Here is Ben Bernanke’s prepared testimony for today’s appearance before the Financial Crisis Inquiry Commission. You can watch it live here.

Chairman Ben S. Bernanke
Causes of the Recent Financial and Economic Crisis
Before the Financial Crisis Inquiry Commission, Washington, D.C.
September 2, 2010

Chairman Angelides, Vice Chairman Thomas, and other members of the Commission, your charge to examine the causes of the recent financial and economic crisis is indeed important. Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.

Appropriately, the problem of too-big-to-fail, and the policies that the government uses to address that problem, will be a particular focus of your forthcoming report and in the hearing today. In my view, the too-big-to-fail issue can best be understood in the broader context of the financial crisis itself. Accordingly, this testimony provides an overview of the factors underlying the crisis, as well as some of the problems that complicated public officials’ management of the crisis. Too-big-to-fail financial institutions were both a source (though by no means the only source) of the crisis and among the primary impediments to policymakers’ efforts to contain it. As you requested, I will also briefly discuss monetary policy during the period prior to the crisis. Before proceeding, I should state that my testimony reflects my own views and not necessarily those of my colleagues on the Board of Governors of the Federal Reserve System or the Federal Open Market Committee (FOMC).

Triggers of the Crisis

In discussing the causes of the crisis, it is essential to distinguish between triggers (the particular events or factors that touched off the crisis) and vulnerabilities (the structural weaknesses in the financial system and in regulation and supervision that propagated and amplified the initial shocks). Although a number of developments helped trigger the crisis, the most prominent one was the prospect of significant losses on residential mortgage loans to subprime borrowers that became apparent shortly after house prices began to decline. With more than $1 trillion in subprime mortgages outstanding, the potential for losses on these loans was large in absolute terms; however, judged in relation to the size of global financial markets, prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis. (Indeed, daily movements in global equity markets not infrequently impose aggregate gains or losses equal to or greater than all the subprime mortgage losses incurred thus far.) Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-response toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.

In midsummer 2007, events unfolded that would engender a sea change in money market conditions, triggered by fears of subprime losses that had been growing during the first half of the year. To choose one of several possible key dates, on July 30, 2007, IKB, a medium-sized German bank, announced that in order to meet its obligations, it would be receiving extraordinary support from its government-owned parent and an association of German banks. IKB’s problem was that its Rhineland off-balance-sheet vehicle was no longer able to roll over the asset-backed commercial paper (ABCP) it had been issuing in U.S. markets to fund its large portfolio of asset-backed securities. Although none of the securities in the Rhineland portfolio was in default and only some were subprime-related, commercial paper investors had become concerned about IKB’s ability to meet its obligations in the event that the securities Rhineland held were downgraded.

Around the same time, other vehicles similar to that of Rhineland were also finding funding rollovers to be more costly and difficult to arrange. These difficulties intensified over subsequent weeks, as investors around the world pulled back funding; indeed, outstanding U.S. ABCP plummeted almost $200 billion in August. The economist Gary Gorton has likened this pullback to a traditional bank run: Lenders in the commercial paper market and other short-term money markets, like depositors in a bank, place the highest value on safety and liquidity.1 Should the safety of their investments come into question, it is easier and safer to withdraw funds–”run on the bank”–than to invest time and resources to evaluate in detail whether their investment is, in fact, safe. Although subprime mortgages composed only a small part of the portfolios of most structured credit vehicles, cautious lenders pulled back even from those that likely had no exposure to subprime mortgages. The resulting funding pressure was in turn transmitted to major banks that had sponsored or provided funding guarantees to vehicles. Short-term funding in the interbank market became more difficult and costly. Over subsequent quarters, instability in global money markets worsened and posed an increasingly serious threat to the functioning of a range of financial markets and institutions, which in turn constricted the flow of lending to nonfinancial borrowers. Ultimately, the disruptions to a range of financial markets and institutions proved far more damaging than the subprime losses themselves.2

Although subprime mortgage losses were the most prominent trigger of the crisis, they were by no means the only one. Another, less well-known triggering event was a “sudden stop” in June 2007 in syndicated lending to large, relatively risky corporate borrowers. Funding for these “leveraged” loans had migrated in recent years from banks to special purpose vehicles; these vehicles funded themselves by issuing collateralized loan obligations (CLOs), a type of asset-backed security. CLOs were purchased by a variety of investors, including ABCP vehicles. At the time, the sudden stop in origination of new syndicated loans was seen by some as a bargaining ploy by lenders seeking higher interest rate spreads, but a side effect was a modest drop in the market prices of outstanding loans, which in turn raised the possibility of downgrades of some CLOs. As in the case of subprime mortgages, the perceived potential losses on leveraged loans in the late summer of 2007 were significant, although not large enough by themselves to threaten global financial stability. But they damaged the confidence of short-term investors and, consequently, the functioning of money markets and the broader financial system.

Other triggers also helped begin the cascade of events that became the crisis. My purpose is not to provide an exhaustive list but to convey that problems that may be individually manageable can set off a crisis when the financial system is sufficiently vulnerable. I turn now to a discussion of some of those vulnerabilities, beginning with those in the private sector.

Vulnerabilities in the Private Sector

As the severity of the crisis has eased over the past year and attention has focused on financial reform, much of the discussion has been about shortcomings of public-sector policies and responses. Those shortcomings were important, and I will return to them shortly. However, many key vulnerabilities were products of private-sector arrangements.

Dependence on Unstable Short-Term Funding

Shadow banks are financial entities other than regulated depository institutions (commercial banks, thrifts, and credit unions) that serve as intermediaries to channel savings into investment. Securitization vehicles, ABCP vehicles, money market funds, investment banks, mortgage companies, and a variety of other entities are part of the shadow banking system. Before the crisis, the shadow banking system had come to play a major role in global finance; with hindsight, we can see that shadow banking was also the source of some key vulnerabilities.

Leading up to the crisis, the shadow banking system, as well as some of the largest global banks, had become dependent on various forms of short-term wholesale funding. Over the past 50 years or so, a number of forms of such funding have emerged, including commercial paper, repurchase agreements (repos), certain kinds of interbank loans, contingent funding commitments (such as commitments that investment banks provided for auction rate securities, used primarily to finance municipalities), and others. In the years immediately before the crisis, some of these forms of funding grew especially rapidly; for example, repo liabilities of U.S. broker dealers increased by 2-1/2 times in the four years before the crisis.

As was illustrated by the ABCP market meltdown discussed earlier, the reliance of shadow banks on short-term uninsured funds made them subject to runs, much as commercial banks and thrift institutions had been exposed to runs prior to the creation of deposit insurance. A run on an individual entity may start with rumors about its solvency, but even when investors know the rumors are unfounded, it may be in their individual interests to join the run, as few entities can remain solvent if their assets must be sold at fire-sale prices. Thus, fears of a run have the potential to become at least partially self-fulfilling, and a run may blur the distinction between an insolvent and an illiquid firm.

An increase in the risk of a run induces financial firms to hoard liquidity, for example, by shifting asset holdings into highly liquid securities such as Treasury securities. The supply of highly liquid securities being relatively inelastic in the short run, such efforts do not increase the liquidity of the financial system as a whole, but serve only to raise the price of liquid assets while reducing the market value of less-liquid assets such as loans. Liquidity pressures thus make firms less willing to extend credit to both financial and nonfinancial firms. Central banks, such as the Federal Reserve, can mitigate liquidity problems by lending against less-liquid but nevertheless sound collateral; indeed, serving as “lender of last resort” has been central banks’ key weapon against financial panics for hundreds of years. However, the Federal Reserve under normal conditions is permitted to lend only to depository institutions and had the authority to lend to nondepositories only in unusual and exigent circumstances. Thus, the Federal Reserve could not directly address liquidity problems at nondepositories until the crisis was well underway.

Money market mutual funds proved particularly vulnerable to liquidity pressures. A large portion of the investments of these funds were in short-term wholesale funding instruments issued or guaranteed by commercial banks. When short-term wholesale funding markets came under stress, particularly in the period after the collapse of Lehman Brothers, money market mutual funds faced runs by their investors. Although actions by the Treasury and the Federal Reserve helped arrest these runs, the money market mutual funds responded by hoarding liquidity, thus constricting the availability of financing to financial and nonfinancial firms.

Currency mismatches also contributed to the disruption of wholesale funding patterns during the crisis. For example, major European financial institutions guaranteed the liabilities of some shadow banks. Some of them mainly bought dollar-denominated asset-backed securities and raised funding in the U.S. dollar commercial paper market. When these vehicles lost access to commercial paper funding, their bank guarantors sought dollar funding in dollar-denominated wholesale markets and foreign exchange swap markets. The heavy demand for dollars, coupled with investor concerns about the health of some European banks, put significant stress on these markets. This stress could not be alleviated by foreign monetary authorities through their normal operations, which provide liquidity in their own currencies but not in dollars. The Federal Reserve and other central banks addressed the problem by establishing dollar liquidity swap agreements.

