An improvement in the economy is not too far off, Minneapolis Federal Reserve Bank President Gary Stern said Tuesday. Actions taken by the Federal Reserve to boost credit markets as well as the fiscal stimulus provided by the government should aggregate demand, he predicted.

Once the economic recovery begins, the pace of the expansion is likely to be subdued for a time, Stern said in prepared remarks delivered before the 2009 Business Law Institute in Minneapolis.

More importantly, in view of the state of the credit markets, it seems a fair bet that it will take time for momentum to build, he added.

However, by the middle of 2010 healthy growth should resume, he predicted.

Resurrecting the impaired financial system to restore a healthy, smoothly functioning system is essential for a full economic recovery, Stern said.

He noted that some markets remain closed, unable to price the financial instruments that normally trade on them. Barring an improvement in credit conditions, these market disruptions threaten to prolong the recession, Stern warned.

In addition, Stern called for a healthy banking system, helping to mitigate the problem of overwhelming demands on the banks from nonbank financial institutions that make it difficult for banks to also help smaller customers.

Stern addressed the issue that he is best known for, one he has covered extensively - some might say obsessively - the too-big-to-fail question.

Explaining his analysis, Stern said that the bottom line.is that creditors of such complex financial institutions expected, on the basis of relatively well-established precedents and on an understanding of policymakers' motivations, protection if failure threatened.

Therefore, with that expectation risk was underpriced, that leading institutions took excessive amounts, leading to an economy highly leveraged and on the brink of collapse.

Addressing the problem is essential for policymakers, Stern said, and will take center stage as the economy begins to recover.

This effort should be among our highest priorities and should focus on correcting the incentives that contributed to the problem and the instability that followed from it, he said. Proposals aimed at TBTF which fail to align incentives properly are not likely to succeed and should be avoided, else they waste valuable time and resources.

Stern, the longest-serving Federal Reserve Bank president at 23 years in the position, will officially retire in the summer.

Stern, 64, assumed the position as Minneapolis Bank president in 1985. In recent years he has been outspoken on the too-big-to-fail problem so evident in the current financial crisis. In his statement leaving the bank, Stern called the current financial crisis the most difficult he's faced in his career with the bank.

However, he added that he is confident that with Bernanke's leadership, the financial system will fully stabilize and economic growth will return.

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