The Education of Ben Bernanke

January 20, 2008
By ROGER LOWENSTEIN
(NYT Magazine) Ben Bernanke’s first exposure to monetary policy was reading the works of Milton Friedman, the Nobel laureate. That was 30 years ago, when Bernanke was a graduate student at M.I.T., and he has been studying central banking ever since. By the time President Bush nominated him to run the Federal Reserve, at the end of 2005, Bernanke knew more about central banking than any economist alive. On virtually every topic of significance — how to prevent deflationary panics, for instance, or to gauge the effect of Fed moves on stock-market prices — Bernanke wrote one of the seminal papers. He championed ideas for improving communications between the Fed — whose previous chairman, Alan Greenspan, spoke in riddles — and the public, believing that clearer guidance about the Fed’s aims would help the economy run more smoothly. And having devoted much of his career to studying the causes of the Great Depression, Bernanke was the academic expert on how to prevent financial crises from spinning out of control and threatening the general economy. One line from his “Essays on the Great Depression” sounds especially prescient today: “To the extent that bank panics interfere with normal flows of credit, they may affect the performance of the real economy.”
Bernanke, who came to the job with a refreshing humility — a desire to be less an oracle like Greenspan than a plain-speaking technocrat —faces exactly this sort of crisis now. Ever since last summer, a meltdown in financial markets has led to daunting losses in the banking industry and throughout Wall Street. Despite having written extensively on how to deal with such episodes, Bernanke has thus far been unable to reinstill a sense of confidence. His faith in modern forecasting models notwithstanding, he failed to foresee that the sudden rise in homeowner defaults, which triggered the crisis, would have such far-reaching effects. And the monetary medicine that he has prescribed, including some of the very tools that he lovingly detailed in his research, have yet to produce a turnaround.
At the same time, Bernanke’s attempt to improve the way the Fed communicates has misfired and often left investors confused, partly because he has repeatedly shifted course over the future direction of interest rates. His hero, Milton Friedman, is said to have warned against an indecisive Fed acting like a “fool in the shower” fumbling with first the hot water and then the cold. Bernanke has gotten close. Perhaps worst of all, he has failed to persuade investors that the Federal Reserve, which was formed in 1913 for the very purpose of halting market panics, is up to the job. “Bernanke is seriously behind the curve,” says David Rosenberg, chief North American economist for Merrill Lynch, one of many critics who maintain that the Fed has not responded to the crisis with sufficient vigor.
For Bernanke, who is now 54, it has been an education unlike any at M.I.T. And yet there is a case to be made that he has made many more right moves than wrong ones. The current crisis is a hangover from a half-decade of heady speculation in both housing and home mortgages and does not necessarily admit to a speedy fix. Moreover, it has fallen into Bernanke’s lap just as oil prices have spiked to a record $100 a barrel, the dollar has hit an all-time low against the euro and unemployment has ticked upward. None other than Alan Greenspan has said that constellation of problems facing Bernanke is tougher than anything he experienced in the 18 years that he held the job.
Many observers, including Lawrence Summers, the former Treasury secretary, as well as a group of bearish stock traders, say the United States may already be sinking into a recession. The rise in unemployment reported two weeks ago stoked those fears. The White House has started talking about proposing relief. And just recently, Bernanke sent the clearest signal yet that the 17-member Federal Open Market Committee (which governs the Fed’s interest-rate policy, and over which Bernanke presides) would cut interest rates when it meets at the end of the month. In a speech, Bernanke warned that “the downside risks to growth have become more pronounced,” a gloomier assessment of the economy than he had given previously.
Bernanke also has strong reasons to worry, however, about easing rates too much. Inflation has failed to fall as the Fed expected. (In fact, lately it has been rising.) Also, lower interest rates induce foreigners to switch out of dollar-denominated investments like Treasuries and into currencies with higher yields. Thus, any rate cut would tend to escalate the stampede out of the dollar.
