If the U.S. economy were to plunge into a serious slowdown, the Fed currently does not have tools that are strong enough to offset it, former Fed Chairman Ben Bernanke said at the Penn Wharton Public Policy Initiative event, “Economic Crisis and Rebuilding the American Economy,” in conversation with Wharton finance professor Jeremy Siegel.

While the Fed could cut rates even further, provide more forward guidance and embark on another round of quantitative easing, “if there was a serious slowdown, and I’m not anticipating one but if there was one, the Fed is low on bullets at this point,” said Bernanke, who was on campus in mid April to discuss his book, The Courage to Act: A Memoir of a Crisis and Its Aftermath.

Chairman of the Federal Reserve from 2006 to 2014, Bernanke executed a series of unconventional moves to guide the economy through the financial crisis and the Great Recession. Following a freeze in the credit markets in 2008, the Fed aggressively slashed its target for short-term rates to near zero to encourage lending by banks and embarked on asset purchases of longer-term Treasury securities and mortgage-backed securities in bouts of quantitative easing — an effort to force down longer-term rates, which benefits home buyers and others.

But he has also been criticized for backing the bailout of AIG and Wall Street banks, as well as questioned by Congress for purportedly pressuring Bank of America – along with then-Treasury Secretary Hank Paulson — not to ditch its planned acquisition of Merrill Lynch once the extent of its liabilities was discovered. Bernanke has said the Fed acted with the “highest integrity.”

Looking back at the Fed’s actions overall, Bernanke said its moves were necessary. “The financial system is critical to the health of the overall economy and if the financial system collapsed, it would bring down everything. It wouldn’t just be folks on Wall Street who would be suffering, but it would be people in the heartland who would also be hit.” The Fed was trying to curtail a crisis that he now believes was worse than the Great Depression of 1929.

Such a responsibility made it a “very lonely” time for the Fed, Bernanke recalled. After Lehman Bros. failed and the credit markets were seizing up, the Fed had to make a decision on whether or not to bail out AIG. He remembers then-Senate majority leader Harry Reid saying in a September 2008 meeting with political leaders, “Don’t mistake anything anyone has said here as constituting congressional approval of this action. I want it to be completely clear, this is your decision and your responsibility.”

“If there was a serious slowdown, and I’m not anticipating one but if there was one, the Fed is low on bullets at this point.”

But Bernanke said the Fed’s job was to prevent a disastrous bank run: “What was clear to me was that we were at tremendous risk for another Great Depression.” Moreover, the problem went beyond the subprime mortgage market. As the extent of the banks’ overleveraging became clearer, panic spread to infect money market funds, the commercial paper market, the repo market, the asset-backed securities market and others. “Panic was in an extraordinary state and we didn’t want the panic to get worse,” he said.

It was this panic that gave $800 billion in outstanding subprime mortgages the power to jeopardize more than $100 trillion in financial assets globally. In that sense, subprime was a “modest asset class” that nearly became a “world-destroying” asset class, Bernanke said.

Why Bail Out AIG and Not Lehman?

Asked why he bailed out AIG but not Lehman Bros., Bernanke said people mistakenly assumed that he was playing favorites. Coming from academia as a Princeton professor, “I didn’t know anyone on Wall Street.” But AIG looked better than Lehman because only a part of it was in trouble and “if we took the entire company as collateral, it would have been enough” to pay back the loan it was given, he said. In contrast, the entire Lehman firm was in trouble and it did not have enough assets to secure a loan. Moreover, Bernanke said, no buyer emerged for the investment bank because it was $50 billion in the red – factors that ensured its failure.

At the time, the Fed had the authority to rescue AIG, after invoking section 13(3) of the Federal Reserve Act. Later, the Dodd-Frank Act of 2010 – regulations meant to prevent another financial crisis of 2008 – would restrict this option of lending to insolvent entities under unusual times, among other rules. But it is one authority Bernanke said he didn’t mind losing because he believes it should take a combination of fiscal and monetary efforts to handle such meltdowns.

