Three Lessons Bernanke's Students Could Have Learned in School
It wasn't your typical academic who stepped in to deliver four lectures about the Federal Reserve in March and April to a class of George Washington University undergrads. This visiting professor had his own security detail and a day job as one of the most powerful people on the planet -- chairman of the Fed.
But Professor Ben Bernanke faced one disadvantage. Unlike most college instructors -- generally free to speak their minds in class -- Bernanke was constrained in what he could say in public, lest he shake financial markets or stir political controversy.
Here are three truths about the Fed and America's economic prospects that Bernanke might have told his class, if he were free to open up.
Truth Number 1: The Fed has only limited power to influence the economy, and it has probably never been weaker than it is now. The Fed's primary tool is the federal funds rate -- what it charges banks for overnight loans. Lowering overnight rates is supposed to lower rates for longer-term loans and thus stimulate the economy. Raising overnight rates is supposed to slow growth and lower inflation. But so many other factors are at work in the economy that it's hard to know how much Fed actions affect growth or inflation.
Lots of times, there's not even much connection between overnight rates and other interest rates. From mid-2004 to early 2005, the Fed raised overnight rates from 2.5% to 4%, and rates for both 30-year mortgages and car loans actually dropped instead of increasing. At other times, such as early 2001 to late 2002, cutting rates hardly reduced real-world loan rates at all.
And when the federal funds rate is already zero, as it has been for four years, it can't be cut further to boost growth. That's why the Fed started buying up bonds to give banks more money to lend -- what is referred to as "quantitative easing." Although this helped the U.S. avoid a depression when banks stopped lending in 2009, subsequent rounds of quantitative easing in 2010 and 2011 have had a pretty small impact. Thirty-year Treasury bonds were 4.13% in June 2010, and they averaged exactly 4.13% until the second bond program ended last summer. Honestly, banks have plenty of money. They're not lending because too few customers seem creditworthy in such a lousy economy.
No chairman of the Fed would say that its power is limited, of course, because the Fed's greatest power is the belief that it's powerful. In the short term, it can do a lot to stop a panic. But faced with a major structural problem in the U.S. economy, such as America's high level of debt, its arsenal is pretty limited.
Truth Number 2: America is still living way beyond its means, saving too little and borrowing too much, and that will continue even if Congress enacts an ambitious deficit-cutting plan. Most people know that the U.S. saved too little before the crash and most probably think that it's now saving more. Not true. Net U.S. saving was nearly zero last year and isn't increasing. The long-term average has been 7% of national income, and savings averaged 4% of income for the decade before the crisis. Counting all savings by households, business and government, the U.S. is saving less than Europe, Japan, China, India and almost any other nation not stuck in abject poverty.
Savings are vital for a healthy economy because they're the source of investment, providing capital for businesses to build new factories and buy equipment, for the government to build schools and improve infrastructure, and for households to fund education or retirement. Such investments raise productivity and allow the standard of living to rise. Without enough domestic saving by business, households and government, either productivity and economic growth suffer or the U.S. must borrow more from abroad.
Even if Congress were to cut federal borrowing by $4 trillion over 10 years -- a big "if" -- the effect would be to boost the aggregate national savings rate to only 2%-3%, not enough to fund the investment needed to maintain healthy growth on its own.
At that low level of saving, either growth will wane or the U.S. will have to borrow more and more from abroad, potentially at a heavy cost. As China and other lenders invest in building their own modern economies, they will have less to spare and will charge higher interest rates. That, in turn, will force interest rates up in the United States and slow economic growth. Moreover, continued borrowing and too much debt will trigger another financial crisis.
So inadequate domestic saving is a lose-lose proposition. The only way to avoid the bad consequences is for Americans to save more and consume less -- a lot less than the U.S. produces -- for a decade or more to rebuild national savings. That means a much leaner lifestyle than most Americans are used to.
Truth Number 3: Many weaknesses in the financial system haven't yet been fixed, including the problem of banks that are "too big to fail." That reality may not be evident now, but it will be if the U.S. is threatened with another crisis. Sure, the system is much safer today than it was five or six years ago. Banks are holding more reserves to survive a panic, and the government's "stress test" audits are more thorough. But there are two reasons the system is probably still not secure enough:
First, in a global financial system of giant multinational banks, risk can't be controlled by one nation. Regulators in Europe and elsewhere aren't joining the U.S. in limiting some risky bank activity, partly because failing to do so gives their banks a competitive advantage in higher-risk, higher-return business. So although some risky trading may be banned in New York, the financial system isn't safer when U.S. investors can still do it in London or Frankfurt, Germany.
Second, banks are bigger than ever, and a failure by JPMorgan Chase, Citibank or Bank of America is still unthinkable. Banks are just as large a share of the economy as they were before the crisis, and the industry is even more concentrated today than it was five years ago. Investors know that the government would again bail out these giant banks if they got in trouble, and that expectation is already encouraging bank executives to take more risk than they otherwise would. If the past is any guide, banks will find new ways to seek more profits -- at the expense of taking greater risks -- outside of regulatory control.
Of course, Bernanke will never hint at these truths while serving as Fed chairman. He'll hew to the official line that bailouts are a thing of the past, that a major budget deal would go a long way toward addressing American’s debt problem, and that the Fed stands willing and fully capable of promoting growth and price stability.