Bernanke's test - Johan Van Overtveldt

Bernanke's test - Johan Van Overtveldt

[Narrates history of Fed and its last 2 governors, and present governor, Bernanke. Since I have prior knowledge, I find it difficult to understand the underling factors. I think, I should read the classic book on this topic - A monetary history of United States, 1867-1960 by Milton Friedman & Anna Schwartz. It's a crucial and critical role that affect us - both locally and globally. This role in generally goes to great economist]

Fed has dual mandate: its bears responsibility not only for price stability but also for maximum employment. This dual mandate is discussed extensively later in this book.

Greenspan as the book recalls, did not get or complete his PhD.D in Columbia university, but later bestowed to him by NYU for his published articles which is almost like given him a decorative PhD.D. There are many western countries bestowed him with their highest civilian awards (UK & France) and there were many who gave him all the praise, but at the end, he got all the blame for the current disaster. As per Greenspan, 'I got all credits for things I did not do and at the end, I am being blamed for things I didn't do. Bernanke also cannot escape from this incident as he wholeheartedly supported Greenspan as one of the Fed governor.

One of the fundamental difference between Greenspan and his predecessors, Greenspan always preferred to present monetary policy as a kind of mystery because that gave him the flexibility to move in whatever direction he wanted. wanted. The monetary policy is mainly based on Taylor rule.

Taylor rule links the interest rate targets by policymakers (e.g. to set the federal interest rate) to three variables: the natural (or neutral) interest rate, the change in inflation and the fluctuation in output produced by the economy.

Fed's role as per Bernanke is as follows:

" The Fed has two broad sets of responsibilities. first, the Fed has a mandate from the Congress to promote a healthy economy - specifically, maximum sustainable employment, stable prices, and moderate long term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial systems. The Fed likewise has two broad sets of policy tools. It makes monetary policy, which today we think of primarily in terms of the setting of the overnight interest rate, the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight ,and a lender-of-the-last resort functions....

By using the right tool for the right job, I meant that, as a general rule, the Fed would do best by focusing its monitory policy, instruments on achieving, its macro goals... while using its regulatory, supervisory and lender-of-the-last-resort powers to help ensure financial stability... In particular alone and in concert with other agencies, the Fed should ensure that financial institutions and markets are well prepared for the contingency of a large shock to asset prices....This ius a robust strategy in that - although it certainly does not eliminate all economic and financial instability - it protects the economy against truly disastrous outcomes, which history has shown are possible when monetary policy goes severely off the track."

Prof. Paul De Grauwe says, " Suppose a hedge fund is hit by withdrawals. That is a liquidity problem. The hedge fund is then pressured to sell assets to reduce its leverage. Asset prices decline and the liquidity problem turns into a solvency problem. In the financial sector liquidity and solvency problems are always closely linked."

Another major concern listed in the book the role of Fannie & Freddie. As Economist magazine well articulated as, " The implicit gov. guarantee allowed the pair to borrow cheaply....It also allowed Fannie and Freddie to operate with tiny amounts of capital".

As per Raghuraram Rajan, a professor at the university of Chicago Graduate school of Business and the former chief economist at IMF, " how do you convert a pig - the NINJA loan - into a princess the AAA bond investors wanted? You securitize it..... More complicated pools, bundling the securities sold by the mortgage pools into securities pools, and selling tranches claims against them.... The the lesser quality securities were pooled and further securities issues against them to get more AAA bonds. Thus were born CDO(Collateral debt obligation), the CDO squared and so on. Over 95% of securities tghus generated were rated A and above and 80% rated AAA."

Regarding the stringent rules for better monitoring, Greenspan who been branded as 'an anti-regulatory zealot, reacted indirectly in FT as the following..

" I have no doubt that we can effectively squash bubbles...[but]... what price do you pay in terms of suppressed economic activity?... There were no bubbles in the Soviet Union.... If we want rapid growth in productivity, innovation, standards of living, we may have to accept that there will be periods of turmoil."