A decade is a long time in central banking. Ten years ago Ben Bernanke used his speech at the Jackson Hole symposium for central bankers to explain the tumult that was rippling through financial markets at the time.
He explained that while there were problems in the US housing market, the global financial system was pretty well prepared for the a fall in house prices. Looking back, this is pretty alarming reading.
Credit markets had all but frozen barely a week before the speech and the vast securitisation market was essentially shutting down. Bernanke’s speech noted the recent “slippage in [mortgage] underwriting standards” that had occurred in recent years, the “opaque and complex” nature of structured products and the fact that “global financial losses [on subprime mortgages] have far exceeded even the most pessimistic projections of credit losses on those loans”. But also that the “past efforts to strengthen capital positions and the financial infrastructure place the global financial system in a relatively strong position to work through this process.” The tornado had inched into view and was gaining strength as it scooped up first the housing market, and then the world’s credit market. Yet, Ben Bernanke essentially thought that the storm would spread no further.
Clearly, Mr Bernanke and his colleagues could not have fully foreseen the full extent of the crisis which was breaking into view. The magnitude of the collapse in the financial system really was like nothing we had ever seen before. No one understood just how inter-connected the system was, how fast issues could spread and how appallingly long the legacy of the crisis would be.
But what is so frustrating looking back is that Mr Bernanke and his colleagues had almost all the pieces in their hands, but didn’t put the puzzle together. His speech connects the US housing market’s issues, with those in the securitisation market and specifically notes that the losses there were greater than anyone had expected. Moreover, Bernanke was a scholar of the Great Depression, and the contemporary struggles of the Bank of Japan with its deflation problem was a clear and present reminder of how monetary policy may not be able to deal with a big downturn. Yet the Fed’s response was minimal.
It’s conceivable that Mr Bernanke knew the situation was worse than his speech suggested. That he didn’t let on because doing so would create panic that would make a bad situation worse. But if that were the case then he could have simply kept quiet and started aggressively cutting interest rates to stimulate the economy. Yet the Fed had only really made a small cut to the rate at which it leant money to banks by the time of Jackson Hole. The minutes from the Fed’s meetings around this time showed that they were more pre-occupied with inflation exceeding their target than the fact that parts of the financial system were starting to topple.
No doubt as the crisis got worse in the following summer of 2008 the Fed stepped up and did much to stop the crisis from getting even worse. But Mr Bernanke would surely acknowledge it was a mistake to not do more, sooner.
So what lessons might he draw from rereading his speech from a decade ago? Most obviously: that the Fed had got it really, really wrong. This was not the contained event that they thought it was.
There were serious gaps in the Fed’s understanding of how flaws in the underlying plumbing of the financial system could jeopardise the whole economic system, stemming in part from the nature of the economic models they studied. No one at the Fed had joined the dots between an explosion in credit, the growth of the securitisation market, deteriorating mortgage lending standards, a housing market on steroids, and the instability of the wholesale funding market for banks. Economists and the Fed have gone a long way to rectifying these models, but we still don’t really know how successful the currently fashionable “macroprudential” policy will be in dealing with financial stability risks.
Just because something hasn’t happened before, it doesn’t mean it can’t happen in the future.
Second, just because something hasn’t happened before, it doesn’t mean it can’t happen in the future. Mr Bernanke thought that the US housing market would behave as it had done in the past. By which he meant that a nationwide collapse in house prices would be very unlikely to happen, and even if it did, it wouldn’t bring the whole economy down. Indeed it is precisely the risks you are less worried about that often turn out to be the ones that hurt the most, as you make the least effort to adjust.
But while the past doesn’t allow us to perfectly predict the future, past errors can inform the actions of the future. So as Janet Yellen, Mr Bernanke’s successor at the Fed, prepares her speech for this year’s Jackson Hole Symposium she may reflect on the lessons of the past and remember to expect the unexpected.
This article previously appeared in the Telegraph on 23rd August 2017.