Bernanke at Jackson Hole: 1999 Paper Remains Relevant

At the Kansas City Federal Reserve’s annual economic symposium at Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke provided a sketch of last year’s financial panic, laid out an account on how the contagion rippled through the financial system, discussed the importance of good liquidity management for the financial sector, and reaffirmed the central bank’s role as a lender of last resort. Noteworthy as that address was, the paper he and Mark Gertler presented at the 1999 symposium remains relevant for some of the lessons it provides.

Some highlights follow:

• Two possible sources of “non-fundamental” fluctuations in asset prices involve “poor regulatory practice” and “imperfect rationality on the part of investors.” There is evidence that financial liberalization that led to poor regulatory practices led to asset price booms in Japan in the 1980s, Scandinavia in the 1990s, among other places. Often financial liberalization led to large capital inflows. Research by Charles Kindleberger revealed that a large proportion of such inflows was allocated to financial investments, touching off a rapid rise in asset prices.

• Problems arise when financial liberalization is not coordinated with the regulatory safety net. Examples of the regulatory safety net include bank deposit insurance and a central bank’s lender-of-last-resort commitments. In such cases, excessive risk-taking can unfold. Bernanke and Gertler explained, “If liberalization gives additional power to private lenders and borrowers while retaining government guarantees of liabilities, excessive risk-taking and speculation will follow, leading, in many cases, to asset-price booms.” Bernanke and Gertler added that this development characterized “reasonably” the S&L crisis in the U.S., the financial crisis in Japan following the collapse of its real estate and stock market bubbles, and the Asian financial crisis, among others.

• Asset prices have an impact on the real economy. The most important connection between asset prices and the real economy is through the balance sheet channel. Cash flows and balance sheet strength are important determinants of agents’ lending and borrowing capacity. The balance sheet channel helps explain the “financial accelerator” effect under which macroeconomic activity strengthens during a rapid rise in asset prices. It also helps explain the slowdown, and sometimes, debt-deflation mechanism, that develops following a sharp contraction in asset prices.

As a caveat, it should be noted that there is significant disagreement on the issue of whether monetary policy should respond aggressively to potential asset bubbles, particularly real estate bubbles that involve large amounts of leverage. The Bernanke-Gertler paper argued against intervention when it came to stock market bubbles. It did not address real estate bubbles. The paper asserted that when monetary policy aggressively targets consumer and producer inflation, “whether policy also responds independently to stock prices is not of great consequence.” In contrast, in recent years, the International Monetary Fund has increasingly called for greater consideration of asset prices in the rubric of inflation measurements.

Nevertheless, in the end, the Bernanke-Gertler paper offers policy makers some important guidance in developing a post-financial crisis regulatory framework. Most importantly, policy makers will need to ensure that the regulatory regime is compatible with the regulatory safety net. As a corollary, policy makers will need to take steps to ensure that the extraordinary intervention during the financial crisis will not breed the kind of moral hazard that could fuel a fresh wave of excessive risk-taking in the near- or medium-term. One key to such an approach would entail addressing the “too big to fail” issue. If that issue is resolved, then the extraordinary intervention would be perceived as a rare exception, not the norm of what could be expected should a future crisis erupt.

For now, even as prospective regulatory reforms have been introduced, the overall process is still in its early stages. For that reason, the 1999 Bernanke-Gertler paper can offer policy makers some valuable guidance as they pursue regulatory reform.

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