U.S. policymakers must recognize and act on parallels from past financial crises when responding to future ones, said former Federal Reserve Chairman and former Princeton University economics department head Ben Bernanke on Tuesday.
In a public lecture hosted at the University by the Bendheim Center for Finance, Bernanke laid out a general framework for identifying and responding to financial panics by comparing the US panics of 1907 and 1914 with the recent crisis of 2007.
Most crises happen when the economy is slowing or credit is tightening and begin with a triggering event, Bernanke said. “It can be a very small event, it doesn’t have to be a huge thing, but what it does is it creates a different mindset,” he explained. “It makes people worried about some set of things that they weren’t worried about before.”
As an example, he noted that while the crisis of 1907 caused one of the most severe recessions in U.S. history, it was triggered by a surprisingly trivial event: a couple of brothers speculating in the stock market.
Similarly, the 2007 crisis was triggered when a French bank announced that the liquidity in the market for subprime mortgages had dried up, Bernanke said, noting that subprime mortgages by themselves were a relatively small asset class.
“We calculated at the Fed that if every subprime mortgage in the world went bad on the same day, it would be like a bad day in the stock market, that’s all the loss would be,” he said. Bernanke explained that the real problem came from the fact that subprime mortgages were packaged into securitizations, and once packaged, no one knew whether a certain securitization contained one or not.
Other defining features of panics are runs on short term funding, liquidity crunch, and fire sales of risky and illiquid assets, Bernanke said – actions that all stem from skyrocketed public demand for safe liquid assets in times of financial uncertainty. Fear in the epicenter of the panic then gains momentum and spreads through interconnected financial institutions, he said.
“Contagion can happen because you think that the bank across the street is having a run, [and think], well my bank has made the same types of investments, is my bank also at risk?” he explained.
As credit continues to contract, wealth continues to decline, and people continue to hoard short-term liquid cash in an adverse feedback loop, the panic turns into broader economic decline, Bernanke said.
One of the most important response mechanisms in a panic is a lender of last resort, who is able to lend cash to a bank facing runs, so that the bank can pay off depositors and end the panic, Bernanke said. He noted that in 1907, banker J.P. Morgan served as such a lender to banks, stockbrokers, and even the city of New York; in 1914, the US Treasury printed $500 million of emergency currency and lent it to New York banks.
Both panics occurred before the establishment of the Federal Reserve, which today serves as the lender of last resort, proving that panics can be still stopped by entities other than central banks, he said.
In the 2007 crisis, the Federal Reserve not only loaned to banks, but also created facilities that backed securitizations of individual loans and bought unwanted commercial paper, Bernanke said.
“It was really important to get people to be more comfortable and confident in a financial system that was, in fact, stable and safe again,” Bernanke said, explaining that Federal Reserve regulators conducted stress tests of banks to see how they would fare in the event of another deep recession.
Bernanke contended that while the US recovery has not been as strong as economists would have liked, the domestic economy has improved significantly and the main source of the weakness is from the global economy.
When asked whether China’s economic slowdown may have contributed to the weaker recovery, Bernanke responded that the slowdown is expected of a country transitioning from a top-down, centrally-planned economy to a more organic, consumer-led one.
“What’s been surprising is that other emerging markets besides China seem to not have adapted to that as well as we thought they might have,” he said, noting that commodity producers who rely on China’s demand have suffered.
He also said that “a good policy which is politically feasible is better than a great policy which is not politically feasible,” when asked whether he believed if the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was effective enough to prevent future crises in the US.
In the end, identifying and analyzing analogies between past and current financial crises is ultimately the most important tool for preventing and quickly stopping panics, Bernanke said. He concluded, “The world is changing, institutions are changing, the markets are changing, but the basic phenomenon [of financial panics] still recurs.”