Deficiencies in Risk Management

Although the vulnerabilities associated with short-term wholesale funding can be seen as a structural weakness of the global financial system, they can also be viewed as a consequence of poor risk management by issuers and investors Unfortunately, the crisis revealed many other significant defects in private-sector risk management and risk controls. Examples included a significant deterioration of mortgage underwriting standards before the crisis, which was not limited to subprime borrowers; a similar weakening of underwriting standards for commercial real estate loans, together with poor management of concentration risk and other risks by commercial real estate lenders; excessive reliance by investors on credit ratings, especially in the case of structured credit products; and insufficient capacity by many large firms to track firmwide risk exposures, including off-balance-sheet exposures. Among other problems, risk-management weaknesses led to inadequate risk diversification by major financial firms, so that losses–rather than being dispersed broadly among investors–proved in some cases to be heavily concentrated, threatening the stability of the affected companies. Risk-management weaknesses were spread throughout the financial system, including at many institutions that were neither large nor too-big-to-fail. For example, problems with commercial real estate lending were concentrated in regional and community banks. Subprime lending was done by small as well as large firms.

Private-sector risk management also failed to keep up with financial innovation in many cases. An important example is the extension of the traditional originate-to-distribute business model to encompass increasingly complex securitized credit products, with wholesale market funding playing a key role. In general, the originate-to-distribute model breaks down the process of credit extension into components or stages–from origination to financing and to the post-financing monitoring of the borrower’s ability to repay–in a manner reminiscent of how contemporary manufacturers distribute the stages of production across firms and locations. This general approach has been used in various forms for many years and can produce significant benefits, including lower credit costs and increased access of small and medium-sized borrowers to the broader capital markets. However, the expanded use of this model to finance subprime mortgages through securitization was mismanaged at several points, including the initial underwriting, which deteriorated markedly in part because of incentive schemes that effectively rewarded originators for the quantity rather than the quality of the mortgages extended. Loans were then packaged into securities that proved complex and unwieldy; for example, when defaults became widespread, the legal agreements underlying the securitizations made reasonable modifications of troubled mortgages difficult. Rating agencies’ ratings of asset-backed securities were revealed to be subject to conflicts of interest and faulty models. At the end of the chain were investors that often relied mainly on ratings. Even if the end-investors wanted to do their own credit analysis, the information needed to do so was often difficult or impossible to obtain.

Leverage

Excessive leverage is often cited as an important vulnerability that contributed to the crisis. Certainly, many households, businesses, and financial firms took on more debt than they could handle, reflecting in part more permissive standards on the part of lenders. A notable example was the decline in down payments required of many home purchasers, which, together with the increased use of exotic mortgage instruments and the availability of home equity lines of credit, resulted in some homeowners becoming highly leveraged. When house prices declined, the equity of those homeowners was quickly wiped out; in turn, “underwater” borrowers who owed more than their houses were worth were much more likely to default on their mortgage payments. Nonfinancial firms, in contrast, do not seem to have become overleveraged before the crisis; collectively, these firms did see a small increase in debt-to-asset ratios from 2006 to 2008, but these ratios tend to be volatile, and the short-term increase was superimposed on a two-decade-long downward trend.

Assessing trends in leverage for financial firms is not completely straightforward, in part because available statistics are inadequate and also because, in a world of complex financial instruments, leverage can be very difficult to measure. Traditional measures do not show a large increase in aggregate financial-sector leverage. At large U.S. commercial bank holding companies, for instance, equity capital relative to assets increased somewhat from 2001 through 2006. However, the quality of capital declined–for example, the share of intangible assets increased; consequently, in the crisis, true loss-absorbing capital was often much lower than accounting measures suggested. Moreover, many derivatives contracts have something similar to balance sheet leverage embedded in their structures, so that investors in derivatives can be more leveraged than their balance sheets imply. And, of course, some individual financial firms were overleveraged even by traditional measures.

Leverage tends to be procyclical–rising in good times, when the confidence of lenders and borrowers is high, and falling in bad times, when confidence turns to caution. This procyclicality increases financial and economic stress in the downturn. For example, the decline in required down payments on home purchases seen before the crisis has now sharply reversed, with required down payments of 20 or 30 percent of the house price becoming increasingly common. These tougher requirements, while understandable from the perspective of lenders, have reduced the pool of potential homebuyers. With fewer buyers, downward pressure on home prices increases. Lower house prices help to improve affordability but also weaken the financial positions of current homeowners, reducing their capacity to service their mortgages, to purchase new homes, and to consume goods and services.

Another procyclical pattern in leverage occurred in the financing practices of many financial firms. For example, recent academic studies have focused on the financing practices of hedge funds, securities broker-dealers, and other similar entities.3 These entities’ assets are primarily marketable securities, and much of their financing is in the form of repos. When times are good, the value of the assets rises and repo lenders impose smaller haircuts on the collateral, allowing more securities to be financed by a given amount of repo borrowing–effectively, an increase in leverage.4 When times turn bad, the value of the assets falls and more-cautious repo lenders demand higher haircuts. In such a situation, the borrower’s main available response is to sell assets. However, in the aggregate, such forced sales, particularly into illiquid markets, tend to amplify the downturn in asset values. Declines in asset prices, together with fears of further declines, tend to result in lenders demanding still higher haircuts, which forces more asset sales, and so on. Such phenomena were particularly important in the run-up to the acquisition of Bear Stearns in March 2008 and in the most intense phase of the crisis in September and October 2008.

Derivatives

Derivatives had a mixed record in the crisis. Throughout the period, virtually all derivatives contracts settled according to their terms, and there were few reported instances of bankruptcy or financial stress resulting from speculative use of interest rate, foreign exchange, commodity, or equity derivatives, which taken together form the vast majority of contracts outstanding. In many cases, derivatives allowed financial and nonfinancial entities to better hedge their risks. However, some entities did use credit derivatives as a tool for taking excessive risks, most notably the insurance company American International Group (AIG). In that case, the problem was perhaps less the use of derivatives than a massive failure of risk management, especially by the parts of AIG that took large positions in credit derivatives. AIG neither hedged nor provided adequate capital against the large, correlated risks that it was taking. AIG’s actions were facilitated by gaps in prudential regulation, as I will discuss. The consequences for the broader system were so severe because AIG was a large financial firm closely interlinked with other systemically important financial institutions and markets.

A useful distinction can be drawn between the derivatives instruments themselves and the infrastructure for clearing and settling derivatives instruments. For over-the-counter derivatives, the clearing and settlement infrastructure was seriously inadequate. This point was recognized before the crisis; the Federal Reserve made some progress through voluntary cooperation with the industry and other regulators.5

At times, the complexity and diversity of derivatives instruments also posed problems. Financial firms sometimes found it quite difficult to fully assess their own net derivatives exposures or to communicate to counterparties and regulators the nature and extent of those exposures. The associated uncertainties helped fuel losses of confidence that contributed importantly to the liquidity problems I mentioned earlier. The recent legislation addresses these issues by requiring that derivatives contracts be traded on exchanges or other regulated trading facilities when possible and that they be centrally cleared. The legislation also requires stronger prudential standards for financial firms that use derivatives and clearinghouses. These changes should increase the quality and availability of information, though measuring exposure is likely to continue to be a challenge.

Vulnerabilities and Shortfalls in the Public Sector

The vulnerabilities of the private sector amplified the triggers of the crisis, creating stresses and uncertainties that posed grave threats to financial and economic stability. The public sector also had important vulnerabilities, which exacerbated the crisis and made the public-sector response less effective than it should have been, both in the United States and in other countries. These vulnerabilities included both gaps in the statutory framework and flaws in the performance of regulators and supervisors.

Statutory Gaps and Conflicts

The statutory framework of financial regulation that was in place before the crisis contained serious gaps.

Critically, shadow banks were, for the most part, not subject to consistent and effective regulatory oversight. Many types of shadow banks lacked meaningful prudential regulation, including various special purpose vehicles (such as CLOs), ABCP vehicles, hedge funds, and many nonbank mortgage-origination companies. No regulatory body restricted the leverage and liquidity policies of these entities, and few if any regulatory standards were imposed on the quality of their risk management or the prudence of their risk-taking. Market discipline, imposed by creditors and counterparties, helped on some dimensions but did not effectively limit systemic risks these entities posed. Of these shadow banks, both special purpose vehicles and nonbank mortgage originators contributed significantly to the crisis; hedge funds, which were often cited as a potential systemic risk before the crisis, generally did not, perhaps because the concerns about them meant they were subject to more-effective market discipline.

Other shadow banks were potentially subject to some prudential oversight, but weaknesses in the statutory and regulatory framework meant that in practice they were inadequately regulated and supervised. For example, the Securities and Exchange Commission (SEC) regulated broker-dealer holding companies but only through an opt-in arrangement that lacked the force of a statutory regulatory regime. Large broker-dealer holding companies faced serious losses and funding problems during the crisis, and the instability of such firms as Bear Stearns and Lehman Brothers severely damaged the financial system. Similarly, AIG’s insurance operations were supervised and regulated by various state and international insurance regulators, and the Office of Thrift Supervision technically had authority to supervise AIG as a thrift holding company. However, oversight of AIG Financial Products, which housed the derivatives activities that imposed major losses on the firm, was extremely limited in practice.

A lack of statutory authority carried with it a lack of information. Shadow banks that were unregulated were not required to report data that would adequately reveal their risk positions or practices. Moreover, the lack of preexisting reporting and supervisory relationships hindered systematic gathering of information that might have helped in the early days of the crisis.

A broader failing was that, for historical reasons, regulation and supervision were focused on the safety and soundness (or the practices) of individual financial institutions or markets. However, in the United States and most other advanced economies, no governmental entity had sufficient authority–now often called macroprudential authority–to take actions to limit systemic risks. For example, most ABCP vehicles were small relative to the size of the sponsoring bank. Had the Federal Reserve or another regulator attempted to shut down or restrict these vehicles, sponsoring banks could have argued (quite correctly) that, individually, these vehicles were too small to threaten the safety and soundness of their sponsoring institutions. But many small vehicles, and a few big ones, that were spread across a lot of banks added up to a systemic vulnerability. This example also highlights the importance of international cooperation in a globally connected system. U.S. action to more tightly regulate such vehicles would have been ineffective unless foreign regulators had taken similar actions, as many of the vehicles were sponsored by financial institutions overseas.

