute for congressional appropriations to finance the federal government's credit activities designed to deal with the financial crisis.

The public wants to keep monetary policy out of politics and understands that financing government by printing money is dangerous. Perhaps the Federal Reserve will be successful in withdrawing the money at the appropriate time, but if not, we have a serious inflation problem in our future. The Fed will face this problem in a weakened political position because of its political decisions in granting credit over the past year.

Given the importance of a non-political monetary policy, which requires central bank independence from everyday politics, and of a reliably non-inflationary policy, Chairman Bernanke does not deserve reappointment.

Marshall Auerback and the downside of more Bernanke

We may be the most anti among the Bernanke observers you've heard, but here is Marshall Auerback of New Deal 2.0, voicing his displeasure with this choice for most powerful unelected person in the World.

Woe and behold, more Ben Bernanke
Wednesday, 08/26/2009 - 1:09 pm by Marshall Auerback | Post a Comment

money-question-150The king of the Washington financial triumvirate gets to stay…to the detriment of the country and the economy. Roosevelt Institute Braintruster Marshall Auerback explains why the Bernanke reappointment is bad news, and what we really need to be doing to the banks — and to their shareholders.

Obama’s decision, announced yesterday, to reappoint Ben Bernanke to a second term as chairman of the Federal Reserve confirms what we already know and fear: This administration’s determination to save the big banks guarantees that we will emerge from this slump with an unreformed financial sector in the hands of the same people who produced the disaster in the first place.

Let’s be honest.It wasn’t Bernanke’s “bold” creative decisions that stemmed the onset of “Great Depression 2.0?; automatic fiscal stabilizers did the actual heavy lifting to stave off the depression — as they always have done since the onset of the New Deal.

Expanding lending to his member banks by progressively accepting more and more collateral helped but the liquidity crisis was caused by the Fed never having understood that requiring any collateral from member banks is both redundant and disruptive in the first place. Bernanke has yet to recognize this, as per his current discussions and policies.

He has also failed to recognize and articulate the essence of policy regarding bank capitalization, viz. TARP and related policies. This failure burned substantial political capital by presumably inflating the federal deficit (even though this was more accurately described as a Federal Reserve operation, rather than a Treasury purchase of real assets), when in fact it did nothing of the sort, and nothing that would not have been identically accomplished by the FDIC simply allowing the banks to operate with less regulatory capital under letters of understanding and penalties as desired by the regulators.

There has to be some serious restructuring in the financial and banking sector across the world. The worst thing about the current stimulus packages has been the way significant dollops of public money have gone to further the private interests of the top 1 percent of the population. In varying degrees this has happened in most countries, but Bernanke has been a key figure in championing and legitimising this regressive transfer of wealth.

My view is that if a bank cannot pay up it should be nationalised and the monetary capacity of the government then be used to guarantee deposits. Quantitative easing has done and does nothing more than lower longer term rates, which is more directly done by a reduction in Treasury bond issuance, something Bernanke has yet to articulate that he understands.

He has also come out repeatedly against budget deficits, contributing to the myths that keep us from using that avenue properly to restore aggregate demand proactively.

To be sure, the debt problem we face today is very serious, but the current concern for the federal deficit and its effect on the public debt is misplaced. Not only is the government debt low relative to the size of the economy, but also, as a matter of national accounting, deleveraging in the private sector cannot happen without an increase in the government’s deficit (the government’s deficit equals by identity the nongovernment’s surplus, so if the US private sector is to rebuild its balance sheet by spending less than its income, the government will have to spend more than its tax revenue; the only other possibility is that the rest of the world begins to dissave massively—letting the US run a current account surplus—but that is highly implausible). In addition, if the government deficit does not grow fast enough to meet the saving needs of the private domestic sector, national income will decline, and, given the size of the private sector’s debt problem, a full-blown debt-deflation process will emerge.

With Bernanke now firmly entrenched (and, apparently, about to get a huge increase in power as the country’s chief systemic regulator), it doesn’t take a prophet to see what’s coming, especially given the ongoing control of fiscal policy by Timothy Geithner and Lawrence Summers. While some bad assets will recover value, many will not, and losses will either go unrecognized or they will be transferred, via public-private partnerships, first off the balance sheets of the banks — and then when the mortgages default, to the taxpayer, via the non-recourse feature of the FDIC’s loans. We could assess the likelihood of this happening, if we chose, by the simple step of auditing the loan tapes underlying a fair sample of sub-prime securities, to determine the prevalence of missing documentation, misrepresentation and prima facie fraud, but fraud seems to be one of those concepts that remains anathema to America’s monetary and fiscal authorities (as well as a large chunk of the economics profession).

