Bernanke In Jackson Hole Reveals How Much He Learned ~ Steve Blitz Morning Notes
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Friday, August 21, 2009

Bernanke In Jackson Hole Reveals How Much He Learned

Fed Chairman Ben Bernanke spoke this morning to the annual gathering of like-minded bankers and economists in Jackson Hole, Wyo. that is sponsored by the Fed Bank of Kansas City. The speech this morning contains everything that one would expect the Chairman to say -- we saw, we acted, we saved the world (italics are mine):
As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year monetary, fiscal, and financial policies around the world have been aggressive and complementary. Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

The self-congratulation is nice, and yes he did finally figure it out after turning a big problem into a catastrophic one, but there is no reference to the Fed's complicity in all this-- allowing credit growth to accelerate unabated because CPI inflation remained low and allowing the financial system to do whatever because of Bernanke's and others strong belief in the market system to self-regulate and democratize risk. This part of the speech tells us exactly what he didn't know going in and learned and I find it particularly scary in a Fed Chairman (italics mine):
. . a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities, and in which suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence. Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit. . . .

. . . As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.This unstable dynamic was apparent around the time of the near-failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September. As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry.

. . . during the crisis runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of "runs"--for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.

Ben learned an awful lot about markets and financial systems. After all, if he knew all this in August 2007 he would have immediately known that lowering interest rates would not fix a collateral problem set off by a weakening housing market and ebbing inflows of foreign capital. The market indicators were there to indicate all of this, but in the "efficient market" view of the world those indicators were neither standard or accepted.

He ends the speech with this (italics mine):
We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years
And how exactly is Mr. Bernanke going to employ these new regulations given that he gives no reason to believe that he learned anything other than the plumbing that makes a financial system function. If I were in Congress and able to ask him questions at his confirmation hearing, this is what I would want to know.

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