Resident Fellow  Desmond Lachman

In central banking timing is everything. Eighteen months into Mr. Bernanke's term as Federal Reserve Chairman, one has to start wondering whether he has the required timing either for diagnosing problems before they get out of hand or for responding to crises as they arise. More troubling still, one has to wonder whether even now he continues to be overly sanguine about the severity of the current global credit crunch and overly tardy in cutting interest rates.

Mr. Bernanke's response to the progressive unraveling of the sub-prime mortgage crisis constitutes perhaps the clearest instance of his poor timing in diagnosing problems. For it was as late as March 2007 that Mr. Bernanke even acknowledged that something might be amiss in the sub-prime mortgage market. Never mind that during 2005 and 2006 a staggering US$1 trillion in these "liar loans", which required no income and no asset verification, were being made.

It also took Mr. Bernanke a long time to grasp the serious ramifications for the global financial system of the unraveling of the sub-prime mortgage market. Even six weeks after Bear Sterns and BNP Paribas had reported acute sub-prime related problems in a number of their funds, Mr. Bernanke was still hewing to the line that the sub-prime problem would be "contained".

More remarkable still was the Federal Reserve Open Market Committee's misplaced sangfroid during the early days of August at the very time that the U.S. financial system was seizing up. Indeed, as late as August 7 at its regular six-weekly meeting, the FOMC saw no need for any change to its tightening bias for interest rate policy.

It was only once credit markets displayed the clearest of signs of seizing up and once global equity markets threatened to go into freefall that the Fed was forced to make an abrupt U-turn in its policy stance. At last, on August 17, the FOMC grudgingly conceded that financial market developments posed a real threat to economic growth, which prompted the FOMC to cut the discount rate. However, it still stopped short of cutting the federal funds rate, its key policy interest rate.        

The question that now has to be asked is whether Mr. Bernanke is correct in responding to the present credit crunch by treating the problem as if it were solely one of liquidity rather than also one of solvency. It also needs to be asked whether Mr. Bernanke is right in insisting that no Federal Reserve support need be given to the non-banking financial system, which now dwarfs in size the banking system.
         
Ben Bernanke has a well-deserved reputation as a serious scholar of the Great Depression and of the more recent Great Japanese Deflation of the 1990s. One only hopes that his deep knowledge of those earlier experiences now sensitizes Mr. Bernanke to the real risks of not responding with sufficient force and timeliness to the present financial market crisis by  starting to aggressively cut interest rates.

Desmond Lachman is a resident fellow at AEI.