A key weakness in Ben Bernanke’s view on long-run economic growth

U.S. Federal Reserve Chairman Ben Bernanke laughing with former U.S. Rep. Tim Penny at a meeting of the Economic Club of Minnesota on Thursday.
REUTERS/Eric Miller
U.S. Federal Reserve Chairman Ben Bernanke laughing with former U.S. Rep. Tim Penny at a meeting of the Economic Club of Minnesota on Thursday.

President Obama and Federal Reserve Chairman Ben Bernanke each gave speeches Thursday. The president’s speech focused on policies to reduce unemployment and was covered widely. Bernanke, speaking to the Economic Club of Minnesota, did not receive the same attention, but two points he made – on the prospects for U.S. economic growth and the stability of the financial system — deserve more emphasis and analysis.
Back to normal?
Mohamed A. El-Erian, CEO of PIMCO, coined the term “new normal” for his view of the economic recovery. He argues that industrialized economies such as the United States will experience slower economic growth for the foreseeable future as they deal with the aftereffects of the financial crisis and recession. El-Erian believes that growth rate of potential output — the maximum sustainable amount of real GDP that an economy can produce — will be permanently lower. This implies that even when the economy recovers, we will see standards of living growing at a slower rate than we have experienced over the past 30 years.

El-Erian’s views have attracted much attention and support, but Bernanke, near the end of his speech, rejected this idea. He did it in a way that was subtle and easy to miss: “I do not expect the long-run growth potential of the U.S. economy to be materially affected by the financial crisis and the recession if — and I stress if — our country takes the necessary steps to secure that outcome.”

This is a pretty bland statement on its face. Yet what Bernanke is saying is critically important: The long-run productive capacity of the U.S. economy will continue to grow at its historical rate of 3 percent a year despite the trauma inflicted during the past three years. This implies that economic policy needs to focus on getting the economy back on to this long-run growth path. Once that is accomplished, everything will be back to normal.

How stable is the financial system?
An important element in getting the economy back to potential — one of Bernanke’s “ifs” — is the smooth functioning of the financial system. I was taken aback when Bernanke’s said that looking back over the past three years, “In the financial sphere, our banking system and financial markets are significantly stronger and more stable.” He attributes this improvement to structural reforms and improved regulation of the system.

I don’t believe that this is the case. In particular, the “too-big-to-fail” problem has not been solved and may even be worse.

A financial institution is too big to fail when that institution is so important to the functioning of the financial system that if it were to collapse there would be serious damage to the general economy. Citibank, Bank of America and J.P. Morgan, to name three of the largest banks in the United States, were too-big-to-fail in 2008 — and are now even bigger than they were then.

Minneapolis Federal Reserve Bank President Gary Stern gave a speech to the Economic Club of Minnesota in March 2009 in which he set out what needed to be done to mitigate the too-big-to-fail problem. These policies include early identification of potential weaknesses in too-big-to-fail banks, prompt corrective action when weaknesses are found and clear communication of these actions by policymakers.

These ideas were not included in the Dodd-Frank reforms that were passed in the wake of the financial crisis. Instead, Congress and the president opted to create “living wills,” pre-arranged plans for liquidating a troubled bank. Bernanke thinks that this will enhance the stability and strength of the banking system.

I disagree. It would be extremely difficult and disruptive to liquidate a bank the size of Citibank or Bank of America, even with a plan in place to do so. The U.S. Treasury and the Federal Reserve would be forced to bail out the troubled bank, just as they did in 2008.

We’ll see if Bernanke’s views on long-run growth and financial stability are correct. I hope he is right. If he isn’t, we are in for a long period of slower growth and continued financial market volatility.

Louis Johnston is associate professor and chair of the Department of Economics at the College of Saint Benedict and Saint John’s University.

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Comments (4)

  1. Submitted by Paul Udstrand on 09/09/2011 - 09:44 am.

    I think the fundamental flaw is in expecting that people who’ve spent their careers engineering bubbles will create a stable and well regulated system. Near as I can tell Bernanke has spent the last three years trying to re-inflate burst bubbles rather than stabilize the markets.

    We should have just nationalized the troubled banks, bought the bad debt for pennies on the dollar, cleaned up the mortgage crises, paid off the public debt and then dumped it all back into newly a reconstituted and stabilized financial sector. We’re still sitting on trillions of dollars bad debts the banks haven’t reported, and wages and salaries are stagnate at best. The irony is that Bernanke’s approach guarantees this will be the new normal rather than refutes it.

  2. Submitted by Neal Rovick on 09/09/2011 - 01:52 pm.

    The strategy for dealing with the financial institutions has been to allow the continued over-valuing of assets (not recognizing the “bad” nature of many of the loans on the books), allow the charging of excessive fees to customers, allowing the late payment and interest payment penalty increase amounts on the books as additional assets for loans that will never be paid back, slow-walking of fore-closures, legal recognition of dubious documents, and back-door subsidies via the Fed.

    Nothing has really addressed the fact that there are hundreds of billions in loans, both commercial and residential, that will never be paid back.

    We are moving into the phase of the game, where the supposed safe assets, such as municipal bonds are starting to show cracks, further weakening the fiscal position of the financial institutions.

    Yet it is clear that even more concentration into fewer institutions has happened–disbursement of risk has not occurred.

    The problem really is, in the interface between executives and financial institutions, the idea that making a killing while riding the institution into a death spiral as a viable career path has been confirmed.

    What penalty have any executive personally faced for their misdeeds? How about hundreds of thousands of forged documents? How about billion in loans that they knew couldn’t be repaid? But they still made their millions and they are back making their millions. Not because they solved their solvency problem but because they have managed to hide it for another quarter or two.

    Besides, if you remain “too big to fail”, how can you be allowed to fail?

  3. Submitted by Neal Rovick on 09/09/2011 - 02:02 pm.

    Also, where is it written that 3% growth is America’s birthright?

    The post-WW2 trend line growth was based on conditions for workers and companies that no longer exists in the world.

    The golden age when the US economy was the only industrial power left standing after WW2 does not exist any more. Modern production methods no longer millions of workers doing repetitive actions, year after year, especially being paid much more than Asian competitors.

    It is far more likely that the US will assume the flat trajectory of Japan than to assume an ever-upward path.

    But I guess a 3% growth rate is easy to predict, especially with the qualifier, “if — and I stress if — our country takes the necessary steps to secure that outcome.”

    The question is how. Using the same qualifier, I could say 5% growth like Mr. Pawlenty recently assumed is possible.

    The question remains, “how?”.

    Until we have a credible plan for how, it’s all blather.

  4. Submitted by Patrick Wells on 09/09/2011 - 06:54 pm.

    I believe that the decline of bank stocks in recent days is an indication that many investors believe that Bank of America is insolvent.

    Bad mortage documentation, misrepresentation of credit quality, robosigning,etc. All of the foregoing is evidence of gross mismanagement. The Fed has given interest free money. Warren Buffet has put in $5 billion. However, trust is gone. Confidence is gone.

    A Washington article recommends a straightforward approach. As a former banker and credit officer, I support the approach suggested in the Washington Post Article. See the link: http://www.washingtonpost.com/a-how-to-guide-for-fixing-americas-banks/2011/08/26/gIQAdbUijJ_story.html

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