This is why Paul Volcker is a legend: When he became chairman of the Federal Reserve Board in 1979, he inherited a catastrophe. Half of the central bank’s job is to ensure stable prices, but inflation had reached 13 percent, destroying the value of people’s savings, eroding their standard of living, and driving up costs for businesses. So Volcker tightened the money supply, pushing short-term interest rates up to 20 percent.
The move stamped out inflation but unleashed back-to-back recessions in the early 1980s, a surge in unemployment to over 10 percent, and a bipartisan battle cry against the Fed. Home builders, furious that high interest rates (and thus fewer mortgages) were decimating the construction industry, mailed two-by-fours to the central bank. Farmers, crushed by debt, blockaded its Constitution Avenue headquarters with their tractors. The Senate majority leader pleaded with Volcker to “give us a little air, to get [the Fed’s] foot off the nation’s neck.” But Volcker didn’t budge. He kept rates high and allowed himself to be vilified, sacrificing his short-term reputation for the long-term good of the economy. Eventually, vindication: Inflation was down to 4 percent when Volcker left the Fed in 1987, and it receded further over the next decade. By setting the stage for more than two decades of stability interrupted by only mild recessions, economists say, he guided America through the dark.
Today’s chairman, Ben Bernanke, keeps one of those two-by-fours on a bookshelf in his office. If Volcker went to war for price stability, Bernanke went to war for the Fed’s other legal mandate: maximum employment. This part of the bank’s mission is to foster the kind of economy that will put people to work—a tough job during and after the worst financial crisis since the Great Depression. The bank bailout, the auto rescue, the 2009 stimulus bill, and the Fed’s low interest rates may have averted a deeper recession, but the job market remains moribund. Today, 7.9 percent of Americans are still unemployed, and millions of others have simply stopped seeking work, meaning they’re not even counted in the jobless rate.
So Bernanke got creative. He has done things that no Fed chairman had ever thought of. To pile-drive long-term interest rates, he bought Treasury bonds and mortgage-backed securities; replaced one kind of security in the Fed’s portfolio with another; and began describing the central bank’s long-term strategy so investors would know when they might expect higher rates. All of which has elicited a (mostly partisan) backlash to rival Volcker’s. Conservative economists, who at first congratulated the Fed for preventing deflation, now fear that Bernanke has set the stage for inflation and ignored the price stability Volcker fought so hard to ensure. On the campaign trail in 2011, Texas Gov. Rick Perry accused Bernanke of treason and even hinted that the chairman might face bodily harm if he visited Perry’s state. Republicans in Congress say the chairman has turned the Fed into a fourth branch of government and warn that he could induce another economic crisis by nurturing an asset bubble. In a hearing this week, Sen. Bob Corker, R-Tenn., called Bernanke soft on inflation. “I don’t think there’s any question that you would be the biggest dove, if you will, since World War II,” Corker said.
Volcker, at 6 feet 7, was a brusque, cigar-puffing behemoth who cowed congressional opponents of his inflation-fighting crusade. But Bernanke, who prefers to build consensus, is more diffident. He has sought—and failed—to win over skeptics by force of argument. He is no less steely in the face of criticism, but he has not been able to shut it down. So an old movement has revived to take away the Fed’s max-employment mandate. While Republicans mull how to clip Bernanke’s wings, the two-by-four in his office reminds him that unpopular decisions today don’t preclude absolution tomorrow. If you have the courage of your convictions, a lumber beat-down is just part of the job.
THE DUAL MANDATE
Economics is a soft science. Better models and controlled experiments have improved its accuracy over time, but in the postwar years, economists still relied heavily on correlation and guesswork. One theory popular in the 1960s and ’70s held that if policymakers were willing to tolerate higher inflation—say, 6 percent instead of 2 or 3 percent—they could hold down the jobless rate by keeping interest rates low and getting people to spend money. This turned out to be ruinously wrong: Surging prices made employers hesitant to hire, which is why stagflation (high inflation, low growth) crippled the country in the 1970s.
A corrective arrived in 1977, when Congress gave the Fed new marching orders: It was to seek both maximum employment and stable prices—a “dual mandate.” Right away, some economists worried that the two objectives could work at cross-purposes. At a meeting in 1978, Volcker, who was then head of the powerful Federal Reserve Bank of New York, said the instructions could leave the central bank in an “awkward position.”
