Ben S Bernanke: Economic challenges - past, present, and future
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the Dallas Regional Chamber, Dallas, Texas, 7 April 2010.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
This is a momentous time. During the past two and a half years, our nation has endured the
worst global financial crisis since the Great Depression, a crisis that in turn helped cause a
deep recession both here and abroad. During some of the worst phases of the crisis, a new
depression seemed a real possibility.
Fortunately, today the financial crisis looks to be mostly behind us, and the economy seems
to have stabilized and is beginning to grow again. But we are far from being out of the
woods. Many Americans are still grappling with unemployment or foreclosure, or both. Cities
and states are struggling to maintain essential services. And, although much of the financial
system is functioning more or less normally, bank lending remains very weak, threatening the
ability of small businesses to finance expansion and new hiring.
In my comments today, I will briefly describe the origins of the financial crisis and economic
downturn, with a particular focus on the policy response of my institution, the Federal
Reserve. I will then turn to some near-term and longer-term challenges facing our country.
Origins of the crisis
The financial crisis that began in the summer of 2007 was an extraordinarily complex event
with multiple causes. Its immediate trigger was a downturn in the national housing market
that followed a long period of rapid construction and rising home prices. The housing slump
in turn brought to light some very poor lending practices, especially for subprime mortgages
extended to less-creditworthy borrowers. Relative to the global financial system, the market
for subprime mortgages was quite small, probably less than 1 percent of global financial
assets. How, then, did problems in this market appear to have such widespread
consequences? One important reason is that the subprime mortgage market was closely
linked to a broader framework for credit provision that came to be known as the shadow
banking system. That broader framework, at least as it was structured during the run-up to
the crisis, proved deeply flawed.
The innovation underlying the shadow banking system was that it helped provide a wide
range of borrowers indirect access to global credit markets. For example, originators of
subprime mortgages did not typically retain the loans they made on their own books. Instead,
the mortgages were packaged together in complex ways, sometimes with other types of
loans, stamped with a seal of approval from one or more credit rating agencies, and sold to
investors worldwide, thus - it was thought - broadly dispersing the underlying risks. Credit
risks were further dispersed - again, at least in theory - through the use of derivative
financial instruments such as credit default swaps. Importantly, residential mortgage markets
were not the only markets caught up in the boom. In part because large flows of capital into
the United States drove down the returns available on many traditional long-term
investments, such as Treasury bonds, investors' appetite for alternative investments - such
as loans to finance corporate mergers or commercial real estate projects - increased greatly
in the years leading up to the crisis. These securities too were packaged and sold through
the shadow banking system.
As we now know, however, neither the investors, nor the rating agencies, nor the regulators,
nor even the firms that designed the securities fully appreciated the risks that those securities
entailed. Nor were the risks as widely dispersed as thought: For example, many complex
securities were held in off-balance-sheet vehicles financed by short-term loans. When
investors lost confidence in the underlying securities and pulled their funding, many firms that
sponsored the off-balance sheet vehicles found that they were bound by explicit or implicit
promises to stand behind the securities. Together with other direct or indirect exposures to
risky debt, these commitments left financial institutions dangerously exposed to rising losses.
These risks grew rapidly in the period before the crisis, in part because the regulators - like
most financial firms and investors - did not fully understand or appreciate them. But
significant gaps in the regulatory framework itself also contributed to the inadequate
government response. For example, firms like the insurance giant American International
Group (AIG), which sold credit insurance on large quantities of risky securities, or the
investment bank Lehman Brothers, which speculated heavily in these securities, were not
subject by law to strong consolidated supervision by federal regulators. Moreover, none of
the federal regulators had a mandate or sufficient powers to evaluate and respond to the
risks posed by large financial organizations to the financial system as a whole.
Thus, the stage was set for the unraveling that began in the summer of 2007 and continued
throughout 2008. As house prices and the equity of homeowners fell, mortgage
delinquencies and defaults soared. As I mentioned, investors - stunned by the resulting
losses on mortgage-backed securities and other credit instruments they had believed to be
safe - pulled back from a wide range of credit markets and financial institutions. As funding
dried up, losses mounted, and confidence plummeted, a number of major financial firms,
both here and abroad, came under severe pressure. In March 2008, the investment house
Bear Stearns became the first major firm to come to the brink of failure, nearly collapsing
before being purchased, with government assistance, by JPMorgan Chase. In August, the
two largest players in the housing market, the government-sponsored enterprises (GSEs)
Fannie Mae and Freddie Mac, were taken into conservatorship. In September, the sharply
intensifying panic hit the investment bank Lehman Brothers, and soon after, AIG. Much as in
a traditional run on a bank, the creditors and counterparties of these companies raced to call
in loans or demand extra collateral, ratcheting up the pressure on already shaky firms.
