November 6, 2010
Dennis Lockhart: For this last session, which I know is going to be very special, we invited Paul Volcker to attend, and unfortunately he's out of the country. But we got the next best thing: Paul Volcker, in fact, will introduce this panel; so we'll start with a video.
Paul Volcker Video: Well, I'm sorry I'm halfway around the world and unable to participate in this great restoration of Jekyll Island and the return to that place where the Federal Reserve idea took form. You know, none of us can claim personal memory of the creation of the Federal Reserve, but your panel discussions are going to encompass years of experience. Gerry Corrigan started back in the 1970s; Alan Greenspan was there for a very long tenure (it almost seemed forever); now Ben Bernanke's there and in the middle of a great crisis, one of the most challenging periods in all of Federal Reserve history. In that group, I claim only one distinction: I walked into the Federal Reserve Bank in New York, that great fortress downtown, in 1949. I think that's before Ben Bernanke was born. So I do have a little perspective; somehow, I sometimes think that was only yesterday when I first entered the Federal Reserve.
You know, we have had a large crisis, still have the remnants of that crisis, or maybe more than the remnants. And we're tempted to think that the Federal Reserve has never been so challenged as in these recent years, and that may be true. But it's certainly not true that there weren't a lot of controversy and challenges right through the history of the Federal Reserve. You know, the United States experimented with central banking back in the late 1700s and early 1800s, and that was very controversial, not very successful; it became a matter of controversy in presidential elections. The central bank ended in the 1820s, and it wasn't until 1913 when Woodrow Wilson, the great achievement of his administration, founded the Federal Reserve.
It was quite a different institution; there was a lot of suspicion that it would be politicized or dominated by Wall Street or too-concentrated power. Some of those suspicions were reflected in the fact that the Federal Reserve in those days didn't even have the authority to buy government securities. There wasn't any idea of open market operations. There really wasn't any concept of monetary policy in the interest of stabilizing a growing economy.
Now that's all past, but the controversy clearly has remained, the challenges have remained. The Federal Reserve has taken heroic action in recent years; it's acted fully up to the limits of its authority, it stabilized the financial system, saved the economy. It's been, to me anyway, an unexpected reward for those efforts. Somehow we come out of that crisis with the Federal Reserve regulatory authorities enhanced.
Now I don't want to suggest the controversy surrounding the Federal Reserve system has in any way diminished, but I do want to make just one point: I think there's a consistent thread through the Federal Reserve's history, and it's a thread that I consider of enormous importance, not just for monetary policy, not for the economy, but for the country more generally. The leadership of the Federal Reserve—and it's exemplified by Gerry Corrigan and Alan Greenspan and Ben Bernanke—have really embodied a certain confidence. It's embodied the nonpolitical nature of the system, it's embodied a leadership of the system through the country. The Federal Reserve is respected. And it's respected at a time when respect and trust in all our government institutions is all too rare. It's that respect and that trust that, at the end of the day, is vital to the acceptance of its independence and to support for its policies. It's those intangibles—to me more important than any technical analysis or intellectual brilliance—that in times of crisis makes it possible for the Federal Reserve to step in, to act, and to act forcibly in the national interest.
Respect and trust—it's those qualities that need to be maintained, and I'm sure that's the challenge for the system in the future.
Lockhart: We're pleased to have an eminent economist in his own right, Raghu Rajan, as the moderator of this historic session, so let me turn it over to Raghu.
Raghuram Rajan, moderator: Thank you very much. I think from the last day and a half of conversations, we have had a very rich set of papers and discussions, and I hope this panel is the crowning glory of this wonderful conference. This is a great opportunity to go back in time, to see how three stalwarts of the Fed dealt with many of the big issues that have confronted us over the last 25 years. And it would be wonderful if we could get your perspective on what the big challenges were at that moment, what the uncertainties were, how you thought about them, and how we moved forward and the system learned.
So let me start by asking each one of you about a particular episode that you confronted. Let me start with Mr. Corrigan. You were there during the great fight against inflation, the "Volcker disinflation," if you will. What was the thinking going on at that time? Did you anticipate the extent of economic disruption that would take place, and how did you stay the course against what presumably were tremendous political pressures?
Gerald Corrigan: First of all if I could, I want to join others who have congratulated Dennis and his team at the Atlanta Fed for putting together this program and say that for me and many others, just the opportunity to spend a couple of days and a couple of long nights with my former colleagues in the Federal Reserve has been a true joy. So Dennis, thank you very much. I guess I also have to acknowledge that Chairman Volcker always has a way with words, and "respect and trust" I think captures what all of this is all about, as the chairman made clear.
Now, on the events of the very late '70s and the early 80s, let me try to capture as much of it in a couple of minutes as I can. Needless to say, it was discussed at great length yesterday, the inflation period of the '70s, the emergence of Volcker's pragmatic monetarism after he became president of the Federal Reserve Bank in New York in 1975, and then was appointed chairman by President Carter in the summer of 1979.
Part of the folklore that existed after he was appointed chairman was that Paul went off to the IMF meeting, which I think was in Belgrade, in September of 1979 and that somehow or other he was persuaded at the Belgrade meeting that he had to do something very dramatic. The fact of the matter is, I think he had already made that decision long before he went to Belgrade.
And I certainly know that, in the days and weeks leading up to that Saturday FOMC meeting—on, I think it was, the 6th of October if I'm not mistaken—he was laying the groundwork for what emerged at that meeting and thereafter. That Saturday FOMC meeting had something in common with the Jekyll Island meeting in 1910, and that is the participants in the meeting were instructed to go to great lengths to arrive in Washington in a surreptitious fashion; no one was allowed to stay at the same hotel so as not to attract attention. I remember very distinctly that the heavy drapes found in the boardroom for that Saturday meeting were completely closed; it was almost pitch dark in the room! And I also remember early on (I was of course seated on the sidelines there), early on that Saturday morning I heard a great deal of commotion out on the Mall across Constitution Avenue from the Fed's headquarters. And I managed to open the blinds and the drapes a little bit, and it turned out that the pope's helicopter had just landed on the Mall, and I said to myself, "Well, we got a little ecclesiastical support going here!"
