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Words on the National Economy

Fed President: Hard Knocks Help, Recovery Will Be Slow

By Robert Struckman, 8-14-08

Gary Stern, president and CEO of the Minneapolis branch of the Federal Reserve Bank

The Federal Reserve Bank should allow banks to fail—to teach managers the right tough lessons—said Minneapolis Federal Reserve Bank president Gary Stern in Three Forks this afternoon. He also suggested the U.S. economy today was similar in many ways to that of 1990 and 1991, although he noted a few significant differences.

Stern said his speech did not reflect the views of the Federal Reserve Bank as a whole but his own analysis. Research and writings of Stern have broad implications, though, and work from the Minneapolis Branch of the Federal Reserve Bank is progressive and influential, such as work by the bank on the importance of early childhood education as a community investment with one of the highest returns.

Stern is not a gregarious man, and he doesn’t often make his speeches available beforehand or on paper. In this case, he gave his text to a spokeswoman in his Minneapolis office, who forwarded it to me. (The text has also just been posted on the branch’s Web site.)

Stern began his remarks by saying bailouts of banks deemed too-big-to-fail actually have the worst possible effect, by dulling the pain of poor decision-making and thereby encouraging riskier behaviors. The role of bank regulators should be to make sure banks don’t get so big that one failure would spark a rash of failures. Then the regulators should step out of the way and let banks live or die.

In his discussion of the current economy, Stern said he saw a lot of parallels to the early 1990s, known as the “headwinds” episode. Then, like today, potential borrowers had a hard time getting credit. Residential construction shrank then, too, although the modern housing correction has been more severe, as it is tied to dropping home values. High energy and commodity prices are another drain on the current economy, too. Other factors in today’s economy are better than the early 1990s, though, he added.

Specifically, the analogy implies the economy will continue its modest expansion and unemployment may rise, but inflation will diminish, unless energy and other commodity prices surge upwards again.

“In considering these prospects, it is worth recalling that, despite early challenges, the 1990s turned out to be an excellent decade for the U.S. economy by almost all metrics,” Stern said. “The economy is fundamentally flexible and resilient, and these characteristics should ultimately prevail.”

Tobias Madden, a regional economist with the Minneapolis Branch of the Federal Reserve Bank will be speaking at the third annual conference on Real Estate and Development in the Northern Rockies in late October.

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