Volcker, his successor, Alan Greenspan, and other Fed officials found a way around that awkwardness. For years, when members of Congress hauled them to Capitol Hill to ask what the bank was doing to promote maximum employment, they simply said that low and stable inflation would do the trick. In other words, don’t look for a quick fix. Employers wouldn’t hire and the economy wouldn’t grow quickly amid runaway prices. Recalling the unpopular heroism of the Volcker years, Fed officials after him told the oversight committees that they needed enough independence to make tough inflation-fighting calls, and that lawmakers should back off their employment complaints.
Over the years, this view—that growth depends on stable prices—took hold. Conservative opponents of the dual mandate, including those at the Fed, say the bank can’t do much to influence the job market anyway, so it should focus narrowly on its main policy lever (short-term interest rates) to fight inflation or, in rare cases, to prevent price declines known as deflation that tend to occur only in severe downturns such as the Great Depression. During the 1990s, Sen. Connie Mack III, a Florida Republican, pushed a bill that would have made price stability the Federal Reserve Board’s main objective. The bill found support among some Fed officials, including presidents of its regional banks.
If conflict between the two mandates was just a theoretical menace, conservatives saw a more immediate cause for anxiety when Bernanke began his Shermanesque march on joblessness. Suddenly, it seemed possible that all of the Fed’s new tools (its bond-buying schemes and its declarations of long-term intent) put entirely new incentives in place. When interest rates stay low, conservatives said, investors “reach for yield”—the practice of taking riskier but potentially more rewarding positions. Safe securities (long-term Treasuries or high-quality corporate bonds) no longer offer big returns, so buyers might rush into stocks or junk bonds, causing an asset bubble. Esther George, president of the Federal Reserve Bank of Kansas City, voted in January against continuing the board’s “quantitative easing” program because she thinks “financial imbalances” could make the country vulnerable to another crisis.
With the biggest financial fires of the crisis now out, the dual doubters are pressing their case. They say Bernanke is giving the economy a “sugar high” that will ultimately send prices soaring. That’s why, last month, Republican Sens. Corker and David Vitter of Louisiana introduced the Federal Reserve Single Mandate Act of 2013, which would direct the bank to seek “long-term price stability [and] a low rate of inflation.” By stripping the max-employment mandate, they hope to give the bank less leeway to take the kinds of actions Bernanke has favored. The dual mission fostered “within the Fed an overconfidence in their abilities, especially recently,” Corker says. “This most recent quantitative easing … is about one thing, and it is about unemployment.”
On the other side, most economists see less to worry about. The Consumer Price Index has been running at an annual rate of 1.6 percent, below the 2 percent rate that even inflation hawks view as moderate. The PCE deflator, an inflation gauge the Fed watches closely, is at an even more modest 1.3 percent. Bernanke has a Zen demeanor, but when Corker attacked his anti-inflation credentials at the Tuesday hearing, he shot back. “You called me a dove. Well, maybe in some respects I am,” he said. “But on the other hand, my inflation record is the best of any Federal Reserve chairman in the postwar period. Or at least one of the best.”
Removing the employment mission would allow the Federal Reserve—one of the few institutions that can shape the economy—to stand by and do nothing about the 7.9 percent unemployment rate, dual defenders say. Harvard economist Benjamin Friedman teased out this scenario in a 2008 paper that envisions a Senate hearing during an economic crisis with 17 percent unemployment. With only prices to worry about, the Fed chairman could tell the panel that he is “pleased to report that during the past year U.S. monetary policy has been outstandingly successful.” The chairman might cite an inflation rate of 1.5 percent and conclude by saying, “My colleagues and I are here to accept this committee’s congratulations and those of the American people.” This is reductio ad absurdum, but it’s not impossible in a future where the Fed doesn’t bother about jobs.
For now, critics on the Fed’s left argue that the bank has done too little, not too much, for the job market. “Do you agree that at least for the next few years the danger of inflation is quite low?” Sen. Chuck Schumer, a New York Democrat, asked Bernanke at a hearing last summer. Yes, the banker responded, and there was even a modest risk of deflation. Schumer went on: “And you certainly agree that unemployment has been too high and is sticky, and despite ... two false starts, that we’re having a much rougher time than we ever imagined getting unemployment down?” Bernanke agreed. “So, get to work, Mr. Chairman,” the senator said, chuckling.