Should the Fed have foreseen the financial crisis? Bernanke said the Fed was aware of problems in the subprime mortgage market and noticed that home prices were quite high. “The miss was not seeing the extent to which the banks were overleveraged,” he said. “You can certainly point a finger at … regulators and Congress, and private sector actors.” Bernanke added that “what made [the crisis] so bad was not just the individual decisions but the system that made all these things interact.” He likened it to a plane crash in which small errors – the pilot not paying attention, weather issues and the like — came together to result in a catastrophe.

“If the financial system collapsed, it would bring down everything. It wouldn’t just be folks on Wall Street who would be suffering, but it would be people in the heartland who would also be hit.”

Negative Interest Rates, Deflation

Since the crisis, the U.S. economy has been on the mend, with the labor market at full employment. Current Fed Chair Janet Yellen is guiding the economy through a low-interest rate environment and working through the challenge of raising rates gradually to normalized levels but at a pace that will not derail economic growth.

At the last Federal Open Market Committee (FOMC) meeting in mid-March, the Fed noted that labor market conditions are improving with real GDP (after inflation) picking up “somewhat” from prior quarters and inflation running below the long-term target of 2%, due to lower energy prices and lower prices of non-energy imports. Meanwhile, consumer sentiment has stayed elevated, stocks have rebounded from their malaise from earlier this year and the housing market is recovering. But the FOMC believes the global economy poses risks.

Japan, the European Central Bank, Switzerland and certain Scandinavian countries have cut interest rates to negative territory to revive their economies. As for the U.S., Yellen has said that the economy would have to get much worse before the Fed would consider going negative. At its March meeting, the FOMC kept the Fed Funds rate target unchanged at 0.25% to 0.50% after raising rates by 0.25% in December 2015, the first time in nine years.

During a panel discussion with three other living Fed chairmen — Bernanke, Paul Volcker and Alan Greenspan — in New York, Yellen said the U.S. economy is improving solidly with some hints of inflation and thus the Fed is on track for further rate increases, according to an April 8 story in Reuters.

Notable bond investor Bill Gross told Barron’s recently that zero or near-zero interest rates are detrimental, affecting the business models of insurance companies and pension funds that are relying on capturing a certain rate of interest, as well as demolishing the retirement portfolios of individuals. He said zero interest rates tell companies and savers about the “futility of taking on risk.” If banks charged people to hold their money, savers would keep their cash. “Without deposits, banks can’t make loans anymore, so the system starts to collapse,” Gross said.

“What was clear to me was that we were at tremendous risk for another Great Depression.”

Bernanke argues that before embarking on negative interest rates, there are ways to lower longer-term rates through other means, such as “forward guidance” — giving the market guidance that short-term rates would stay low for a while as a way to talk down longer-term rates such as mortgage rates — or quantitative easing. However, he has acknowledged that a new round of easing could be less helpful than before. A consequence of QE is that banks now hold plenty of reserves with a lesser need to borrow from each other, so Fed Funds market activity has plunged — diminishing the power of the Fed in manipulating this rate.

If the Fed had to slash rates down to negative levels, Bernanke said the goal is for banks to shift funds to other short-term assets to avoid being charged a fee on their reserves. This would fuel buying in these assets, driving up the prices and yields down, eventually dampening longer-term rates as well such as those on mortgages and corporate bonds.

But Bernanke also argued that a dip into negative territory might not make much of a difference if it is a small step. A bigger drop into the negative, though, could make people hoard cash instead of spending it. Thus far, however, other nations with negative rates have not seen much currency hoarding.

Bernanke said the Fed looked at negative interest rates in 2010. “My own reaction to this – it’s kind of a low benefit, low-cost policy,” he said. “It’s neither going to bring the world to an end nor is it going to be a savior. It’s one more thing central banks can do on the margin but it’s not a big powerful tool.”

Bernanke noted that Switzerland is at negative 75 basis points (0.75%) but the U.S. “can’t get that close.” “Storing money does have costs. We could go below zero but not much more.” The Fed’s analysis put the boundary at negative 35 basis points for the U.S.

The bottom line is that when Fed tools such as rate cuts lose some of their power, it necessitates a combination of fiscal and other monetary policies to get the economy going again. The Fed has “more bullets than other central banks, but is still pretty low. And so it would be very important to at least consider other policy makers to be engaged in this response as well,” Bernanke said. “There are bullets left, but a more balanced policy approach including fiscal policy would be much better.”