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The Nobel Prize in Economics was recently awarded to former Federal
Reserve Chairman Ben Bernanke, as well as professors Douglas
Diamond and Philip Dybvig, for their work on understanding the role
banks play in the economy, especially during a financial crisis.
All three of them have done important work that’s worthy of
recognition. Banks are key parts of the economy that, by assessing
the creditworthiness of borrowers, help channel the savings of
households and companies into productive investment. Bank
failures, in turn, threaten to make it tougher for an economy to direct
savings to where they’re most useful.
However, like many recent Nobels this award seems to ratify
expansionary government policy. Bernanke’s approach to the
Financial Panic of 2008-09 included a massive bailout of the financial
system, monetization of government spending, and a huge
expansion in the Federal Reserve’s balance sheet.
The Bernanke approach did not include fixing mark-to-market (MTM)
accounting, which was the key ingredient that turned a limited
financial fire into a raging inferno that almost burned down the entire
US financial system.
To review, in late 2007 the Financial Accounting Standards Board
(FASB) forced financial firms to use market prices to value securities,
rather than models or cash flow. Within a year, the U.S. was in the
middle of the worst financial panic in a hundred years. This was not a
coincidence.
On the surface, MTM made sense. Markets usually provide
transparent and verifiable prices, so companies couldn’t just make
up numbers. The problem is that market prices often deviate –
sometimes substantially, but always temporarily – from underlying
fundamental value. Since markets are forward looking, MTM
forced financial firms to take hits to capital over something that
might happen in the future but hadn’t happened yet. It was like
forcing homeowners to come up with more capital as a hurricane
approaches because their homes might get destroyed.
This, in turn, created a vicious cycle as capital constraints hurt banks,
undermined the economy and drove asset prices lower, and then
destroyed more capital. In 2008, when markets for even prime
mortgage-backed securities became illiquid, the financial crisis
intensified.
Finally, in March 2009, six months after TARP and QE were put
in place, the stock market was still falling. That’s when Congress
(specifically, Barney Frank) started to twist arms, forcing FASB to
loosen up its rules and allow cash flow to be used when markets were
illiquid. This seemingly small adjustment did the trick. Banks were
finally able to raise new capital, the stock market surged, and the
economy started a long and sustained recovery. This was no mere
coincidence, but Ben Bernanke, as far as we know, has never publicly
discussed it.
We find that odd because Bernanke should be familiar with the
damage MTM can do. Bernanke is a student of the Great Depression
and Milton Friedman won the Nobel Prize for his work on the Great
Depression, as well. In addition to his focus on the money supply,
Friedman also wrote about how a MTM rule in the 1930s caused
many banks to fail. Not coincidently, the Roosevelt Administration
suspended MTM in 1938 and, simultaneously, the Depression ended.
We, and others, including Peter Wallison, have written extensively
about the economic damage done by the MTM accounting rule…
especially to the financial markets. Yet, the Fed, other government
agencies, and academics have ignored it. Apparently, even if you
have solid evidence that TARP and QE really didn’t end the 2008
Panic, you should be ignored. The only narrative allowed is that free
markets caused the crisis and the government saved us.
And now, Nobel Prize or not, the bill is coming due on the “abundant
reserves” monetary model that is the result of Bernanke’s research.
The US has its highest inflation rate in 40 years. True, this didn’t
happen in the aftermath of the 2008-09 crisis, because the M2
measure of money remained more stable. But government spending
surged much more during COVID and Bernanke’s new system
monetized it.
Having some insights into the role banks play in an economy is not
the same as fully understanding the economy. And dismissing the
role of MTM accounting seems intellectually dishonest. We have
second thoughts about anyone who does.