help me, obi-wan bernanke. you’re my only hope!
The depressing financial news to day is of a coordinated Fed/Bank of England/European Central Bank rate cut this morning, which occasioned a brief spike in stock prices, followed by a significant drop. Not so coincidentally, I read the following quote last night:
I am now somewhat sceptical of the success of a merely monetary policy directed toward the rate of interest. I expect to see the State, which is in the position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking on ever greater responsibility for directly organising investment; since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital, calculated on the principals I have described above, will be too great to be offset by any practicable changes in the rate of interest.
Any takers on guessing who wrote this?
One irony in this quote is that in fact, this exercise in expanding the monetary supply actually comes after (or really, in the midst) of other measures that are closer to “taking over responsibility for organising investment.” Essentially, Bernanke is trying any and all measures to restore stability.
Here is another irony, which is also not so encouraging:
I confess not knowing much about Bernanke’s research, but something I read (can’t remember what) pointed out how his key contribution was to recognize that the Great Depression was made deeper and longer by non-monetary mechanisms that made banks unwilling to lend– in particular, their inability to distinguish good from bad credit-risks, coupled with their need to preserve capital. That local banks (obviously, the dominant form in that era) specialize in distinguishing the borrower wheat from chaff (i.e., limiting adverse selection; and also pressuring borrowers ex post, to limit moral hazard), and that strong, “embedded” relationships are key to this is now well-understood in both the finance (e.g. and e.g.) and economic sociology literatures (see Uzzi’s 1999 ASR paper; see also my favorite MBA teaching case, Mark Twain Bancshares). Here is the cite to what seems to be Bernanke’s main paper on this:
Title: NON-MONETARY EFFECTS OF THE FINANCIAL CRISIS IN THE PROPAGATION OF THE GREAT-DEPRESSION
Author(s): BERNANKE BS
Source: AMERICAN ECONOMIC REVIEW Volume: 73 Issue: 3 Pages: 257-276 Published: 1983
Times Cited: 311
Why do I say there is a painful irony? Well, in arguing for the bank’s role in interpreting “soft” information, he argues that it is essentially wrong to assume the kind of financial market that is:
described by Eugene Fama (1980), .. which .. are complete and information/transactions costs can be neglected. In such a world, banks and other intermediaries are merely passive holders of portfolios. Banks’ choice of portfolios or the scale of the banking system can never make any difference in [such a market], since depositors can offset any action taken by banks through private portfolio decisions (p.263).
Rather, he says that instead, we should:
Assume… that banks specialize in making loans to small, idiosyncratic borrowers whose liabilities are too few in number to be publicly traded (such that) the real service performed by the banking system is the differentiation between good and bad borrowers…. (Such service) includes screening, monitoring, and accounting costs, as well as the expected losses inflicted by bad borrowers…. (The costs of providing this service are minimized) by developing expertise at evaluating potential borrowers; establishing long-term relationships with customers; and offering loan conditions that encourage potential borrowers to self-select in a favorable way.
He then goes on to argue that the Great Depression was longer and deeper than it otherwise might have been because these costs essentially skyrocketed as the value of people’s collateral deteriorated.
The irony of course is that the rise of debt (especially, mortgage) securitization was effectively based on the now-obviously faulty premise that you could build a (shadow) banking sector on Fama-like principles. (So yeah, economists sometimes make markets; but they also break them). And effectively what this did was to lower the nominal cost (to, e.g., mortgage brokers) of providing financial intermediation without changing the realcost of such intermediation– where by this distinction, I mean to include the “screening, monitoring… and expected losses inflicted by bad borrowers” in real, but not in nominal. Worse, by bundling both good and bad borrowers together into pools, it becomes that much harder to price the securities, and especially hard for speculators in such securities to figure out how one another will price them (which is key to the point I will develop in the promised follow-up post to my last one.) And then much worse, the “badness” of these borrowers is something that is not fixed, but is endogenous to the economy (specifically, real estate prices), which is in turn driven down by the collapse of the financial system. Ugh.
So, if there is any silver lining in this, it is that I’d much rather have someone like Bernanke than Greenspan at the Fed. Not only does Greenspan deserve a lot of blame for this mess, but Bernanke seems sensitive to the key issues. Here is how he ends this article:
Institutions which evolve and perform well in normal times may become counterproductive during periods when exogenous shocks or policy mistakes drive the economy off course. The malfunctioning of financial institutions during the early 1930’s exemplifies this point.
I think we now have another case to exemplify his point.
A final note: besides placing hope in Bernanke, I also greatly sympathize with him. Besides having to deal with a momentous mess that is not of his own making, I’m sure he is working non-stop these days and will have to work over Yom Kippur. More generally, I’m sure he has no time to assume any identity other than the Chairman of the Fed. And that’s sad. For myself, I will be signing off for a few days for the observance of YK (exciting year for us– our oldest son [12 yrs] is fasting for the first time; definitely a major stage as a parent when you encourage your child to not drink or eat for 25 hours!). I pray that we are all in a better state when I am next online.