The Chairman Speaks

The Lehmann Letter ©

On December 7 Federal Reserve Chairman Ben Bernanke spoke before the Economic Club of Washington, D.C.:

Chairman Bernanke dealt with four frequently asked questions:
1. Where is the economy headed?
2. What has the Federal Reserve been doing to support the economy and the financial system?
3. Will the Federal Reserve’s actions lead to higher inflation down the road?
4. How can we avoid a similar crisis in the future?

Here are brief excerpts from some of Chairman Bernanke’s responses.

1. Where is the economy headed?

“Though we have begun to see some improvement in economic activity, we still have some way to go before we can be assured that the recovery will be self-sustaining. Also at issue is whether the recovery will be strong enough to create the large number of jobs that will be needed to materially bring down the unemployment rate. Economic forecasts are subject to great uncertainty, but my best guess at this point is that we will continue to see modest economic growth next year–sufficient to bring down the unemployment rate, but at a pace slower than we would like.”

2. How can we avoid a similar crisis in the future?

“Although the sources of the crisis were extraordinarily complex and numerous, a fundamental cause was that many financial firms simply did not appreciate the risks they were taking. Their risk-management systems were inadequate and their capital and liquidity buffers insufficient.”

Chairman Bernanke concluded his speech by saying:

“In sum, we have come a long way from the darkest period of the crisis, but we have some distance yet to go. In the midst of some of the toughest days, in October 2008, I said in a speech that I was confident that the American economy, with its great intrinsic vitality, would emerge from that period with renewed vigor. I remain equally confident today.”

The chairman could have mentioned another contributing factor: Household balance sheets were distorted by years of borrowing and households’ dependence upon capital gains for continued solvency.

At the end of WWII household balance sheets were strong and liquid. They had a high ratio of liquid assets to debt and these liquid assets comprised a good portion of household net worth. In addition household debt was a small portion of household income.

Years later those ratios have changed. Households have relied upon capital gains in the stock market and residential real estate, rather than on saving, to boost their net worth. Consequently liquid assets are relatively small and debt relatively large because borrowing has supported household asset (particularly real estate) acquisition. In addition household indebtedness has grown more rapidly than household income.

The recent recession made matters worse by reducing net worth as stock-market and real-estate values melted down.

Now households’ over-extended balance sheets hinder their ability to borrow and spend. Unfortunately, our economy’s growth depends upon household borrowing and spending to support residential construction and automobile purchases. If households’ distorted balance sheet prevents their borrowing and spending, how will the economy grow sufficiently rapidly to achieve the Chairman’s objectives?

© 2009 Michael B. Lehmann