The partitioning of authority that characterized bank supervision and regulation in the United States before the crisis amounted to another statutory gap, or at least a gray area in the law. The Gramm-Leach-Bliley Act required the Federal Reserve in its supervision of bank holding companies to defer to the primary supervisor of functionally regulated subsidiaries as much as possible, a system often referred to as “Fed-lite.” For example, the Fed was required to defer to the Office of the Comptroller of the Currency (OCC) in the case of national bank subsidiaries, and to the SEC for broker-dealer subsidiaries. Although the agencies shared information and their cooperation was cordial, in practice the Gramm-Leach-Bliley requirements made it difficult for any single regulator to reliably see the whole picture of the activities and risks of large, complex banking institutions.

Some of the most significant and costly problems arose in the government-sponsored enterprises related to housing, Fannie Mae and Freddie Mac. Although these two companies were subject to regulatory oversight, the statutory framework for that oversight was problematic. Fannie and Freddie were nominally private corporations, but they enjoyed cost advantages from the implicit federal guarantee on their liabilities; these cost advantages allowed them to act as a duopoly in a number of businesses, including providing credit guarantees and securitizing conforming mortgages. Their securities were exempt from a number of SEC registration and reporting requirements. Until mid-2008, their prudential regulator was the Office of Federal Housing Enterprise Oversight (OFHEO) within the Department of Housing and Urban Development, which had a dual–and sometimes conflicting–mission of promoting homeownership and preserving the safety and soundness of Fannie and Freddie. As a practical matter, the dual mission made it more difficult for OFHEO to promote safety and soundness if its actions might limit the volume of mortgage originations. Fannie and Freddie were permitted to operate with capital that was both of low quality and of inadequate size to buffer the risks in their portfolios. In addition, their balance sheets were allowed to grow rapidly, including through purchases of subprime mortgage-backed securities.

Many of these statutory gaps have been addressed by the recently passed financial reform legislation. Notably, the establishment of a Financial Stability Oversight Council, together with new authorities for regulators, should increase the macroprudential orientation of regulation and supervision. Under the new legislation, all systemically critical financial institutions, including those that are not bank holding companies, will be subject to consolidated supervision; additionally, the Gramm-Leach-Bliley restrictions have been modified to allow the Federal Reserve to gain a more comprehensive view of large financial companies.

Ineffective Use of Existing Authorities

Statutory gaps were an important reason for the buildup of risk in the system and for the inadequate response of the public sector to that buildup. But even when authorities did exist, they were not always used forcefully or effectively enough by regulators and supervisors. I will give a few examples of flaws in execution by U.S. bank regulators because I am most familiar with them, but I want to note that, with the benefit of hindsight, many financial regulators around the world fell short on various dimensions.6

For the most part, bank regulators did not do enough to force large financial institutions to strengthen their internal risk-management systems or to curtail risky practices. For example, the Federal Reserve’s supervisory capital assessment program (SCAP), popularly known as the “stress tests,” demonstrated that many institutions’ information systems could not provide timely, accurate information about bank exposures to counterparties nor complete information about the risks posed by different positions and portfolios. Regulators had recognized these problems in some cases but did not press firms vigorously enough to fix them. The SCAP also revealed inadequacies in many banks’ internal capital assessment methods that might have been recognized earlier.

A number of triggers of the crisis were linked to deficiencies in the protection of consumers in the financial marketplace, notably in subprime mortgage lending. The Federal Reserve addressed a number of these issues prior to the crisis through guidance to banking organizations and through enforcement, and in the past three years or so the Fed has issued strong regulations to protect consumers in a number of key areas, including mortgages, credit cards, and debit cards. However, in the period before the crisis, the Fed was slow to identify and address abuses in subprime lending, especially those outside the banking firms that the Fed regulates directly.

Although the absence of macroprudential authorities was an important statutory gap, regulators could have done more to try to identify risks to the broader financial system. In retrospect, stronger bank capital standards–notably those relating to the quality of capital and the amount of capital required for banks’ trading book assets–and more attention to the liquidity risks faced by banks and other financial institutions would have made the financial system as a whole more resilient.

For its part, the Federal Reserve has moved vigorously to address identified problems. On the regulatory side, we are playing a key role in ongoing international efforts to ensure that systemically critical financial institutions hold more and higher-quality capital, have enough liquidity to survive highly stressed conditions, and meet demanding standards for company-wide risk management. We also addressed flawed compensation practices by issuing guidance to help ensure that compensation structures at banking organizations provide appropriate incentives without encouraging excessive risk-taking.7

To improve both our consolidated supervision and our ability to identify potential risks to the financial system, we have made substantial changes to our supervisory framework. So that we can better understand linkages among firms and markets that have the potential to undermine the stability of the financial system, we have adopted a more explicitly multidisciplinary approach, making use of the Federal Reserve’s broad expertise in economics, financial markets, payment systems, and bank supervision. We are also augmenting our traditional supervisory approach that focuses on firm-by-firm examinations with greater use of horizontal reviews that look across a group of firms to identify common sources of risks and best practices for managing those risks. To supplement information from examiners in the field, we have begun an enhanced quantitative surveillance program for large bank holding companies that will use data analysis and formal modeling to help identify vulnerabilities at both the firm level and for the financial sector as a whole. This analysis will be supported by the collection of more timely, detailed, and consistent data from regulated firms. Many of these changes draw on the lessons provided by the SCAP.

Improvements in the supervisory framework will lead to better outcomes only if day-to-day supervision is well executed, with risks identified early and promptly remediated. To facilitate swifter, more-effective supervisory responses, we have increased the degree of centralization of the oversight and control of our supervisory function, with shared accountability by senior Board and Reserve Bank supervisory staff and active oversight by the Board of Governors. Supervisory concerns will be communicated to firms promptly and at a high level, with more-frequent involvement of senior bank managers and boards of directors and senior Federal Reserve officials. Where necessary, we will increase the use of formal and informal enforcement actions to ensure prompt and effective remediation of serious issues.

Crisis-Management Capabilities

Once a crisis occurs, timely and effective action by the government is critical to containing the severity of financial disruptions and their economic effects. Ultimately, financial stability was regained through congressional action to recapitalize the banking system, the provision of liquidity by the Federal Reserve and of debt and deposit guarantees by the Federal Deposit Insurance Corporation (FDIC), and important actions by the Treasury Department. However, the crisis revealed large gaps in the government’s ability to respond quickly, effectively, and with minimum cost to taxpayers and the economy.

Crucially, in contrast to the regime in place for depository organizations, no one in the U.S. government had legal authority to resolve failing nonbank financial institutions, including bank holding companies, in a way that would impose appropriate losses on creditors while limiting systemic effects. Especially during the short time frames required by a crisis, Chapter 11 bankruptcy, which focuses on creditor rights rather than on financial and economic stability, is not an effective vehicle for managing the liquidation or restructuring of large, complex, and highly interconnected financial institutions. The failure of Lehman Brothers through Chapter 11 proceedings worsened the crisis enormously. Loans were made to AIG because a bankruptcy filing by that company would have redoubled the severity of the crisis.

The creation of a resolution regime for systemically critical nonbank financial firms is a critical innovation of the recently passed financial reform bill. Work is under way to implement this framework. Supervisors are also working to address other resolution-related challenges that policymakers faced during the crisis, including unnecessarily complex corporate structures at many financial institutions and complications arising from the global nature of operations of many large financial institutions.

In a time of panic and liquidity shortages, central banks must be able to provide funding to sound financial institutions. In the United States, the Federal Reserve lacked established procedures to provide short-term funding to shadow banks, such as broker-dealers, money market mutual funds, or special purpose vehicles, so it had to develop programs to provide such funding quickly during the crisis. The Federal Reserve had the authority to lend to depository institutions through the discount window; however, to a surprising extent, banks were reluctant to use the window, even when they had pressing needs for funding. This reluctance arose from the “stigma” of using the window; each bank feared that if it went to the window and markets learned they had done so, such action would be interpreted as a sign of weakness, and their funding problems would worsen rather than improve.

However, the Federal Reserve was able to supply liquidity to both banks and nonbanks, through a variety of means, to stem the panic. It auctioned fixed amounts of term funding to depository institutions, which seemed to circumvent the stigma problem. The Federal Reserve also created other facilities, in most cases using its emergency authority under section 13(3) of the Federal Reserve Act, to provide collateralized short-term loans to nonbank financial institutions in situations in which market-based funding mechanisms had broken down.

“Too Big to Fail”

Many of the vulnerabilities that amplified the crisis are linked with the problem of so-called too-big-to-fail firms. A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences. Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. Common means of avoiding failure include facilitating a merger, providing credit, or injecting government capital, all of which protect at least some creditors who otherwise would have suffered losses.

In the midst of the crisis, providing support to a too-big-to-fail firm usually represents the best of bad alternatives; without such support there could be substantial damage to the economy. However, the existence of too-big-to-fail firms creates several problems in the long run.

