Bernanke in denial

The current chairman of the US Federal Reserve Bank, Ben Bernanke, pronounced on the causes of the financial collapse of 2008 and the subsequent Great Recession in testimony to the US Financial Inquiry Commission ( on 2 September.

Now he has returned to his old economics department at Princeton University to give a speech on whether the economics profession had been found wanting in forecasting and managing the financial crisis (Ben Bernanke, The implications of the financial crisis for economics, 24 September 2010,

What the current helmsman of world capitalism concluded is that the “recent financial crisis was more a failure of economic engineering and managements than of what I call economic science”. In other words, the principles and theories of orthodox economics are broadly right and stood up to the test of the crisis; it was the implementation of those theories and the monitoring of their execution that went wrong.

Anybody who has read my recent paper, The causes of the Great Recession and past posts on this blog (see Vulgar economics in despond, 27 May 2010), knows that this claim is nonsense.  Never has orthodox mainstream economics been more exposed as apologetic, self-serving and worthless in its failure to see the recent financial crisis coming or in its ensuing denial that it would lead to a major economic slump.

Indeed, before the crisis, Bernanke (like his predecessor, the great ‘maestro’, Alan Greenspan) claimed that all was well.  During the crisis, Bernanke continually dismissed the magnitude of damage to the economy that would ensue.  And now after the crisis, he wants to argue that mainstream economics did not fail – on the contrary, it actually helps to understand what happened!  As he puts it, “The shortcomings of what I call economic science were for the most part less central to the crisis; indeed, although the great majority of economists did not foresee the near-collapse of the financial system, economic analysis has proven and will continue t0 prove critical in understanding the crisis, in developing policies to contain it and in designing long-term solutions to prevent its occurrence.”

What has mainstream economics contributed to understanding the crisis?  According to Bernanke, it can show that excessive reliance on short-term funding of key institutions will cause instability in the system (he cites the 19th century monetary economist Walter Bagehot for this). Well, this is certainly digging deep.  Relatively obscure Walter Bagehot saves the day, not Adam Smith, David Ricardo, Kurt Wicksell, Frederick Hayek, Milton Friedman and the whole of Chicago School, and certainly not, JM Keynes, or even Ben Bernanke, leading authority on the economics of the Great Depression.  None of the theories of these eminent mainstream economists can help explain the causes of the crisis.

No, it’s Walter Bagehot and his theory that banks should not borrow short-term money, but instead get long-term capital.  Let’s examine this proposition.  If banks just relied on customer savings deposits or on long-term bonds and equity investors for their funding, would that have stopped the financial crisis?  In my view, it would not.

That’s because the cause of crisis lies in increasing difficulty for capitalist companies to sustain their profitability in productive investment in the lead-up to the crisis.  As a result, the financial sector switched more and more to speculative investment in real estate and monetary instruments (of ‘mass destruction’).  But to fund the increasing demand to speculate, they had to borrow more money.  Leverage or debt rose sharply.  When the value of all these unproductive assets (mortgages, credit derivatives etc) started to fall, the financial crisis ensued.  It was nothing particularly to do with ‘short-term funding’.  That only came into play when banks rushed to get more money to service their debts and found that they would not lend to each other.  As Marx long ago explained, in a crisis, suddenly a surfeit of money becomes a famine and then there is a desperate rush to hold onto it.

Ben Bernanke also claims that behavioural or information economics can help to explain the crisis.  Sometimes, he says, bank executives take risks with shareholder capital because they are incentivised to do so (through big bonuses etc).   Apparently, mainstream economic theory knows excessive risk-taking is inherent in modern finance capitalism.  It’s just that nobody did anything about it.

Bernanke reckons that mainstream economics needs to look more closely at ‘human behaviour’.  Economics is too tied to theories that assume economic agents make decisions with a fair degree of knowledge about the risks and probabilities.  However, during the crisis it became clear that “investors, employers and consumers metaphorically threw up their hands and admitted that they did not what they did not know, or as Donald Rumsfeld might have put it , there were too many ‘unknown  unknowns'”. Apparently, there are times under capitalism when decision-makers cannot assign meaningful probabilities to alternative outcomes, as economist Frank Knight once argued.

Indeed, Bernanke told his old economics department in Princeton, it is really impossible to predict a crisis occurring.  As his close colleague at Princeton, Markus Brunnermeier, put it: “we do not have many convincing models that explain when and why bubbles start”.  Bernanke adds that “also we don’t know very much about how bubbles stop either”!

It seems that mainstream economics can tell us little after all.  You see, according to Ben, “economic models are only useful in the context for which they are designed.  Most of the time, serious  financial instability is not an issue.. the standard models were designed for these non-crisis episodes.” So economics is designed for periods when all is well – that’s helpful.

In his testimony to the Financial Crisis Inquiry Commission, Bernanke was desperate to defend his own corner.  He claimed that the credit boom and the subsequent financial collapse could not be blamed on the Federal Reserve having a too lax monetary policy that kept interest rates low and thus encouraged risk-taking and home purchases beyond people’s means.  Bernanke denied there was any empirical evidence linking the Fed’s rate of interest with house prices – the housing boom was much more to do with over-optimism and speculation feeding back into prices and the massive inflow of capital to buy US assets from abroad.  In other words, it was not Fed policy that caused the credit boom but capitalist market action itself!  Exactly.

Bernanke blundered on by saying that if Fed monetary policy was not the cause, it was also not a “practical policy solution” because the Fed policy could not really affect all prices in the capitalist economy.  So government regulation of financial institutions and Fed manipulation of money supply and the cost of borrowing turns out to be useless.  From the horse’s mouth.

As for Bernanke’s own forecasts about the financial crisis, we only have to remember his statement to Congress in May 2007, when the sub-prime mortgage collapse was just getting under way.  He told Congress “at this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.  Importantly, we see no serious broader spillover to banks or thrift institutions from the problems in the subprime market”. He went to estimate that the likely losses to the financial sector of the mortgage crisis in the US would be “between $50 billion and $100 billion”.  It turned out to be $1.5trn in the US and another $1.5trn globally.

In sum, Ben Bernanke tells us that the US central bank in charge of monetary policy and the stability of the US banking system was not at fault.  And mainstream economics is fine because it could not have predicted what eventually happened because it was an unknown, unknown (a black swan).  He concludes that all is well now and nothing else needs to change.  He’s in denial.

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