Bernanke and Credit Crunch, 1990-91

Federal Reserve Board chairman Ben Barnanke is trying to hold the line. Although I disagree with much of the current commentary disparaging Alan Grenspan and his supposedly nefarious "Greenspan put"--the notion that the former Fed chairman would bail out investors whenever turmoil theatened--it's clear that Bernanke would like Darwinian market processes to discipline profligate investors. In others words, he wants Wall Street to remember that risk is a four letter word.

Bernanke was a leading scholar of credit during his previous academic tenure at Princeton University. What did he think about credit crunches back then? "The Credit Crunch", a 1991 paper co-authored with Cara S. Lown, economist at the Federal Reserve Boad of New York, gives a hint. The research paper looked at the impact of financial distress and credit crunch (or what the scholars argue should be more accurately called a capital crunch) on the economy in the early 1990s.

Like now, the financial mantra in the latter part of the 1980s was borrow, borrow, borrow. Deal mania was in full swing and much of the takever activity was financed by junk bonds. Shopping mall developers borrowed huge sums of money; so did homeowners. When the debt started to go bad, lenders retreated. A school of thought argued that a "credit crunch" was behind the 1990-91 recession. It's a perspective I agree with.

But not Bernanke. In essence, the paper finds compelling evidence of a bank-centered credit crunch around the time of the 1990-91 recession. But the scholars seem to take every opportunity to minimize the results on the real economy. "What is out overall assessment of the macroeconomic effect of the credit crunch in the banking sector?," ask the scholars. "We cannot be certain, but the pieces of evidence that we have turned up are not consistent with a large role for the credit crunch."

This perspective informs their judgment of the implications of a credit crunch for monetary policy, "We argue that a credit crunch does not seriously affect the Federal Reserve's capacity to stabilize the economy but that it may make indicators of monetary policy more difficult to read," they write.

The discussant to the paper is Benjamin Friedman, economist at Harvard University. Friedman argues that the paper finds strong empirical evidence for a credit crunch. He believes the authors downplay their results too much. He also thinks they don't take the popular notion that lenders ration credit in trbulent times seriously enough.

"By contrast, the credit crunch of the 1990s resulted from the impact on bank balance sheets of the credit excesses of the 1980s, and just as banks were not alone in participating in those excesses, they are not alone in suffering the consequences. The same problems that have impaired some banks' capital have also shrunk the 'surpluses' of insurance companies, have caused profitability problems for finance companies, and have led to the collapse of the junk-bond market. In short, all other things have not been equal, and Bernanke and Lown's inference that credit demand has been weak does not follow from the pervasiveness of the slowdown in credit extensions among bank and nonbank lenders."

Today, we aren't facing a combination of a capital crunch and weak demand. This is a credit squeeze that risks turning into a credit crunch.