Bernanke separates the Fed's response to the crisis into two parts:
First, our financial system during the past 2-1/2 years has experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit.To the modern intellectual, such an economic state appears to be an unprecedented mystery without cause or explanation (as does every other action in the universe). After all, such panics have been occurring regularly for hundreds of years. They appear to be a random phenomena associated with markets. Wasn't the Federal Reserve system created to deal with just these types of "panics"? Bernanke continues:
In its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide well-secured, mostly short-term credit to the financial system. These programs, which imposed no cost on the taxpayer, were a critical part of the government’s efforts to stabilize the financial system and restart the flow of credit. As financial conditions have improved, the Federal Reserve has substantially phased out these lending programs.Let's put aside Bernanke's contention that these programs "imposed no cost on the taxpayer" and his contention that "conditions have improved" and take a wider perspective. What he is describing is a "credit crunch", a classic economic effect associated with government caused boom-bust cycles.
Government induced credit expansion or inflation, which occurred in dramatic fashion in the years preceding the crisis, causes two primary effects. Quoting Dr. George Reisman (see Capitalism, p.938-940):
Inflation does two critical things. It superinflates people's revenues and incomes, while making them correspondingly illiquid, and it leads them to pile up substantial debts against those revenues and incomes.In other words, the rapidly expanding base of money induces illiquidity by incentivizing firms and individuals to hold smaller cash balances. This is because funds are easily available and it becomes extremely profitable to borrow. Reisman continues:
Inflation in the form of credit expansion encourages borrowing by holding down the rate of interest in relation to the rate of profit. It makes borrowing exceptionally profitable; and the more so, the more leverage the borrowing provides. Another important way that inflation encourages debt is simply by leading people to borrow in anticipation of rising prices. Housing purchases are a prime example of this effect of inflation. People go heavily into debt to buy houses at already inflated prices, because they expect housing prices to go on rising. The same thing happens with business spending for plant and equipment and inventories. [emphasis mine, keep in mind, this book was published in 1993]Why does this ultimately lead to a "credit crunch"? Eventually, once the inflation stops, prices and revenues stop rising, individuals must raise their cash holdings to repay their debts.
As a result, spending and the velocity of circulation fall, with the further result that people's money revenues and incomes fall. The effect of this, in turn, is that they cannot pay their debts. A substantial number of business and personal bankruptcies occur.This causes a credit death spiral
as the assets and capital of banks which have lent to such borrowers is correspondingly reduced, and many of them also fail.Reisman's next passage is very important (as it hints at the problem of fractional reserve banking.)
The failure of banks, of course, causes the money supply to actually be reduced, since the banks' outstanding checking deposits are part of the money supply. The reduction in the money supply then leads to a further decline in spending, revenues, and incomes and thus to still more bankruptcies and bank failures.He points out that this process feeds on itself to the point of potentially destroying all fiduciary media
The reduction in the quantity of money can be avoided only if the government is prepared to create additional fiat standard money to whatever extent may be necessary to guarantee the fiduciary media of the failing banks. But this lays the foundation for a still greater expansion in the supply of fiduciary media in the future.Note, that this is exactly what Bernanke is describing in his testimony. Another reinforcing factor is that the inflation causes malinvestments, which Reisman defines as:
Anyone who bought a home at the peak of housing prices several years ago understands this effect. Inflation leads to depression by reducing the availability of real capital:
investments which are only profitable on the basis of inflation itself. When the inflation comes to an end, the unprofitability of the malinvestmets is revealed.
This is because the existing capital funds of many enterprises, are made inadequate by the rise in wage rates and material prices caused by the previous injections of credit in the form of new and additional money. The consequence is that firms requiring credit turn out to need more credit than they had planned on, while those firms normally supplying credit turn out to be able to supply less than had been counted on , and may even need credit themselves in order to meet the requirements of their own internal operations at these higher wage rates and prices. Thus, as the need for credit surges and as suppliers of funds become demanders of funds, or at least supply less funds, firms that had counted on borrowing money, or on refinancing their existing borrowings, find that they are unable to do so.Reisman summarizes "the essence of the inflation-depression process":
So, is the inflation-depression process a mystery? Evidently not. The governments arbitrary creation of paper money which becomes leveraged or pyramided through the fractional reserve banking system sets the stage for this inflation-depression process. Of course, the particular nature of any given crisis will depend on other factors as well. For example, during the dot-com boom, the inflation found its way into stock prices. In the aftermath of that crash, inflation found its way into the housing market due to government tax and regulatory incentives as well as direct government support through agencies like Fannie Mae and Freddie Mac which underwrite mortgages.
The critical factors are: artificial inducements to illiquidity and to a corresponding superinflation of revenues and incomes; the piling up of a mass of debt against these superinflated revenues and incomes; and then a contraction in spending, revenues, and incomes following the end of the inflation. The contractions phase leaves people with no means of paying the mass of debt they have accumulated, and can operate to produce a self-reinforcing downward spiral of deflation of the money supply.
Given these facts, do you think that it would be prudent for the government to understand how its fiat money credit expansion coupled with fractional reserve banking coupled with market distorting tax and regulatory policies leads to boom-bust cycles? Do you think that this understanding could be used not only to solve the current crisis, but to make sure that such a crisis never occurs again?
Second, after reducing short-term interest rates nearly to zero, the Federal Open Market Committee (FOMC) provided additional monetary policy stimulus through large scale purchases of Treasury and agency securities. These asset purchases, which had the additional effect of substantially increasing the reserves that depository institutions hold with the Federal Reserve Banks, have helped lower interest rates and spreads in the mortgage market and other key credit markets, thereby promoting economic growth.So, the Fed has driven short term rates to zero by creating money out of thin air, in particular, by purchasing over $1 trillion of mortgage backed securities thus helping to prop up the mortgage market which serves to encourage home buying more than otherwise. In other words, it's response to the crisis has been to engage in the very policies which caused the crisis!
[To see this in detail, see the Fed's most recent balance sheet. On the asset side, note that they have purchased $970 Billion of mortgage backed securities and $164 Billion of federal agency debt. They paid for this by creating reserves (printing money). When the Fed creates money, it creates a corresponding liability. In this case, since only a small amount of the funds have gone directly into the banking system, which shows up in the line "Currency in circulation", the funds must show up in the item "Reserve balances with Federal Reserve Banks". Currently, this item is over $1.1 trillion. The money is still on "reserve" at the Fed because the Fed began paying interest on these reserves under a newly created policy - a policy designed for this very purpose, i.e., incentivizing banks to keep their money at the Fed instead of lending it.]
If Bernanke does not realize that the very act of this money creation is a problem, he does realize that the trillion dollars that has been created out of thin air does represent a potential problem.
Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.In other words, "at some point", he is "fully confident" that the Fed will be able to simply remove the money they have created without any negative repercussions. And just how will he accomplish this?
In subsequent parts, I will discuss the real cure for the economy including a discussion of the Fed's so-called "tools" for tightening monetary policy, how its current policies are exacerbating the problem, and the history and essential problem of fractional reserve banking in causing crises that provided justification of the creation of the Federal Reserve system and the overthrow of the gold standard.