First, too-big-to-fail generates a severe moral hazard. If creditors believe that an institution will not be allowed to fail, they will not demand as much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm’s risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad. Where they have the necessary authority, regulators will try to limit that risk-taking, but without the help of market discipline they will find it difficult to do so, even if authorities are nominally sufficient. The buildup of risk in too-big-to-fail firms increases the possibility of a financial crisis and worsens the crisis when it occurs. There is little doubt that excessive risk-taking by too-big-to-fail firms significantly contributed to the crisis, with Fannie Mae and Freddie Mac being prominent examples.

A second cost of too-big-to-fail is that it creates an uneven playing field between big and small firms. This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability.

Third, as we saw in 2008 and 2009, too-big-to-fail firms can themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. The failure of Lehman Brothers and the near-failure of several other large, complex firms significantly worsened the crisis and the recession by disrupting financial markets, impeding credit flows, inducing sharp declines in asset prices, and hurting confidence. The failures of smaller, less interconnected firms, though certainly of significant concern, have not had substantial effects on the stability of the financial system as a whole.

If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own. Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.

The new financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a three-part strategy to address too-big-to-fail. First, the propensity for excessive risk-taking by large, complex, interconnected firms must be greatly reduced. Among the tools that will be used to achieve this goal are more-rigorous capital and liquidity requirements, including higher standards for systemically critical firms; tougher regulation and supervision of the largest firms, including restrictions on activities and on the structure of compensation packages; and measures to increase transparency and market discipline. Oversight of the largest firms must take into account not only their own safety and soundness, but also the systemic risks they pose.

Second, as I already discussed, a resolution regime is being implemented that allows the government to resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders. Ensuring that that new regime is workable and credible will be a critical challenge for regulators.

Finally, the more resilient the financial system, the less the cost of a failure of a large firm, and thus the less incentive the government has to prevent that failure. Examples of policies to increase resiliency include the requirements in the recent bill to force more derivatives settlement into clearinghouses and to strengthen the prudential oversight of key financial market utilities such as clearinghouses and exchanges. Even if such steps do not meaningfully affect investor perceptions about too-big-to-fail, they are worthwhile in that they will reduce the vulnerability of the financial system to future shocks. In addition, prudential regulators should take actions to reduce systemic risks. Examples include requiring firms to have less-complex corporate structures that make effective resolution of a failing firm easier, and requiring clearing and settlement procedures that reduce vulnerable interconnections among firms.

Monetary Policy and Related Factors

Some have argued that monetary policy contributed significantly to the bubble in housing prices, which in turn was a trigger of the crisis. The question is a complex one, with ramifications for future policy that are still under debate; I will comment on the issue only briefly.

The Federal Open Market Committee brought short-term interest rates to a very low level during and following the 2001 recession, in response to persistent sluggishness in the labor market and what at the time was perceived as a potential risk of deflation. Those actions were in accord with the FOMC’s mandate from the Congress to promote maximum employment and price stability; indeed, the labor market recovered from that episode and price stability was maintained.

Did the low level of short-term interest rates undertaken for the purposes of macroeconomic stabilization inadvertently make a significant contribution to the housing bubble? It is frankly quite difficult to determine the causes of booms and busts in asset prices; psychological phenomena are no doubt important, as argued by Robert Shiller, for example.8 However, studies of the empirical linkage between monetary policy and house prices have generally found that that that linkage is much weaker than would be needed to explain the behavior of house prices in terms of FOMC policies during this period.9 Cross-national evidence also does not favor this hypothesis. For example, as documented by the International Monetary Fund, even though some countries other than the United States had substantial booms in house prices, there was little correlation across industrial countries between measures of monetary tightness or ease and changes in house prices.10 For example, the United Kingdom also experienced a major boom and bust in house prices during the 2000s, but the Bank of England’s policy rate went below 4 percent for only a few months in 2003.

The evidence is more consistent with a view that the run-up in house prices primarily represented a feedback loop between optimism regarding house prices and developments in the mortgage market. In mortgage markets, a combination of financial innovations and the vulnerabilities I mentioned earlier led to the extension of mortgages on increasingly easy terms to less-qualified borrowers, driving up the effective demand for housing and raising prices. Rising prices in turn further fueled optimism about the housing market and further increased the willingness of lenders to further weaken mortgage terms. Importantly, innovations in mortgage lending and the easing of standards had far greater effects on borrowers’ monthly payments and housing affordability than did changes in monetary policy.11

The high rate of foreign investment in the United States also likely played a role in the housing boom. For many years, the United States has run large trade deficits while some emerging-market economies, notably some Asian nations and some oil producers, have run large trade surpluses. Such a trade pattern is necessarily coupled with financial flows from the surplus to the deficit countries. International investment position statistics show that the excess savings of Asian nations have predominantly been put into U.S. government and agency debt and mortgage-backed securities, which would tend to lower real long-term interest rates, including mortgage rates. In international comparisons, there appears to be a strong connection between house price booms and significant capital inflows, in contrast to the aforementioned weak relationship found between monetary policy and house prices.12

International investment position statistics show that the United States also received significant capital inflows from Europe in the years before the crisis. Europe’s trade has been about balanced over the past decade or so, implying no large net capital flows on average. However, substantial gross flows occurred in the years running up to the crisis. Notably, European institutions issued large amounts of debt in the United States, using the proceeds to buy private-sector debt, including securitized products. On balance, the effect of these sales and purchases on Europe’s capital account balance approximately netted out, but the combination led to growing European exposures to the kind of distress in U.S. private-sector debt markets that occurred during the crisis. The strength of the demand for U.S. private structured debt products by European and other foreign investors likely helped to maintain downward pressure on U.S. credit spreads, thereby reducing the costs that risky borrowers paid and thus, all else being equal, increasing their demand for loans.

Even if monetary policy was not a principal cause of the housing bubble, some have argued that the Fed could have stopped the bubble at an earlier stage by more-aggressive interest rate increases. For several reasons, this was not a practical policy option. First, in 2003 or so, when the policy rate was at its lowest level, there was little agreement about whether the increase in housing prices was a bubble or not (or, a popular hypothesis, that there was a bubble but that it was restricted to certain parts of the country). Second, and more important, monetary policy is a blunt tool; raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy. In this case, to significantly affect monthly payments and other measures of housing affordability, the FOMC likely would have had to increase interest rates quite sharply, at a time when the recovery was viewed as “jobless” and deflation was perceived as a threat.

A different line of argument holds that, by contributing to the long period of relatively placid economic and financial conditions sometimes known as the Great Moderation, monetary policy helped induce excessive complacency and insufficient attention to risk. Even though the two decades before the recent crisis included two recessions and several financial crises, including the bursting of the dot-com bubble, there may be some truth to this claim. However, it hardly follows that, in order to reduce risk-taking in financial markets, the Federal Reserve should impose the costs of instability on the entire economy.

Generally, financial regulation and supervision, rather than monetary policy, provide more-targeted tools for addressing credit-related problems. Enhancing financial stability through regulation and supervision leaves monetary policy free to focus on stability in growth and inflation, for which it is better suited. We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so. However, whenever possible, supervision and regulation should be the first line of defense against potential threats to financial stability.

Conclusion

The findings of this Commission will help us better understand the causes of the crisis, which in turn should increase our ability to avoid future crises and to mitigate the effects of crises that occur. We should not imagine, though, that it is possible to prevent all crises. A growing, dynamic economy requires a financial system that makes effective use of available saving in allocating credit to households and businesses. The provision of credit inevitably involves risk-taking. To achieve both sustained growth and stability, we need to provide a framework which promotes the appropriate mix of prudence, risk-taking, and innovation in our financial system.

Federal Reserve

The Wall Street Journal published an article this morning that offers a glimpse into the divisiveness in policy stances within the Fed’s Board of Governors as the economy hits a crucial inflection point on our road to recovery.  Although this latest FOMC Statement still only had one dissenter, the rest of the Board was far from united in deciding to embark on QE Lite.  With markets set to open decidedly lower today, it is a particularly intriguing time to discuss the future of Federal Reserve policy, but first let’s take a look at some of the debate from this latest FOMC meeting.

Whereas Alan Greenspan ran the FOMC as his own mini-dictatorship in which he required unanimous consent with his own views, Ben Bernanke takes a different, more democratic approach.  This offers us some important insight into what policy maneuvers we should expect from the Fed moving forward:

The meeting was a case study in Mr. Bernanke’s management style, which reflects his days as chairman of Princeton University’s economics department when he had to manage a collection of argumentative academics with strong personalities and often divergent views. Mr. Bernanke encourages debate and disagreement, and then weighs in at the end with his own decision, which has helped him win loyalty at the Fed, even among those who disagree with him, several officials say.

Seemingly this particular debate only set the stage for what is to be a much larger, more contentious debate moving forward:

The debate over the decision to keep the Fed’s $2.05 trillion stock of mortgage debt and U.S. Treasury holdings from shrinking, described in interviews with several participants, set the stage for a more consequential discussion inside the Fed that remains very much alive: what to do next, if anything, about America’s stubbornly weak recovery and troublingly low inflation.

And the Fed members all:

…seek to avoid either deflation, a broad decline in prices and wages, or an upsurge of inflation. And they share a strong desire to get the economy growing fast enough to sustain a recovery without unusual government support.

Basically the Fed understands that the stakes are incredibly high right now.  As we all know, the real, consequential debate is whether the Fed should restart quantitative easing altogether.  While it appears that it would have been difficult to build a consensus within the FOMC to move towards all out quantitative easing, market action alone necessitated some form of tweaked policy:

Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed’s portfolio, had grown concerned….The Fed’s portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. That in turn meant the mortgage-backed securities held by the Fed were being paid off.