That we’re not getting to the bottom of this crisis and uncovering the bad behaviour that went on before means that we’re just setting up the banks for additional fraud. Given the increasingly parlous state of the bank’s hitherto unrecognized liabilities, coupled with a seemingly endless government guarantee, the current structure almost guarantees continued bad behaviour on the part of the banks. “Betting the bank” makes sense when you know that your institution is full of toxic junk, which is effectively underwritten by the taxpayer, enabling you to indulge in questionable accounting and pernicious compensation practices. That’s been the story of 2009 so far.

I and others have offered several answers to the “What should we do?” question, but here’s another idea: Banks’ shareholders need to be wiped out so that we can get rid of this horrible “too big to fail” structure once and for all, cut the banks down to size and minimize their pernicious influence in the government. The government should counteract that with additional fiscal policy, directed toward the needs of the productive economy — buying goods for the productive economy, for instance — and not toward a banker’s bottom line.

As Hyman Minsky argued, banks serve an important public purpose and thus are rewarded with access to the lender of last resort and to government guarantees. Those government guarantees provide cheap and virtually unlimited credit to banks in the form of insured deposits. Because there is no “market discipline” via bankruptcy that will be imposed on bank management, the banks themselves need to be regulated like utilities. Otherwise, the bank concerned can increase its profits on equity by raising the return on assets given a capital ratio, and by reducing the ratio of capital to assets (i.e., raising leverage). Each of these actions will increase the riskiness of banks—but can dramatically raise profitability for owners without increasing their capital at risk. Instead, it is the government insurer that absorbs any losses once the bank’s equity is destroyed by losses on bad assets. Bernanke, like Summers and Geithner, embraces this neo-liberal approach completely. The “market” has tried to downsize the financial sector, but Bernanke, Summers and Geithner only let market forces work their “magic” inside the bubble, not when it bursts.

All the programs championed by Bernanke, Geithner and Summers have failed to deal with the core issue at stake: many financial institutions are probably insolvent and need to be closed; assets must be analyzed carefully to figure out their profitability potential and the true financial state of financial institutions; an investigation must be open to determine responsibility among top managers. Even though financial markets have stabilized, they are still under heavy assistance by the government and we have not dealt with the solvency problems. Banks have been posting profit but, gains largely come from exceptional cash inflows (e.g., the sale of Smith Barney by Citi), they still need large government help to make those profits (Goldman Sach repaid $10 billion of Capital Purchase Program money to avoid the executive pay limit, but still got $12.9 billion from the help provided to AIG (Scheer 2009)), and suspicions of accounting manipulation (if not fraud) are surrounding the valuation of assets.

Yesterday, as usual, the “change” President simply perpetuated the status quo. Mind you, it could have been worse: Obama could have selected Larry Summers.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.

Galbraith questions whether Bernanke saved the economy

James K. Galbraith - "President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen."

Two pieces are reproduced and linked below. The first is the day after comment on Bernanke's reappointment. The second is a review of David Wessel's In Fed We Trust, with Galbraith's questioning of the received wisdom that Baffled Ben rescued the economy. (emphasis below added)

Resist False Optimism
James K. Galbraith

Odds are, Mr. Bernanke’s second term will not be as interesting as his first.

Ben Bernanke came to the Federal Reserve imbued with academic notions. One of these was that central banks should concentrate on “inflation targeting.” Another was that we were living in a Great Moderation, that efficient financial markets would provide for stable economic growth evermore. Ha, and ha-ha-ha. Both of these ideas, Mr. Bernanke had to chew and swallow. His merit is that he did so, quickly, when the time came.

In the crisis, he cut interest rates to zero, nationalized the commercial paper market, lent with abandon here and abroad –- and kept the financial system afloat. He deserves credit for this. But President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen.

One challenge will be to overcome fixed ideas on deficits -– ideas sadly shared in Washington.

Keeping big banks alive is not the same as restoring credit flows. Credit will not recover until the housing crisis subsides. Right now, with record inventories, collapsed cure-rates, and a flood of foreclosures we’re far from that. The jobs picture remains grim. Low interest rates alone can’t fix these problems, nor can “quantitative easing.” Mr. Bernanke’s first challenge, going forward, will be to recognize these facts — and his own limited power.

His second challenge will be to overcome fixed ideas on deficits -– ideas sadly shared throughout Washington. Fiscal expansion remains necessary. More is needed, especially to sustain state and local public services. This is no moment for people who are made nervous by a big government debt. With the private sector still flat, the public sector has to grow, or the economy will not.