Concerted government attempts to find a buyer for Lehman proved unavailing; lacking
sufficient collateral to secure a Federal Reserve loan, the company's only option was
bankruptcy.
In contrast to Lehman, AIG had sufficient assets to secure credit from the Federal Reserve
and thus avoid imminent failure. I have said before that nothing made me angrier during the
crisis than the irresponsible decisions at AIG that put our entire financial system and
economy at grave risk and left the government with no good options. However, with the
financial system already teetering on the brink of collapse, the disorderly failure of AIG, the
world's largest insurance company, would have undoubtedly led to even greater financial
chaos and a far deeper economic slump than the very severe one we have experienced.
The rapidly worsening crisis soon spread beyond financial institutions into the money and
capital markets more generally. Losses on Lehman's commercial paper at a prominent
money market mutual fund led to a run on that fund and many others; over the subsequent
weeks, fearful money-fund investors withdrew more than $400 billion. Equity prices fell
precipitously, large firms and banks hoarded cash, and short-term credit became available, if
at all, only at very high interest rates and for very short terms.
As we now know, the financial turmoil dealt an economic body blow that spread worldwide.
Businesses slashed production and payrolls, including in countries that had not thus far
experienced much effect. International trade collapsed, and many nations dependent on
trade experienced even sharper slides in economic activity than the United States.
The Federal Reserve's policy response
As the crisis became global, the policy response became global as well. After watershed
meetings in Washington of finance ministers and central bank governors on October 10-11, 2008,
many countries, including the United States, announced comprehensive plans to stabilize
their banking systems. They expanded deposit insurance, injected public capital into banks,
guaranteed bank-issued debt, and increased access to funding from central banks.1 This
strong and unprecedented response - a sharp contrast to the failures of international
cooperation that helped make the depression of the 1930s so devastating - proved broadly
effective. During the subsequent months the risk of a global financial meltdown and
economic collapse receded.
In support of these efforts to stabilize the financial system, and in its traditional central bank
role as backstop liquidity provider, the Federal Reserve developed innovative programs to
provide well-collateralized, mostly short-term credit to the financial system. Without this
credit, otherwise sound financial institutions could have been forced to dump assets onto the
market, further depressing prices, or even been driven into failure, intensifying the crisis. We
provided this liquidity through a number of channels. To help stabilize banks of all sizes, we
eased the terms of lending to banks through our regular short-term lending facility, known as
the discount window, and auctioned fixed quantities of discount window credit. We also
expanded access to our short-term lending to many securities firms, whose normal funding
sources had been disrupted by the crisis. And we worked closely with the Treasury to
develop programs that successfully ended the run on the money market mutual funds.
The Federal Reserve also acted to help restore normal functioning in key financial markets.
We established a backstop commercial paper facility to help address severe strains in the
commercial paper market, on which many firms rely to finance their operations. To improve
the availability of credit more broadly, we created a facility to support the issuance of
securities backed by a range of assets including small business loans, auto loans, credit card
receivables, student loans, and commercial real estate. Additionally, after heavy foreign
demand for dollar funding began to disrupt money markets and squeeze credit availability in
the United States, we established cooperative programs with 14 foreign central banks to
allow them to provide sufficient dollar funding to help calm markets in their own jurisdictions.
Importantly, these programs - most of which have been deemed no longer necessary and
shut down - not only helped stabilize financial conditions and restart the flow of credit to
American families and businesses, they did so at no financial cost to taxpayers and with no
credit losses.
Beyond its actions to help stabilize the financial system, the Federal Reserve also responded
to the deepening recession with an aggressive monetary policy, in both conventional and
less conventional forms. We lowered interest rates sharply, including, in October 2008, an
unprecedented coordinated rate cut with five other major central banks. For the past
15 months, we have maintained our target short-term interest rate near zero. In a less
conventional operation, we also purchased more than $1.7 trillion of Treasury securities and
securities issued or guaranteed by the housing-related GSEs. These purchases contributed
to a marked improvement in credit markets. In particular, they significantly lowered mortgage
interest rates, which made housing more affordable and allowed millions of Americans to
reduce their payments by refinancing.
Finally, the Federal Reserve also responded to the crisis in its capacity as a bank supervisor.