But, clearly, that meeting, which lasted, I think, from 8 in the morning till 6:30 at night, really was quite dramatic. Because while Paul had shared with a few of the Governors some of the specifics of what he had in mind, it all had to be laid out in great detail at the meeting because he understandably was quite reluctant about circulating papers in advance of the meeting under the circumstances. And it was really quite dramatic, and of course I was a 38-year-old kid; it was especially dramatic for me because I kept saying to myself, "Oh my God, you know, this is the real thing!"
I think it's probably fair to say that everyone realized the consequences, the short-run consequences, which were going to be quite dire in terms of the economy, unemployment, and all the rest of it. I don't remember, or maybe I chose not to remember, whether there were actual forecasts of unemployment, things like that presented at the meeting, but everybody knew what was involved here. And, of course, the Volcker "pragmatic monetarism" put great emphasis on the money supply, and there was always this kind of cynical view that that was an excuse to rationalize how and why you could produce these gargantuan increases in interest rates. I don't think it was all that clear that this was kind of a sham. I think Paul did realize, and I think the committee realized, that there was something to this proposition—that money and inflation kind of went together—and there was that inherent attraction of trying to paint the picture in those terms. But it is also true that, as things unfolded, that focus on the money supply produced its own problems. Because, as some of you will remember, in those days the Fed produced money supply statistics on Thursday afternoons; and it got to be that Thursday afternoons were just utter chaos. And to make matters worse, early on in the process, I'll never forget this, one of the banks made a big mistake in reporting their statistics that underlie the M1 numbers, and I mean all hell broke loose; I mean there were congressional hearings, and then there were the other problems with Regulation Q and all the rest of it. But nonetheless, the chairman and the committee, for that extremely difficult period, were literally always of one central mind, and that central mind was we had to get that inflation problem behind us once and for all.
You know, there were very difficult moments. Homebuilders were mailing 2 x 4s to the Federal Reserve headquarters. There were a whole collection of other events: President Carter had his credit control program, we had the Monetary Control Act, we had the Hunt silver market crisis; it was really an extraordinary period. But it was when I, at least as a young guy, saw the best of the Federal Reserve. And this has already been mentioned several different ways, but the collegiality of the committee in that time frame was off the charts in terms of a willingness to work with each other, listen to each other, respect each other, and stay the course. Of course, I probably don't want to take other people's time, but the rest of it kind of is history—there was a gradual, gradual movement away from sole emphasis on money supply to nonborrowed reserves. I think it's unquestionably true that unemployment rates, for example, ended up higher than I think certainly most of us thought. But at the end of the day, it worked! And I still think, and I'm sure Chairmen Bernanke and Greenspan would agree with this, that it is not an accident that we in the United States, and in other countries as well, since then have had essentially 30 years of something pretty damn close to price stability. And the dividends of that, for our people and for our societies, despite the problems of the last couple of years, I think have far outweighed the short run, and you know, substantial costs that were incurred to get from point A to point B. So I'll stop there; thank you for your attention.
Moderator: Thank you. Turning now to Chairman Greenspan, your—soon after you took over the helm of the Fed—you had a baptism by fire with the Great Crash of 1987. What happened?
Alan Greenspan: That's exactly the question I asked when it happened! You know, Paul was mentioning the fact that he was showing up at the New York Fed in 1949, and I at the time had a best friend by the name of Tilford Gaines, whom I suspect Gerry remembers. And he was an assistant vice president at the New York Fed, and I met Paul at Til's 1950 Christmas party; and he was taller then than anybody I had remembered, and his stature has remained the same as far as I'm concerned. But, you're quite right. I showed up on the scene despite actually really quite considerable knowledge about how the Federal Reserve System worked, and obviously I was chairman of the Council of Economic Advisers for two and a half years and had very close relationships with Arthur Burns at the time, and I knew everybody on the board, and I knew the people on the staff, so it wasn't as though I was coming in cold.
But when you're at a new institution, having just gone through a one-person seminar about that extraordinary staff, and every subject under the sun—103 percent of which I did not have a clue about—but it was remarkable in the sense that the crash occurred basically as I was getting on a plane for Dallas, out of Washington. And I knew that the market had started down but I didn't realize the size it was until I arrived at the gate in Dallas and was told that the market was down—it was 502 or something—I said, "Wow, … it must have rallied all the way back." And I got a look, and I realized at that point that we had just had the most remarkable collapse in equity values, percentage-wise, in the history of this country. I also knew that all of our past histories had indicated that the "wealth effect"—as we have defined it now, or in a more general way, the issue of assets as a very significant determinant in how our economy functions—was critical.
And I remember very distinctly when I arrived on the scene saying, "There is no way we can get out of this without a significant economic contraction." And then, as Gerry will remember, we all got on the phone, and you had a remarkably welcoming remark as I recall, saying, "OK, buddy, it's all on your shoulders." I think I forgot to thank you. Thank you!
Corrigan: That's not an exaggeration either!
Greenspan: Any event, what … the following morning I get a call from the White House operator, who says, "Senator Baker wishes to speak to you." Howard Baker was then chief of staff for Ronald Reagan. And I pick up the phone, and I said, "Senator," and then there was a little silence, and then out comes, "Help!" And so I got trundled off to Washington as quickly as I can. But as Gerry remembers, the conversations that we had—remember there were several different meetings we had by phone—it was generally agreed that in that condition, in that event, you just open up the taps because you had no notion of the shock that, what the liquidity was, and as a consequence of that, you had no real judgment as to, with this historic event, what the appropriate actions were, but you knew the direction. And what we did, as you may recall, is we moved the funds rate down, fairly significantly, for a short period of time. And the thing that startled me was I had expected many subsequent disruptions to the financial markets because it's extremely rare to get a crisis of that type in which a speculative market, whether it's Hunt silver or whether or not it's stocks or anything else. You're looking at a situation in which you get the first shock down, you get tendencies to recover, but usually there are second and third testings of the market. And we indeed went through that. And it was touch and go with such problems as whether or not the New York Stock Exchange would shut down.
