Dr. BERNAKE: INSIGHTS FROM HIS ACADEMIC WORKS

• Ben Bernanke’s academic career has produced a number of published works from which insight into the character that he will bring to the Federal Reserve can be drawn. Bernanke is a principal contributor to the Credit View of economic theory. Two of this theory’s tenets are 1) that securities (e.g. bonds) are imperfect substitutes for bank credit and 2) a bank’s decisions in regard to its assets are as relevant as its decisions in regard to its liabilities (deposits are, in part, a bank’s liabilities). If Bernanke has brought economic theory into the Federal Reserve, then the rational for current monetary policy may be found in the elements of the Credit View.
• There exists a similarity between the current economic climate and that of the early 1990s. In both decades, a “credit crunch” existed where bank lending slowed.
• In a 1991 paper, Bernanke and his co-author Cara S. Lowen, suggested that tightening credit in 1990 was caused (on the supply side) by low demand for loans by borrowers and the securitization of loans. In 1990, the economy was in recession where lower demand would be expected, but demand was further suppressed by falling real estate and increased leverage carried over from the 1980s. In 2007, it could be argued that the “credit crunch” is entirely a supply-side effect, there is no recession to dampen demand (at least not in September 2007) and many consumers wish to escape the adjustable rates of their existing loans. While the effects securitization of loans was considered small in1990, the effects were understood: securitization removed loans from the balance sheet of a bank. Unlike the “credit crunch” of 1990, securitization of loans clearly dominates market volatility in 2007. Historically low interest rates preceded and precipitated the current crisis. The 1980s saw federal funds rates that exceeded the current peak. Yet there is a third cause of the 1990 credit crisis, as described by Bernanke and Lowen, which has not surfaced in the media in 2007: a shortage of bank capital (or a “capital crunch”). In 1990, shortages of bank capital were significant, but not dominate. If this shortage of capital exists, it is not a dominate factor in today’s market either.
• Also in their 1991, Bernanke and Lowen concluded that traditional economic indicators will give conflicting signals, monetary policy will not be ineffective and open market interest rates will be lower than those expected when a “credit crunch” is not affecting the economy. Taking into account the Credit View and Bernanke’s published research, some rational may be assigned to recent Federal Reserve actions.
• In July and into August, the turmoil due to tight credit seemed to be limited to the financial markets where the securitized loans were traded. From the elements of the Credit View, these loans were off the balance sheets of the banks and these securities were not equivalent to loans.  Chairman Bernanke had stated in the media that the purpose of the Federal Reserve is not to protect lenders or investors from their poor financial decisions, but to provide stability for the economy.  There was no indication, in the opinion of the Federal Reserve, that the volatile financial markets would affect the economy.
• When the Federal Reserve decided to act, it lowered the discount rate (August 17). Perhaps this was implemented to improve bank capital. By traditional descriptions open market operations, it did improve the balance sheets of the banks. Lowering interest rates increased reserves and beneficially affected the assets of the banks. At least in theory, this should ease the tightening of credit. Empirically, the discount rate must be considered to be of importance to the Federal Reserve. It was lowered twice, by 50 bp in each action, where the federal funds rate was lowered only once.
• In each instance when the discount rate was lowered, this seemed to be a conservative approach to addressing market volatility. Pundits, who exist on the financial rather than economic side of the debate, argued for a lowering of the federal funds rate. Until September 18, Chairman Bernanke did not give any indication that lowering this interest rate was necessary. This question lingers: did the Federal Reserve give in to political pressure?