Last spring we led a forward-looking, simultaneous evaluation of the financial conditions and
capital positions of 19 of the largest bank holding companies in the United States, with the
Treasury committing to provide public capital as needed. The goal of the Supervisory Capital
Assessment Program - popularly called the stress test - was to ensure that these firms held
sufficient capital, in both quantity and quality, to withstand worse-than-expected economic
conditions over the subsequent two years and yet remain healthy and capable of lending to
creditworthy borrowers.2 This exercise was unprecedented in scale and scope, as well as in
the range of information we made public regarding the projected losses and revenues of the
tested firms, which allowed private analysts to judge for themselves the credibility of the
exercise. Markets responded favorably to the release of the stress test results, and many of
the tested banks were able to raise substantial amounts of capital from investors and to
repay government capital.
Overall, the policy actions implemented over the past two and a half years by the Federal
Reserve and other agencies in the United States and abroad have helped stabilize key
global financial markets: Short-term funding markets are essentially back to normal,
corporate bond issuance has been strong, and stock prices have partially recovered. Bank
lending remains constrained, as I will discuss in a moment, but critically, fears of financial
collapse have lessened substantially. Most important, the economy has stabilized and is
growing again, although we can hardly be satisfied when 1 out of every 10 U.S. workers is
unemployed and family finances remain under great stress.
Toward better financial regulation and supervision
As I noted earlier, we found some of the choices that we faced during the financial crisis
exceedingly distasteful. The Federal Reserve has always recognized the importance of
allowing markets to work, and government oversight of financial firms will never be fully
effective without the aid of strong market discipline. The decisions we took, in collaboration
with the Treasury, to assist distressed firms during the height of the crisis thus ran strongly
against the grain of our institution. However, as I said, our options under extremely difficult
circumstances were bad and worse, as our ability to respond effectively was sharply limited
by the lack of tools available to act in a crisis. In particular, the U.S. government lacked any
workable means to address the potential disorderly failure of a large, systemically important
firm in a way that protected the economy and taxpayers from severe collateral damage.
With the crisis largely behind us, we as a country must now turn to fixing structural
weaknesses in the financial system, in particular in the regulatory framework. We need tough
new rules to make financial institutions safer and to constrain excessive risk-taking, and we
need a regulatory framework that gives the Federal Reserve and other agencies the ability to
address risks to the financial system as a whole. Critically, so that we will never again face
the unpalatable choice between bailouts and a disorderly bankruptcy that threatens to bring
down our financial system, we must bring an end to the belief that some financial institutions
are too big to fail. To do that, we urgently need a new resolution regime for large, complex,
and interconnected financial firms, similar to that already established for banks. To end
toobig-to-fail, the new regime should permit regulators to close a failing firm and impose losses
on shareholders and creditors; indeed, I would argue that no financial instrument counted as
regulatory capital should be allowed to receive any protection from losses. At the same time,
regulators must have the tools necessary to minimize the associated disruption to the
financial system and the broader economy.3
The Federal Reserve strongly supports ongoing congressional efforts to reform our financial
regulatory framework, but we are not waiting for new legislation to make improvements. We
have been working hard to strengthen our own oversight of financial institutions and to
broaden our field of vision to include potential risks to the financial system as a whole as well
as risks to individual firms. For example, we have played a key part in ongoing international
efforts to ensure that systemically critical financial institutions hold more and higher-quality
capital and have sufficient liquid assets on hand to be able to survive a market crisis. And we
are leading the international and domestic initiative to push banking organizations of all sizes
to ensure their compensation practices link pay to performance and do not encourage
excessive risk-taking.
To make our supervision more effective and better able to identify risks to the financial
system as a whole, we are also making fundamental changes to our daily operations. For
example, we have adopted a more multidisciplinary approach that makes better use of the
wide range of expertise and skills at the Federal Reserve - in economics, financial markets,
payments systems, and other specialties, as well as bank supervision. We will be doing more
cross-firm comparisons to better understand differences in the practices of different firms and
the risks they face, and we will be complementing on-site examinations with off-site,
quantitative analyses by experts in a range of disciplines. As we improve our supervision, we
will be sure not to lose sight of the diversity of our banking system. Banks of all sizes,
including regional and community banks, make critical contributions to our economy; thus,
we must continue our efforts to ensure the stability and vitality of smaller banks as well as
larger ones.