I remember having conversations with John Phelan (I think was then chairman of the New York Stock Exchange) and he was telling me, "We're going to have to shut down in an hour." And I said, "John, don't think of shutting down. Think of how you will reopen if you shut down." And we were very fortunate, because as that hour approached, for some, from where I do not know, but a flood of investment funds moved in, it stabilized it, and we got past that. And it was pretty rough for the week subsequently. Now I haven't a clue to this day whether it was the injection of massive amounts of liquidity in the short run which stabilized the system, or it was utterly irrelevant. But we had never seen that type of phenomenon before, and we had no way of judging it, and we haven't had, really—with the exception of the most recent crisis, which is complex by so many other aspects—really essentially, what one makes of that period. But the data show, of course, is that we had a major decline; and one could describe it as a bubble because the run-up in stock prices in the summer of that year was really quite extraordinary. But granted it was a bubble, it had no footprint on the GDP that I could find even to this day, and we ran into the same thing in the dot com boom. And the dot com boom had many of the characteristics of what happened in 1987; and, again, you cannot tell that there was any significant financial problem.
Then we ran into 2007 and 2008, and it's a wholly different ball game. I think that is going to create more PhDs and more work for advisers and a lot of paper from dissertations, and I hope it is to a successful and is to this day; we fully don't understand what has gone on and how it's going to come out, how it's all going to come out. Well, I've spoken long enough, Mr. Moderator, Mr. Chairman, whatever you want to be called, Raghu.
Moderator: No, Raghu's fine. Chairman Bernanke, no surprise about what I'm going to ask you about—the panic of 2008 and the Fed's response. It's rumored that if you work on a book on the crisis, eventually, it will be called Before Asia Opens. You had many tough weekends full of activity. What was the thinking at that time? How do you see the actions with the perspective of a little bit of hindsight? And, you know, while you were doing all this was the political fallout a concern? How did it play out?
Ben Bernanke: Well, let me start off by saying, thanking President Lockhart and Jekyll Island staff and all for putting this interesting conference on. In the last paper, someone noted the importance of Sharpe theoretical models as a way of improving our thinking about monetary policy. Well, I think there's a dialectic between theoretical models and history. And in my own academic career, I tried to look at both sides of that, and I found, in my experience of the last few years that both modern monetary economics of the most, you know, the most sophisticated type, together with, you know, my reading and work on the Depression and other periods, that both of those were extraordinarily helpful in thinking about the crisis.
I came into the Federal Reserve, having been appointed by President Bush, thinking that crisis was an important part of my job. And in fact one of my very first acts was to create a staff committee of senior staff members who were supposed to be looking at financial stability issues and trying to identify problems. Now obviously they didn't anticipate the problems, and that was no criticism of them; it was a relatively small group of people looking at a restricted set of issues. What we found out, of course, was that the crisis that began in 2007 and hit its peak in the fall of 2008 was an extraordinarily complicated phenomenon. It wasn't simple bank runs or a stock market crash; it was an interaction of so many different, complex, and global aspects of the financial system. I recently testified before the Financial Crisis Inquiry Commission, which is charged with explaining the crisis, and I wish them great luck. But my testimony, which is available, sort of summarizes what I think are some of the key features, including leverage, which you talked about in the last session, problems with risk management, gaps in the regulatory system, and the shadow banking system, and many other complex and interacting features that that led to the crisis.
But I think one example which I found very instructive relates to work by Gary Gorton, who looked at the interesting analogies between the shadow banking system and the classic, or the traditional, banking system. Gary pointed out that the traditional commercial banking system didn't have enough insured or safe liabilities to satisfy the huge demand for liquid assets, this was a point also that Martin Goodfriend was making earlier. And so the shadow banking system arose, and what it did was essentially it created, on the one hand, all of these so-called AAA assets. And O'Neill's picture of how magic of the alchemy of financial engineering transformed sort of mediocre underlying assets into AAA, that the shadow banking system held those as assets and then created short-term, liquid liabilities with which to finance those assets. And so it was very much the same structure as a bank except it didn't have the protections, the guarantees, and the oversights that a bank has. As Gary explains it, in some nice papers (and others have worked on this as well), the essence of a banking system when you have liquid assets is that you believe that the assets on the other side are essentially perfectly safe, or guaranteed in some way, and once that belief is shattered then your best response is to pull out—is to run—is to pull out your short-term liquidity as quickly as possible. That's essentially what happened in the fall of 2007 when a couple of hedge funds said they couldn't value some underlying collateral and problems with subprime mortgages were becoming evident and the decline in house prices was putting pressure on those mortgages. It became increasingly evident that the so-called AAA securities were not AAA, that there were going to be losses, and that, of course, as in any classic bank run situation, generated a broad panic in the shadow banking system and in the money markets.
So it was interesting in that this was a, in some ways, an absolutely clear, predictable, and understandable phenomenon in the sense that it looked very much like a banking crisis of the 1830s. And yet because it was in such a complex and novel institutional context, one that was, had outgrown the underlying regulatory structure, our ability to detect it and to anticipate it and protect against it—well, perhaps someone more omniscient than me could have done it—but it was difficult for us to do given the, particularly given the sort of silo aspects of our regulatory system, where individual regulators had different responsibilities. So the crisis, as you know, began in '07 and intensified with the Bear Stearns phenomenon, which, again, was very much tied into a run, in that case in the repo market. After Bear Stearns there was a period of some calm, but then we saw Fannie and Freddie and, of course, things picked up with Lehman Brothers and AIG, etc., etc., in the fall.
Now people who have written about the crisis have focused very much on the individual institutions and the attempts of the Federal Reserve and the Treasury and others to protect or rescue them. Let me just say, first of all, that I, you know, based on historical experience and also just knowledge of markets and theory, I was persuaded that, given where we were, and given the global nature of the crisis, that we had to do all we could to avoid the collapse of these major global financial institutions. Not again, of course, as you all understand, not because of any desire to protect the predators or equity holders of those firms, but because, as we found out, with Lehman Brothers, that the collapse of one of these firms could have enormous effects on the broad financial system.
