America’s real estate bust was only a secondary driver behind the precipitous plunge in the country’s economic fortunes during the financial crisis, according to Ben Bernanke, who steered the US Federal Reserve during the debacle.
Mr Bernanke, who is now a fellow at the Brookings Institution and adviser to two investment groups, said the panic in the funding and securitisation markets was the main reason for the severity of the Great Recession, and that its early stages would have been “significantly less severe” absent the collapse in confidence on Wall Street.
The former Fed chairman’s analysis, to be presented on Thursday, will add new intensity into the debate over whether the US central bank and other authorities concentrated too much public money on rescuing Wall Street from 2007-09, and whether they were negligent in failing to tackle the hazards brewing in the US property market in the lead-up to the meltdown.
Mr Bernanke has defended the authorities’ focus on arresting the panic on Wall Street in the face of complaints in Congress and elsewhere that struggling households received too little attention and financial support.
In his paper, which will be presented at Brookings on Thursday, Mr Bernanke looks at the two principal drivers behind the deepest slump in output since the Great Depression and the accompanying increase in unemployment to 10 per cent. One is the reversal of a surge in borrowing which, combined with a collapse in house prices, depressed household spending and sparked intense deleveraging.
The other source was the fragility of the financial system itself, in which mortgage-related losses triggered a big Wall Street panic, including runs by wholesale funders and fire sales of securitised assets. The problems under this channel were on the supply side of the credit markets, with a “devastating credit crunch” propelling the economy into a severe downturn.
The two drivers imply different policy responses, Mr Bernanke notes. If household debt was the main problem, it would imply the focus should be on stabilising housing markets and modifying troubled mortgages. The markets-focused driver implies the “policy imperative” was to end the panic in the financial sector — putting the focus on the interruptions to the supply of credit, not on demand for it.
Mr Bernanke’s analysis finds that developments associated with the panic in the securitisation markets and the run on short-term funding were the best predictors of “adverse economic changes” during the period. “Ending the panic is likewise associated with relative economic improvement,” Mr Bernanke found.
“These results do not rule out important effects through each of the identified channels, including channels linked to household balance sheets, but they do highlight the central role of the panic in setting off the Great Recession.”
Mr Bernanke claimed his findings were supportive of the unpopular strategy he and the other US authorities pursued during the crisis — which was to target enormous amounts of money at reversing the Wall Street panic and bailing out financial institutions with public money. Critics have since argued that the Fed and the Bush and Obama administrations devoted too much money to rescuing big banks from the consequences of their own folly.
The former Fed chairman said the findings support measures taken requiring banks to carry hefty capital cushions as policymakers seek to avoid future financial crashes. He counts himself as “less sanguine” over the Fed’s current firefighting toolkit, however.
For example, new disclosure requirements on the Fed’s crisis-battling tools have “stigmatised the discount window and other lending facilities to the point that they might prove useless in a crisis,” Mr Bernanke found.
“The limitations on firefighting tools mostly reflect a (fully understandable) political reaction to some of the policy interventions of the crisis. However, the evidence of this paper supports the view that those interventions were largely necessary to protect the broader economy,” he said in his paper.
This weekend marks the 10th anniversary of the collapse of Lehman Brothers, an event that triggered the most intense phase of the financial panic.
At an event marking the anniversary at Brookings this week, Mr Bernanke has already discussed the handling of the crisis alongside Tim Geithner, who led the New York Fed in 2008, and Hank Paulson, former Treasury secretary. “The fact is people don’t like banks and during a financial crisis they really don’t like banks. But if you make it too tough on the banking system you damage the public,” Mr Paulson said.