As long as Democrats control the White House or at least one chamber of Congress, they will not let lawmakers clip the Fed’s wings. But Republicans could protest (and have) by throwing obstacles before nominees to the central bank’s Board of Governors or proposing legislation to audit its interest-rate decisions—proposals that the Fed sees as threats to its independence, sources there say.
WHAT BEN KNOWS
Bernanke, famously, sees the Great Depression—the focus of his academic work—as a foundational event. “He said, ‘Well, look, if you want to understand geography, study earthquakes,’ ” says Mark Gertler, Bernanke’s longtime friend and coauthor. “The Great Depression was the greatest economic calamity in modern times, so his feeling is he’d get insights about the economy by studying the Depression.” The chairman declined an on-the-record interview for this story.
When he studied the Depression’s bank failures and credit turmoil, Bernanke found that those conditions weren’t merely symptoms of the crisis; they were factors in worsening it. The takeaway: When credit markets seize up, they must be repaired to prevent broader damage to the economy. Growth is not just the end, but also a means, of recovery. Those conclusions built on the work of economists Milton Friedman and Anna Schwartz, who had linked overly tight monetary policy—caused by the adherence to the gold standard—to the severity of the Depression.
Central bankers’ caution makes sense in normal times, Bernanke has argued, but they must be willing to try unorthodox methods in a crisis, as President Roosevelt did when he abandoned the gold standard in 1933 and created the Federal Deposit Insurance Corp. “The country is lucky that it was Bernanke who was chairman during these exceptional times,” says former Federal Reserve Governor Laurence Meyer, now a senior adviser to the research firm Macroeconomic Advisers. “He wrote the playbook of what policy tools were available when you hit the zero bound [on interest rates]. And, basically, he went through that playbook.”
The country first got a peek at this playbook in a speech Bernanke delivered to the National Economists Club in November 2002, shortly after he left Princeton University to become a Fed governor. He outlined a set of unconventional tools the bank could theoretically use if it were ever confronted with 1930s-style deflation: commit to keep short-term rates low for a specific period; make loans to the private sector indirectly through banks; and buy foreign or domestic government debt that it could use in case its main policy lever, short-term interest rates, ever approached zero.
When Bernanke was nominated as Fed chairman in 2005, liberals worried that he might focus too much on price stability. As an academic, he had advocated inflation targeting, a practice used by other central banks in which they spell out specific inflation goals, helping investors predict when they might raise and lower interest rates. To some Democrats, this was code for caring more about inflation than employment. But Bernanke has always said that the dual-mandate serves the country well.
And when the financial crisis struck, he proved it by bringing out his 2002 playbook. The original fear was deflation, but he put it to work against joblessness, too. In 2008, the Fed explicitly cited “maximum employment” in a policy directive, something it hadn’t done in the 30 years since the adoption of the dual mandate, according to a study by Daniel Thornton, a senior official at the St. Louis Fed. It also provided loans to institutions other than commercial banks for the first time since the 1930s. It orchestrated the takeover of investment bank Bear Stearns and lent emergency cash to insurance giant American International Group. Between December 2007 and December 2008, the central bank chopped the federal-funds interest rate down from 4.25 percent to near zero.
Since the rate couldn’t go any lower, the Fed then began buying up securities in 2008, including mortgage-based and Treasury bonds, as way to inject more money into the struggling economy. It racked up $1.7 trillion in purchases during that first round of quantitative easing, which continued into 2010. QE2, an additional $600 billion in purchases, followed in November 2010, and QE3 began in September 2012. This last was particularly unorthodox. Rather than buying a fixed amount, the Fed made an open-ended pledge to purchase tens of billions of dollars in mortgage-backed securities each month until the labor market improved “substantially.” The bank now has $3 trillion worth of assets on its balance sheet, more than triple what it had in 2008. This was no longer solely about prices.