Now the reason that those, in some sense, that those episodes were so dramatic was in a sense that we as a country were completely unprepared to deal with that kind of phenomenon. Given our congressional-presidential system (unlike, not a parliamentary system where the government can act relatively quickly), we didn't have mechanisms for quick response from the government. We didn't have tools to safely resolve firms that were not banks; you know we have (the FDIC has) a set of tools for resolving banks. We didn't have any analogous tools to resolve a large insurance company or a large investment bank. And so a lot of that, a lot of those episodes were ad hoc; we were using the tools that we could put together, cobble together. I think if anything good has come out of this, I hope it is that we will in the future both create a much stronger ex ante supervisory regime over systemically critical firms, which is what the Dodd-Frank Bill attempts to do, so that it's much less likely that they will come to this kind of brink situation and that, should that happen, that we have a resolution regime and a set of well-established principles for resolving these firms in a way that does minimal damage to the broader system. So that part of the whole episode, the response to individual firms, which was the thing that cost us the most sleepless nights, was really an attempt to deal with what was really a very inadequate institutional structure and political structure for dealing with this particular kind of problem.
Now beyond those, though, I think beyond these dramatic events, I think that history and theory provided some very useful tools for addressing what happened in the crisis. And I'll just talk briefly about two broad sets. First of all, you know, the Federal Reserve was set up to ensure financial stability. We know from Bagehot, we know from Thornton, how central banks are supposed to respond in a period of panic. In particular, we are supposed to lend freely against good collateral, to provide liquidity; and that's precisely what we did. I mean I thought of this whole thing as being that Bagehot would have been happy with what we did. We set up all kinds of new mechanisms, recognizing that commercial banks were not the only run-prone institution in the current environment; we had to worry about money market mutual funds, and the repo market, and many others. And we were creative, and we worked with the Treasury and did what we could to set up provision of liquidity to those troubled firms and markets. And I think ultimately that proved successful. We ended essentially all our major interventions, our major liquidity programs, at the beginning of this year. So that part, you know, I really think of it as the classic central bank lender-of-last-resort response, again, adapted for the complexity of the financial system. I would add, in addition to that, that we also made good use of our supervisory function throughout the entire episode, as was the case in the crises faced by my colleagues here. An example I would give would be the stress tests that we led in the spring of '09 that were very successful in providing information to investors and to the public about the state of the banks and which was essential for them to be able to raise capital and strengthen themselves in the subsequent months.
So that's the liquidity/financial stability half; the other part of policy was monetary policy. And there again, I think that our approach was, you know, nothing unusual about it in the sense that we were trying to respond to a collapsing demand and a contracting economy; we cut rates very quickly. Of course, we ran into zero bound, which we had had some brush, some discussion with in 2003. We ran into the zero bound quite literally in December of 2008, when we brought the federal funds rate down to the range of 0 to 25 basis points, and from there on, we had to, you know, change our methods of operation. Again, Marvin talked about this very well. I think the point I'd like to leave with you is that there's a sense out there that "quantitative easing" or asset purchases or some completely foreign new and strange kind of thing, and we have no idea what the hell's going to happen, and you know, just, it's just an unanticipated, unpredictable policy. Quite the contrary—this is just monetary policy. Monetary policy involves the swapping of assets—essentially, acquisition of Treasuries and swapping those for other kinds of assets. And similarly, the way federal funds rate management essentially is aimed at reducing medium- and longer-term interest rates and raising asset prices, quantitative easing has exactly the same objectives, and so it'll work or not work in much the same way that monetary policy—ordinary, or conventional, familiar monetary policy—works. So there is not really, in my mind, as much of a discontinuity as people think. Monetary policy is monetary policy; it's just that the specific tools that are used to create easier, more supportive financial conditions are somewhat different.
But, you know, we took action in this line, as you know, earlier this week. The motivation is precisely the one that we all have learned is the appropriate motivation, which is that we have inflation; we've seen disinflation; we see inflation that is low, below the target, or below the preferred range of most of the members of the FOMC. And we see an economy which has a very high level of underutilization of resources and a relatively slow growth rate. So, you know, the standard considerations suggest that we should be using expansionary monetary policy, and that was the purpose of the action. Again, nothing extraordinary, just a different set of tools to achieve essentially the same kind of results. So I'll stop there.
Moderator: Thank you. Now let's get into a little bit of conversation. President Corrigan, you have a note up there which suggests that you worry a little bit about the inflationary consequences of, I would guess, more stimulus. Let me let you explain what your concerns are at this point.
Corrigan: First of all, that note that's out there was stated a little more precisely than you just referred to it. First of all, let me say at the outset that, as you would expect, I have asked myself hundreds of times over, what would have I done had I been in the situation that Chairman Bernanke and his colleagues have been in the past couple of years. And this is not flattery, Ben—I think I have said this to you privately; I think the best answer I could give is I would have done pretty much exactly what Chairman Bernanke and his team did except I might not have been clever enough to think of some of the things that they thought of. I just want to make sure that's very much a part of the record. And, again, that is what central banking is all about, so there's no great mystery to this.
Now the issue that is referred to in the note that was circulated at this meeting (that is, I'm so compulsive that if I have something like this I feel like I have to write something), it is simply the following. And I went out of my way to describe this as a very low-probability risk, and I went out of my way to say (as many of the people in this room know), I kind of have a fetish about low-probability risks, because those, when something goes wrong, it can really go wrong. So let's keep this all in perspective. The point that I raised—which I'm sure Chairman Bernanke and the FOMC itself has thought about many times—is that if you seek to nudge up the inflation rate, even with these very, very, very low rates of capacity utilization, labor market conditions, and all the rest of it, is there a risk that nudging it up to, pick a number, 2 percent or whatever you want to use, may turn out to be easier than capping it at 2 percent or whatever. That's essentially the source of—and I use the word very carefully— uneasiness that I wanted to register. That is in no way intended to be taking exception with the course that the FOMC has set out for itself as was announced earlier this week, and it was just summarized by Chairman Bernanke this morning. But I think all of us, when we're on the Open Market Committee or when we're not, should think about contingencies, and that was the spirit in which I raised that issue.