Perhaps the last Fed chief to face such a difficult one-two punch of inflation and slowing growth was Arthur Burns, who was also the last academic to hold the job. President Richard Nixon, concerned that high unemployment could cost him re-election in 1972, told Burns to concentrate on revving up the economy. “No one ever lost an election on account of inflation,” Nixon confidently told him. Burns did as he was directed. An eventual result was runaway inflation and, for Burns, a legacy of failure.
Bernanke is aware that he holds the same potential for influence as Burns — which is to say he has a profound ability to affect the political landscape this year. Polls show that the economy is now the most important issue to voters in the presidential election (more important even than the war). A recession would seem to be a clear repudiation of President Bush’s policies and, by extension, the Republican Party. Those who know Bernanke, however, say he is not motivated by politics. “He wants to be known as a great central banker,” says Mark Gertler, his close friend and an economics professor at New York University. “Those with the worst reputations are the ones who helped politicians.”
A wage-and-price spiral similar to that in the 1970s would not only be a political nightmare for the Republicans, it would also be a crushing blow to Bernanke’s reputation as a Fed chief. And with oil and food prices going through the roof, inflation is already a worry. The consumer price index surged 4.3 percent over the past 12 months — more than twice the inflation rate that Bernanke has delineated as the upper bound of his comfort range. (The widely watched “core” rate of inflation, which does not include volatile food or energy prices, is not as high as the overall rate, but it, too, has edged higher than Bernanke would like.)
“I think Bernanke is in a very difficult situation,” Paul Volcker told me. Volcker was the Fed chief who preceded Greenspan and who conquered, painfully, the great inflation of the 1970s and early ’80s. (He was chairman from 1979 to 1987.) “Too many bubbles have been going on for too long,” Volcker added. “The Fed is not really in control of the situation.”
… Bernanke has a serious manner, befitting a scholar who once expected to spend his entire career in academia. He is shy and seemed faintly ill at ease, stiffly folding his arms while we talked; his hand trembled slightly when he gave me one of his books. He answered questions with an absence of emotion but with a torrent of carefully worded fact.
“It’s been a challenging economic situation,” he granted, “and also a difficult, rather tenacious set of problems in credit markets. However, I have the advantage of having a terrific committee” — the Federal Open Market Committee — “and strong staff support, and I think we have a good hold and understanding of the situation.”
Behind the modesty and blandness of such remarks, Bernanke is uncommonly thoughtful and also resilient. He was late to recognize the severity of the subprime mortgage crisis, which intensified when European banks experienced credit problems in August, but he has dealt with it deliberately and creatively since then. With more than a million households facing the possibility of home foreclosure in the next year, he will need all of his resourcefulness and more. …
The Fed is facing two distinct threats — an apparent slowing of the economy over the intermediate term and a short-term market panic that has caused lenders (both banks and investors) to tighten credit lines, putting a squeeze on banks and other institutions that rely on short-term borrowing.
To ease the immediate crisis, the Fed has made credit more available through the so-called “discount window,” where it lends to private banks. Among other things, the Federal Reserve Bank is a bank — actually a group of banks with branches around the country. Lending at the discount window is one way that the Fed fulfills its unstated mission, which is to be the banker of last resort in times of crisis.
The Fed also has two formal missions that are codified in law: to promote “maximum employment” (thus its duty to head off recessions) and, of course, to maintain a stable purchasing power, which is generally interpreted as keeping the inflation rate at a tolerable level. There is a general notion that the Fed has vast powers over the economy itself. … Actually, it has very little influence over most of what makes the economy tick, like improvements in productivity, educational levels or whether commodity prices are trending higher or lower and so forth.
The Fed’s principal power is its control over the supply of money. … Its principal monetary lever is something called the federal funds rate, which is the rate that private banks charge one another for overnight loans.
The Federal Open Market Committee cannot “set” the fed funds rate by fiat; when it wants to, say, lower the rate, which as of this writing was 4.25 percent, it directs the New York Fed to inject cash into the system. The New York Fed lends money to major dealers in government securities, taking Treasuries as collateral. (Conversely, to tighten rates, the New York Fed borrows money.) This power to expand the money supply is unique. If one bank purchases bills from another, there is no net change in the banking system’s liquidity. Only the central banker, the Fed, can create new money.