Not only did the Fed’s balance sheet shrink since the last FOMC meeting, but so too did markets encounter a whirlwind of volatility.  Many market observers had expected, or rather had the hopeful expectation, that the Fed would unleash a full bout of QE 2.0 in light of the recent weakness in equity markets.  However, according to the WSJ, the debate focused extensively on whether to maintain the balance of the Fed’s existing portfolio, and did not broach the topic of a new round of quantitative easing beyond a discussion as to whether a move to maintain the balance sheet would lead market participants to expect more easing.

The debate over the maintenance of the present portfolio size was seemingly contentious enough to make it sound like all out quantitative easing would be a tough sell to the FOMC at present.  However, much of that seems to result from the fact that many at the Fed do not presently see enough deflation to warrant some sort of action.  In reading the WSJ article, and considering the quotes offered from both present and past FOMC members, much of it seems like a “feeler” in order to gauge market sentiment towards another round of quantitative easing.  The article concluded with the following observation:

One thing is clear: Mr. Bernanke, though striving for consensus, is determined to avoid mistakes of past central bankers that created devastating bouts of deflation. As a Princeton professor in the 1990s, Mr. Bernanke lectured Japanese officials for being too timid about combating deflation. And in now-famous remarks he delivered as a Fed governor at a 90th birthday celebration for Milton Friedman in 2002, Mr. Bernanke promised the Fed would never allow a repeat of the deflation of the 1930s.

If his background as a professor is any indicator, then we should most certainly expect a more aggressive policy move from the FOMC in the near future.    In my recent FOMC preview, I offered some quotes from Bernanke’s pre-Fed Chairman days to highlight some of his beliefs. We must remain cognizant of the fact that when facing deflation, quantitative easing is not the only tool remaining in the Fed’s arsenal: inflation targeting remains a realistic possibility.  In a paper entitled Japanese Monetary Policy: A Case of Self-Induced Paralysis?, then Professor Bernanke offered the following critique of the Bank of Japan’s reluctance to use inflation targeting in its fight against deflation:

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. (And, as I will argue, the Bank does have tools to move the economy.) But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the BOJ to help the macroeconomic situation.

What really remains a mystery is what exactly will the Fed look for to take a more proactive policy stance.  The allusion to Bernanke’s academic days makes it sounds all but conclusive that the Fed will in fact do something more moving forward, but when exactly remains a mystery.  Is the FOMC waiting for tangible signs of deflation?  Some sort of catalytic event in capital markets?  More time to build a consensus within the FOMC for action?  Only time will tell, but we now know that the FOMC remains as divided as everyone else on which, if any policy to pursue.

“Extended Period…”

Today’s FOMC announcement, due out at 2:15 p.m. EST is the first Federal Reserve Bank announcement in quite some time to generate uncertainty amongst investors.  In the past, many had focused on whether or not the Fed would remove the “extended period” language from the statement.  Although some had expected the removal of this language for several rounds of FOMC meetings, this time around, that is increasingly unlikely.

The Fed Fund Futures, an index which tracks expectations on interest rates now makes it clear that any change to interest rates will at minimum be on hold until the latter half of 2011.  This change in expectations is a double-edged sword.  On one hand, it reflects the fact that growth expectations for the economy have decreased substantially over the course of the past three months.  I certainly expect the Fed to express this reality by saying that the downside risk to the economy is a lack of growth and/or deflation, and not inflation.

One the other hand, Fed Chairman, Ben Bernanke has made it explicitly clear throughout both his academic and professional career that the Federal Reserve Bank should use language to shape expectations.  Considering both the way in which the economy collapsed, and the extent to which it fell, this is not your typical recession, and as such, Bernanke wants US investors to understand that these low rates will last for more than just a while.  They will in fact last for an “extended period.”  In a 2004 speech in Japan, while a member of the Fed Board of Governors, Bernanke had the following to say about language as a policy tool:

Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that “policy accommodation can be maintained for a considerable period,” a formulation replaced a few meetings later with the comment that the Committee could be “patient” in removing policy accommodation. These statements conveyed information to markets about the Committee’s economic outlook as well as its policy approach. In my view, this language served an important purpose, illustrating in the process the value of central bank communication. At the time that “considerable period” was introduced, the market was pricing in a significant degree of near-term policy tightening, presumably on the expectation that the sharp pickup in growth in the third quarter of 2003 would induce the FOMC to raise rates.  [emphasis added]

Quantitative Easing 2.0?

Heading into today’s meeting, many have been openly discussing the prospect for the Fed to unleash Quantitative Easing 2.0 (QE 2.0), to the point where some even expect it.  The Fed has made clear that their intention was not to implement Quantitative Easing as was the case in Japan, but rather to execute credit easing.  The following passage from Bernanke highlights the crucial differences, and these differences are instrumental in shaping our expectations:

The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006.  Our approach–which could be described as “credit easing”–resembles quantitative easing in one respect:  It involves an expansion of the central bank’s balance sheet.  However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental.  Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves.  In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses.  This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes [emphasis added].

While Quantitative Easing 2.0 is now a far more realistic option that it was in the past, don’t expect any change on this front from the Fed.  When Bernanke embarked on his “Helicopter ride” to increase our money supply, the goal was to ease what had been frozen credit markets.  At this point in time, although growth remains tepid, credit markets are in fact functioning properly.  Even in the latest economic flare up over the past few months, credit spreads stayed within manageable parameters.   Moreover, since the Fed stopped open market purchases of mortgage backed securities (MBSs) at the end of March, rather than rise, mortgage rates have continued to fall. it’s not much talked about, but is a very real possibility.

Inflation Targeting is a Wild Card…

While I think QE 2.0 is an unlikely, but real possibility, I think that inflation targeting would be a far more likely and less radical outcome and it would comfortably fit with Bernanke’s desire to use language as an instrument to shape economic expectations.  Additionally, this fits nicely with what Bernanke, as a Princeton professor, offered up as advice to the Bank of Japan in its fight against inflation (hat tip to Paul Krugman for the quote):

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. (And, as I will argue, the Bank does have tools to move the economy.) But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the BOJ to help the macroeconomic situation.

In this passage, Bernanke specifically asserted that it would not hurt the Bank of Japan’s inflation fighting credentials; however, when asked the about the prospect of inflation targeting in the US just six months ago, Bernanke had the following to say (hat tip to The Economist for the passage):

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

So here, unlike in his academic days, Bernanke is arguing that inflation targeting could hurt the Fed’s credentials as an inflation-fighting institution.  Why is it that considering this quote I still think inflation targeting to be a real possibility?  Well much has changed since that time.  Around when Bernanke had made that quote, the focus had been on how the Fed would go about the withdrawal of all its aggressive monetary policy.  Many had been ringing the bells about the looming prospect of hyperinflation, and there remained significant, albeit misguided, concern about inflation in the short-run.

Now that we’re six months down the timeline, with the Eurozone having just gone through a deflationary storm, the risks are much clearer to the downside in growth.  One of the Fed’s biggest inflation hawks, James Bullard went on record as concerned about a deflationary situation in the US.  The landscape of the policy world has been shifting in the face of current events and this is a significant development unto itself.  Although Bullard specifically cited Quantitative Easing as a preferable policy tool, I think that inflation targeting may be the more likely for its ability to anchor expectations of growth and expansion into a bleak economic outlook.

All that being said, I still do not expect outright inflation targeting from the Fed in today’s decision.  What I do expect is some sort of stronger language that the downside risk to the economy at the moment comes from a lack of inflation, and as such, the Fed will do all it can to get the economy back to the targeted 2% inflation rate.  So while no rigid inflation target will be set, look for some sort of “soft” policy on this front.

The Economist recently released their fun Big Mac Index. Forget what Federal Reserve Chairman Ben Bernanke or Wall Street says, the value of the US Dollar is best determined by how many McDonald’s (NYSE: MCD) all-beef patties you can get around the world for a buck …

THE Big Mac index is based on the theory of purchasing-power parity (PPP)-exchange rates should equalise the price of a basket of goods in different countries. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark. So our light-hearted index shows which countries the foreign-exchange market has blessed with a cheap currency, and which has it burdened with a dear one.

Much of the rage these days has been about “how to get businesses to spend.”  Watching CNBC, one would easily conclude that we are in the midst of a supply side slump, in which businesses curtailed production due to uncertainty in policies from Washington.

With the US Chamber of Commerce unleashing a wave of negativity on the present policy landscape, I think it’s important to take a step back and look at what is fundamentally taking shape in our economy. Economics has become so politicized to the point that discourse has become detached from the source of the problem.   Let’s analyze where we are and where we came from in an apolitical manner, focusing solely on the simplified economic elements.

What is the problem?

In a nutshell, the problem is debt.  We are in the middle of a rolling credit crisis.  It all started with the private sector accumulating far too much debt–the leverage ratios in the financial and residential sectors reached unprecedented heights–and has now transitioned into one in which the US government has accrued a substantial fiscal debt.  The following chart, borrowed from Steve Keen’s Are We “It” Yet paper (definitely worth the read for those who enjoy more advanced economics), offers a great illustration of exactly what has transpired.  As you can clearly see, when the lines representing finance and business turn downward, the government’s line accelerates upwards.

Once the first shock (sub-prime trouble started in 2006 and heightened throughout 2007) hit debt markets, the shock sent ripples throughout US debt markets.  When Lehman Brothers collapsed in September 2008 and AIG required a bailout just to meet its collateral requirements, debt markets completely froze and finance essentially came to a halt.

