Saturday, January 23, 2010

Senators: Reject Chairman Bernanke - Alpha

In this post, I will argue that the US Senate, in its capacity to “advise and consent” to the President’s appointments, should reject Benjamin Shalom Bernanke’s nomination for a second term as Fed Chairman.

I must begin by saying I bear no personal animus to Mr. Bernanke. I believe he is an honest and capable civil servant, a first-rate economist (having read much of his work), and a person who truly cares about what’s best for the people of the United States. I believe Bernanke is quite disgusted that he was forced to bail out the banks.

Mr. Bernanke Prays for the Senate to Reconfirm Him

Time magazine recently named Mr. Bernanke its “Person of the Year.” This is misguided. Many economists and the media are not holding Mr. Bernanke accountable for his numerous mistakes. The deeper problem is that the American people are not holding their public officials accountable for mistakes (one hopes the recent MA election is a sign of change). Now it’s time for the US Senate, representing the American people, to reject Mr. Bernanke. The three reasons I propose are:

1) Rates and Regulations Fumbled: Mr. Bernanke as Fed Chairman failed the American financial system in setting too easy a monetary policy – he kept interest rates too low for too long and did not regulate banks properly. He helped create the housing bubble.

2) Reserve Requirements Too Low: Mr. Bernanke as Fed Chairman failed the financial system as an overseer in letting bank reserves fall too low – he let weak and poorly capitalized banks threaten the entire system.

3) Strict Liability Rejection: A Fed Chairman should be held “strictly accountable” for his mistakes – despite doing the right thing in the eye of the crisis, Mr. Bernanke helped get us there and shouldn’t be the Chairman leading us out. He also seems to lack original ideas to put the mess behind the country.

So let me begin:

1) Rates and Regulations Fumbled: The Fed under Mr. Bernanke had too loose a monetary policy from 2004 to 2008. This kept interest rates low and fuelled the housing bubble. In addition, the Fed didn’t regulate lending terms, allowing deviations from standard mortgage terms. A standard mortgage is a fixed-rate, 30 year mortgage, with 20-30% down – and the owner occupies the property. Without regulation and oversight from the Fed, many subprime lenders allowed “NINJA” loans of “no income, no job, no assets” along with “adjustable rate mortgages” (ARMs) with low teaser rates that would reset at much higher, unaffordable levels. This created a speculative bubble in housing.

The Fed Kept Rates Too Low, Contrary to the Respected Taylor Model

Mr. Bernanke and former Fed Chairman Greenspan saw some “isolated froth” but denied the housing bubble as it occurred. They were regulators sleeping on the job (and Mr. Greenspan has admitted and apologized for this). While the buildup of the subprime crisis was complex (see the papers below), the one thing that is clear is that Mr. Benanke was the main regulator responsible (the SEC and OFHEO also take much blame).

“The Subprime Crisis: Cause, Effect and Consequences” (Whalen)

Understanding the Subprime Mortgage Crisis (Demyanyk & Van Hemert)

For a broader and more cutting analysis of the meltdown and Bernanke's responsibility (along with other regulators), see the recent book by Judge Richard Posner:
A Failure of Capitalism

A few weeks ago, Mr. Bernanke gave a self-serving speech to a convention of economists (the annual AEA meeting) where he failed to take responsibility for Fed failures since 2004. Read the speech here, and the rebuttal of the respected economist John Taylor (of Stanford) here.
Bernanke's speech to the AEA - Jan. 2010
John Taylor of Stanford's response

Even Mr. Bernanke's supporters admit the Fed Chairman has made many mistakes, while Bernanke hunkers down and won't admit to them: see Econbrowser here arguing Bernanke be kept.

The point of this: Mr. Bernanke is still not taking responsibility for his mistake on rate-setting and the housing bubble. He claims that in only hindsight people can see a bubble. Yet economists and business magazines were saying from 2002 to 2005 that they saw a housing bubble. See the quotes below and the magazine covers.

Dean Baker, economist and co-director of the Center for Economic & Policy Research:
We've never seen this sort of run-up in home prices in U.S. history. In the past, home prices have always moved pretty much at the same rate with inflation's overall rate. But in the last seven years, they've outpaced the rate of inflation by 60 percentage points. This kind of run-up becomes unsustainable. Right now, the market is caught up in the psychology of a bubble. You see the fastest increases just before the collapse. (Businessweek, June 2005)

John Templeton, Investor:
Every previous major bear market has been accompanied by a bear market in home prices. . . . This time, home prices have gone up 20%, and this represents a very dangerous situation. When home prices do start down, they will fall remarkably far. In Japan, home prices are down to less than half what they were at the stock market peak. . . A home price decline of as little as 20% would put a lot of people in bankruptcy. (Interview with Robert Flaherty in Equities magazine, 2003)

Cover Stories of Fortune magazine in 2002 and Businessweek in 2005:

Mr. Bernanke, unlike Mr. Greenspan, cannot admit that he was and is wrong. He should be rejected by the Senate.

