Steve Blitz Morning Notes

Fed Chairman Bernanke speaks today at Morehouse College in Atlanta asking the "Four Questions About The Financial Crisis." He mirrors the Passover Seder ritual where the youngest asks four questions to understand the why and how of Passover. The answers Bernanke offers for the current credit collapse of near biblical proportion proves a wisdom far less than the Rabbinic sages whose answers are repeated at the seder. Bernanke fails to note the Fed's passivity in the face of foreign saving inflows that "drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives."

If the Fed invoked credit growth instead of a single focus on inflation as a reason to adjust policy, as the Rabbinic sages would have had the wisdom to do, those returns never would have been driven so low as to so distort domestic investment and saving. If the Fed started tightening sooner and more aggressively policy would have effectively done what the FX market was not doing -- raising the cost of domestic credit so that domestic investment and saving could move towards balance.

Here is a paragraph from his talk:

Mortgage markets were not the only ones caught up in the credit boom. The large flows of global saving into the United States drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives. To satisfy the enormous demand for investments both perceived as safe and promising higher returns, the financial industry designed securities that combined many individual loans in complex, hard-to-understand ways. These new securities later proved to involve substantial risks–risks that neither the investors nor the firms that designed the securities adequately understood at the outset.

By failing to note that the Fed's myopic attention on flawed inflation indexes was complicit in creating the situation, the Fed risks creating the same situation all over again. Bernanke concludes with

. . . the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.

If that is to be true, the Fed must focus on credit growth and put aside inflation targeting. The next collapse will not find the Federal government as underleveraged as it was this time. Between now and the next crisis, however, the management of monetary policy suggests a period of tremendous profit for financial institutions. Yet again. This is no way to, as Paul Krugman wrote, "make banking boring again".