The Financial Accelerator, Revisited

This was on the WSJ blog by Greg Ip and I though it was worth passing on.

Fed Chairman Ben Bernanke’s newfound urgency in addressing the risk of recession can be traced in part to the insights he gleaned from his pioneering research on the financial system and the Great Depression.

Bernanke

Last June, Mr. Bernanke delivered a speech on the “financial accelerator,” which describes how weakness in the financial system can compound an economic downturn. He developed the theory in the 1980s to explain the depth and duration of the Great Depression, and later expanded on it with the collaboration of Mark Gertler at New York University.

Real Time Economics wrote last June: Mr. Bernanke has spoken on countless issues … But to understand where his economic heart truly lies, read the speech he delivered at the Atlanta Fed today, “The Financial Accelerator and the Credit Channel.” Mr. Bernanke doesn’t say it, but the current crisis in the subprime mortgage market may be a perfect illustration of the financial accelerator at work today.

Rereading that speech helps explain the new urgency in Mr. Bernanke’s assessment of economic conditions, which was manifested in Tuesday’s 0.75 percentage point cut and a likely cut next week, and his advocacy of fiscal stimulus.

Fed commentary these days contains a lot of references to “feedback loops” and self-reinforcing spirals of declining confidence and asset prices. Those are the hallmark of the financial accelerator in action. They give the current economic cycle a different cast from the typical post-war cycle which was driven largely by trends in inventories, employment and, in 2001, capital investment.

On Jan. 11, governor Frederic Mishkin said in a speech: “An economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption restrains economic activity; such a situation could lead to greater uncertainty and increased financial disruption, causing a further deterioration in macroeconomic activity, and so on. In the academic literature, this phenomenon is generally referred to as the financial accelerator.”

It’s worth paying close attention to Mr. Mishkin’s views because he was an occasional collaborator of Mr. Bernanke when the two were in academia together, and at the Fed they continue to consult each other on research topics of common interest that often crop up in speeches.

In a separate speech Jan. 10, Mr. Bernanke, foreshadowing this week’s action , said: “economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.” Note the reference to “news”: it’s not just economic and financial developments but how market confidence is affected by news of those developments that can aggravate the downward spiral. The Fed, he said, was “prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.”

That may explain why just the threat of a steep stock decline Tuesday played a part in Mr. Bernanke’s decision to cut rates: allowing the drop to play out may have had confidence-damaging consequences beyond the lost stock market wealth. The Fed, he felt, had an obligation to try and stop those effects from propagating, even at the price of appearing too ready to respond to stock prices.

“Given the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy,” Mr. Gertler said in an email Friday. “The Fed action offset this potentially disruptive chain of events. Of course, we can’t do the counterfactual of examining what would have happened had the Fed done nothing (just as we can’t for the intervention last August.) But many would agree that a real disaster might have ensued.”

While the financial accelerator conjures up the Great Depression, that almost certainly overstates the risks today. There are many institutional differences, from federal deposit insurance and the government’s larger role in economic activity to absence of the gold standard that militate against a repeat. But the financial accelerator can still produce nasty results; Paul Krugman has argued it explains the severity of the economic pain many Asian countries felt during their financial crisis in the late 1990s.

Does their awareness of the financial accelerator today imply anything for what Fed officials do at next week’s meeting? It’s hard to say, but it would certainly reinforce the Fed’s current inclination to err on the side of doing more rather than less than it ultimately thinks necessary. –Greg Ip