The Time Bernanke got it wrong

Worship at the alter of Bernanke helped fuel the fiscal crisis. As the New York Times article chronicles, on of the sources of tinder for the massive upswing in risk-taking during the middle of the last decade was the theme being pushed by Bernanke in his writings and speeches as deputy Chairman of the Fed, entitled “The Great Moderation.” The basic idea was that, largely as a result of the brilliant economic management by Central Banks, the amplitude of swings in major economies had become muted.

What Bernanke ignored was that the combination of cheap money and nearly infinite access to derivatives (with his boss fighting hard to prevent better regulation) was encouraging banks (and others) to massively leverage up their balance sheets to take advantage of this perceived decline in economic volatility. The result was a wonderful lesson in chaos theory: how positive feedback loops in a nonlinear system can cause the entire system to go spinning out of control.

In simpler English, lower perceived economic swings = more leverage and risk-taking, and ultimately, vastly wider economic swings.

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