Published by EH.Net (August 2013)

Ben S. Bernanke, The Federal Reserve and the Financial Crisis. Princeton, NJ: Princeton University Press, 2013. vii + 134 pp. $20 (hardcover), ISBN: 978-0-691-15873-0.

Reviewed for EH.Net by Kris James Mitchener, Department of Economics, University of Warwick.

This book is the product of a series of university lectures given by Federal Reserve Chairman Ben Bernanke in March 2012 at George Washington University. It is short, crisp, and clear, with only five footnotes and no references.? The four chapters are called ?lectures? and the prose is written in a conversational style reflecting the original form of delivery. Indeed, the unedited lectures are also available for free on the web. They could easily be absorbed while driving one?s car, though this reviewer does not necessarily endorse that form of consumption, nor would one expect that to be the Fed?s official position. Since the original audience consisted largely of undergraduates, concepts are kept simple throughout, largely at an introductory level of economics. Student questions from the lectures are included at the end of each chapter.

Not often does one get to read a book that articulates the beliefs and actions of an incumbent policymaker, let alone one who was charged with conducting monetary policy during a severe financial crisis unless, of course, one is reading sworn testimony given to a public agency, but that is an altogether different exercise than what is undertaken here. The value of this book is that it allows one to observe how the Chairman of the Federal Reserve reacted to the events of 2007-2009 and how that response is justified. What makes it especially delightful to read or listen to is that Chairman Bernanke puts his decision making in a long-run context, describing the particular ?lessons? from the Fed?s history that he drew on during the crisis period. It thus provides a shining example of how policymakers use history in formulating economic policy.

It probably comes as no surprise to those familiar with his academic research on central bank transparency that Chairman Bernanke is the first standing Fed Chairman to write a book while in office. That said, one must keep expectations in check while reading the book. Although he is not afraid to discuss mistakes that the Fed made in its past nor to acknowledge that it could have possibly done more prior to the recent crisis, the chairman presents the official rationale of the most controversial decisions. Some economists, such as Alan Blinder (2013), have drawn attention to differences between the rationale policymakers provided to the President, Congress, and the American public and their actual motivations during the crisis.

Lecture 1 provides a review of the history of the founding of the Federal Reserve System and discusses the tools that central banks have at their disposal for maintaining financial stability and limiting the size and duration of aggregate fluctuations. It covers themes that will be very familiar to most readers of this review: the origins of central banking, the advantages and disadvantages of the gold standard, nineteenth-century banking panics, and ?Bagehot?s Rule.? This lecture and the subsequent one serve the purpose of providing the historical and institutional context for the lessons that Chairman Bernanke applied during the financial crisis that peaked in 2008-2009. They also lay out a case for the Fed?s learning process: the Fed made a variety of mistakes in the 1930s and 1970s, for example, which it subsequently drew on in formulating later policies. In this lecture, Chairman Bernanke acknowledges that the Fed failed with respect to monetary policy and financial stability during the Great Depression, as witnessed by the severity of the banking crisis and the depth and duration of the economic decline. He suggests that FDR?s abandonment of the gold standard and the enactment of federal deposit insurance were actions taken to offset policy errors. Detailing the Fed?s policy mistakes of the 1930s allows him to later contrast the Fed?s policy response to the recent financial crisis.

Lecture 2 continues the examination of the Fed?s history, focusing on the post-World War II period. The first part of it is devoted to the Great Inflation and the associated policy mistakes (overconfidence in the ability to fine tune the economy and loose fiscal and monetary policy) as well as the Great Moderation, with substantial credit given to Paul Volcker and Alan Greenspan?s stewardship of the monetary policy. An omission from this period of policymaking is a discussion of the S&L crisis. Although savings and loans were outside the Fed?s regulatory domain, the episode might have been one that the Fed could have learned from, at least with respect to the idea that it could have refocused the Fed?s attention on ensuring financial stability. (An interesting theme throughout the book is that the Fed?s role of providing financial stability fell into neglect until the recent crisis hit.)

The second half of lecture 2 presents his views on what factors led to the intensity of the financial crisis of 2008-2009, which he casts as a ?classic financial panic? that took place in a broader institutional context (multiple financial markets rather than just banks). He provides a laundry list of weaknesses in the financial system that likely transformed a modest recession into a more severe crisis. For example, he points to household leveraging (driven partly by a decline in the standards for mortgage underwriting and exotic mortgage products), inadequate risk management by banks, short-term funding exposure of banks, and the use of CDS and other exotic derivatives as private-sector catalysts. With respect to public sector vulnerabilities, he suggests that supervision of insurance companies, investment banks, and GSEs was inadequate and that the economy lacked a systemic regulator that could oversee risks across different types of financial institutions. It is unsurprising that he places little stock in the view that the Fed set rates too low early in the 2000s, citing cross-country evidence of other housing booms, the timing of the bubble, and the size of the house price increases relative to changes in monetary policy as evidence against this argument. However, he does acknowledge that the Fed did not fully anticipate how large of an effect a decline in house prices could have on the overall economy.

Lecture 3 provides a description of the Fed?s response to the recent financial crisis and a sense of the real-time decision making that was required during the peak period of the crisis when problems in different sectors of the financial system were springing up on an almost daily basis. This is where it is entertaining for the reader to play armchair central banker, and think whether one?s own policy choices would have deviated that far from the path that the Fed actually took. Important for his description of the Fed?s response to the crisis is the fact that, even though the total losses due to subprime mortgages were not very big, they were spread out across different financial markets, making the size of the losses and the bearers of those losses uncertain. Because many financial firms were using wholesale funding, the uncertainty over losses created the potential for short-term funding to dry up as lenders re-assessed the health of borrowers. Firms in need of short-term funding faced fire sales of assets and runs rippled through the financial system. In response, the Fed provided liquidity to illiquid banks via the discount window and to other financial firms like broker-dealers through special liquidity and credit facilities. Interestingly, although he does not state that the Fed could have done more to save Lehman Brothers (arguing it was an investment bank and the Fed and Treasury tried to find either a buyer or more capital), he does seem to acknowledge that its failure was systemically important (p. 75), and he goes on to describe the effects its failure had on money market mutual funds such as Reserve Primary Fund. Finally, he discusses the coordinated international response of central banks to the financial crisis, contrasting it with the lack of coordination of the 1930s.

The last lecture provides a discussion of what the Fed has been doing in the wake of the crisis, how it is working to implement Dodd-Frank, and what that law means for future Fed conduct. This lecture includes a cogent discussion of the Fed?s quantitative easing policies, which are aimed at influencing long-term interest rates and stimulating the housing sector, and it discusses its continued effort to satisfy its dual mandate by focusing on the persistently weak labor market conditions. Since this lecture provides a detailed description of the expansion of the Fed?s balance sheet and the piling up of reserves by Fed member banks, it would have been nice to see this discussion connected more directly to the continued low levels of bank lending.

This book will be particularly useful for those teaching a class in either macroeconomics or economic history of the twentieth century at the undergraduate level, as these lectures provide a succinct and accessible account of U.S. macro policymaking over the last hundred years. Companion questions, written by Stephen Buckles of Vanderbilt and referencing the video presentation, are also available on the Fed?s website.

Alan Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead, New York: Penguin, 2013.

Kris James Mitchener is professor of economics at the University of Warwick and Research Associate at NBER and CAGE. Recent publications include ?Globalization, Trade and Wages: What Does History Tell Us about China?? (with Se Yan) International Economic Review (February 2014) and ?Shadowy Banks and Financial Contagion during the Great Depression: A Retrospective on Friedman and Schwartz? (with Gary Richardson) American Economic Review (May 2013).
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