Bernanke: Could I comment? I'm very sympathetic, Gerry, to what you're saying. Of course, there are contingencies in different directions, and there are both upside and downside risks. We are very committed on the FOMC to our price stability objective. I have rejected any notion that we are going to try to raise inflation to a supernormal level in order to have effects on the economy. I think that our credibility must be maintained; I think it's critical for us to maintain inflation at an appropriate level, and we've provided through our projections a pretty clear sense of what the committee thinks is the appropriate long-run level for inflation.
Now that being said, we've had, at least according to many measures, we've had a fairly significant disinflation since the peak of the business cycle in December of 2007. That's at least indicative of a world in which monetary policy is insufficiently stimulative. We can all debate about how much the monetary policy can do for the real side of the economy—personally, I think it can be helpful—but nominal quantities are the Federal Reserve's responsibility. And if inflation is declining, and continuing to decline, I think at a minimum we should not be satisfied with a situation where we have both a large amount of slack on the employment side and inflation which is below our generally agreed on preferred level and seems to be declining over time. So, in that respect, I think that's a signal that more should be done, as I said in my speech in Boston. That was the motivation for the action taken earlier this week. But I couldn't agree with you more. Again we're not in the business of trying to create inflation; our purpose is to try to provide some additional stimulus to help the economy recover and to avoid potentially additional disinflation, which I think we all agree would also be a worrisome outcome. But we are equally committed to both sides of our mandate.
Moderator: Chairman Greenspan, let me get back to you on an issue which is somewhat closely linked with your tenure, which is asset prices, asset price bubbles, and the notion that there was a "Greenspan put" out there in the markets. What's your sense of that? Was it fair or unfair? And how did you think about that episode?
Greenspan: Well, first of all, it's a slightly ambiguous concept in the sense that I get a lot of different definitions of what that means, so I will interpret it by the definition I would like to respond to. The issue is basically that the Federal Reserve tended to react far more significantly to weakness in the economy than the upside—that there was an asymmetry of response to the economic events. And if you look at the data, there is no question that monetary policy eases far more rapidly than it tightens. But that has got nothing to do with the issue of asset prices or the issue of setting up a put; that's what the economy is doing. Because the National Bureau, for example, say over the past 50 years, indicates that our economy was in recession 14 percent of the time. And if you look at the unemployment rate, you will find that it rises very sharply, and then eases down very generally. So what is being observed and what is being interpreted as the Greenspan put—and I appreciate the notion that this is a great invention of mine—is essentially the way one would expect a central bank to respond to the economy.
Now I don't deny that because we endeavored increasingly over time to try to be anticipatory and preemptive as best we could on the basis of the knowledge we had—and obviously if you begin to see very major changes in equity values in the economy, and you know what the wealth effect concepts are, and you know the impact of changes in equity prices on, for example, the market value of financial intermediaries. Because clearly, the extent to which you have problems in a financial intermediary to a large extent depends on the market value of the equity of the intermediary because it is that market value which is the support for the liabilities of the institution. And, essentially, a big infusion of unrealized capital gains in a financial institution enables it to very substantially improve on its ability to lend, and, indeed, the credit rating agencies, hopefully better than they've been done, obviously rise for the senior debt of a financial institution if the market value of equity expands.
The converse of that, when you're seeing a sharp decline, is that we know that there are certain effects that are going to occur in the economy, and we tend to respond to them. But we're responding to the economy, not to the markets, not to interest rates; we're responding essentially to what our job is—namely, to stabilize the system. Now if, in effect, the Greenspan put is a notion which says you're stabilizing the system, I say, "Well, I hope so." That's indeed what we're here for, to celebrate the origination of the Federal Reserve system, which was created largely because of the extraordinary panic in 1907, which cumulated a long series of such panics. And monetary policy, if it's a functioning issue at all, has got to largely be an issue of trying to stabilize the economy. So that I don't really have an understanding of why that has become a pejorative term. I mean I listen to it, I know what they're saying, and I'm saying if I understand you correctly, what we're doing is what we should be doing! And in that sense, it's an issue of success, not failure.
Moderator: Let me just push a little harder; maybe I'll ask President Corrigan on this. Is there a role for the Fed to maybe lean a little bit against the tide, as it's taking prices up, so that you get more…you prevent the upturn which has to be in a sense…?
Greenspan: Well, if I may say, I don't think that's what happens. In fact, going back to, say, 1994, what we observed—and Marvin Goodfriend's sort of piece had many quotes directly out of the FOMC hearings—at that time, we were talking about bubbles in the financial markets and in the stock market, and our general view was basically that there was a speculative froth going on, and we indeed were tightening. And that 300 basis point rise in 1994 was not directly related to stock market speculation, but we were aware that there was an incipient bubble in the market emerging, and it appears directly in the FOMC discussions at the time. What happened, in fact, is that we raised the funds rate that is pushing against the issue by 300 basis points and did stop the stock market cold for a year. As soon as we stopped raising rates, the market took off again. And we went through the same process later in the decade. I concluded from that that while we may have thought that we were trying to lean against the wind and diffuse it, we in fact did precisely the opposite. Because what the market (this is now an obvious interpretation) the market was probably saying to itself, "Wow, the stock prices went through a 300 basis point crunch, and nothing happened. Therefore, we have underestimated the equilibrium level of the Dow Jones Industrial Average." And it took off from there.
So this presumption that you can incrementally diffuse these bubbles is working very fine in an econometric model in which we define the structure of the model in such a way to get that conclusion. All it tells me is that we're missing a variable in our models which doesn't capture this feedback effect, which I suspect is very real, and, in a sense, this notion that you can incrementally impact on the economy or on the markets is really something which exists only within our models. It doesn't exist in the real world, and there's another reason incidentally. You know, if monetary policy has long and variable lags, how do you get the feedback effect in time to know whether or not the incremental actions you're taking are actually working? I mean, if we're sitting there, and we're saying, "Well, we're going to increment the funds rate," the problem is that the delayed effect is so long and so variable, we have no way of knowing how to increment. So this notion that is fairly general I find very puzzling because I don't think the evidence at all supports it.