2) Reserve Requirements Too Low:
Mr. Bernanke as Fed Chairman failed the financial system as an overseer in letting bank reserves fall too low – he let weak and poorly capitalized banks threaten the entire system. Few economists and journalists are pressing this error. At the core, reserves are cash that a bank must keep with a central bank to protect depositors and show the bank is stable and well-capitalized. Banks don't like to keep this money lying around and not earning interest, so regulators force them by law to do it. Reserves are a much more powerful tool than rates to prick a bubble before it starts. See this background for why reserve requirements are important, from the Fed, from the lax NY Fed, and from a hard-headed Chinese government central banker.

One reason that the crisis occurred in 2008 was that many financial institutions were massively overleveraged and had too little tangible book equity capital to sustain their debts. Along with their tangible book equity, their reserves with the Fed were also too low. While the broker-dealers (which the Fed didn’t directly regulate, until they last few converted to bank holding companies) were the worst offenders, numerous banks like Wachovia, Washington Mutual, Corus Bank, Indymac, and others were making bad loans with little equity to back it up. Their reserve levels were too low. It’s arguable that Citigroup and Bank of America had far too low levels. So when the crisis hit, the banks' cushions to absorb losses were too thin, and this created the domino effect of failing banks, fire sales in bad assets, falling asset prices, and so on in a vicious cycle.

In general, the leverage of the financial system was far too high (reserves and tangible equity were too low). More problematically, as bad US policies let the real income levels of middle classes stagnate, the Fed’s hands-off approach allowed banks to increase the crushing debt load on middle class Americans. The Fed should take direct responsibility for this.

To highlight the intentional tragedy of this, I remember a personal conversation with an analyst at a large financial institution (whose name you will know), one of the largest issuers of credit cards in the US. He told me the financial models his division created were made to maximize debt loads on the holders of credit cards, and earn money through fees and interest. Their models assumed that a majority of borrowers would never pay the bank back and go bankrupt, but that the bank would still make money off of fees and interest to overcome that. Why isn't the Fed regulating this sort of predatory lending? Credit card regulation falls under the Fed's powers; yet the Fed has fought a turf battle to keep the President from forming a new Consumer Protection Agency even as it has failed to protect consumers.

See the charts below for middle class debts and high bank leverage.

Middle Class Debt Gets Higher as Banks Take on More Leverage

3) Strict Liability Rejection: A Fed Chairman should be held “strictly accountable” for his mistakes – despite doing the right thing in the eye of the crisis, Mr. Bernanke helped get us there and shouldn’t be the Chairman leading us out. Strict liability means the person in charge should be held accountable for failure whether or not we can prove he is at fault. So if you buy a new car and the brakes fail the next day, the auto company should be held at fault without you having to prove it made a car with bad brakes. The US Navy has a long-standing policy for ship captains. If a captain gets a ship into a major accident, he/she is relieved of duty, no matter who is at fault. Whether the captain is not competent or merely unlucky doesn’t matter. It’s not a harsh rule for an institution, but only a common sense one in a world where proving fault in difficult.

While I believe the facts below show Mr. Bernanke to be at fault, I don’t believe the US Senate needs to find fault. It should just apply “no fault” strict liability and not confirm Mr. Bernanke for the failure under his watch. "Bernanke kept a recession from becoming another Depression" just isn't a good enough reason to keep him because he was one of the regulators helping to cause the current recession.

Captains of Crashed Ships are Held Strictly Accountable

As a final point to the strict liability argument, Mr. Bernanke seems tired and without fresh ideas. His prevention of a financial system meltdown in October 2008 was creative and well-done (many smart investors, from Warren Buffett to Bill Gross and George Soros were expecting Armageddon at one point, and Mr. Buffett went on to make his Pearl Harbor speeches). Yet Mr. Bernanke doesn’t have any original ideas for the Fed to help the US get out of the mess and reduce the massive amounts of debt. Ken Rogoff of Harvard has suggested targeting 5-7% inflation, far against the central bank orthodoxy of 1-3% inflation. The Bank of Japan, for better or worse, has allowed deflation to hit. Mr. Bernanke has started the US on the right steps with quantitative and qualitative easing (though he rejects calling a spade a spade for the latter), but he has no new ideas.

As a side note, Mr. Bernanke will still be around as a Fed Governor and member of the FOMC even if he doesn’t get reappointed (his term there lasts till 2020). That will give him a chance to redeem himself from a place where he can do less harm.

In sum, the US Senate should use its good sense and judgment to reject Mr. Bernanke’s nomination as Fed Chairman. Recent news suggests some Democratic senators are leaning this way. I hope their constituents (you – the American people, to whom your representatives listen) bombard the Senate with calls and letters to reject Mr. Bernanke.

Some other competent candidates for the Fed Chairman position that President Obama should consider are (from all sides of the political spectrum):
-Janet Yellen (SF Fed President)
-Sheila Bair (Head of the FDIC)
-Paul Krugman (Professor at Princeton)
-Kenneth Rogoff (Professor at Harvard)
-Martin Feldstein (Professor at Harvard, former Chair of President Reagan’s CEA).

One candidate I reject is current CEA Chair Larry Summers, who has already shown himself to be an advocate for the banks and not policies to strengthen the American middle classes. Witness his opposition to Paul Volcker’s suggested and necessary bank reforms. Despite his brilliance at arguing, Mr. Summers has failed as a steward of financial and economic policies, as his speculative betting at Harvard shows.

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