'tis you 'tis you must go and i must bide ♪ coming up here on c-span3, federal reserve chairman ben bernanke, who spoke to students today in washington, d.c. then the u.s. ambassador to the united nations, susan rice, on the obama administration's foreign operations budget. after that, the surgeon general presenting her report on youth smoking. and later, a house oversight committee hearing on fraud in the food stamp program. in march 1979, c-span began televising the u.s. house of representatives to households nationwide. and today, our content of politics and public affairs, nonfiction books and american history is available on tv,

radio and online. >> we sell the american people short when we think you have to spoon feed them and kid them and say you can all v all these things and don't pay for them. they know better than that. they don't trust you if you try to flimflam them. say to them, sure. tax and spend. that's right. it's more honorable than borrow and spend. >> c-span, created by america's cable companies as a public service. c-span's road to the white house will have results from the illinois primary with speeches from mitt romney and rick santorum. your phone calls and some of politico's coverage. that will be live at 7:00 eastern on c-span. federal reserve chairman ben bernanke returned to his roots as an economics professor today. he gave an hour-long lecture to about 30 students at george

washington university in the nation's capital. one student asked about returning to the gold standard which mr. bernanke said is not feasible in a modern economy. >> well, good afternoon. i think the students here may know who i am, but for those watching the broadcast, i am steve knap, president of the george washington university. it's really a pleasure to welcome you to today's first class in a series entitled reflections on the federal reserve and its place in today's economy featuring the chairman of the federal reserve, dr. ben bernanke. i am pleased to acknowledge that we have with us two of the number of falculty members. some of them will be teaching later in the series. today is the first university lecture series delivered by a sitting chairman of the federal reserve. and i think it does provide an extraordinary opportunity for the students who are here in the classroom, but also for those watching online who have an opportunity to gain insight into

the nation's central banking system and a wide range of issues that affect this country and the world. i do want to say there are microphones available for the students and certainly encourage you when the chairman's lecture is over, to avail yourself to those and we hope there will be a lively exchange of questions and answers at the end of the lecture. it's now a distinct honor to introduce the chairman of the board of governors of this federal reserve system, dr. ben an bernanke. he servesas chairman of the federal reserves open market committee. before his appointment as chairman, dr. bernanke was involved with the federal reserve in several roles as a member of the board of governors, as a visiting scholar and as a member of the academic advisory panel at the federal reserve bank of new york. he also served as chairman of the president's council of economic advisers from june 2005 to january 2006. now chairman bernanke is no stranger to academia. he's been a faculty member at

princeton, stanford and new york university as well as a massachusetts institute of technology. he's held a guggenheim and sloan fellowship and is a fellow hef econometrics society. he received a bachelor of arts from harvard and ph.d. from m.i.t. please join me in welcoming the chairman of the federal reserve, dr. ben bernanke. >> thank you very much, president knapp. gee, this is great. this is what i used to do before i got in this line of work. for 23 years. and i've always enjoyed engaging with college students. thank you for being here. i hope we do have a good conversation. let me particularly thank president knapp and professor fort and george washington university as everybody here knows, these lectures are part of a real course. and after i get off the scene,

there will be other professors talking about other aspects of the fed and you'll hear different points of view, which is great. and you'll have to do some papers and all kinds of things. and i'm going to read a few of the papers. so i look forward to doing that. so i will be talking from slides, which is, in part, for the purpose of making this available to others who might be interested. these slides will be posted on the federal reserve's website, federal reserve.gov. as we go through. and so if you need extra copies or -- by all means, do that. and as president knapp said, i'm going to be talking for a while from the presentation, but at the end, i hope we can have some questions and answers. so let me get started. what i want to talk about in these four lectures is the federal reserve and the financial crisis.

now my thinking about this is very much conditioned by my experience as an economic historian. i think when you talk about the issues that just occurred over the last few years, it makes the most sense to think about it in the broader context of sfrl banking as it's taken place over the centuries. so even though we're going to be focusing a good bit of the lectures, particularly next week, on the financial crisis and how the fed responded, i think we need to go back and look at the broader context. so as we talk about the fed, we'll be talking about the origin and mission of central banks in general. and we are looking at previous financial crises, most notably the great depression and see how that informed the fed's actions and decisions in the recent crisis. so let me just give you a road map of the four lectures. today, lecture one, we won't touch on the current crisis at all. instead, we'll talk about what