Corrigan: Let me try to quickly put this issue in perspective. And part of the perspective is the following. If we look at the 30 years between 1980 and today, by my count over that 30-year period we have had eight financial disturbances, all of which had at least some potential elements of systemic risk associated with them. Now in the vast majority of those disturbances, including the most recent one, the overwhelming majority of losses and write-downs were directly or indirectly attributed to the credit origination process, although in this last sequence, as Ben has already mentioned, the securitization process and all of the excesses that went with that aggravated that problem. But the underlying problem was still largely credit on the credit origination side. I think you can make a decent argument that of those eight episodes, the two that don't seem to fit the credit-dominated phenomenon were the two that Chairman Greenspan mentioned—in other words, the '87 stock market crash and the dot com thing. Because those were the two in which it's hard to see, as the chairman suggested, convincing evidence of any significant damage to the real economy.
Now, that pattern—I'm sure there are scholars in this room that have looked at this in a more systematic way than I have—but that pattern raises a variety of questions in my mind in terms of, "Well, is there something inherently unstable about the system?" And you can't casually rule that out. Or, in the alternative, have there been at least limited cases in which the extent to which bubbles were financed through credit expansion contributed to these sources of instability? Now I don't pretend to have all the answers to those questions, but I do think how you think about those questions and their answers bears enormously on this whole question of financial reform. In other words, if we just all put ourselves in a time capsule and said, "Well, we'll wake up on," today is what, "November 6th, 2015." And will we find on November 6, 2015, that we've inherited a financial system that is inherently more stable, less accident-prone, and even when accidents do happen, they don't cause as much damage as we've just witnessed? That question—of what the system is going to look like in the future—I think personally the probabilities favor a more stable system, but I don't think it's baked in the cake.
Greenspan: Gerry's raising a very important point here. I think you have to ask yourself whether credit restraint on lending or capital is what you want to do. And I ask myself, what, in retrospect, would have been required to prevent the crisis of the post-Lehman Brothers default crisis? And the obvious question is that Lehman Brothers, I think, went to the wall with 3 percent tangible capital. What if it had had 20 percent capital? Or 50 percent capital, like they used to have prior to the Civil War? The answer essentially has got to be at some point if there is adequate capital—and the word "adequate" is a crucial word here—by definition, you do not have defaults of senior debt. And you do not have contagion, with the exclusion of the wealth effect, in a system in which there are no defaults.
And as far as I'm concerned, much of what we have run into here is a misjudgment as to what the tail risk of the probability distributions were (and, in effect, as I recall—I'm not sure, Ben has been far more involved in this than I, there has been a very interesting discussion going on prior to the Lehman event, or even prior to the Bear Stearns event) that the tail risk was not a normal distribution—that it was a very nonlinear distribution which had a fat tail but which we had never actually observed because we never got to the point that we got to in 2008. And, in the event, if you look through the actual tracing and make it retrospectively, putting it in where the [unknown word] risk distributions would appear, that the tail was not fat—it was obese. And the problem essentially is that we had an extraordinary implosion as a consequence of that.
And I think the lessons that at least I've learned—I don't know to what extent we're going to get it in the regulatory system—but I think that the financial intermediary system in the United States, and I suspect elsewhere as well, was implicitly subsidized by the taxpayers. I know in our case because we had less capital through that period than in retrospect we should have. And the question is that therefore the financial system was subsidized by the taxpayer. The bill didn't come due until after September 15, 2008; that's just because the billing relationships took a long time. But it's all capital that I see is the problem, and I'm not saying there are lots… I think there was rampant fraud in a lot of what was going on in these markets. But my general judgment is that there are two fundamental reforms that we need; one is to get adequate capital, and two, to get far higher levels of enforcement fraud statutes. Existing ones—I'm not even talking about new ones. Things were being done which were certainly illegal and clearly criminal in certain cases, which in fraud is a fact. Fraud creates very considerable instability in competitive markets. If you cannot trust your counterparties, it won't work, and indeed we saw that it didn't.
Bernanke: Just one comment that all of these points lead to, which is that there is a difference between an equity bubble and a credit bubble. An equity bubble, particularly if it's an unleveraged bubble, is a loss of wealth, and unless it's a huge bubble, like perhaps the Japanese case, it's going to be absorbable by the system, as we saw in '87 and a relatively mild recession in 2001. If it's a credit bubble, which is highly leveraged and leads to loss of capital and loss of capacity to intermediate new credit, then the damage is much, much greater. Now what that suggests is that all of this talk about the Greenspan put or the Greenspan-Bernanke put or whatever, which thinks implicitly about the stock market is more or less beside the point. I mean the real issue is what can we do to keep our financial intermediation system strong. And the position I've maintained throughout is that the first line of defense, at least, should be capital, supervision, liquidity, and other restrictions to make the intermediation system as strong as possible, so I agree with Chairman Greenspan about that.
Corrigan: If I could, Ben and Alan, just add a footnote to that, it seems to me unambiguous that one of the lessons learned here is that going forward, particularly for the so-called systemically important institutions, that we really have to look at capital adequacy and liquidity adequacy as a single discipline. Because it's very clear that if you focus on just capital without a systematic integration of how you think about liquidity, the probability of train wrecks of a major proportion go up. So I think that the work, Ben, that the Basel Committee and the Fed is doing to pull together this single integrated approach to capital and liquidity adequacy is probably one of the two or three single most important things I think we have to do.
