FED Adds QS To QE: Here's The Transcript of Bernanke's Testimony

Appearing before the US Senate Banking Committee Thursday, FED chairman Ben Bernanke began his testimony on the recently approved US legal overhaul  – the regulation of the financial system. In a prepared speech, Bernanke praised the Dodd- Frank Act for addressing critical regulatory gaps that were revealed by the financial crisis, pointed out that the Federal Reserve was working closely with other regulators to enact the law that was approved by Congress in July. The chairman also introduced “quantitative surveillance” of the US banking system.  Read the full transcript of Mr. Bernanke’s testimony.

“The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools.”

Ben Bernanke


“As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles; we do not have many convincing models that explain when and why bubbles start. I would add that we also don’t know very much about how bubbles stop either.”

The FED chief thanked the Senate for confirming two of three outstanding Federal Reserve Board governor nominees , filling key slots on the central bank’s board.

The lawmakers approved Janet Yellen as a member of the board, as well as vice chairman of the FED, and Sarah Bloom Raskin as a member of the board.

Bernanke will over the next days participate in a panel taking questions from Senators on implementation of the latest financial overhaul. The panel also includes Sheila Bair, head of the Federal Deposit Insurance,  Mary Schapiro, head of the Securities and Exchange Commission and Gary Gensler, head of the Commodity Futures Trading Commission.

Ben Bernanke started his opening statement by saying:

“In the years leading up to the recent financial crisis, the global regulatory framework did not effectively keep pace with the profound changes in the financial system. The Dodd-Frank Act addresses critical gaps and weaknesses of the US regulatory framework, many of which were revealed by the crisis. The Federal Reserve is committed to working with the other financial regulatory agencies to effectively implement and execute the act, while also developing complementary improvements to the financial regulatory framework.”

Adding:

“The act gives the Federal Reserve several crucial new responsibilities. These responsibilities include being part of the new Financial Stability Oversight Council, supervision of nonbank financial firms that are designated as systemically important by the council, supervision of thrift holding companies, and the development of enhanced prudential standards for large bank holding companies and systemically important nonbank financial firms designated by the council,  including capital, liquidity, stress test, and living will requirements.”

“In addition, the Federal Reserve has or shares important rulemaking authority for implementing the so-called Volcker Rule restrictions on proprietary trading and private fund activities of banking firms, credit risk retention requirements for securitizations, and restrictions on interchange fees for debit cards, among other provisions,” he said.

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Introducing QS 1

According to Mr. Bernanke, a critical feature of a successful systemic or macroprudential approach to supervision is a “multidisciplinary perspective.”

“Our experience in 2009 with the Supervisory Capital Assessment Program – popularly known as the bank stress tests – demonstrated the feasibility and benefits of employing such a perspective. The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools,” he told the senators.

“Building on that experience, we have reoriented our supervision of the largest, most complex banking firms to include a quantitative surveillance mechanism and to make greater use of the broad range of skills of the Federal Reserve staff,” he said.

Here’s the full transcript of chairman Ben Bernanke’s testimony before Banking Committee today.

And Defending QE 2

One of the things Mr.Bernanke probably will have to explain to the senators is the – now famous – monetary policy called quantitative easing.

The policy, based on the economic theories of John Maynard Keynes,  means in practice to pour money into the the financial system in numerous ways to stimulate economic growth in times of contraction.

Many economists, commentators and other financial experts have started to question the theories, used by both central banks and governments to build their arguments and actions.

After spending unknown trillions of dollar to counter the economic downturn, without much visible results, it’s quite understandable.

However, Ben Bernanke, will defend the FED’s policy with the strongest conviction.

Speaking at a conference at Princeton last Friday, he said:

“Standard macroeconomic models, such as the workhorse new-Keynesian model, did not predict the crisis, nor did they incorporate very easily the effects of financial instability. Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? I think the answer is a qualified no.”

“Economic models are useful only in the context for which they are designed. Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context. Notably, they were part of the intellectual framework that helped deliver low inflation and macroeconomic stability in most industrial countries during the two decades that began in the mid-1980’s,” Ben Bernanke said at the conference, sponsored by Center for Economic Policy Studies and the Bendheim Center for Finance.

PS: Don’t Blame The Models

On the other hand, human behavior is still a big problem.

Or as the FED chief puts it: “Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of “expected utility” – a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.9 An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors – including investors, employers, and consumers – metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know.”

The idea that at in certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes –  even not think of all the possible outcomes – is known as Knightian uncertainty, after the economist Frank Knight who discussed the theory in the 1920’s.

“Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors,” Bernanke replies.

Another issue that clearly needs more attention is the formation and propagation of asset price bubbles, the FED chairman acnowledge.

“Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, “We do not have many convincing models that explain when and why bubbles start.” I would add that we also don’t know very much about how bubbles stop either.”

“The financial crisis did not discredit the usefulness of economic research and analysis by any means; indeed, both older and more recent ideas drawn from economic research have proved invaluable to policymakers attempting to diagnose and respond to the financial crisis. However, the crisis has raised some important questions that are already occupying researchers and should continue to do so. As I have discussed today, more work is needed on the behavior of economic agents in times of profound uncertainty; on asset price bubbles and the determinants of market liquidity; and on the implications of financial factors, including financial instability, for macroeconomics and monetary policy,” Ben Bernanke concludes.

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Here’s a copy of the Princeton speech.

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