Big Ben

The biggest revelation offered by Ben Bernanke’s memoir of his time as chair of the U.S. Federal Reserve is just how much the public, the media, and especially elected officials have misunderstood the real lessons of the 2008 financial crisis and the subsequent Great Recession—events that defined Bernanke’s tenure, which began in 2006 and ended in 2014. Bernanke spends much of the book justifying what should be self-evident: that the risk of a second Great Depression called for precisely the sort of active monetary policy that he and his colleagues at the Fed pursued.

As Bernanke makes clear, the crisis was a traditional financial panic of the sort that led to the creation of the Fed in the first place. Bernanke and his colleagues responded correctly to the challenge, rapidly cutting interest rates to zero and then purchasing assets, primarily U.S. Treasury bonds, on a large scale, a practice known as “quantitative easing.” Both steps aided the U.S. economy by increasing credit availability, raising inflation expectations, encouraging investors to repurchase risky securities they had sold off during the initial panic, and generally restoring confidence.

Anyone who reads Bernanke's memoir in good faith will be impressed by the depth of Bernanke’s analysis and insight.

Unfortunately, some pundits and some radical members of the U.S. Congress have distorted that fairly straightforward story, contributing to widespread but unjustified mistrust in the Fed and leading to the imposition of legal and political constraints on the central bank that will make it much harder to save the global economy the next time a financial crisis hits. Just as troubling, misguided attacks on activist monetary policy have distracted attention from the important question of how and why the financial system became so fragile in the first place. Meanwhile, the Fed’s unwillingness and inability to preempt the panic before it spread remain unaddressed. As a result, the next time a financial crash starts, is it likely to get out of control even faster than the last one did.

ARGUING WITH SUCCESS

Anyone who reads The Courage to Act in good faith will be impressed by the depth of Bernanke’s analysis and insight, to which I can attest personally, having co-authored a book on monetary policy with him in the mid-1990s. But in his memoir, as in person, Bernanke wears his erudition lightly, accessibly and concisely explaining key elements of the modern economy (such as the importance of adequate bank capital) and also illuminating relevant issues in economic history (such as why the Great Depression was so deep). Bernanke was one of the most frequently cited and influential macroeconomists in the world prior to his joining the Fed’s Board of Governors in 2002. Without the deep understanding of the Great Depression and monetary policy that Bernanke’s earlier academic work fostered, none of the policymakers involved in the response to the crisis would have performed as well as they did.

Thus, it actually does Bernanke and other Fed officials a disservice to paint him as a uniquely heroic figure in the battle against recessionary forces; doing so minimizes just how mainstream the policies he chose actually were. Bernanke’s preternatural calm may have helped overcome the opposition of some Fed board members and congressional overseers to significant quantitative easing. But Bernanke’s academic work had already helped build a consensus among the overwhelming majority of mainstream macroeconomists about how to respond to financial panic. Put simply, they would have done the same thing in his position, albeit perhaps not as deftly.

The extent of expert support for Bernanke’s policies has been obscured by the almost hysterical rhetoric that has surrounded quantitative easing. In November 2010, Republican politicians, including Representative Mike Pence of Indiana, derided the policy as merely “printing money” and thus likely to result in high inflation without any benefits. The campaign of Mitt Romney, the GOP’s presidential candidate, repeated that charge during the race for the White House two years later; another Republican candidate, Governor Rick Perry of Texas, said that if Bernanke stuck to his “almost . . . treasonous” policies, Texans would “treat him pretty ugly.” Even today, editorials and op-eds in The Wall Street Journal regularly warn of the dangers of the hyperinflation yet to come as a result of Bernanke’s monetary activism.

Without the benefit of Bernanke’s early academic work, none of the policymakers involved in the response to the crisis would have performed as well as they did.

But quantitative easing—even on the massive scale that Bernanke undertook—is nowhere near as radical a policy as its critics claim. Central banks have bought and sold securities, including private-sector securities, for centuries. It was only during a brief period—the so-called Great Moderation, which spanned the 15 years or so prior to the financial crisis—that economists and policymakers felt confident that simple adjustments to short-term interest rates were the only tool central banks needed to move markets in line with policy goals. It’s true that economists still disagree about which kinds of assets central banks should buy, but most agree that such purchases in and of themselves hardly represent an extreme act.

What is more, few bother to dispute the good such large-scale asset purchases accomplished. As Bernanke describes, in the roughly nine months after the Fed finished its first round of quantitative easing, in March 2009, the Dow Jones Industrial Average rebounded by 40 percent after having dropped in a panicked selloff; the U.S. GDP growth rate crossed into positive territory, rising to nearly four percent; and yields on long-term U.S. Treasury bonds ticked up, suggesting that “investors were expecting both more growth and higher inflation.” Although they recognized that the yield increase was not attributable solely to the Fed, Bernanke and his colleagues rightly took it as “a sign 
of success.”