Moderator: We don't have a huge amount of time, so I want to make sure we touch on all the issues that were on the table in this conference. One of the issues that Marvin Goodfriend brought up was the difficulty for the Fed, in occasionally being the only game in town, having the flexibility, having the capacity to undertake certain actions which should in theory be the realm of other agencies of the government. The example he brought up was the Mexican loan. One could think of, for example, today, where a number of economists have argued that fiscal policy might be more effective at this point than monetary policy, but monetary policy might be the only game in town because of the state of play in Washington. What's your sense about how much…how do you choose—difficult choice—between being a team player, stepping up to the plate but at the same time risking, sort of being part of the political process and perhaps losing a certain amount of independence? I think Marvin had a case study there where he described some of the content of the discussion. Has that thinking…how has that thinking evolved over time? Maybe first with Chairman Greenspan…
Greenspan: Well, remember that the Federal Reserve is the fiscal agent for the United States Treasury, that there is really only one monetary authority in the United States. We, unfortunately, in our bookkeeping back in 1968 when we decided to create the unified budget, left the Fed outside of that, and it's caused all sorts of distortions, and it's created an illusion that the sovereign credits that are employed by the Federal Reserve, the central bank, are different from those of the Treasury. They are not. There is only one sovereign credit that's involved in this whole process. And so I think that you have no choice but to coordinate with Treasury, and the question there raises a major problem of Federal Reserve independence. And that is one of the most difficult problems I think that the institution has—to fulfill its role as a partner in the maintenance and care of the sovereign credit of the country and the independence of the central bank from government. Those are not obviously reconcilable views, and there is a considerable tension that always exists; it always will exist, and I don't know how you make any difficulty there.
I, for example, think, I've argued that 13(3)—everyone knows what 13(3) is by now, I hope—had to be used when we had what I think was the greatest global financial crisis ever. Not the greatest economic crisis—that was the Great Depression. But I don't recall the history indicating the extent to which the shutdown occurred in financial markets, in the commercial paper market, in the RP market, in money market mutual funds, trade credits. Those things never shut down previously, and the call money market, for example, was open during the Great Depression; the rates went to 20 percent, but it never shut down. It is true that there was a major contraction of credit availability because of failed banks in the '30s, but the institutions stayed open. In 1907, there was one day in which the call money market shut down, and I think the bid rate went up to, I think, 168 percent or something like that. But I don't recall, and I've reached back into history as best I can, but I've never yet found an instance of anything remotely close to what the Federal Reserve had to deal with here. And, I think that 13(3) is clearly useful, and indeed it was the thing that we actually amended as late as 1994. I mean, it wasn't as though this is some obscure depression vehicle which we never thought of and we pulled out.
The interesting question here, however, is that if the Fed is going to put things on its balance sheet, I think that it's incumbent upon the United States Treasury Department to take the Fed out. Those are not monetary assets; 13(3) is, can be, and has turned out to be a nonmonetary vehicle, and it's properly used as essentially a fiscal agent. But the Fed should not be asked to keep that stuff on its balance sheet, and in so doing, you create really serious political effects, which I think are self-evident at this stage and I think are unnecessary. The reason, of course, goes all the way back to the 1960 Unified Budget Procedure. For the Treasury to do that, they would have had to have gotten appropriated funds, where the same credits are employed by the Federal Reserve without such things.
Bernanke: I think there's a lot of intellectual confusion about what Federal Reserve independence means and what it's for and also about cooperation and what it's for. The clearest case for independence is in making monetary policy because we want to avoid short-term political interference in monetary policy decisions, and there's a good case for why a longer-term perspective makes sense. And throughout the crisis, the Federal Reserve has been completely and entirely independent in all of its monetary policy decisions; there's been no issue there whatsoever. A second area is supervision. There are good reasons for supervisors to be independent—so that they can carry out closing a bank, for example, without interference from Congress. But that being said, the independence that a supervisor has is different from the kind that a monetary policymaker has, and when the Fed is operating in its role as a supervisor, its relationship to Congress is somewhat different. For example, we are carrying out the statutory laws and the framework that the Congress has put down. Now, in the case of a financial crisis, obviously we don't want to compromise our independence, but I think there is both plenty of precedent and plenty of clarity that cooperation, in trying to arrest the financial crisis, is perfectly appropriate. And, in fact, you can see that in things like the systemic risk exception in the fiducial law, which requires a collaborative decision by the Fed, the Treasury, etc., and the FDIC, that a systemic crisis exists. The Financial Stability Oversight Council it just passed is also a collaborative institution. So a collaboration, in itself, to arrest a financial crisis I think is not in any way inconsistent with monetary policy independence, which is a different function.
Now that said, in carrying out financial stability operations, there are different roles. And the Federal Reserve made every effort, and I think we were pretty successful, in restricting our role throughout the process to liquidity provision. That is, we were required by law to lend against good collateral, or technically, to be secure to the satisfaction of the president of the Reserve Bank making the loan, and we've had no losses, and we've been repaid, and most of our programs are being shut down. So I would argue that, you know, as best as we could, and I think pretty effectively, we collaborated with the Treasury on managing the crisis, but we still tried to respect each others' roles, where the Treasury injected capital and took losses and the Federal Reserve, wherever possible, lent against good collateral. The reason that we couldn't save Lehman, which was before the Treasury was authorized to put capital into companies, was that, given that the company was insolvent, there was no way that the Fed, using its strictly liquidity-providing authorities, could avoid that. Later, of course, that would have been a different story. So even as we collaborated we tried to make sure as best we could that we were each using our own separate authorities, and there was an agreement between us and the Treasury, which tried to lay out—it was sort of a new accord, I guess you might call it—but at least tried to lay out clearly that credit risk is the Treasury's responsibility; liquidity provision is the Federal Reserve's responsibility.
Corrigan: I guess the only thing I would add is that, human nature being human nature, I think it's inevitable—notwithstanding the obvious accuracy of what Ben has just said about cooperation with the Treasury and so on, that's clear enough—but I do think again human nature being human nature that there is some risk coming out of this last episode (not to say things about earlier episodes) that the public and politicians may find it all too convenient to really try to convince themselves that the Fed or monetary policy or both, you know, can solve all of our economic and financial ills. I think there has to be some danger at the margin that the great successes of the past couple of years—and indeed I would go back to the successes of the Volcker initiatives—create that perhaps a bit of a false sense of comfort. I do think we have to be careful about that, and I do think that regardless of whether you use the word independence or autonomy, or however you want to dress up the semantics of it, that that concern, I think, inevitably does raise questions about the standing and status of the central bank of the United States over the longer term. I think it can be managed, but to think that those issues won't surface, or haven't surfaced, I think is perhaps being a bit naïve.