central banks are. what they do. how central banking got started in the united states. and we'll do some history. we'll talk about how the fed engaged with its first great challenge, the great depression of the 1930s. the second lecture on thursday will take up the history. will review developments in central banking and with the federal reserve after world war ii. talking about the conquest of inflation, the great moderation and other developments that occurred after world war ii. we'll spend a good bit of time in lecture two talking about the build-up to the crisis and some of the factors that led to the crisis of 2008-2009. then next week we'll get into the more recent events in lecture three, we'll talk about the intense phase of the financial crisis. its causes, its implications. and particularly, the response to the crisis by the federal reserve and by other policymakers. and then in the final lecture,

lecture four, we'll look at the aftermath. we'll talk about the recession that followed the crisis. the policy response of the fed, including monetary policy. the broader response in terms of changes in financial regulation and a little bit of forward looking discussion about how this experience will change how central banks operate and how the federal reserve will operate going forward. so this is our topic today. origins and missions of the federal reserve. so let's talk in general about what a central bank is. if you have had some background in economics you know a central bank is not a regular bank. it's a government agency. and it stands at the center of the monetary and financial system of a country. central banks are very important institutions. they have helped to guide the development of modern financial systems, modern monetary systems and play a major role in economic policy.

now we've had various arrangements over the years, but today, virtually all countries have central banks. the federal ree japan in japan, bank of canada and so on. the main exception is only cases where you have what's called a currency union where a number of currents collectively share a central bank. the most important example by far of that is the european central bank which is central bank to 17 european countries who share the common currency the euro. but even if n that case, each of the participating countries does have its own central bank which is part of the overall system of the euro. central banks are now ubiquitous. even the smallest countries typically have central banks. now this is a very important theme here. what do central banks do? what is their mission? and as i'll discuss throughout the lectures, it's convenient to talk about two broad aspects of

what central banks do. the first is to try to achieve macroeconomic stability. and by that i generally mean stable growth in the economy, avoiding big swings, recessions and the like. and keeping inflation low and stable. so that's the economic function of a central bank. the other function of central banks, which is going to get a lot of attention, obviously, in these lectures is the financial stability function. central banks try to keep the financial system working normally and in particular, they either -- they try to prevent or if unsuccessful in tigate finan panics or financial crises. and i'll talk more about what those are. now what are the tools that central banks use to achieve these two broad objectives? very -- in very simple terms, they are basically two broad

sets of tools. on the economic stability side, the main tool is monetary policy. in normal times, the fed, for example, can raise or lower short-term interest rates. it does that by buying and selling securities in the open market. again in normal times if the economy is growing too slowly or inflation is falling too low, the fed can stimulate the economy by lowering interest at through to a broad range of other interest rates. that encourages spending, acquisition of homes, for example, construction, investment by firms, borrowing. it just generates more demand, more spending, more investment in the economy and that creates more thrust and growth. so that -- to stimulate an economy, you lower interest rates. and similarly, if the economy is growing too hot, if inflation is

becoming a problem, then the normal tool of central bank is to raise interest rates. so by raising the overnight interest rate, known in the united states as the federal funds rate, higher interest rates feed through the system and help to slow the economy by raising the cost of borrowing, of buying a house, of buying a car or of investing in capital goods and that will slow the economy and reduce pressure of overheating. so monetary policy is the basic tool that central banks have used for many, many years to try to keep the economy in a more or less even keel in terms of both growth and inflation. now a little less familiar is the main tool of central banks in dealing with financial panics or financial crises. and that tool is the provision of liquidity. so to address financial stability concerns and for reasons i'll explain, one thing that central banks can do is

make sure term loans to financial institutions. as i'll explain, providing short-term credit to financial institutions during a period of panic or crisis can help calm the market, can help stabilize those institutions and can help mitigate or bring to an end a financial crisis. so this activity, which is an old one as i'll discuss, is known as the lender of last resort tool. so again if financial markets are disrupt, financial institutions don't have alternative sources of funding, then the central bank stands ready to serve as the lender of last resort, providing liquidity to the system and, thereby, helping to stabilize the financial system. now there's a third tool which the fed has had from the beginning and most central banks have which is financial regulation and supervision. central banks usually play a role in supervising the banking

system, assessing the extent of risk on their portfolios, making sure their practices are sound. and that way trying to keep the financial system healthy. to the extent the financial system can be kept healthy and its risk-taking within reasonable bounds, then the chance of a financial crisis occurring in the first place is reduced. however, this activity, although i'll come back to it, this is something which is not unique to central banks in the united states, for example, there are a number of different agencies like the fdic or the office of the control of the currency that work with the fed in supervising the financial system. so this is not unique to central banks. so i'll be downplaying this for the timebeing and focussing on the two principipal tools. now where do central banks come from? one thing people don't appreciate, i think, is that central banking is not a new development. it's been around for a very long

