David A. Price interviews Mark Gertler in Econ Focus, published by the Federal Reserve Bank of Richmond (Fourth Quarter 2013, pp. 32-36), mainly focusing on the dynamics of financial crisis ad th Great Recession. Here are some of Gertler\’s comments:
On how he looks back at the causes of the financial crisis of 2007-2008:
I liken the crisis to 9/11; that is, there was an inkling that something bad could happen. I think there was some sense it was going to be associated with all the financial innovation, but just like with 9/11, we couldn’t see it coming. When we look back, we can piece everything together and make sense of things, but what we didn’t really understand was the fragility in the shadow banking system, how it made the economy very vulnerable. I always think of the Warren Buffet line, “You don’t know who’s naked until you drain the swimming pool.” That’s sort of what happened here. I think when we look back on the crisis, we can explain most of what happened given existing theory. It’s just we couldn’t see it at the time.
On the concept of \”financial accelerators\” that Gertler developed with Ben Bernanke and Simon Gilchrist:
That’s what we wanted to capture with the financial accelerator, that is, the mutual feedback between the real sector and the financial sector. We also wanted to capture the primary importance of balance sheets — when balance sheets weaken, that causes credit to tighten, leading to downward pressure on the real economy, which further weakens balance sheets. I think that’s what helped to develop the concept of financial accelerators one saw in the financial crisis. . . .Then we found some other implications, like the role of credit spreads: When balance sheets weaken, credit spreads increase, and credit spreads are a natural indicator of financial distress. And again, you saw something similar
in the current crisis — with a weakening of the balance sheets of financial institutions and households, you saw credit spreads going up, and the real economy going down.
I didn’t speak to Bernanke a lot during the height of the crisis. But one moment I caught him, asked him how things were going, and he said, “Well, on the bright side, we may have some evidence for the financial accelerator.”
On the Federal Reserve holding high levels of excess reserves:
The way I think about it is that we had a collapse of the shadow banking system, a drastic shrinkage of the shadow banking system. What were shadow banks doing? They were holding mortgage-backed securities and issuing short-term debt to finance them. What’s happened is that that market has moved to the Fed. The Fed now is acting as an investment bank, and it’s taking over those activities. Instead of Lehman Brothers holding these mortgage-backed securities, the Fed is. And the Fed is issuing deposits, if you will, against these securities, the same way these private financial institutions did. It’s
easier for the Fed, because it can issue essentially risk-free government debt, and these other institutions couldn’t. . . .It’s possible, as interest rates go up, that the Fed could take some capital losses, as private financial institutions do. But the beauty of the Fed is it doesn’t have to mark to market; it can hold these assets until maturity, and let them run off. So I’m in a camp that thinks there’s been probably a little too much preoccupation with the size of the balance sheet.
On the state of knowledge about optimal capital ratios:
[W]hat do we do ex ante before a crisis? How should regulation be designed? That’s a huge question that we still haven’t figured out. For example, what’s the optimal capital ratio for a financial institution? . . . I’m reminded of a comment Alan Blinder makes. There are two types of research: interesting but not important, and incredibly boring but important. And figuring out optimal capital ratios fits in the latter category. The reality is that we don’t have definitive empirical work, and we don’t have definitive theory that gives us a clear answer.