In a long speech to the annual Kansas City Fed gathering at Jackson Hole, Wyoming, Fed Chief Ben Bernanke gave a history lesson about the recent financial crisis. It is worth reading in its entirety since it reminds us of just how close we came to absolute catastrophe.

He recounts the demise of Lehman Brothers and the decisions to bail out Fannie Mae ([/url]), Freddie Mac ([url=http://www.zacks.com/stock/quote/fre]FRE) and American International Group (AIG), as well as the shotgun marriages of Bank of America (BAC) with Merrill Lynch and J.P. Morgan (JPM) with Washington Mutual.

The full speech can be read here: http://www.federalreserve.gov/newsevents/speech/bernanke20090821a.htm.

While most of the speech focused on the recent past, he gave the following assessment of the current situation:

“Overall, the policy actions implemented in recent months have helped stabilize a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitization markets has picked up.

“Stock prices have partially recovered, and U.S. mortgage rates have declined markedly since last fall. Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be leveling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.

“Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit.

“Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.”

I have to agree with his basic assessment that the economy is stabilizing, but that the recovery will be exceptionally anemic. As a central banker, he is obligated to speak in soft tones and not say anything that has the potential to alarm markets. If he were back teaching at Princeton, he would probably use stronger language.

Historically, sharp downturns are followed by sharp and strong recoveries. That is not likely to happen this time around. Still, we have seen some encouraging signs, most recently the pick-up in existing home sales and the tentative rebound in industrial production.

These signals probably mean that the NBER will eventually say that the recession ended around now. They will not get around to doing so until perhaps the first quarter of next year, just as they did not tell us the recession started in December of 2007 until November of 2008, when any fool could tell we were in a recession.

Bernanke only touched lightly on what was likely going forward and did not really address how the programs of the last year will be unwound — the timing of which will be extremely difficult. If the Fed acts too quickly, we could easily be back where we were last fall. If it waits too long, inflation expectations will rise, and given the huge amount of excess reserves the Fed has injected into the system, inflation could rapidly get out of control.

Some insight into this timing would have been nice in this speech, but I didn’t find it. Still it was a useful history lesson. Here is his conclusion:

“Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge.

“As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year monetary, fiscal and financial policies around the world have been aggressive and complementary.

“Without these speedy and forceful actions, last October’s panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

“Although we have avoided the worst, difficult challenges still lie ahead. We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years. I hope and expect that, when we meet here a year from now, we will be able to claim substantial progress toward both those objectives.”

The effort the build an new regulatory framework is going to be critical, and is something that the public has to be aware of. Since it is a highly complex and difficult subject, it is just the sort of thing where lobbyists can have the greatest influence.

Already the effort to create a new agency focused on consumer protection from abusive financial products seems to be floundering under intense opposition from the banking lobby. The country did an enormous favor to the banking industry last year, but in the final analysis it was in the public interest to do so (as a general proposition of stepping in, the actual implementation was FAR too nice to the banks).

It would be nice if those efforts led to changes that would prevent a reoccurrence of this disaster. So far, there is little evidence of that happening.

The regulatory overhaul as proposed by the Obama Administration would be a good first step, but needs to be strengthened as it moves through Congress. However, it seems more likely that as the bank lobby sets its teeth in, it will be substantially weakened instead.

Thus, we will face another crisis like the one we had last year, maybe not this year or next, but 10 or 20 years down the line. Let us hope that Bernanke is right and a year from now we will see substantial progress towards these objectives, but I fear that we will not.
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