A third challenge will be to resist deceptive optimism. In July, 2007, Mr. Bernanke was still testifying that our housing problems could be managed. I don’t believe that he didn’t see the impending collapse. But he didn’t want to precipitate it — understandable, but bad policy. He should now beware of cheerleading for a recovery that may, at best, leave millions behind.

Ben Bernanke is smart and capable, honorable and honest. Yet his renomination signals continuity in policy from the late Bush era, through this year and onward. President Obama passed up a chance to reorganize his economic team. When the moment comes that the policy has to change, the task will not be easier, because of this.

Fed Up
Did Ben Bernanke really save America's financial system?

By James K. Galbraith

In Fed We Trust:
Ben Bernanke's War on the Great Panic
by David Wessel
Crown, 336 pp.

David Wessel’s new account of the Great Crisis, In Fed We Trust, has many merits: it is timely, well written, and informative. The protagonists—Ben Bernanke, Henry Paulson, and Timothy Geithner—were faced in September 2008 with a supreme challenge. Wessel gives us, without judgment, a narrative of what they did. As history, this is first-draft stuff, but it’s as good a first draft as one could hope for, less than a year after the events it describes.

Wessel begins with the collapse of Lehman Brothers, as the crisis climaxed. We see the government acting as the ultimate investment banker, an uber-manager for the too-big-to-fail. Bernanke, Geithner, and Paulson shuttle between New York and Washington, send signals, urge Lehman to find a buyer, court Bank of America and then Barclays, and pressure other Wall Street CEOs to join a deal. It is all in direct line of descent from J. P. Morgan’s epic rescue of the Trust Company of New York in the panic of 1907—a comparison Wessel does not neglect to draw.

Bernanke, Paulson, and Geithner could not repeat Morgan’s achievement. They did try. Ben Bernanke, the academic economist, had no sympathy with the oft-stated view that such matters should be left to the market; in Wessel’s words, he “thought that was idiocy.” And though Paulson “made what sounded like an unambiguous declaration that he had been unwilling, not unable, to save Lehman,” Wessel contradicts him: “That was not true.” At the time (later statements revealed) they doubted the government had legal authority to rescue—with public funds—an investment bank whose assets were largely pledged or worthless, and so could not be used as security for a public loan. Two days later, when AIG failed, they paid for this judgment. After that, lesson learned, whatever powers were needed would be found, and no other large financial institution would be permitted to fail.

From this opening, the story turns to the Federal Reserve, the institution whose face for so many years was Alan Greenspan, secular oracle, the man who believed in markets. As Wessel documents, Greenspan did not miss the housing bubble. He saw the crisis coming. He was warned of the impending crash, notably by the late Fed Governor Edward Gramlich. He knew what he would have to do. But he elected—he chose—not to do it.

Greenspan’s reputation is now shattered, not least by his own confessions, but it is still useful to read here of the cult of obsequy that surrounded the Federal Reserve chair in his time. Wessel quotes a cringe-inducing 2005 assessment by economists Alan Blinder and Ricardo Reis: “No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although both may come in time as the legend grows.” The chapter on Greenspan is aptly titled “Age of Delusion”—a phrase borrowed from a manuscript Ben Bernanke had been working on at Princeton. Bernanke’s subtitle: “How Politicians and Central Bankers Created the Great Depression.”

Ben Bernanke ascended to Greenspan’s post by dint of academic merit, low-keyed but clearly superior intelligence, and—most curiously—a largely apolitical appointment process within that most political of White Houses, that of George W. Bush. (Wessel explains that Fed Governor Kevin Warsh, “the networker,” acted as Bernanke’s link to high Republican politics. Will President Obama now give the Fed a comparable link to the Democrats? Don’t hold your breath.) Once in, Bernanke set out to shape monetary policy to his academic values: collegiality, transparency, more focus on what he imagined was the Fed’s core mission, namely “fighting inflation.” Clearly the Age of Delusion wasn’t over.

Bernanke’s merit, in these pages, was quick learning. By Wessel’s timetable, learning took hold in December 2007, when he first moved to cut rates in order to ward off, or anyway help mitigate, the oncoming recession. (The financial crisis had started the previous August, with the collapse of the interbank lending market.) Soon there would be the forced sale of Bear Stearns, which was at—or perhaps over—the limits of law and precedent in central banking. To Vincent Reinhart, a former senior Fed staffer, it “meant that the Fed would always be expected to bring money to the table when trying to arrange the rescue of a big financial firm.” With AIG, with TARP, and after, the commitments cascaded—dollars by the trillions went into commercial paper, into the banks, into foreign central banks—in processes neither collegial nor transparent. Thus, in the phrase that forms the second subtitle of this book, “the Federal Reserve became the fourth branch of government.” And the system survived.