Moderator: Well, we have about five minutes, so I'd be remiss if I didn't ask a slightly tougher question. Allan Meltzer yesterday said that the Fed "displayed persistent interest in near-term events while persistently ignoring longer-term consequences of its behavior." And, specifically. he suggested the attention paid to deflation in 2002–2003 was an example of this, and I would guess, by extension—and I'm putting words in his mouth—he would argue that the deflation scare of 2010 might fall in the same bucket. Is he being unfair?
Greenspan: Are you asking me? I think, as I recall, Allan is a very great supporter of Milton Friedman. And let me just argue, for example, with respect to the 2002–2003 experience, that I wrote a rather extensive analysis of that period for a Brookings paper, which published in June of this year, in which I think the evidence that the "bubble" was a consequence of the endeavor of the Fed to move rates down when we were confronted with a fall in inflation rate in that period. My judgment is that at that point, and I think Ben Bernanke remembers it, I'm sure, because we both sat and worried about it, but it was clear that the probability of getting deflation at that time was less than 50/50. But had it occurred, the impact would have been much too difficult to deal with. And the result is that we brought rates down. And what were the consequences? Well, first of all, all of the evidence that I can see says that housing prices are a function of long-term mortgage interest rates with a lag of a significant number of months. It worked. There was a very important relationship between the federal funds rate and long-term rates, and therefore housing prices in earlier years. But with the emergence of a globally arbitraged bond market, the 10-year note in the United States became a function of what was going on in the global markets and essentially detached from the federal funds rate. Prior to then, that correlation between the federal funds rate and the long-term rates—for example, the 10-year Treasury note—was very high, and when you moved the federal funds rate, you would get a movement in the 10-year note, effectively saying that the term structure was stable. And the Federal Reserve staff was very much aware of the fact that we were moving incremental estimates of the term structure. But the notion that it would essentially collapse, as it did in the period following 2001, when we got this tremendous flood, as Ben pointed out, of savings moving into the global economies, the consequence of, in my judgment, the end of the Cold War, which led to a major shift towards market economies in much of the developing world, which in turn created a huge level of income, which they couldn't spend because they didn't have an infrastructure or a culture to do that, and that spewed over into the markets, and we had a major rise in ex ante savings relative to ex ante investment in the United States and globally.
And the consequence of that is that, if you look at the data, subsequent to 2002 we were getting a M2…however, I think money supply by any measure was very stable during that period. I just find it very nonconceivable that the overnight rate in that sort of environment can capitalize 20-year to 30-year assets. It's got have…the capitalization rate has got to be fixed at the same maturity that the life of the asset is. Now the notion of this pumping of liquidity in is a very fine analogy, but the channels are never defined sufficiently. You can't just jump and say, "It's therefore…"—and I find the word "therefore" is utterly inappropriate— and if you look at the correlations (and I suggest to those of you who are interested in refuting my argument, please go to the June publication at Brookings, it's the Brookings Panel on Economic Activity, and if the argument is wrong, I'd very much like to hear it because I'll change my point of view). But let me just say this: With respect to the period, Milton Friedman said, this is in January 2006, "There is no other period of comparable length in which the Federal Reserve system has performed so well. It is more than a difference of degree; it approaches a difference of kind."
Now, being that Milton Friedman was the most severe critic of the Federal Reserve up to that point, I do think that sometimes, his viewpoints ought to be considered in this particular case, and I'm surprised that—I don't know whether or not you're quoting Allan correctly, frankly—but if he said that, and I don't like to quote people, especially when they're here—but all I can say is that if that's the case, Allan, both Milton and I disagree with you.
Bernanke: I have great respect for Allan and particularly his magisterial work on the history of the Federal Reserve, but Chairman Greenspan reminded me of something I think will be provocative, because Allan Meltzer wrote an editorial recently, an op ed, saying that Milton Friedman wouldn't approve of the Federal Reserve's behavior. I grasp the mantle of Milton Friedman. I think we are doing everything Milton Friedman would have us do. Besides the stability of the period that Chairman Greenspan just referred to, I think what Milton Friedman would say is that the Federal Reserve is responsible for the stability of nominal aggregates, including prices. And that means that, in particular with respect to inflation, that you don't want inflation to be too high, but you also don't want it to be too low. And as someone mentioned earlier, based on what we knew, given the data in 2003, the downside risk was greater than the upside risk. And we adjusted appropriately, and we did so in a way that did not lead to long-term inflation, and achieved quite a bit of stability of the monetary aggregates and of inflation. Likewise, in the more recent period, our objective has been, among other things, to try to keep inflation neither too high nor too low. If you look at what's happened to key nominal aggregates, like nominal GDP growth or broad money aggregates, they're all saying that we need to do more. Because nominal GDP has been growing very, very slowly for the last 2 or 3 years. Broad money aggregate's been growing very, very slowly. So, even from a strictly monetarist's perspective, we need to do more.
So, I just disagree. We have…the issue in the long term for the central bank, of course, is inflation. There are many other issues that the fiscal authorities and so on have to deal with, but as I said at the very beginning, we are committed to both parts of our mandate. We are confident we have the tools to manage our balance sheet in a way that will allow us to achieve price stability in the longer term. But what we are trying to achieve now, which is entirely consistent with monetary theory and practice, is stability of inflation and stability of monetary policy within an extraordinary circumstance, an extraordinary context. So I think we're considering both the long term and the short term.
Moderator: Mr. Corrigan, you have the last word on the panel.
Corrigan: My last word is simply that note that I distributed here. I talk a lot about the culture of the Federal Reserve. And I do think that, especially in these trying times, we should recognize, even for our critical friends in the academic community, that the culture of the Federal Reserve is strong, it's been that way for a long time, and I think it will continue to be that way at the end of the day. The maintenance of that culture, including the feature of collegiality that I've spoken about, that I think at the end of the day is the name of the game, and to the extent that culture is preserved, I think that will just reinforce the capacity of Ben and his colleagues to cope with this incredible agenda and challenges that they're facing right now, and the same will apply to his successors down the road.That's my parting thought.
Moderator: That's fantastic.
Greenspan: All I can say is, "Hear, hear."
Moderator: Thank you very much; this has been a fascinating panel. Thanks again to the Federal Reserve Bank of Atlanta for getting us here.