Minneapolis Fed president 'cautiously optimistic' bailout will work

The president of the Federal Reserve Bank of Minneapolis said today he's "cautiously optimistic" the government's $700 billion bailout plan will prove effective, but not without some more pain reminiscent of the recession of the early 1990s.

Gary Stern, speaking in Minneapolis on the day the Dow Jones Industrial Average dropped another 678 points, said he's not discouraged by the markets' response to the plan.

Still, it may take time for the economy to recover from the series of financial shocks that have frozen some credit markets and sent stock markets tumbling in recent weeks, he warned those attending a National Investors Relations Institute luncheon.

Stern, president of the bank since 1985, said he sees some parallels with the early 1990s recession.

1990s recession crunched credit, too
During those years, credit became expensive and, in some cases, unavailable, even for high-quality borrowers, he said. Consumer and business spending tightened, and both housing construction and home values contracted.

Those years "provide a valuable reference point for thinking about economic prospects," Stern said. "I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation."

It's worth remembering, he said, that while the early 1990s recession was relatively brief, lasting just a couple of years, it was not "especially mild." It's "certainly conceivable" we could see something similar in the months and years ahead.

Stern said in many ways the economy was in better shape heading into this downturn than it was before the early 1990s recession. Those measures include unemployment, interest rates and inflation.

And more fodder for optimists: "We should note that, despite early challenges, the 1990s turned out to be an excellent decade for the U.S. economy by almost all metrics. The underlying flexibility and resilience of the economy are intact, and these characteristics should ultimately prevail."

Stern is co-author of a 2004 book titled "Too Big to Fail: The Hazards of Bank Bailouts." He spent much of his speech arguing for a more proactive approach to regulating large banks.

Stern pushes 'early intervention plan' to head off problems
Regulators and policymakers should work toward an "early intervention" model (PDF), he said, in which accounting and financial market data are used to spot problems before they spread to other banks.

Such a strategy might involve modeling how the system would respond to various hypothetical "shocks," with attention toward areas where one bank's problems spread significantly to other banks.

In situations where problems aren't expected to spread to other banks, the government should avoid intervening, he said. That should send a message to creditors to avoid taking excessive risks with the belief they have a government-bailout safety net.

Now is not the time for major regulatory reform, though, Stern said. Those changes should come during tranquil times when the markets are functioning smoothly.

What happens if the $700 billion bailout package doesn't get us heading back in that direction?

"The honest answer is I don't know," Stern said. "All I would say is I wouldn't underestimate our creativity if necessary."

Dan Haugen is a Minneapolis-based reporter who writes about business and other topics for MinnPost. He can be reached at dhaugen [at] minnpost [dot] com.