Regulators’ Lament

The Lesson of Nobelist Ben Bernanke

Note: This column was inadvertently published prior to editing. This version incorporates minor changes.

Ben Bernanke’s Nobel Prize for economics will inevitably be seen as a plaudit for leading the Federal Reserve (and, in a large sense, the country) out of the financial crisis that enveloped the nation in 2008.

It should also be taken as a warning.

Bernanke was awarded the prize for research into financial crises, including a 1983 paper warning that bank failures can lead to a chain reaction and ultimately a financial crisis. So it was in 2008, when a laundry list of mortgage lenders (Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, and Citi) failed or were rescued by the government — not to mention the titans Goldman Sachs and Morgan Stanley, which were in jeopardy until the Fed offered regulatory protection.

The real harm from the banking crash was on Main Street. The U.S. suffered its worst recession since the Great Depression. Unemployment shot up to more than 10 percent. More than four million homes were foreclosed on.

Bernanke’s medicine, a massive and continuing dose of government lending, was the traditional cure prescribed by the 19th century British economist Walter Bagehot —lend to “this man and that man,” that is, lend broadly. It was the cure that, as Bernanke had written, the U.S. had failed to administer during the Great Depression. And it was the right cure.

The 2008 recession ended with relative dispatch in mid-2009. With millions of mortgages still under water, the patient was far from healed, and the economy’s growth was sluggish. Nonetheless, it did grow, and Bernanke’s policies never produced the high inflation that his many and vocal critics repeatedly forecast. So much for the plaudits.

But Bernanke, appointed Fed chairman by George W. Bush in 2006, was egregiously slow to reckon with the risk of bad mortgage loans as it was developing. As a member of the Fed’s board of governors from 2002-2005, and as the President’s economic adviser from 2005 until his appointment as Fed chief in February 2006, Bernanke was in a position to warn the country, and to urge his fellow regulators to tighten the dangerously wide spigot of risky mortgages.

He failed to do so.

Even over his first year or so as Fed chief, Bernanke continued to insist that the risk of subprime loans (the riskiest mortgages) was contained, and that there was little risk of a crisis spreading to the larger pool of more conventional mortgages — much less to the general economy.

Even as Fed chief — that is, as the country’s chief financial regulator — he didn’t shut down on abusive mortgage practices, the “liar loans,” and the 100% equity loans (“purchases” in which the home buyer put nothing down) before the market failed.

And I think he neglected the risk for a reason. Bernanke’s background was in monetary finance — the business of setting interest rates so that the economy operates at (but not above) its maximum potential. The business of determining interest rates, which help to determine foreign exchange rates and international money flows, is the glorious side of central banking. When bankers jet off to Davos each year, interest rates is what they talk about.

But central banking has another aspect: regulation. Where monetary policy is a theoretically complex science, regulation is gritty and specific. Monetary policy determines the rate of credit flow to the society; regulation monitors specific institutions. It’s as glorious as plumbing. And Bernanke, like his predecessor Alan Greenspan, ignored the systemic risks arising from shoddy regulation.

Bad monetary policy — say, when interest rates are too low — can lead to too many loans, excessive demand, inflation, and inevitably a retrenchment and possibly a collapse. This is what Jay Powell’s Fed is dealing with now.

Many people assume that was the cause of the 2008 collapse, because from 2002-2004 (when Bernanke was a Fed governor), the federal funds rate was at or close to 1%. No doubt, cheap credit stimulated mortgage lending, but it was not the decisive factor. As Bernanke later pointed out, interest rates were low around the world, but not every country had a mortgage crisis. Interest rates were low in Canada, the society most like our own, but our northern neighbor did not experience a similar crisis.

The dispositive factor in America was poor regulation that permitted banks to lend to people who lacked the means to repay their loans.

Such loans were predicated on the notion that dubious borrowers could always refinance, but that could last only for as long housing values kept rising. (Not even banks are dumb enough to lend $300,000 on a home worth only $200,000.)

The lending culture was so corrupt that banks did not want to know how shaky their customers’ finances were. That was why they let poor credits borrow on the basis of stated — not documented — assets, the so-called liar loans. And regulators permitted it.

Ultimately, the ill-effects of the crash extended far beyond mere economic harm. Millions of people with underwater mortgages felt abused by a system that also came to the rescue of Wall Street banks. Social disaffection followed, and we are still dealing with it.

This is not a brief for outlawing risky lending. As the adage goes, no speculation, no railroads. If hedge funds want to gamble and lose, let them gamble (and lose).

But federally insured banks have a duty to prudence, with compliance properly and legally subject to federal regulation.

And regulation is especially needed to govern, and protect, the activity of ordinary citizens, because the consequences of failure are socially destabilizing. This is particularly true when large numbers of people are gambling with their most significant asset—their homes.

Could the Bernanke lesson have a sequel? It might if regulators fail to protect the average American’s other significant asset—their retirement nest egg.

Quick as you can say Fidelity Investments or Kim Kardashian, crypto purveyors are right now champing at the bit to persuade 401(k) sponsors to let employees transfer savings out of productive assets and into crypto.

If millionaires want to gamble on crypto, it’s their right, but retirement savings are federally created vehicles subject to federal supervision. For most people, just as homes were their biggest assets, 401(k)s are their largest—often their only—liquid asset.

People didn’t much like losing their homes. How will they feel when they lose their retirements? Regulators should not make the same mistake again.