Business and the New Economy News

Revisiting an August Speech on Banks: Failure Teaches the Right Lessons

By Robert Struckman, 10-06-08

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

Tomorrow in Chicago, Minneapolis Federal Reserve Bank president Gary Stern will give an updated version of his speech called ”Repercussions from the Financial Shock” in which he argued that banks should be allowed to fail, so managers will learn the harsh lessons only failure can teach.

The text of the new speech at the Council of Institutional Investors won’t be made available. Perhaps the subject matter is too close to a critique of the daily money matters rocking the financial world and the world economy. Not that anything should be read into his decision. Stern is a private Fed president. He speaks less than most others, said Minneapolis Fed spokeswoman Patti Lorenzen, and it’s fairly standard for him to keep the text of his speeches to himself.

The upshot is that unless you’re planning to attend the meeting in Chicago tomorrow, you’ll miss the words of this influential and smart guy. That’s why I thought it would be a good idea to point you to this story I wrote about Stern’s earlier version of this same speech, given in Three Forks in mid-August.

In light of recent events, I might re-write the headline as follows: Fed Reserve Branch Head Says Let Banks Fail.

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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