By Ian McKendry and Denny Gulino

WASHINGTON (MNI) – Federal Reserve Chairman Ben Bernanke, in a
professorial appearance at Princeton University Friday, warned again the
Fed is fully able to tighten monetary policy when the time comes and
said the science of economics has a lot of new research assignments
after the crisis.

Bernanke did not fulfill the hopes of some analysts that he would
expand in any detail on his view of the current economy or comment on
the results of the week’s FOMC meeting. But he did revisit in a general
way the topics he has examined at length before congressional
committees while giving research economists new areas of study.

Instead of being forced to sell assets, Bernanke said the Fed “has
found lots of other ways that we can tighten monetary policy and tighten
interest rates at the appropriate time,” he told a campus audience at
a conference co-sponsored by the Bendheim Center for Finance and the
Center for Economic Policy Studies.

He said that the Fed’s discussion of exit strategies “wasn’t ever
with the point of saying we were about to exit. Rather, it was very
important for us to say how we could exit so that we would have the
confidence of investors and the public that we had control of the
situation and we would be able to exit at the appropriate time.”

In the same answer after his speech, Bernanke went on to say, “At
some point, the time will come — and I don’t know when that is … when
the Fed will normalize monetary policy and at that point, as I said …
we have a list of tools that will allow us to the drain reserves from
the system and normalize interest rates and bring us back to a more
normal monetary policy.” He said he hopes that will be accompanied by “a
normal growing economy with reasonable unemployment and price
stability.”

Looking back, Bernanke said, “conventional monetary policy methods
ran out of room.” The reason for the continuing supporting monetary
policy “is because the economy continues to need to be supported.”

In the realm of fiscal policy, which belongs to Congress not the
Fed, he said, every analysis shows “the U.S. federal deficit and the
federal debt will become unsustainable within few decades.” So, “the
only law I really want to stand up for here is the law of arithmetic.”

The deficit “equals the difference between spending and taxes”
choices have to be made by the American people and Congress, he
continued, while government addresses the issue of too much promised
entitlement spending.

The Fed, even apart from regulatory reform, is transforming itself
as a regulator, he said. “What is new and different,” he said, “is that
we are now, from now on, going to be a whole lot more attentive to the
system as a whole.”

Within the Federal Reserve, he answered, “we are restructuring our
supervisions so we pay explicit attentiont to the whole system from a
macroprudential perspective with financial stability as a primary goal,”
he said.

In his earlier prepared remarks, Bernanke distinguished among
economics science, economics engineering and economics management, while
pointing out “economics as a discipline differs in important ways from
science and engineering.”

“I don’t think the crisis by any means requires us to rethink
economics and finance from the ground up,” he said, though “it did
reveal important shortcomings in our understanding of certain aspects of
the interaction of financial markets, institutions and the economy as a
whole.”

During the crisis he said the problem was not so much finding
answers to the panic “runs” on financial institutions as recognizing
“the potential for runs in an institutional context quiet different than
the circumstances that had given rise to such events in the past.”

Regulatory structures had not adapted to “shadow banking,” he said,
and weren’t attuned to detect systemic risks “as opposed to risks to
individual institutions and markets.”

Financial firm managers, traders and loan officers were encouraged
through bonus pay to take excessive risks, he said, while credit rating
agencies had conflicts of interest in gauging risk at the same time the
financial interests of managers and shareholders were “not perfectly
aligned.”

Huge financial firms were so interconnected with the system they
could for the most part not be allowed to fail because of the consequent
damage for the entire economy, he said — though there were a few very
costly failures and near failures.

The new financial reform laws “took an important step” toward
giving creditors incentives to “price, monitor and limit the risk-taking
of the firms to which they lend.” Financial firm failures will be able
to take place “more safely” and “the authorities will no longer have an
incentive to try to avoid them.”

At a more basic level of concern for the science of economics, he
said, are the areas of fundamental research that now must be developed,
like the more sophisticaed “modeling of human behavior.”

“During the worst phase of the financial crisis, many economic
actors — including investors, employers and consumers — metaphorically
threw up their hands and admitted that, given the exreme and, in some
ways, unprecedented nature of the crisis, they did not know what they
did not know,” Bernanke said.

Research on “the formation and propagation of asset price bubbles,”
and on “the determinants of liqudity in financial markets” also is badly
needed and in fact, is already under way on the Princeton campus, he
said.

Finally, “macroeconomic modeling must accommodate the possibility
of unconventional monetary policies,” he said.

“Disasters require urgent action to prevent repetition,” Bernanke
concluded. “The financial crisis did not discredit the usefulness of
economic research and analysis by any means” but it did raise “important
questions.”

** Market News International Washington Bureau: 202-371-2121 **

[TOPICS: M$$CR$,M$U$$$,MMUFE$,MGU$$$,MFU$$$]