Compare those results to the record of the European Central Bank, which eschewed quantitative easing when an analogous panic hit eurozone bond markets and banks in 2010. Exactly as Bernanke had predicted in private—and as a host of others had publicly warned—the ECB’s inaction led to far higher unemployment, far greater drops in output, far faster declines in prices, and far more suffering among the European public. And although many factors were involved, it is undeniable that after the ECB promised to use quantitative easing, in August 2014, economic conditions improved: unemployment has eased, the panic has subsided, and GDP growth rates have recovered.

EVERYONE'S A CRITIC

Under Bernanke and Alan Greenspan, who preceded Bernanke as Fed chair, the central bank committed sins not of commission—pumping up a bubble, say, or reckless quantitative easing—but of omission. Specifically, the Fed neglected to take sufficient action to prevent the buildup of financial fragility during the first decade of this century, and it failed to act quickly enough in the run-up to the financial crisis. In the years before the crisis, the Fed correctly chose not to raise interest rates as a credit bubble grew; the real estate bubble would have continued to inflate anyway, and unemployment would have increased. But under Greenspan and Bernanke, the Fed failed to use its supervisory powers to curtail the buildup of financial imbalances, such as massively overleveraged bank portfolios, historically unprecedented rises in housing prices, and the proliferation of mortgages offered on the basis of little or no money down. Worse yet, under Greenspan, the Fed even encouraged excesses, such as the emergence of a nearly unregulated market for complex derivatives, the combining of multiple investment activities (including insurance and commercial banking) under one roof, and the widespread adoption of “off-balance-sheet activities” by government-insured institutions.

To his credit, Bernanke points out that Ned Gramlich, a soft-spoken but forceful and independent-minded member of the Fed board from 1997 until 2005, “felt strongly about consumer protection and was skeptical of simplistic free-market dogma.” Within the Fed, Gramlich spoke out about the risk of fraud and speculation in the real estate market. But his colleagues, including Greenspan and Bernanke, failed to heed Gramlich’s warnings about insufficient regulation.

The most credible criticism of Bernanke’s record at the Fed is not that quantitative easing was a mistake but that, once major financial firms started failing in 2007, the Fed never got ahead of events. Analysts have spent years debating whether the Fed was wrong to let Lehman Brothers collapse in September 2008 but then bail out AIG, the foundering insurance giant, later that same month. The truly critical period, however, was the year prior to those emergency decisions. The Fed took little action after the bank BNP Paribas suspended three of its funds in August 2007 owing to troubles in the subprime mortgage market, or in the months that followed, as several U.S.-based lenders failed or were taken over.

After Bear Stearns imploded in March 2008 and the Fed encouraged JPMorgan Chase to salvage what was left of the firm, many commentators and economists predicted that, at a minimum, other investment banks, such as Lehman Brothers and Merrill Lynch, were likely to fail in a similar fashion and warned that panic would continue to spread. Yet Bernanke’s memoir (like others published by people who served as high-level officials at the time) presents no convincing evidence that the Fed undertook any policies in the following weeks or months to prevent that cascade.

To be fair, this was due only in part to the intellectual blinders that central bankers were wearing; in many cases, the Fed simply did not have the authority to intervene before a company’s failure caused an overt systemic risk. Bank supervisors at the Federal Deposit Insurance Corporation can always resort to so-called prompt corrective action, a set of steps that allows them to go into seriously troubled commercial banks and, if necessary, shut them down. But neither the Fed nor any other regulators have the incentive, much less the authority, to take such action against other kinds of lenders, such as nonbank mortgage issuers, which were feeding the panic in the fall of 2008. The question is not whether the Fed or anyone else should be able to shut down a private business on a whim but whether the Fed or some other supervisor has the ability to intervene before that business causes other weak but salvageable firms to sell off their assets and fail, stirring more panic. The Fed did not have that authority during the crisis and faces even more constraints now, despite the fact that most other central banks—from the Bank of England to the Monetary Authority of Singapore to the ECB—have gained that kind of power since 2010 precisely because of the vulnerabilities that the crisis revealed.

The irony, of course, is that Bernanke’s detractors now accuse him not of insufficient boldness but of overstepping the Fed’s bounds and even abusing his power during the crisis. This charge is especially frustrating because what distinguished Bernanke as the Fed chair was his deep commitment to making the Fed more transparent and accountable—a fundamental difference between him and his two predecessors, Greenspan and Paul Volcker. Bernanke also wanted to reduce the power of the Fed chair relative to the rest of the Federal Open Market Committee, which determines U.S. monetary policy by overseeing the central banking system’s purchases and sales of securities. While in office, he lived up to both goals by giving press conferences, making media appearances, and delivering intentionally explanatory public lectures—things that his predecessors had shunned—and by encouraging the Fed board’s governors and the Fed’s regional reserve bank presidents to comment in public to a degree unheard of during the Volcker and Greenspan eras.

