I remember congratulating Alan Greenspan on his timing when he retired as chairman of the Federal Reserve Board in 2006. He left with a reputation for limitless, inscrutable wisdom -- and the stresses he let build up in the economy were going to be somebody else's problem. As it turned out, the crash that Greenspan's policies helped to cause was the worst since the Great Depression. So the books on Greenspan's tenure at the Fed were reopened; the man himself recanted his previous views on the economy; and his reputation was trashed, most avidly by people who had previously led the cheers.
History will not put Greenspan alongside, say, Paul Volcker on the roll of great Federal Reserve chairmen. But is such a place something that Greenspan's successor might aspire to?
Of course. Why else take the job? Ben Bernanke, just named by President Obama to a second four-year term starting in January, has had to cope with the immediate consequences of the financial crisis. He has taken the Federal Reserve into unexplored and even constitutionally dubious territory. His performance may not have been flawless, but the boldness of his interventions -- such a contrast with his quiet, scholarly demeanor -- has been amazing. And the innovation is by no means over.
Conventional monetary policy confines the Fed to influencing interest rates, aiming for moderate growth and low inflation. This already looks passé. Crisis management has given the Federal Reserve an enormous new quasi-fiscal role as well: It has done things, to the tune of trillions of dollars, that the Treasury Department could not do because Congress would never have let it. Next, if the Obama administration gets its way, comes another huge expansion of the Fed's powers. The White House's proposals for financial regulation envisage the institution as a kind of super-regulator.
Bernanke will be around to supervise both the unwinding of his unorthodox financial interventions -- no easy task -- and the creation of the new regulatory apparatus. If he makes a success of all that and the economy stages a convincing recovery, you can bet that he will go down as one of the great Fed chairmen. But making a success of it won't be easy. A lot is still wrong with the economy, much of it beyond the Fed's reach, however creative Bernanke may be. And Congress is understandably reluctant to bestow greater powers on an institution that it partly blames for causing the mess in the first place. Lawmakers are not going to smooth Bernanke's path.
His performance may not have been flawless, but the boldness of his interventions has been amazing.
For an absorbing and balanced appraisal of Bernanke's performance so far, read In Fed We Trust: Ben Bernanke's War on the Great Panic by David Wessel, The Wall Street Journal's economics editor. In my view, this is the best of the many books on the economic crisis to have appeared so far. It gives a closely reported account of how Treasury and the Fed responded to the emergency as it unfolded, vividly describes the main actors and their roles, and provides along the way an accessible guide to the underlying economic and financial issues.
Wessel rightly criticizes the Federal Reserve, both under Greenspan and during Bernanke's first 18 months as chairman up to the summer of 2007, for not seeing what was coming. One particular oversight, of course, was the failure to regulate the subprime mortgage business. Wessel quotes Bernanke owning up to this, but only halfway. "Regulators did not do enough," Bernanke said in a speech this year, "to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation." That is true, Wessel points out, but in the end the Fed used its existing authority to put new restrictions on subprime mortgages, proving, he says, that "it could have done more than it did and earlier."
As Wessel also relates, Bernanke's response to the gathering emergency was initially timid even after he had grasped the possible scale of the problem. The Fed began experimenting with new ways to lend to banks only at the end of 2007, and only at the beginning of 2008 did it "get serious about cutting interest rates aggressively."
Between the Fed-supported sale of Bear Stearns in March 2008 and the collapse of Lehman Brothers six months later, Bernanke, Treasury Secretary Henry Paulson Jr., and Timothy Geithner (then at the New York Fed) failed to prepare either their respective institutions or the country for the next explosion. What was needed was a resolution plan to handle the collapse of big nonbank financial firms, akin to the template used by the Federal Deposit Insurance Corp. when it takes over a deposit-taking bank.
Bear Stearns served federal officials notice of this need, but they did not address the issue by the time Lehman failed. These officials' decision to let Lehman collapse rather than rescue it -- lacking a resolution plan, they had no third course -- shut down the credit system and brought the economy to the edge of the abyss.
"Bernanke and Paulson argue that Congress wouldn't have acted in the spring and summer of 2008 because members didn't perceive the Main Street economy to be at risk," Wessel writes. "Perhaps. But Bernanke and Paulson didn't try. Had they done so, they might have had more credibility later when they needed it. If the two men had a game plan, they didn't explain it."
This will be Bernanke's greatest challenge -- to unwind the Fed's interventions promptly, but not too promptly.
So there is plenty to criticize. Self-evidently, the Federal Reserve failed at crisis prevention, under both Greenspan and Bernanke. But once the emergency was upon us, Bernanke and his team did not hold back. No doubt, talk of another Great Depression was always a little hysterical: An unemployment rate of 25 percent was never in the cards. But this recession could certainly have been longer and deeper than it now looks likely to be. Recent figures show that the decline in output has slowed and that the economy may be at or close to the bottom.
Give some credit for this to the fiscal stimulus and the Federal Reserve's unprecedented interventions. After Lehman, the Fed's operating principle was "whatever it takes." Wessel praises Bernanke for holding "the Federal Open Market Committee [the policy-setting body] together as he pushed the Fed to places it had never gone before, or at least to places it hadn't visited since the Great Depression."
The scale of these interventions is staggering. Adding it all up one way, economist Nouriel Roubini of New York University reckons that Treasury and the Federal Reserve have committed $12 trillion to help the financial markets in the form of bank recapitalization, liquidity support, asset guarantees, expanded deposit insurance, and other measures. Of that, about a quarter has already been spent.
The Federal Reserve has raised the money for part of this initiative by, in effect, printing it. At some point, though, it will have to withdraw the liquidity it has pumped into the financial system. This will be Bernanke's greatest challenge -- to unwind the Fed's interventions promptly, before the flood of liquidity starts to push inflation up, but not too promptly, which might send the economy back into decline.
Getting this right may be a matter of luck more than skill. A strong recovery would make things easier. Not least, it would help Congress and the administration get public borrowing under control. If the recovery is slow, the budget deficit will be much more difficult to reduce, and Treasury will have to continue selling government debt at a rapid pace to finance it. Those debt sales, would, in turn, complicate the Fed's efforts to shed the long-term Treasury securities and other assets it has unconventionally acquired as part of its liquidity support operations.
The question is whether the capital markets would have the appetite to acquire all that debt, once the Fed becomes a seller rather than a buyer. Investors might demand a higher rate of return in exchange. If so, long-term interest rates would rise, further slowing the recovery. If the coming expansion is so tepid that a second fiscal stimulus is needed -- which is entirely possible -- the problem is compounded.
The Fed cannot control the budget or the resulting supply of government debt. That is for the Treasury and Congress to do. And for the time being, the Fed has little or no control over the pace of recovery. Interest rates are already at zero, and it has thrown everything it can think of at the financial markets.
In a way, matters are out of Bernanke's hands. Everything now depends on how quickly confidence returns within the economy at large, and especially among consumers. People have seen the value of their houses and their savings -- in many cases, one and the same -- collapse. Will households try to rebuild their wealth quickly, or take their time about it? A new mood of frugality, desirable as it might seem in some ways, would brake the recovery and mightily complicate the Federal Reserve's exit strategy.
Interesting times. If I were Bernanke, I'm not sure I would have wanted a second term.
This article appeared in the Saturday, September 5, 2009 edition of National Journal.
Want to stay ahead of the curve? Sign up for National Journal’s AM & PM Must Reads. News and analysis to ensure you don’t miss a thing.
Join the Discussion