The fed funds rate does not directly affect rates on car loans or leveraged buyouts or anything else. But when the fed funds rate eases, it’s an indication that the Fed has added liquidity to the system. Since the only thing banks can do with liquidity is lend it out, a flush banking system will act like a healthy heart, pumping credit into the economy.
During the Volcker era, the Fed conducted policy by adding or subtracting money until the total of bank reserves and checking accounts (what is commonly referred to as the “money supply”) reached a desired level. But with innovations in the financial system, like brokerage checking accounts, the lines between “money” and other financial assets blurred, and counting the money supply became too difficult.
So Greenspan switched the Fed’s methodology. Now it simply monitors the interest rate. If it wants to ease the rate, for instance, it keeps adding liquidity until banks react by reducing overnight rates to the target level.
During the first years of the new century, Greenspan lowered the fed funds rate to 1 percent, which was exceptionally low. Low rates were partly an attempt to revive the economy after the dot-com fiasco. In an illustration of how one bubble seems to beget another, however, the Greenspan rate cut greatly stimulated the housing industry. In particular, since adjustable-rate mortgages are determined by short-term interest rates, low rates paved the way for the explosion in ARMs, the very mortgages that lately have been defaulting at an epidemic pace.
As demand for mortgages swelled, banks began to engage in highly dubious lending practices, including issuing mortgages without verifying the income of borrowers. The Fed, which apart from its monetary role is also one of the federal agencies that regulates banks, was warned that standards were slipping. Greenspan, however, ignored the warnings, and the speculative lending continued, reaching a peak during Bernanke’s first year. Thus, in both of its main areas of responsibility — monetary and regulatory policy — Fed laxity has seemingly contributed to the current mess. Bernanke deflects such criticisms, partly because he maintains that the mortgage fiasco had many fathers and partly because he has a scholar’s disdain for perfect-hindsight-type judgments.
Bernanke has also shown his academic bent in how he runs the Fed. He has democratized interest-rate policy by giving the members of the Open Market Committee more of a voice. Bernanke’s collegial style worked at Princeton, where he taught. But as the point man for the U.S. economy in a time of crisis, perhaps the Fed chief should be more commanding, suggests Alan Blinder, a former Fed vice chairman and a former Princeton colleague.
The shadow of the czarlike Greenspan lingers over Bernanke, and as Greenspan has been promoting his memoirs and has otherwise been keeping visible, it is unlikely to go away. Greenspan was known to insist on unanimous support from committee members at critical junctures, to assure the country of the Fed’s resolve; Bernanke has not. Somewhat embarrassingly, he has suffered dissents on both ends of the spectrum. In October, a committee member voted against a Bernanke rate cut; in December, one dissented in favor of a bigger cut than Bernanke wanted.
Under Bernanke, the various Open Market Committee members have felt freer to speak their minds, and they have done so. This free speech has sometimes sounded cacophonous; the president of the Philadelphia Fed has clamored for a more hawkish policy, the Boston Fed for a dovish one. (In Fed parlance, hawks want to tighten rates; doves favor easing them.) Not surprisingly, Wall Street has found this dissonance confusing.
One of Bernanke’s Open Market Committee colleagues admits that he worries about the extent to which “democracy,” however admirable, has dulled the Fed’s aura and, perhaps, its ability to lead. On the other hand, Bernanke has held the group together (committee members respect him enormously), and the wide diversity of their opinions points to Bernanke’s greatest strength, which is teasing out a consensus.
The Federal Open Market Committee is an unwieldy and archaic body in the best of times; it includes seven Fed governors in Washington (at the moment there are only five) and the presidents of the Fed’s 12 regional banks, which are dispersed in cities like Richmond and Cleveland, in the country’s industrial centers circa 1913, when the Fed was founded.
This hydralike form is a result of the country’s abiding fear of concentrated financial power. Congress twice set up central banks in the early years of the republic but let their charters lapse. Throughout the 19th century the country frequently experienced banking panics. After the Civil War, the United States adopted a gold standard, but without a central bank, the amount of money in circulation was fixed according to the available supply of gold — a rigid structure that the economy was outgrowing. The demand for credit was variable. For instance, it was heavy in the fall when the crops came to market.