Or did it?

There is a larger book, as yet unwritten, for which In Fed We Trust will prove a valuable source. That work will have to take on the questions that merely frame the narrative here.

The first question is: Did the system actually survive? It is true that checks still clear, that incipient runs on small banks and money markets were stopped, that neither the dollar nor the euro collapsed, and that the major commercial banks were not nationalized. But does all this add up to survival of finance capitalism as we knew it? Can we expect, with moderate passage of time, that households will resume borrowing, banks will resume lending, and that before long we will pick up the pattern of our economic lives as before?

Or does the fact that the Federal Reserve was prompted, in the heat of the crisis, to issue trillions of direct loans to private institutions fundamentally strip away the capitalist character of the system? Are we left with a system of large institutions of doubtful solvency, state dependent, unable to function without an implicit public guarantee, and therefore also needing government approval for their actions? If so, how is this system different from that in, say, the People’s Republic of China? Wessel notes that Chinese observers described the result as “socialism with American characteristics.” It’s not necessarily a joke.

Second, one must ask whether the Bernanke-Paulson-Geithner measures actually worked, not just in the sense of stopping bank runs, not just to put a floor under a deep slump, but in the larger sense of laying the foundation for a strong recovery and return to high employment.

Were the massive frauds that underlay the housing debacle rooted out, their perpetrators prosecuted and jailed? Not yet. Were foreclosures stemmed? Not yet. Have housing prices reached bottom? There is some evidence for that. Will housing construction recover? Not for years. Did “quantitative easing” get lending started again? Not in a way that would support new business investment or household borrowing.

And how could it? It was the borrowers, not the lenders, who last fall precipitated the economic downturn. Auto sales didn’t collapse because willing buyers could not get loans: they collapsed because people stopped buying cars. Without collateral, without home equity, without job security, householders decided, en masse and rationally, to save what they could. Without prospects for profit, businesses slashed their investment. And when tax cuts were injected by congressional conservatives into the stimulus plan, these too were saved, not spent. And so the housing crisis drags on, and the crises of state and local government finance, and the crisis of mass unemployment, show no signs, yet, of abatement.

Eventually stimulus funds will get spent. Eventually, households will start needing new cars and even new houses. But as the weeks go on, that moment seems to recede. Meanwhile the chorus of deficit hawks and “exit strategists” is swelling—and it looks like the next moves in macro policy will be toward contraction, not growth. It does not help that economic forecasters are always predicting a return to growth six months hence; such forecasts, though often wrong, serve to protect policymakers from pressure to action.

Perhaps, then, the Bernanke-Paulson-Geithner strategy was wrong? Perhaps the right thing to do would have been to put several large institutions through receivership, if not last September then from the start of Obama’s presidency in January 2009? Looking narrowly at monetary policy, perhaps Bernanke and company are wrong that their zero-interest policy helps stimulate activity: no one wants the cheap funds, while low rates reduce income from interest, cutting into spending power. Perhaps it would have been better to keep interest rates up, and to double or triple direct federal spending on investment, in support of state and local budgets and of private purchasing power. Perhaps the right thing would have been less focus on saving banks, and much more on saving jobs, families, and homes.

We will not know for sure, because our leaders did not take this path.

Finally, there is a question of character. David Wessel’s method is to treat each of his major protagonists as an upstanding public servant, hardworking and incorruptible. I do not criticize this approach; otherwise he could not have written the book, and anyway, Wessel is convinced that this view is correct, and there is plenty of evidence—long hours worked, hard decisions made—that supports it. In the history of George Bush’s presidency, no one will confuse Bernanke, Paulson, and Geithner with, say, Michael Brown of FEMA or Paul Wolfowitz and the others who planned the invasion of Iraq.

Still, historians will have a harsher task. Did Ben Bernanke’s academic commitment to Milton Friedman’s monetarist principles (including “inflation targeting”) render him unable to raise warnings, to see dangers, and to take action early enough? Do these ideas today still cause him to overrate monetary policy and underrate what is needed in new spending? Was Henry Paulson influenced, perhaps even driven, by loyalties to Goldman Sachs? Was Timothy Geithner too close to Wall Street—a deal maker, an investment banker—when an actual regulator was required? Is the Age of Delusion over yet?

Time, investigations, and greater detachment than found here will settle these issues, later on.