In the meantime, as the financial sector of the economy collapsed, and the unemployment rate rose, the cycle of defaults and increasing unemployment continued to accelerate in pace.  Demand in the economy took a shift to the left.

In the short-run, the aggregate supply is a vertical line, as production capacity itself is static.  One can clearly see that when demand shifts left, both price and total production also take a corresponding shift to the left.  This is rather different than your typical post-Great Depression recession.  In fact, it is the first time since the Great Depression that we have seen such a shift.

What this means for monetary and fiscal policy?

When aggregate demand takes a leftward shift the remedy called for is different than what has worked in other recent recessions.  In the past, cutting interest rates would induce firms to increase production, as a supply-side recession led to a shortage in production.   We saw this play out as the Fed rather quickly moved interest rates to the zero bound, and sure enough there was no uptick in economic activity. Fiscal policy, on the other hand, could be implemented to fill some of that “demand gap” that results from a shift in aggregate demand, and this is exactly why our government pursued a stimulus plan.

The common thread through all of this is that the problem started as one of too much debt in the private sector.  As a result, demand for dollars increased–demand for dollars is equivalent to saying that firms and households cut consumption in order to save and/or pay down debt.  Debt was (and is still) getting capitalized far faster than the money supply was increasing.  Essentially, we are in the midst of a massive debt to equity conversion in the private sector.  In order to soften the landing, the government lent a helping hand and took on more debt itself so that the private sector could afford to capitalize.  And perhaps most importantly, Helicopter Ben Bernanke unleashed a massive wave of quantitative easing and drastically increased our money supply in order to accommodate the increasing demand for dollars.

Where are we now?

Well now, the government’s deficit has expanded rather quickly.  This is not a bad thing.  Meanwhile, private sector balance sheets have continued to improve, to the point where people are now complaining that companies have too much cash.  This too is not a bad thing.  The next step is to get us into a position for demand to start increasing in the private sector.  Clearly there is demand for investment (as opposed to consumption goods), as is evidenced by the fact that even since the Federal Reserve stopped purchasing mortgage backed securities, interest rates on 30 year mortgages continue to plunge to new record lows: demand outweighs supply in that market.

Why is that?  Well what bank wouldn’t want to lend when they could borrow from the Fed at next to no interest and lend that money out at about 4.5%.  That’s a healthy profit margin right there!  The problem is that demand for mortgages is incredibly low, as over levered households are in no position to take on more debt in buying new real estate (hat tip to Hedgeye for the chart):

Is investment light right now?  Sure it is,  But, while we’re not seeing investment in increased production capacity, we are seeing investment in increased productivity.  Companies are spending large quantities of money investing in the new technology infrastructure.  Intel’s (NASDAQ: INTC) earnings highlight this trend on the supply side, as does Federal Express’s (NYSE: FDX) on the demand side.  Intel beat on account of increased demand from the cloud computing trend, while Federal Express invested in improving the company’s efficiency infrastructure.

We need to add a little more context to what is going on.  Business cycles are just that–cycles.  There are peaks and there are troughs, but all in all, changes take time.  Subprime “popped” in 2006, totally crashed in 2008 and bottomed in 2009.  That was a good three years of negativity there.  We are just through year one of the recovery in equity markets.  Anyone who expects the economy back at full capacity at this point has some sort of agenda.  It’s just impossible and unrealistic.  The key is to remain cognizant of where we came from and where we are, and to continue implementing effective policies to mitigate the deflationary pressures coming from households and financials and to encourage investment in innovative ideas.

In April we were all clear and May-June the world was ending.  There are inherent emotions that contribute to the fluctuations of market prices.  As investors and traders, it’s important to look at this through an unemotional lens.  The market will do its thing (check out Ben Graham’s Mr. Market to get an idea), and the economy will do its own thing.  Now is one of those times to take a step back and put things into perspective.

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University of South Carolina Commencement Ceremony, Columbia, South Carolina on May 8, 2010

I want to begin by thanking the Board of Trustees of the University of South Carolina, President Pastides, and this year’s graduates for the great honor of addressing this commencement ceremony. Although I was born just across the border in Augusta, Georgia, I considered South Carolina my home from early childhood until I married and took my first academic job after graduate school. During most of that time, my family lived in Dillon, a couple of hours’ drive from here. I have had several occasions to visit Dillon and other places in the Carolinas since I got into government work, and I am both amazed and proud about the remarkable economic and social progress that has occurred since I grew up here. South Carolina, like America, is always reinventing itself, despite new and, it sometimes seems, ever more difficult challenges.

I always find it difficult to choose a topic for a commencement talk. I am an economist, but my experience has been that people in a celebratory frame of mind are usually not that interested in an economics lecture. (I can’t quite understand why not.) Instead, they are generally looking for something more personal and inspirational. So I thought I would split the difference between an economics lecture and inspirational remarks and speak briefly about what economics and social science more generally have to say about personal happiness, and what those ideas imply both for economic policymaking and the choices each of you will make as you leave college for other pursuits.

Why talk about happiness? Well, it’s right there in the mission statement of the United States, the Declaration of Independence: The inalienable rights of Americans are “Life, Liberty and the pursuit of Happiness.” If Thomas Jefferson thought it was important to facilitate the pursuit of happiness, maybe we should think a bit about what that means in practice.

In exploring the question, researchers have distinguished between two related, but different, concepts–”happiness” and “life satisfaction.” They use “happiness” to mean a short-term state of mind that may depend on a person’s temperament, but also on external factors, such as whether it is a sunny or rainy day. They use “life satisfaction” to refer to a longer-term state of contentment and well-being.1 The relationship between life satisfaction and happiness, and the factors contributing to each, is not always straightforward. I’ll come back to this issue later.

As you might guess, when thinking about the sources of psychological well-being, economists have tended to focus on the material things of life. This proclivity is why economic policymakers often emphasize the promotion of economic growth. The richer a country is, the higher the material standard of living of its average person. What applies to a country applies to individuals: Higher income equals a higher standard of living, which most people desire.

This traditional economist’s perspective on happiness is not as narrow and Scrooge-y as you might think at first. If I were to ask you what you value in life besides goods and services–a nice car or house, for example–you might begin with, say, your health. Well, richer countries have more resources to devote to medical care, to good nutrition and sanitation, and to workplace safety, and for these and other reasons rich countries have higher life expectancies, lower infant mortality rates, and generally better health indicators than poor countries. Likewise, as the United States has grown richer over time, longevity and other measures of health have improved.

Another thing that most people value is a clean environment. Air and water quality are not included in the broadest measure of economic activity emphasized in government statistics, the gross domestic product (GDP), although some economists have worked on ways to do so. But again, rich countries have more resources to devote to maintaining a clean environment and do tend to have better air and water quality than poor and middle-income countries, notwithstanding the fact that rich countries by definition produce more goods and services. Rich countries also generally provide people more leisure time, less physically exhausting and more interesting work, higher education levels, greater ability to travel, and more funding for arts and culture.2 Again, these linkages, together with the benefits of enjoying a wide variety of goods and services, are the reason that economic policymakers–at the behest of the public–usually put heavy emphasis on job creation and growth. Along with price stability, maximum employment is one of the Congress’s two mandated objectives for the Federal Reserve. And, indeed, economists researching happiness and life satisfaction have found that both inflation and unemployment detract from happiness, consistent with the focus on these macroeconomic conditions in the mandate of the Federal Reserve.3

Even though I hope I have persuaded you that purely economic measures of personal well-being are not as narrow as sometimes thought, I have so far dodged the key questions: Ultimately, what makes us happy? What makes our lives satisfying in the long run? And, more subtly, how is the state of mind we call happiness, at least as social scientists define the term, related to our long-run life satisfaction? We can look inward for answers, but, at least for someone trained as a social scientist, the most direct way to tackle the question is just to go out and ask people–lots of people. In fact, psychologists for some time have been running surveys in which they have asked thousands of randomly selected people in countries all around the world to rate their own happiness or life satisfaction, and recently economists have gotten into the act. There is now a field of study, complete with doctoral dissertations and professorships, called “the economics of happiness.” The idea is that by measuring the self-reported happiness of people around the world, and then correlating those results with economic, social, and personal characteristics and behavior, we can learn directly what factors contribute to happiness.

The results of these studies are quite interesting. One finding is that most people consider themselves to be reasonably happy, despite the undeniable hardships that many people face. Asked a question like, “Taken altogether, how would you say things are these days–would you say you are very happy, pretty happy, or not too happy?”, about 90 percent of respondents in the United States reply that they are very happy or pretty happy, a relatively high percentage.4 Perhaps people don’t want to admit to survey-takers that they are unhappy, but the explanation preferred by most researchers is that human beings are intrinsically very adaptable and are able to find satisfaction in their lives even in very difficult circumstances.

Another area of this research bears directly on what I said earlier about the relationship between income and happiness. Some years ago the economist Richard Easterlin showed that, just as would be expected, wealthier people in any given country are more likely to tell a survey-taker that they are happy with their lives than are poorer people in the same country. However, Easterlin also found two other things that don’t fit so well with the economic perspective. First, he found that as countries get richer, beyond the level where basic needs such as food and shelter are met, people don’t report being any happier. For example, although today most Americans surveyed will tell you they are happy with their lives, the fraction of those who say that they are happy is not any higher than it was 40 years ago, when average incomes in the United States were considerably lower and few could even imagine developments like mobile phones or the Internet. Second, he found that–again, once you get above a basic sustenance level–on average, people in rich countries don’t report being all that much happier than people in lower-income countries. The finding that people in rich countries don’t report much greater happiness than those in lower-income countries–even though, in any given country, the rich say they are happier than the poor do–is called the Easterlin paradox, after its discoverer.5

Now, research in social science is hardly ever the final word, and a large body of more recent research has contested Easterlin’s results, finding that people in rich countries may, on average, be happier or more satisfied after all. But this research still suggests that the increase in happiness flowing from greater wealth is moderate. For example, reported levels of life satisfaction among Americans are similar to reported levels among Costa Ricans, who have about one-quarter the per capita income.6 So I am going to continue under the assumption that, although wealth and income do contribute to happiness and life satisfaction, other factors must also be very important.7 Or, as your parents always said, money doesn’t buy happiness. Well, an economist might reply, at least not by itself.