time. the swedes set up a central bank in 1668, 3 1/2 centuries ago. the bank of england was founded in 1694 and that, of course, for many decades, if not ceur impor influential central bank in the world. and france in 1800. so central bank theory and practice, not a new thing. we have been thinking about these issues, collectively as an economics profession and in other contexts for many, many years. now i've exaggerated slightly in the sense that the bank of england wasn't set up from scratch as a full-fledged central bank. it was originally a private institution. and overtime tarks quired some of the functions of a central bank such as issuing money or serving as lender of last

resort. but over time, the -- these central banks became essentially government agencies, government institutions as they all are today. certainly one important responsibility of central banks for much of the period that i'm talking about was to manage the gold standard, to issue paper money that was backed by gold. and i'll talk more about gold in a few moments. now the lender of last resort function, which i mentioned earlier became important in the -- mostly in the 19th century, nearly the 19th century. the bank of england was doing a lot of this type of activity. and they became very good at it. and as we'll see while the united states was suffering with banking panics in the latter part of the fleenth century, banking panics in the united kingdom were quite rare. so the bank of england sort of

set the pace in some sense. it was the most important central bank and it helped establish the practices and approaches that we still use today. now i need to talk a little bit because it's less familiar about what a financial panic is.s sparked by a loss of confidence in an institution. and i think the best way to explain this is to give a familiar example. how many of you have ever seen the movie "it's a wonderful life"? well, less people are watching christmas movies than they used to be, i guess. well, one of the problems that jimmy stewart runs into as a banker in "a wonderful life" is a threatened run on his institution. and what is a run? well, let's imagine a situation like jimmy stewart's situation before there was any deposit insurance. no fdic. and imagine you have a bank on the corner, just a regular

commercial bank, first bank of washington, d.c., and this bank makes loans to businesses and the like and it finances itself by taking deposits from the public. and deposits are demand deposits which means that anybody can pull out their money any time they want, which is important because people use deposits for ordinary activities like shopping. now imagine what would happen if for some reason a rumor goes around that this bank has made some bad loans and is losing money. as a depositor you say, i don't know if this rumor is true or not but i know if i wait and everybody else pulls out their money and i'm the last person in line, i may end up with nothing. so what are you going to do? you are going to go to the bank and say, well, i'm not sure if this is a true rumor or not, but knowing that everybody else is going to come to the bank, i'm going to go pull my money out.

and so the depositors line up. they pull out their cash. no bank holds cash equal to all their deposits. they put that cash into loans. so the only way the bank can pay off the depositors, once it gets through its minimal cash reserves is to sell or otherwise dispose of its loans. but it's very hard to sell a commercial loan. it takes time. you have to sell it at a discount. and by the time you have gotten around to doing that, depositors are at your door and saying where's my money? and so ultimately, a panic can lead the bank to close and be a self-fulfilling prophecy. the bank will sell. it will have to sell off its assets at a discount price and many depositors might lose money as happened in the great depression, for example. so a bank panic is a problem which is faced by any institution where it has loans or other illiquid-type assets and it finances itself by

short-term deposits or other short-term lending. now panics can be a serious problem. obviously, if one bank is having problems, people at the bank next door might begin to worry about problems in their bank. and so a bank run can lead to widespread bank runs or a banking panic more broadly. sometimes banks, again, pre-fdic, banks would respond to a panic or a run by refusing to pay out deposits and just say no more. we're closing the window. so that restriction on the access of depositors to their money was another bad outcome and caused problems for people who had to make a payroll or buy groceries. many banks would fail. beyond that, banking panics also fred into other markets. we're often associated with stock market crashes and all those things together, as you might expect, were bad for the economy. and so a banking panic could

lead to a crash in the economy as well. so here's a formal definition just for your conference. you see people around -- standing around the corner waiting to take out their money. but a financial panic can occur any time you have an institution that has longer term illiquid assets. think of a bank that has long-term loans that are illiquid in the sense it takes time and effort to sell those loans. and which are financed on the other side of the balance sheet by short-term liabilities like deposits but could be other signs of short-term liabilities. any time you have that situation you have the possibility that the people who put their money in the bank or the lenders or depositors may say, wait a minute. i don't want to leave my money here. i'm pulling it out and you have a serious problem for the institution. so now to come back to what we were talking about before, how

can -- how could the fed have helped jimmy stewart? well, again, lender of last resort is the basic tool. imagine that jimmy stewart is paying out the money to his depositors. he's got plenty of good loans but he can't change those into cash and he's got people at the door looking for money. well, if the federal reserve was on the job, jimmy stewart could call up the local fed office and say, look. i've got a whole bunch of good loans. i can offer them as collateral. give me a cash loan against this collateral. so the central bank would act in this way as a lender of last resort. the jimmy stewart can take the cash from the central bank, pay off his depositors and then so long as he really is solvent, that is as long as his loans are really good, the run will be quelled, will be stopped, and the panic will come to an end.

