Bernanke defensive but not all wrong

When I heard on the news Monday that Fed Chairman Ben Bernanke had given a speech in which he contended that the Fed played little role in the housing bubble that precipitated the financial crisis, I was appalled. I have been influenced by Stanford economist John Taylor's little book making the case that the Fed's departure from the "Taylor rule" on monetary policy was a big factor in the fiasco, flooding the economy with funny money from about 2002 through 2004, and I still think he has a strong case.

I found all the news stories fairly unsatisfactory, so I found a copy of Bernanke's speech (which included more than a dozen pages of charts and graphs) and read and pondered it. I finally decided he has made a case that the Fed's role was less important than is widely believed. It really was more Fannie and Freddie. Bernanke's most telling datum is a reminder that the bubble began expanding in 1999, well before the Fed's post-9/11 expansion, although the expansion accelerated in 2005 -- and Bernanke acknowledged that the Fed probably played a role in that.

I think this Register editorial, in combination with this blog post, summarizes my thoughts fairly accurately.Bernanke made a case, but still unduly downplayed the Fed's role. And his argument that better regulation would better prevent future crises is ludicrous.

Market discipline better than regulation

Here's a link to the Register's editorial on the Fed's decision to keep the discount window open to investment banks, which could presage a move to regulate them directly. As Bill Niskanen, chairman of the Cato Institute, told me, this could create yet another industry with the moral hazard of knowing the government is likely bail them out if they make bad moves, because they're "too big to fail," like Bear Sterns. In retrospect, it might have been better to let Bear-Sterns fail rather than bail it out earlier this year. The reason market discipline is more efficient than regulation is mainly due to the knowledge that a business could fail, which tends to concentrate the attention mightily. Sending the message that investment banks won't be allowed to fail is an incentive for riskier behavior -- probably not immediately, but a few years down the road, when lessons (like the 1980s S&L failures) tend to be forgotten.