What could explain Easterlin’s finding that, beyond a certain point, wealth and income don’t buy happiness? Easterlin’s own view, taking an economic perspective, is that people’s happiness depends less on their absolute wealth than on their wealth compared with others around them. If I live in a country in which most people have only one cow, and I have three cows, then I will have lots of social status and self-esteem and will thus feel happy. But if everyone around me has a luxury car, and I am hung up on status, I won’t feel very special unless I have both a luxury car and an SUV. This relative-wealth hypothesis can explain why rich people are happier than poor people in the same country, but also why people in richer countries are not on average much happier than people in poorer countries. It’s the big fish in a little pond phenomenon.

There is certainly something to this explanation. “Rich” is a relative term. When I was a kid, having a color television was a major status symbol. Now, most households have color TVs, often more than one. Your sense of how well off you are economically depends a great deal on your expectations and aspirations, which in turn are largely formed by the community in which you live.

Easterlin’s research and interpretation, I think, has some personal application. We all know that getting a better-paying job is one of the main reasons to go to college, and achieving economic security for yourself and your family is an important and laudable goal. But if you are ever tempted to go into a field or take a job only because the pay is high and for no other reason, be careful! Having a larger income is exciting at first, but as you get used to your new standard of living, and as you associate with other people in your new income bracket, the thrill quickly wears off. Some interesting studies of winners of large lottery prizes, even in the millions of dollars, found (as you would expect) that they were happy and excited on learning that they had won. But only six months later they reported being not much happier than they were before they won the lottery. The evidence shows that, by itself, money is not enough. Indeed, taking a high-paying job only for the money can detract from happiness if it involves spending less time with your family, stress, and other such drawbacks.

Human adaptability, which I mentioned earlier, also helps to explain the Easterlin paradox. Rich or poor, you tend to get used to your circumstances. Lottery winners get used to being wealthier, and their psychological state may ultimately be not much different than it was before buying the winning ticket. Have you ever said, “If I can just do or get X, I’ll be happy”? “X” might be to graduate, get a promotion, or be named to the all-star team. Well, it appears to be a scientific fact that it’s not true. No particular achievement or occurrence can guarantee long-term happiness by itself, because you will get used to your new status and your degree of happiness will eventually revert to something close to what it was before X, whatever it was, occurred.8 Interestingly, Adam Smith, the intellectual father of modern economics, understood this point; he once wrote: “[T]he mind of every man, in a longer or shorter time, returns to its natural and usual state of tranquility. In prosperity, after a certain time, it falls back to that state; in adversity, after a certain time, it rises up to it.”9 Does this mean that achievement is not worth the effort, that nothing we can do can make us happy? Not at all, and I’ll explain why in a moment.

But first, let’s revisit the central question. If, as your parents always told you, money doesn’t buy happiness, then what factors do contribute to life satisfaction? Psychologists and economists have done good work on this point, going your parents one better by identifying statistically just what factors are linked to self-reported happiness and how short-run happiness is related to, but distinct from, long-run life satisfaction.10

Some of them won’t surprise you, but are nevertheless worth repeating. Happy people tend to spend time with friends and family and put emphasis on social and community relationships. We are social creatures. Research has demonstrated that happiness and life satisfaction are perhaps more closely related to participating meaningfully in a network of friends, family, and community than any other factor.11 I urge you to take this research to heart by making time for friends and family and by being part of and contributing to a larger community.

Another factor in happiness, perhaps less obvious, is based on the concept of “flow.”12 When you are working, studying, or pursuing a hobby, do you sometimes become so engrossed in what you are doing that you totally lose track of time? That feeling is called flow. If you never have that feeling, you should find some new activities–whether work or hobbies.

Another finding is that happy people feel in control of their own lives. A sense of control can be obtained by actively setting goals that are both challenging and achievable. Ultimately, though, there are many things in our lives we cannot control. So it also is important to recognize what is and is not within our control, to cultivate the flexibility to accept unexpected change with equanimity, and to focus our efforts on achieving goals at the limit of, but still within, our reach.

Finally–and this is one of the most intriguing findings–happiness can be promoted by fighting the natural human tendency to become entirely adapted to your circumstances. One interesting practical suggestion is to keep a “gratitude journal,” in which you routinely list experiences and circumstances for which you are grateful.13 Devices like gratitude journals help people remain aware of the fortunate aspects of their lives, offsetting the natural human tendency to take those things for granted after a while.

Happiness research can be useful for individuals, but it also has implications for policymakers. For one, the policy goals of promoting economic growth and employment, though not–as we have seen–the only appropriate goals, are worthwhile nonetheless. On average, as I have already noted, citizens of richer countries report higher levels of life satisfaction, no doubt in part because they tend to be healthier, to have more leisure time to pursue hobbies or socialize, and to have more interesting work. Generally, richer countries also have fewer citizens in severe poverty.

But, again, many things beside income contribute to feelings of well-being. For example, as I mentioned, social interactions appear very important for individual happiness. One application of this insight–and this is just an example of the type of research connected with the “economics of happiness” that may bear policy insights–involved a program in Canada in which recipients of employment insurance or income assistance were offered jobs in community development and opportunities to develop a social network.14 Being unemployed is stressful, not just because of loss of income but also because of feelings of loss of control and diminished self-worth. But individuals who participated in these opportunities reported higher satisfaction than those who did not. Further study could shed light on the effectiveness of alternative approaches to traditional unemployment insurance programs.

More generally, economic policymakers should pay attention to family and community cohesion. All else equal, good economic policies should encourage and support stable families and promote civic engagement. And to help people feel in control of their own destinies, policies should respect the autonomy of individuals, families, and communities to make their own decisions whenever possible, as research has confirmed the intuitive notion that individual freedoms contribute to life satisfaction.

Notwithstanding that income contributes to well-being, the economics of happiness is also a useful antidote to the tendency of economists to focus exclusively on material determinants of social welfare, such as the GDP. GDP is not itself the final objective of policy, just as an increase in income may not be a good enough reason for you to change jobs. Obtaining broader measures of human welfare is challenging, but not impossible. Indeed, the United Nations has produced its human development reports for 20 years, and the Organisation for Economic Co-operation and Development has been engaged in a comprehensive project to examine the progress of societies in order to ensure that economic policymaking focuses on improving human welfare, broadly construed.15

But even though GDP or income should not be the only goal of our strivings, we can go one step further and recognize as well that happiness itself, at least to the extent that the term is associated with immediate rather than long-lasting feelings and emotions, should not be our only goal either. Remember that I began by distinguishing between happiness and life satisfaction. Happiness is just one component of the broader, longer-term concept of life satisfaction, and only one indicator of how the fabric of our lives is being shaped by our choices and circumstances. I am reminded of a story about Abraham Lincoln. According to the story, Lincoln was riding with a friend in a carriage on a rainy evening. As they rode, Lincoln told the friend that he believed in what economists would call the utility-maximizing theory of behavior, that people always act so as to maximize their own happiness, and for no other reason. Just then, the carriage crossed a bridge, and Lincoln saw a pig stuck in the muddy riverbank. Telling the carriage driver to stop, Lincoln struggled through the rain and mud, picked up the pig, and carried it to safety. When the muddy Lincoln returned to the carriage, his friend naturally pointed out that he had just disproved his own hypothesis by putting himself to great trouble and discomfort to save a pig. “Not at all,” said Lincoln. “What I did is perfectly consistent with my theory. If I hadn’t saved that pig, I would have felt terrible.”

The story points out that, sometimes, happiness is nature’s way of telling us we are doing the right thing. True. But, by the same token, ephemeral feelings of happiness are not always reliable indicators we are on the right path. Ultimately, life satisfaction requires more than just happiness. Sometimes, difficult choices can open the doors to future opportunities, and the short-run pain can be worth the long-run gain. Just as importantly, life satisfaction requires an ethical framework. Everyone needs such a framework. In the short run, it is possible that doing the ethical thing will make you feel, well, unhappy. In the long run, though, it is essential for a well-balanced and satisfying life.

Thank you for this opportunity to address you. This is an exciting day for the graduates and their families. I congratulate you on your accomplishment and wish you the best in the next stage of your lives.

Last night, the Boston Celtics sealed the deal and topped the Cleveland Cavs to advance to the 2010 NBA Semi-Finals. Will King James finally head to the Knicks to become King of New York?

In May of 2009, a group of Chinese investors led by Jian-hua ‘Kenny’ Huang purchased a 15% stake in the Cleveland Cavaliers in hopes to establish the presence of King James for the long-term. Kenny Huang was the first college graduate from the People’s Republic of China to work at the New York Stock Exchange (NYSE:NYX). He is a founder and director of Sportscorp China, a group that bridges the sports and sponsorship industries between the United States and China.

