Gary Gorton replaces Gordon Gekko at the Fed

Ben Bernanke appeared in front of the Financial Crisis Inquiry Commission yesterday. The NY Times reports:

While Mr. Bernanke stuck with his long-held stance that the Fed had not aided the housing bubble by keeping interest rates too low for too long in 2002-4, he embraced the view of Gary B. Gorton, an influential Yale finance professor.

Professor Gorton has compared the crisis to a classic bank run, but with the “banks” in this case being short-term wholesale financing markets — a loosely regulated, uninsured system known as shadow banking.

This is not noteworthy because Bernanke says he was wrong (he did so before), but it is noteworthy because he seems to finally have understood what happened (see Gorton’s book which I reviewed in July). For the first time since the crisis broke out I believe that the Fed has regained some intellectual awareness of what is going on. The problem now is that they have to find new ideas how to run monetary policy by whatever instruments they can think of. (Accepting Gorton’s view means putting inflation-targeting in the bin.)

I am not sure whether the Fed will get a chance to correct its mistakes. There was too much credit flowing around because the Fed did not understand how the shadow banking system worked, and now the financial world is dependent on cheap credit. However, giving credit for free to people who the markets deem losers is not a very good way of doing things. The institutions that were able to go deep into debt control a lot of money, and they use it to lobby the US government to get bailed out. These institutions should never have gotten that big in the first place.

The financial system ensures that people who can repay get credit, why people who can’t don’t. It is a system of social book-keeping, as Axel Leijonhufvud stressed over and over again. If you let some people (or firms) pile up debt on the basis of, well, being indebted, that means that you give credit to those that already have taken out a lot of debt. Does it make sense to run a system like that? Certainly not.

However, this kind of macroeconomics was forgotten and replaced with fancy mathematics that looked very sophisticated to some people. In these model, “shocks” made the economy move away from equilibrium. In reality, bad macroeconomic management let a financial sector turn predatory by allowing it to build up a house of cards on collateralized debt. Of course this cannot be corrected easily. There are some things that would soften the resulting “balance sheet recession” – like a fiscal stimulus, like raising the wages of government workers, like giving credit to home owners in trouble, etc.

The question will be whether the Fed understands this and if so, whether it has the will to engage in those policies. After all, many people in the Federal Reserve System have subscribed to the neo-classical dogma (austerity, low inflation and laissez-faire financial markets). And boy, do they struggle with reality.

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