so by providing short-term loans, taking as collateral the illiquid assets of the institution, central bank can put money into the system, pay off depositors, pay off short-term lenders and calm the situation and the panic. this was something that bank of england figured out very early. a very key person in the intellectual development here was a journalist named walter badg badg badgett who thought a lot about central banking policy. and he had a dictum which said that during a panic, central banks should lend freely, whoever comes to your doors, as long as they have collateral, give them money. this is during a banking panic. against good assets to make sure that you get your money back, you need to have collateral. and that collateral has to be good or it has to be discounted. you can lend half the value of

the collateral, for example. and charge a penalty interest rate so that people don't just take advantage of the situation but rather they signal that they really need the money because they are willing to pay a slightly higher interest rate. so if you follow badgett's rule, you can stop financial panics. as a bank or other institution finds that it's losing its funding from depositors or other short-term lenders, it borrows from the central bank. the central bank provides cash loans against collateral. the company then pays off its depositors and again, things calm down. without that source of funds, without that lender of last resort activity, many institutions would have to close their doors. they could go bankrupt. if they had to sell their assets at discount fire sale prices, that would also create problems because other banks would find the value of their assets had gone down. and so the panic through fear or

rumor or through declining asset values could spread throughout the banking system. so it's very important to get in there aggressive's lose a central banker, provide that short-term liquidity and avoid the collapse or at least the serious stress on the system. so again, using the assets as collateral, banks borrow from the central bank. so that's a little bit of general theory about central banks and what they do. again, their two broad functions of macro economic stability and financial stability. and they have tools on both sides of that equation. so let's talk a little bit about specifically the united states and the federal reserve and what we'll find is that the federal reserve which was founded -- the law passed in 1913. it was founded eventually in 1914. we'll find that concerns on both sides of this equation motivated

the decision of congress and president wilson to create the federal reserve. let's talk first about financial stability in the united states. now after the civil war and into the early 1900s, there was no federal reserve. there was no central bank. so any kind of financial stability functions that couldn't be done, say, by the treasury had to be done privately. and there were some interesting examples of private attempts to create lender of last resort functions. so for example, a very interesting example is the new york clearing house. the new york clearing house was a private institution. it was basically a club of ordinary commercial banks in new york city. and it was called a clearing house because initially it was -- it served as a place where banks could clear checks against each other. they came at the end of each day and they traded my checks against you and your checks

against me and it was a way of reducing the cost of managing checking. but as time evolved, clearing houses began to function a little bit like central banks. so, for example, if one bank came under a lot of pressure, the other banks might come together in the clearing house and lend money to that bank so it could pay its depositors. they served as a lender of last resort. another possibility was sometimes the clearing houses would all agree we're going to shut down the banking system for all banks. and then they would -- they would go look at the bank that was in trouble and evaluate its balance sheet and determine whether it was, in fact, a sound bank. if it was it would reopen. normally that could calm things down. so there was some private activity to try to stabilize the banking system. however in the end, these kinds of private arrangements were just not sufficient. they didn't have sufficient

resources. they didn't have the credibility of an independent central bank. after all, people could always wonder whether the banks were acting in other than the public interest, since they were all private institutions. and so it was necessary for the united states to get a lender of last resort that could stop runs on illiquid but still solvent commercial banks. so this is not a hypothetical issue. financial panics in the united states were a very big problem. so here's the period basically from the restoration of the gold standard after the civil war in 1879 through the funding of the federal reserve and the graph here shows the number of banks closing during each of the six major banking panics that occurred during that time in the united states. you can see in the very severe financial panic of 1893 more

than 500 banks failed across the country. that was a really big panic and had significant consequences for the financial system and for the economy. now 1907 was also a pretty sharp financial crisis. the banks that failed were larger. and it was after that crisis that the congress began to say, well, wait a minute. maybe we need to do something about this. maybe we need a central bank. a government agency that can address the problem of financial panics. so that process began. there was a very substantial amount of research done. 23-volume study was prepared for the congress about central banking practices. and congress moved deliberately towards creating a central bank. before the new central bank was established, though, there w