Fed chairman Ben Bernanke has for the first time provided a clear appraisal of what happened last September and, more importantly, he has explained where we all go from here in 2009. His speech to the London School of Economics last night was in the usual dry language of a central banker, but in many ways it was full of drama – a stunning description of a system in crisis and a group of policymakers desperately trying to make it up as they go along.
Bernanke himself is a student of past Depressions, in particular the 1930s and Japan in the 1990s. But as he explained, things are very different this time: “Credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing.”
Markets liked his speech because he more or less urged the US government to cough up the rest of the TARP (Troubled Asset Relief Progam) money and buy more troubled assets from the banks — an issue that has been debated since outgoing Treasury secretary Hank Paulson shelved the program in November, mumbling that it didn’t seem like it would be very effective.
Markets had another conniption at the time and haven’t really recovered from it yet. Even ineffective rafts are clutched at by drowning people.
In his speech last night, Ben Bernanke basically labelled the fiscal stimulus plans of the incoming Obama Administration as ineffective rafts as well, or rather suggested they won’t be enough unless the financial system is stabilised as well. By the end of the session, Wall Street was focusing more on that part of the speech.
Stabilising the financial system means relieving the banks of their stupid mistakes (he didn’t say that of course).
He laid out three ways of doing it: public purchases of troubled assets (the troubled TARP); asset guarantees, in which the government agrees to absorb future losses in return for warrants or other compensation; and setting up and capitalising “bad banks” which would buy the mistakes from the banks.
By the way, Citigroup’s CEO, Vikram Pandit, is this morning said to be looking at dividing Citi into a good bank and bad bank — basically giving up on the financial supermarket idea that was behind its merger with Travellers. If so, there is little doubt that the government will have to be involved in capitalising its bad bank.
In response to community concerns about governments rescuing these banks from the consequences of their own follies while other industries and businesses are left to flounder on their own, Bernanke basically said: “Suck it up.”
“This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt.”
He also addressed, simply and powerfully, the concern that the Fed was printing too much money, and that hyperinflation would result.
This concern was no better expressed than in a Barron’s magazine roundtable a few weeks ago that included Bill Gross of Pimco, Marc Faber, Mario Gabelli, chairman of Gamco Investors, Oscar Schafer, managing partner OSS Capital Management and Fred Hickey, editor of High Tech Strategist, plus six other financial market luminaries. It’s worth quoting a section of it in full.
HICKEY: The Fed has tripled the size of its balance sheet and is plowing ground we have never seen before. Here are my facsimiles of deutsche marks from Weimar Germany [holds up sheaf of papers]. They collapsed in value when Germany started printing money after World War I. It happened very quickly and it can happen again.
The Germans were successful at reflating. But they weren’t successful in saving their economy. Bernanke is on record saying, “I will not make the mistakes of the 1930s. I will not make the mistakes of Japan in the 1990s.” He is pushing the limit right now.
GABELLI: So you’re saying he’s going to make the mistake of the Weimar Republic?
HICKEY: There is a possibility of that. Every month that there is a horrible employment report, the government prints more money.
GABELLI: It took Weimar Germany a brief time.
FABER: The worse the economy, the more they will print. It is like in Zimbabwe now, and Latin America in the 1980s. They had large deficits and printed money, and in local currency everything went up. But the currency collapsed.
SCHAFER: Isn’t the federal government increasing its balance sheet to offset the private sector?
GROSS: Exactly. The situation isn’t similar. The Weimar Republic basically reflated to get out from under its wartime debts. Zimbabwe is a situation unto itself. In the US there has been asset destruction in the trillions of dollars that has to be repaired. To say the Fed’s balance sheet has expanded by a few trillion dollars and that this will create hyperinflation is a miscalculation.
FABER: I’m prepared to bet Bill that in 10 years the US has very high inflation. With growing fiscal deficits that may reach as high as $2 trillion next year, it will be hard for the Fed to lift interest rates in real terms. Once they push up rates again, there will be another disaster.
GROSS: Marc, you’re smarter than that. You know that credit creation is at the heart of economic growth, and to the extent that credit creation has been thwarted, stultified, basically cut by 10 or 20 per cent, economies can’t grow.
FABER: The US economy is credit-addicted. In a sound economy, debt growth doesn’t exceed nominal GDP growth. Would you agree with that, or do you think debt should always grow at a faster pace than nominal GDP?
GROSS: I’m with you there.
I’m betting Bernanke was referring to that exchange last night when he said: “Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary.”
Basically his answer was to agree with Bill Gross: yes, he said, Fed activities have resulted in large increases in reserves held by banks, which, together with currency, make up the narrowest definition of money.
But they’re not lending it. The banks are leaving it sitting on deposit with the Fed. As a result the broader measures of money supply, M1 and M2, are not expanding.
When credit markets recover and banks start lending again, the Fed’s own lending activities will “unwind automatically”. That’s the plan anyway.
And what happened in September that brought the financial system undone? Well, it wasn’t directly the collapse of Lehman Brothers. It was the fact that a prominent money market mutual fund (Reserve Primary Fund) “broke the buck” as a result of Lehman’s collapse — that is, its net asset value went below a dollar.
That led to a run on all money market funds. Said Bernanke: “Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened.”
He didn’t say this, but the $US5 trillion commercial paper market was, and is, supported by bank guarantees. If that market fell over, the global banking system would have gone too because the banks don’t have $US5 trillion.
Bernanke and Hank Paulson decided to let Lehman Brothers go on that fateful weekend in mid-September because they thought the credit default swaps market could handle it. What they didn’t know was that Reserve Primary Fund held $US785 million in Lehman commercial paper.
Last night’s speech in London was a description of the mess left by that decision, and what he is still doing to clean it up.