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ECONOMIC ANALYSIS: Financial services sector unfair in attacking Fed chief

March 17, 2008

The Federal Reserve's Ben Bernanke has come under a lot of glib criticism from the financial-services sector. Generally, Wall Street types are unhappy because they think he should have addressed the subprime crisis with a greater sense of urgency. The truly bizarre rant by Jim Cramer on "Mad Money" has morphed into lower-level critiques of Bernanke's experience and judgment appearing in columns and trade journals.

But is this characterization fair or even correct? I think not, and here's why.

The financial services industry gloriously botched two important things during the subprime mess. First, it failed in the risk assessment of loans. Actuaries-a reliable lot when data is plentiful and unambiguous-failed to integrate changing loan practices into their assessment of risk and return. This led to lots of purchases of mortgage-backed securities that were riskier than their rewards would have justified. Second, large securities firms simply lacked the ability to trace these purchases to the borrower.

The combination of unanticipated risk and uncertainty has clobbered many-but by no means all-in the financial services industry. Industry officials are frustrated that Bernanke didn't come to their rescue more quickly. However, a bit more analysis suggests the rescue might have been plenty quick enough.

We all know as parents that children learn from mistakes, and that too many a rescue by doting parents robs from kids the chance to learn. Like children who are shielded from error, firms that are buffeted from the challenges of the marketplace do not grow. One needs only to cast an eye to the economic powerhouse that is Cuba or North Korea to see the effects of overt paternalism.

In this time of difficulty in the financial services industries, the banks and other institutions that balanced risk and reward correctly in the mortgage markets will strengthen their position. Those that were imprudent, like Countrywide, will suffer or disappear. This is a happy outcome.

However, it is financial markets themselves that are sending the first signals that the Federal Reserve's actions to lower interest rates may have been premature. Instead of widespread relief about a recession forestalled, we now are seeing signs of inflation.

As the Federal Reserve lowered interest rates and eased liquidity concerns, the money supply rose. The broad measures of money supply spiked over the past two months, and with them the first telltale signs of inflation.

The value of the dollar has continued to plummet in foreign-exchange markets-a sign there are too many available dollars-and inflation indexes are rising. Most important, rates for long-term loans, like mortgages, actually have risen.

In this case, leaders of the financial services industry have taken a break in their criticism of Bernanke to acknowledge the very real danger of inflation on their business. In the end, their own markets clearly proclaim that the Federal Reserve has been plenty quick with the rescue.



Hicks is director of the Bureau of Business Research at Ball State University. His column appears weekly. He can be reached at bbr@bsu.edu.
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