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The Fed: Hero or Villain?

Washington Post columnist Neil Irwin stopped by to discuss his book, The Alchemists: Three Central Bankers and a World on Fire. It's a great read on the history of central banks, including how they responded to the financial crisis and the challenges they face in the future.

Some credit the Fed with saving the economy in the aftermath of 2008, while others blame them for causing the crisis in the first place. In this video segment, Neil suggests that both views may in fact be correct. The question is, have they learned enough from their mistakes to prevent it from happening again? A full transcript follows the video.

Morgan Housel: When we're talking about the Fed, I guess there are two extreme views that come out when people talk about the Fed. One is that they cause the problems that we're dealing with by inflating bubbles. The other is that maybe Bernanke single-handedly saved the economy in 2008 by the policies that he put forth.

Neil Irwin: Those are not mutually exclusive, I would argue.

Morgan: Let's hear that.

Neil: Yeah. There's this interesting question of how much culpability does the Fed have for what happened? The answer is, a good deal of culpability.

How you calibrate that, you can debate all day long, but look. There's no question that banking regulation was substandard in the 2000s. Well, who's the biggest bank regulator in the country? The Federal Reserve. There's others, but they're the biggest one that oversees the bank holding companies.

You can say there was a credit bubble building. Well, what's the one institution with any power to really pop the credit bubble? Once again, the Federal Reserve.

You can argue that there's been this cycle the last few decades, where any time there's a slight downturn, the Fed floods the system with money and the recession is mild -- that's what happened in 2001, for example -- and this creates low risk premia, it creates a sense of complacency among investors.

That's part of why mortgage-backed securities that turned out to be quite risky were yielding 1% more than Treasuries, back in the boom years.

Well, you can say that the Fed made all those mistakes. Then there's the micro stuff on regulating housing mortgage finance, and are you going to ... the Fed did not, in the mid-2000s, go in and listen to or respond in any way to the complaints of a lot of consumer groups saying, "There's some really shaky mortgage lending happening in the subprime category."

Those are all mistakes they made.

At the same time, if we'd gone into 2008 and they had not intervened on a massive scale to try and prevent the entire financial system from imploding, I think any look at history tells you we would be in a much darker place, and this whole thing could have gone -- 7.5% unemployment is high, it's unfortunate -- it's nothing compared to what we could have experienced if things had really gone off the rails.

Morgan: They're both the arsonist and the firefighter.

Neil: It's a harsh way to put it, but I think there's something to that.

Morgan: Have they learned from it, and are we doing anything differently now?

Neil: I think so. People make fun of Dodd-Frank and criticize different aspects of Dodd-Frank. The truth is, over at the Federal Reserve building in Foggy Bottom in Washington right now, there are a lot of people spending a lot of time scrutinizing these different financial markets and different corners of the debt markets, trying to understand where bubbles might be building and where, if they change, if they reverse course, whether it will affect the economy.

For example, there are a lot of people who think high-yield bonds are overpriced right now, that the junk bonds are too pricy, yields are too low.

Well, what the folks at the Fed are doing is trying to analyze, "OK, well, is that true? How much are they above historical fundamentals? And if this were to reverse, if prices were to fall, would that result in bank collapses? Would that result in a freeze-up in the financial system? Or is it just a few rich people would lose a little money?"

We'll see what answers they come up with, but I think there's a lot more people and a lot more brain power being attuned to those types of issues than there ever was in the 2000s.

I think if you talk to bankers at the big banks, they complain every day about these capital requirements they're facing. They're more and more having to hold much higher capital buffers to be able to weather whatever downturns they might encounter.

One example of this approach is these stress tests. The big banks, every year they're having to run through their loan portfolios and analyze, "All right, what if there was a recession, a pretty bad recession, unemployment went to 10-12%? What would happen to our loan portfolio? Would we still be well capitalized?"

They have to have a capital buffer that would get them through that period. Those are all things that never would have happened in 2006, 2007.

Morgan: The banking system is much stronger today than it was back then, even if we are blowing bubbles today?

Neil: I think that's true, yeah.

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