Surely, Chinese fans have continued the cheers from abroad for James, but in his last home game of the 2010 NBA Playoffs, his disappointed hometown Cavs fans boo-ed their King off the court.

Earlier this year, LeBron James signed a blockbuster endorsement deal with McDonald’s (NYSE:MCD). With MCD trading at $70 per share, I’d look for a pullback first before jumping on board the King James McDonald’s train:

Back in May 2003, LeBron signed a seven-year, $93 million contract with powerhouse Nike (NYSE:NKE). He recently re-upped his contract with Nike this year, but deal terms were not disclosed. We can only assume the terms were very comparable or better than his prior deal given the growth of the King James stocks since then. As NKE shares have breached their 200-day moving price average today, I would suggest remaining cautious but looking at the technical range of $68-$70 as a safer place to play ball with LeBron.

China has been the sleeping giant that has awoken since their Olympics hosting.  But with King James on the fence and the Cavs’ Chinese stake, will the luster for China fade as global eyes are set on the Brazilian World Cup and Olympics hosting in the New Decade?

The King James Trade Takeaway: Pullbacks are buying opportunities for MCD and NKE, while China’s FXI could enter a chop zone of concern for LeBron’s next possible move.

Shortly after U.S. markets opened, the University of Michigan‘s consumer sentiment survey revealed the printing presses are still yielding sustained U.S. consumer sentiment spending over rioting. Now, lets’ see if the latest European stimulus package can draw the same result from the U.S. playbook…

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Presidents

1. John Adams

2. John Quincy Adams

3. Rutherford B. Hayes

4. Theodore Roosevelt

5. Franklin Delano Roosevelt

6. John F. Kennedy

7. George W. Bush

8. Barack Obama

Business

1. Bill Gates – Microsoft (MSFT)

2. Lloyd Blankfein – Goldman Sachs (GS)

4. Sumner Redstone – National Amusements (CBS, VIA, DWS)

5. Bill O’Reilly

William James “Bill” O’Reilly, Jr. (born September 10, 1949) currently hosts The O’Reilly Factor, a political commentary program on the Fox News Channel (NWS), which is the most watched cable TV news program in America. His entire career was involved with both broadcasting and print, as an American television host, author, syndicated columnist, and political commentator. O’Reilly has worked at various television stations in news reporting and anchoring positions, and authored eight books. He is considered by many to be a conservative commentator, and characterizes himself as a “traditionalist.”

6. James McNerney – Boeing (BA)

Since 2005, Walter James “Jim” McNerney, Jr., (born August 22, 1949) has been the CEO of Boeing, a major aerospace and defense corporation. He has also held various positions with other major corporations, including Procter & Gamble (1975-1978), McKinsey & Co., Inc. (1978-1982), General Electric (1982-2000), and 3M (2000-2005). In 2004, McNerney was named Chief Executive Officer of the Year by Industry Week, and one of the best managers of 2003 by BusinessWeek. Boeing is the largest global aircraft manufacturer in terms of revenues, orders, and deliveries.

7. Stanley Marcus – Neiman Marcus

Harold Stanley Marcus (April 20, 1905-January 22, 2002) served as CEO of Neiman Marcus (Dallas-based luxury specialty retail department store) from 1973-1994. He is remembered as an important historical figure, involved with the development of American retail merchandising and marketing. In addition, he wrote a 15-year weekly column for The Dallas Morning News, and authored several retailing-oriented books, including Minding the Store: A Memoir (1974), the sequel Quest for the Best (1979), and His & Hers: The Fantasy World of the Neiman Marcus Catalogue (1982). His community knew him as a civic leader, and avid fine arts patron.

Movie Stars

1. Matt Damon

2. Tommy Lee Jones

3. Ashley Judd

4. Jack Lemmon

5. John Lithgow

6. Natalie Portman

Government

1. Ben Bernanke

2. Larry Summers

Lawrence Henry Summers (born November 30, 1954) is an American economist and the Director of the White House’s National Economic Council for President Barack Obama. Summers is the Charles W. Eliot University Professor at Harvard University’s Kennedy School of Government. He is the 1993 recipient of the John Bates Clark Medal for his work in several fields of economics and was Secretary of the Treasury for the last year and a half of the Clinton Administration. Summers also served as the 27th President of Harvard University from 2001 to 2006.

3. Al Gore

Albert Arnold “Al” Gore, Jr. (born March 31, 1948) served as the 45th Vice President of the United States from 1993 to 2001 under President Bill Clinton. He is currently an author, businessperson, and American environmental activist who starred in the 2006 documentary An Inconvenient Truth, which won an Academy Award in 2007. Gore also wrote the book An Inconvenient Truth: The Planetary Emergency of Global Warming and What We Can Do About It, which won a Grammy Award for Best Spoken Word Album in February 2009. He and the Intergovernmental Panel on Climate Change were jointly awarded the Nobel Peace Prize in 2007. He is a co-founder and chair of Current TV, a member of the Board of Directors of Apple Inc., and a senior advisor to Google.

(Hat Tip: Mark Green)

4.Jennifer M. Granholm

4. Mike Crapo

5. Mitt Romney

6. Felipe Calderon

7. John G. Roberts

8. David Souter

There are reports that the NCAA is going to expand the Men’s Basketball Tournament from 65 to 96 teams. If this deal is true, the NIT just got kicked in the nuts.

If the NIT loses the best 31 teams in their tournament, they might as well put their brand on a high school tournament. High school basketball has risen to the ranks of ESPN prime time coverage of the hottest future pros in the country. There is lots of money to be made in that emerging space.

I’m not sure what the backend politics are, but if I were the NIT I’d ring my attorney to see whether the NCAA move is an anti-trust violation. This is America: when in doubt, sue.

Personally, I don’t care whether the NCAA expands their field of teams. They know they have a built-in, emotional captive audience for each team — so, it’s a brilliant way to monetize school spirit.

In order for the NIT to survive, they may want to bring their grievance before economic high priest Ben Bernanke. In a last ditch effort, the bubble king may thwart the NCAA’s move simply to prevent a further drop in economic productivity near the Ides of March. Like the surprises and upsets on the hardwood, anything is possible in Washington.

In case you were distracted by Ben Bernanke’s testimony last week, an interesting trend in consumer behavior is taking shape during this year’s tax-filing season.

Based on news from the top tax service companies, you will see individuals are in a very cost conscious state-of-mind. Consumers are quickly selecting the cheaper of the two options: preparing your own tax forms.

In this week’s Edge, we look at H&R Block, Intuit, as well as a quick snapshot of Jackson Hewitt.

H&R Block (HRB): $17.28 The “Hamburger Helper” of Tax Prep

Shares were crushed last Wednesday after the company warned they would miss their puffed up 2010 earnings outlook. H&R Block had expected fiscal 2010 earnings from continuing operations to amount to $1.60 to $1.80 a share. The consensus estimate from analysts polled by Thomson Reuters is at the low end of that range, $1.61 per share.

Past quarter earnings are due out after the bell on March 8th. The current estimate of analysts polled by Thomson Reuters is for a profit of $.16 cents per share on revenue of $959.2 million.

CEO Russ Smyth said, “We believe industry filings are down significantly due to the recession and sustained, high levels of unemployment … the weak economic conditions have also contributed to a greater shift to do-it-yourself tax preparation methods among first-half clients.”

Comment: The Kansas City-based tax services giant has prepared 6.3 percent fewer tax returns — 10.06 million — through Feb. 15 than during the same span last year (10.7 million tax returns prepared). H&R Block will just have to bear the brunt of less clients and more empty desks at their retail locations this season.

Intuit (INTU): $32.36 The Do-It-Yourself Software Provider

The maker of Turbo-Tax earned $.34 cents per share vs. $.26 cents per share in the same period a year ago. Consensus estimates were expected to be $.32 cents per share, an upside beat for Intuit.

Revenue in the most recent quarterly report increased 8%, better than analyst expectations.

President and CEO of Intuit Brad Smith said on the quarterly conference call, “We’re off to a good start and we’re on track to deliver better than expected revenue and earnings growth for fiscal year 2010.”

Sales of best-in-class TurboTax products jumped 11%. Intuit reported selling 10.97 million TurboTax products compared to 9.9 million in the same period a year ago. The web-based version of the product saw a 23% gain in sales, a sign that online tax preparation is leading the way this season.

Comment: Management recently raised full-year guidance estimates for revenue and profits. Also, It’s important to note that Director David Batchelder purchased a sizable insider stake of over 12.5 million shares on December 15, 2009 when the stock was around $30 per share — only slightly lower than today’s price of $32.36 per share. Initial signs show Intuit with a strong start in capturing the demand for do-it-yourself tax prep.

Jackson Hewitt (JTX): $2.44 The Franchise with Ugly Financials

Fiscal 2010 3rd Quarter earnings results are scheduled for March 11, 2010.

Comment: JTX is quickly burning cash. The company has only $60K in cash remaining relative to $311 million in debt obligations. I would steer clear of this company until the financials improve; otherwise, you might get caught holding the bag as this company files for bankruptcy in the near future or becomes a penny stock.

Among the three tax preparation players highlighted above, Intuit is definitely the safest trend play, while H&R Block and Jackson Hewitt are the contrarian higher-risk pullback plays. Jackson Hewitt is definitely the weakest of the three companies, but still possesses a recognized brand name in the marketplace. Consumers do not mind the hold-your-hand service when they have the extra cushion. However, companies like H&R Block are coming to realize the cushion is either minimal or non-existent for most individuals filing taxes this year.

Disclosure: No positions in the companies mentioned.

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