WASHINGTON — Federal Reserve Chairman Ben Bernanke warned Wednesday that the economic slowdown is growing worse and called for greater regulation to prevent future crises like the one now menacing the nation.
Stocks on all three major indices plunged soon after his speech, as new data confirmed a deep and wide national economic retreat.
The Dow Jones Industrial Average closed down 733.08 points, or 7.8 percent, to 8577.91. The S&P 500 finished down 90.17 points, or 9.03 percent, to 907.84. The tech-heavy Nasdaq bled 150.68 points, or 8.47 percent, to 1628.33. The second straight day of declines erased Monday's striking increases.
In a speech to the Economic Club of New York that was followed by an unusual and frank question-and-answer session, Bernanke signaled that the U.S. economy is sure to get worse, hinted at further interest-rate cuts and implicitly criticized the economic-rescue plans that both major presidential candidates are touting.
Later the Fed released its Beige Book, a report from its 12 district banks on economic conditions around the country. All 12 reported worsening conditions, yet another indicator that the economy appears to be in recession.
"Consumer spending was weak in nearly all districts. Consumers continued to pull back on big-ticket items, including autos. Several districts reported that reduced credit availability was restraining auto sales. Tourism was weaker, particularly lower domestic travel," Brian Bethune, an economist with the forecaster Global Insight, said in a research note on the Beige Book.
"Manufacturing activity moved lower in most districts, and there were greater concerns about the economic outlook. Autos and building materials continued to report weak demand conditions, and hurricanes disrupted oil and gas production," Bethune reported.
Earlier Wednesday, the Commerce Department reported that retail sales fell 1.2 percent in September. That was almost twice the consensus expectation and another clear sign, along with big September job losses, that the economy skidded to a halt as the global financial crisis worsened last month.
Bernanke's speech focused on the economic outlook. He suggested that U.S. exports, which had helped keep growth going for much of the year, now are poised to fall as a global slowdown unfolds. He also hinted that last week's coordinated trans-Atlantic half-point reduction in interest rates left room to cut even further. The Fed's benchmark federal funds rate now stands at 1.5 percent.
Under questioning, Bernanke answered with candor unusual for a man whose job usually requires him to be vague in order to avoid spooking the markets.
Asked to compare today with the handling of the Great Depression, Bernanke, a scholar on the period, said that Franklin D. Roosevelt's New Deal fiscal stimulus failed to end the troubles. Roosevelt, however, didn't take office until three and a half years after the stock market crashed in 1929.
Implicit in that answer was this view: The stimulus spending suggested by Democratic presidential nominee Barack Obama or the tax cuts proposed by Republican candidate John McCain are unlikely to end the crisis.
"I think contemporary scholarship argues that, at least in the case of the United States, fiscal policy was not the critical element, unless you count World War II, which obviously mobilized the entire economy," Bernanke said.
A hard lesson being learned now, he said, is that monetary policy — the use of interest rates to accelerate or decelerate the economy's growth as well as the Fed's aggressive push to recapitalize banks with easy loans — has its limits.
"We reached a point ... where the situation required additional firepower," Bernanke said, referring to the $700 billion rescue plan that Congress authorized. He added that "monetary policy ultimately cannot always solve the problems, and you do sometimes need fiscal or financial intervention, and we're getting that currently."
Current law has tied the Fed's hands at times, Bernanke said. He cited last month's bankruptcy of investment bank Lehman Brothers. The Fed did everything possible to save Lehman, he said, but because it was an investment bank not subject to commercial banking laws, it couldn't qualify for the same kind of government rescue as Charlotte, N.C.-based national bank Wachovia, which sold itself to Wells Fargo this month after a silent run on it by fleeing depositors.
When Bear Stearns, another investment bank, fell on hard times in March, the Fed was able to broker its sale to J.P. Morgan Chase because Bear had adequate collateral to offer in exchange for Fed lending. There was no such collateral available with Lehman, he said.
"Lehman was not allowed to fail," Bernanke said, refuting suggestions by European leaders that he'd done just that.
U.S. policymakers must ask, he said, how to prevent a replay of inflated asset prices such as those seen during the dot-com bubble in tech stocks of the late '90s and the subsequent housing bubble. Whether or not he meant to point fingers at his predecessor, these inflated prices occurred on the watch of former Fed Chairman Alan Greenspan, who argued that it was the role of the market, not the Fed, to prick asset-price bubbles.
"Obviously the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the current crisis that we're all going to look at that issue and what can be done about it," Bernanke said.
He suggested that a new supervisory and regulatory structure is needed, a rare move for a Fed chairman. Lawmakers must decide whether monetary policy or supervisory regulation should be the leading approach to prevent financial meltdowns, he said.
"I do believe the latter does have a significant role to play in constraining excessive leverage, excessive risk taking and the other elements that lead to bubbles," Bernanke said, laying blame for today's crisis squarely on Wall Street investment banks that were allowed to borrow huge amounts to make risky investments with scant supervision.
Bernanke also said there were now risks to the global financial system from unregulated credit-default swaps. These are insurance-like products that allow big investors to hedge against potential losses. The market for swaps is thought to total $55 trillion, yet it's a "dark market," unregulated and without transparency, amounting to nothing more than contracts between two sophisticated parties.
"Credit default swaps are not traded on an exchange. They aren't traded through a central counterparty, which means if one of those firms fails, among the consequences would be that the banks and others who had purchased credit insurance would be forced to write down tens of billions of dollars of value," Bernanke said.
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