CONGRESSIONAL COWARDICE

Bernanke shows some restraint when writing about his opponents, particularly elected officials, but he casts the U.S. Congress as the main villain in his book—and he is perfectly justified. In its opening pages, Bernanke recounts meeting with congressional leaders in September 2008 to explain why he and Treasury Secretary Henry Paulson believed it was necessary to bail out AIG in order to avoid a full-on repeat of the Great Depression. According to Bernanke, the Senate majority leader, Harry Reid, a Democrat from Nevada, drew the meeting to a close by telling Bernanke and Paulson, “Don’t mistake anything anyone has said here as constituting congres­sional approval of this action. I want to be completely clear. This is your decision and your responsibility.” Reid’s statement was striking for its sheer pusillanimity. It was not a moral objection or a warning about acting too quickly or a plea that Congress was unprepared: it was simply an abdication of all responsibility, and it was representative of the broader congressional reaction to the crisis. Congress’ inability to deliver coherent budgets also reflected a lack of courage and made the need for aggressive monetary policy all the more urgent.

This unwillingness to take responsibility would not have been quite so objectionable if congressional leaders had not begun scapegoating and interfering with the Fed soon after Bernanke did take the necessary action. The Dodd-Frank financial reform legislation that Congress passed in 2010 has its virtues, but it also introduced a potentially harmful limit on the Fed’s ability to respond to future crises. As Bernanke describes in detail, to stem the overt panic in the early stages of the financial crisis, the Fed invoked Section 13(3) of the Federal Reserve Act, which gave it the emergency ability to buy any securities and make loans to just about anyone, instead of limiting itself to commercial banks and other traditional deposit-taking institutions. That move allowed the Fed to deal with nonbanks, such as money-market funds, insurance companies, and investment firms, which had helped create the conditions for the crisis by overleveraging and making ill-advised bets on the U.S. real estate market and on the performance of other financial firms.

Bernanke casts the U.S. Congress as the main villain in his book—and he is perfectly justified.

In the wake of the crisis, however, both left-wing and right-wing legislators strenuously attacked Section 13(3) for leading to bailouts that, as the saying went, favored “Wall Street over Main Street.” Others argued that the Fed’s emergency capacity increased the willingness of financial firms to take excessive risks. And so Dodd-Frank effectively eliminated Section 13(3), leaving the Fed with fewer options for the next time a panic draws in firms that are not traditional banks but that are nonetheless important to the financial system.

THE FIRE NEXT TIME

Today’s overly constrained Fed and insufficient regulatory measures pose very real risks, and Bernanke should have emphasized that point more in his memoir. Postcrisis reforms have strengthened the resilience of traditional banks one by one, notably by increasing banks’ capital requirements and requiring more liquidity. This should put more of the banks’ own money at stake and thus induce them to be more prudent. But microregulations alone will not prevent many financial catastrophes. Authorities can try to prevent house fires by regulating building materials, threatening to fine builders who don’t follow codes, and persuading homeowners to be extra vigilant by prohibiting insurance payments in cases in which houses burn down owing to carelessness. But cities still need well-equipped fire departments to fight blazes that erupt despite their best efforts at prevention. Limiting Section 13(3) was akin to taking away the fire department’s trucks and hoses. Without the right tools, the Fed will be able to fight only those financial fires that have already spread.

Of course, congressional distrust of central bankers is not just a recurrent theme in Bernanke’s memoir; it is a leitmotif in U.S. history. Still, such disdain seems particularly tragic and harmful to the public interest when directed at the most open Federal Reserve ever, which succeeded precisely where the central bank failed at the outbreak of the Great Depression. Congress has the right to be wary of the Fed, but it is wrong to base its doubts on the Fed’s recent performance. And as is often the case with attempts to limit the power of the U.S. federal government, congressional restraints on the Fed have diminished the American people’s economic security.

Many in the global central-banking community believe that the Fed is constrained only in theory, and that in practice, when the next crisis hits, the Fed will again improvise: at the crucial moment, its leaders will manage to act, just as Bernanke and his colleagues did. I find that faith ill founded. As Bernanke notes, during his tenure, Congress micromanaged so intently that it even tried to dictate how many people he was allowed to have in the room when making critical decisions. To this day, some seats on the Fed board remain unfilled because Republicans in Congress have refused to confirm qualified nominees or even bring them up for a vote. If Congress treated the U.S. military with that level of pettiness, it would be seen, rightly, as self-defeating. It is a sad commentary on the state of U.S. politics that a figure as open, articulate, and deft as Bernanke could not protect the Fed’s ability to act, despite having shown courage and wisdom in action.