As we've been working to make our supervision more effective, we have also been taking
care to ensure we do not inadvertently impede sound lending. Businesses need access to
credit to maintain or expand their payrolls and make productive investments. Banks need to
continue to lend to creditworthy borrowers to earn a profit and remain strong. If bankers
become overly conservative in response to past lending mistakes - or if examiners force
such behavior - it will hurt bankers' own long-term interests and the economy in general. For
this reason, we have joined with the other federal banking agencies to issue a series of
policy statements to examiners: on the importance of bank lending to creditworthy borrowers,
on small business lending, and on commercial real estate loan restructuring.4 We have
followed up this formal guidance with training for examiners and outreach to the banking
industry. Our message is a simple one: Institutions should strive to meet the needs of
creditworthy borrowers, and the supervisory agencies should do all they can to help, not
hinder, those efforts. We also must support sensible efforts to work with troubled borrowers
to bring them back into good standing. To help us better understand what is going on in the
banks we supervise and in the communities they serve, we continue to seek many views. For
example, our Reserve Banks across the country are holding meetings with community
bankers and others to talk about opportunities for and barriers to small business lending.
Additionally, the Federal Reserve continues to demonstrate its commitment to consumer
protection in financial services. We have recently overhauled the regulations governing
mortgage transactions and implemented enhanced protections for credit card accounts and
private student loans. We also have made new rules for overdraft protection programs and
for gift cards. In addition, we have expanded our compliance program for enforcing consumer
protection rules at nonbank subsidiaries of bank holding companies and foreign banking
organizations.
In these and other areas, we at the Federal Reserve will continue to improve how we
regulate and supervise financial firms while continuing to do all in our power to identify and
mitigate risks that may endanger the financial system as a whole.
Economic challenges
Notwithstanding the progress that I've noted, critical challenges - both near term and longer
term - remain. We have yet to see evidence of a sustained recovery in the housing market.
Mortgage delinquencies for both subprime and prime loans continue to rise as do
foreclosures. The commercial real estate sector remains troubled, which is a concern for
communities and for banks holding commercial real estate loans.
Some of the toughest problems are in the job market. The unemployment rate has edged off
its recent peak, but at 9.7 percent, it is still close to its highest level since the early 1980s.
Although layoffs have eased in recent months, hiring remains very weak. More than
40 percent of the unemployed have been out of work six months or longer, nearly double the
share of a year ago. I am particularly concerned about that statistic, because long spells of
unemployment erode skills and lower the longer-term income and employment prospects of
these workers.
That said, my best guess is that economic growth, supported by the Federal Reserve's
stimulative monetary policy, will be sufficient to slowly reduce the unemployment rate over
the coming year. If economic conditions improve, as I expect, we should see increased
optimism among consumers and greater willingness on the part of banks to lend, which in
turn should aid the recovery. Meanwhile, for the near term, inflation appears to be well
controlled. Productivity improvements have helped firms control costs, and little pricing power
is evident. Inflation expectations, as measured in the financial markets or in surveys, appear
stable.
What about the longer term? The economist John Maynard Keynes said that in the long run,
we are all dead.5 If he were around today he might say that, in the long run, we are all on
Social Security and Medicare. That brings me to two interrelated economic challenges our
nation faces: meeting the economic needs of an aging population and regaining fiscal
sustainability. The U.S. population will change significantly in coming decades with the
combined effect of the decline in fertility rates following the baby boom and increasing
longevity. As our population ages, the ratio of working-age Americans to older Americans will
fall, which could hold back the long-run prospects for living standards in our country. The
aging of the population also will have a major impact on the federal budget, most
dramatically on the Social Security and Medicare programs, particularly if the cost of health
care continues to rise at its historical rate. Thus, we must begin now to prepare for this
coming demographic transition.6
The economist Herb Stein once famously said, "If something cannot go on forever, it will
stop".7 That adage certainly applies to our nation's fiscal situation. Inevitably, addressing the
fiscal challenges posed by an aging population will require a willingness to make difficult
choices. The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable
budget deficits, the nation will ultimately have to choose among higher taxes, modifications to
entitlement programs such as Social Security and Medicare, less spending on everything
else from education to defense, or some combination of the above. These choices are
difficult, and it always seems easier to put them off - until the day they cannot be put off any
more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in
the longer run we will have neither financial stability nor healthy economic growth.
Today the economy continues to operate well below its potential, which implies that a sharp
near-term reduction in our fiscal deficit is probably neither practical nor advisable. However,
nothing prevents us from beginning now to develop a credible plan for meeting our long-run
fiscal challenges. Indeed, a credible plan that demonstrated a commitment to achieving
longrun fiscal sustainability could lead to lower interest rates and more rapid growth in the near
term.
Our economic challenges, both near term and longer term, are daunting indeed.
Nonetheless, I remain optimistic that they can be met. History has demonstrated time and
again the inherent resilience and recuperative powers of the American economy. Our
country's competitive, market-based system, its flexible capital and labor markets, its
tradition of entrepreneurship, and its knack for innovation have ensured that the nation's
economy has surmounted difficult challenges in the past. I do not doubt that we can do so
once again.