The more the Fed experimented, the more inflation hawks grumbled that attempts to bring down unemployment were sowing future economic risks. By the time QE2 got started, a New York Post headline declared, “Open Season on Ben.” During the Republican presidential primaries, Mitt Romney, Newt Gingrich, Rick Perry, and Herman Cain all vowed to replace Bernanke, a Republican, if elected. Perry threatened: “If this guy prints more money between now and the election, I don’t know what you all would do to him in Iowa, but we would treat him pretty ugly down in Texas.” (Unfazed, Bernanke did a town-hall meeting with soldiers and their families in Fort Bliss, Texas, three months later.) Vitter and Corker began working on their legislation early this year.
Some GOP critics are especially incensed by what they see as Bernanke’s betrayal of President George W. Bush, who nominated him. They say that he shouldn’t be “printing money” to pay for a Democratic president’s reckless fiscal policies. What’s more, Bernanke launched the ambitious QE3 just two months before the presidential election. On Nov. 7, U.S. News & World Report ran a column headlined, “How Ben Bernanke Helped Obama Win,” voicing a common GOP sentiment.
More substantively, Republicans say the Fed has now fired all its ammunition. “It’s time to face the reality that we have reached the limits to anything monetary policy can do to help the economy,” House Financial Services Committee Chairman Jeb Hensarling, R-Texas, said in statement this month. Or, as Marvin Clark, the managing principal of Monsoon Wealth Management, wrote of QE3, “The nominal effect is tantamount to pouring a third cup of Starbucks coffee down a drunk to sober him.”
But Bernanke doesn’t see it that way. The bank pledges to continue buying bonds every month and to keep the federal funds rate down until joblessness falls to 6.5 percent, meaning it clearly believes it has more ammunition and that failing to fire it would defy the legal mandate to maximize employment. And so Bernanke is moving ahead with his efforts to revive the economy, undaunted.
J.D. Foster, an economist at the conservative Heritage Foundation who served in George W. Bush’s Office of Management and Budget while Bernanke was at the Council of Economic Advisers, offers a hypothesis to explain why the Fed chairman can steam ahead amid the criticism: He cares so much about the plight of ordinary Americans that he’s willing to take certain macroeconomic risks. “Here you have a fellow from a small town in South Carolina,” Foster says. “He sees millions of Americans unemployed. He sees lingering unemployment, economic pain across the country.… In his judgment, the risks that I’m so worried about can be contained and he can make these people’s lives better without risking inflation.”
Bernanke certainly hinted at this philosophy just after he assumed his post. He had returned home to Dillon, S.C., in 2006 to accept the state’s Order of the Palmetto. He spoke of his childhood, working at the family’s drugstore, playing saxophone, and attending the small local synagogue. And he pledged to remember the people in his work in Washington. “I try not to forget what underlies all those data: millions of Americans working hard, trying to better themselves economically, struggling to manage their family finances, and worrying about the price of gas and college tuition,” he said. “I take my work extremely seriously because I know that, if my colleagues at the Federal Reserve and I do our jobs right, we will help our economy prosper and give more people the economic opportunities they seek.”
In other words, Bernanke is going to do the job Congress gave to him, and, darn it, he’s going to do it. If members of Congress don’t like that, they should change the law—which, he is careful to point out, is their prerogative. Until then, he will do what he can to combat high unemployment.
Bernanke probably has just 11 more months to bring his critics around. The chairman’s second term expires next January, and people close to him believe he is tired after seven defensive and turbulent years at the helm.
Potential candidates to succeed him include Fed Vice Chairwoman Janet Yellen; former Treasury Secretary Timothy Geithner; former White House economic adviser and ex-Treasury Secretary Lawrence Summers; former Fed Vice Chairman Roger Ferguson; and White House chief economist Alan Krueger. Yellen, at least, has been explicit in her focus on the unemployment side of the Fed’s dual mandate. But no matter who gets the nod, the debate over Bernanke’s unconventional job-maximizing tools will rage on.
And that, perhaps, is the biggest difference between Bernanke and Volcker. Circumstances demanded that both men worry more about one of the Fed’s two missions. Both hunkered down through the onslaught. And both had to await posterity’s judgment. Volcker’s canonization began in the mid-1980s, during his second term as chairman. But Bernanke must keep waiting. It could be years before we know whether he was the goat who spurred an asset bubble and set the stage for inflation—or the dogged economist who, like Volcker, guided America through the dark.