Second Thoughts on Bernanke's Nobel Prize

The Nobel Prize in Economics was recently awarded to former Federal Reserve Chairman Ben Bernanke, as well as professors Douglas Diamond and Philip Dybvig, for their work on understanding the role banks play in the economy, especially during a financial crisis.

All three of them have done important work that’s worthy of recognition. Banks are key parts of the economy that, by assessing the creditworthiness of borrowers, help channel the savings of households and companies into productive investment. Bank failures, in turn, threaten to make it tougher for an economy to direct savings to where they’re most useful.

However, like many recent Nobels this award seems to ratify expansionary government policy. Bernanke’s approach to the Financial Panic of 2008-09 included a massive bailout of the financial system, monetization of government spending, and a huge expansion in the Federal Reserve’s balance sheet.

The Bernanke approach did not include fixing mark-to-market (MTM) accounting, which was the key ingredient that turned a limited financial fire into a raging inferno that almost burned down the entire US financial system.

To review, in late 2007 the Financial Accounting Standards Board (FASB) forced financial firms to use market prices to value securities, rather than models or cash flow. Within a year, the U.S. was in the middle of the worst financial panic in a hundred years. This was not a coincidence.

On the surface, MTM made sense. Markets usually provide transparent and verifiable prices, so companies couldn’t just make up numbers. The problem is that market prices often deviate – sometimes substantially, but always temporarily – from underlying fundamental value. Since markets are forward looking, MTM forced financial firms to take hits to capital over something that might happen in the future but hadn’t happened yet. It was like forcing homeowners to come up with more capital as a hurricane approaches because their homes might get destroyed.