In 1907, the U.S. suffered a brutal recession in which thousands of banks failed. The panic subsided only when J. P. Morgan Sr., then 70 and semiretired, personally rescued the stock exchange. Financiers realized that America needed a public lender of last resort: a central bank.
Paul Warburg, the scion of a German-Jewish banking family, was frustrated by the primitive financial system of the United States, his adopted home, and he formed a tentative alliance with Nelson W. Aldrich, the powerful chairman of the Senate Finance Committee. In 1910, Aldrich, Warburg and a group of other bankers met in secret on Jekyll Island, off the coast of Georgia, to write a plan for a central bank. Reporters were told they were going duck hunting.
The public was highly suspicious of financiers, especially East Coast financiers, and the Federal Reserve was consciously designed to allay their fears. The regional Fed banks were to be semiautonomous, and they were chartered with their own boards, whose members were drawn from the local communities and a majority of whom could not be bankers. Political authority was vested in Washington; the Fed’s capital, however, was contributed by private banks all over the country.
In its early decades, the Fed had the ability to provide an elastic currency, but was unwilling to use its power to add liquidity except to support an influx of gold, or to finance so-called “real bills” — meaning paper backed by industrial and agricultural goods. In the ’30s, the Fed followed this principle into catastrophe. The head of the Philadelphia Fed lamented, in the midst of the Depression, “If we were to expand now we would be putting out credit when people don’t need it.” He was warning against the very tonic — a little extra liquidity — that might have allowed businesses to start investing money and hiring workers. The Fed did expand the money supply in the mid ’30s, and a recovery ensued, but it contracted too quickly, and business collapsed again.
Early scholarship blamed the Depression largely on Wall Street speculators, who were thought to have fueled overexpansion by businesses. Milton Friedman and Anna Schwartz, however, fingered the Fed for failing to adequately expand the money supply as the economy contracted. That view is now widely accepted, and Bernanke’s scholarship added a dimension by emphasizing the pivotal role of banking panics in aggravating the monetary failure. For Bernanke, the Depression was the unique laboratory for learning his craft.
Bernanke updates Bush and Vice President Cheney several times a year, but he prizes his political independence. Unlike Greenspan, he has avoided taking positions on economic issues that do not relate to the Fed’s mission. (An exception is his affirmation that he “believes in the laws of arithmetic,” a none-too-subtle rejection of the Bush ideology that championed deficit-spawning tax cuts.)
Tension with the White House was long part of the Fed chief’s job description, largely because the bank’s dual mandate (fighting inflation and promoting growth) was seen to be in conflict with itself. No president wants inflation, but most want high interest rates even less. Franklin D. Roosevelt wanted to finance World War II with cheap money, and Henry Morgenthau Jr., his Treasury secretary, simply directed the Fed to buy Treasury bills at a fixed rate of 2.5 percent. This kept rates flat, but led to inflation after the war.
The Fed was liberated from the Treasury in a famous accord in 1951. William McChesney Martin Jr., who was appointed Fed chairman that year, battled Harry Truman and successive presidents to establish the prototype for an independent Fed chief. … And it was Martin who created the quasi legend that Fed chiefs could decide an election. He tightened rates in the latter part of 1959, triggering a recession that began in April 1960. Nixon, the incumbent vice president and Republican presidential nominee that year, blamed Martin for sabotaging his chances in November.
Martin ran into even tougher pressure from Lyndon B. Johnson, who tried to browbeat him into easing rates. One version of what occurred, according to Richard Fisher, the current head of the Dallas Fed, who has studied the history, is that “Lyndon took Martin to his ranch and asked the Secret Service to leave the room. And he physically beat him, he slammed him against the wall, and said, ‘Martin, my boys are dying in Vietnam, and you won’t print the money I need.’ ” Martin ultimately caved. By the time he retired, in 1970, inflation was a worrisome 6 percent. Soon after, President Nixon told Burns to promote maximum employment. In fairness to Burns, he was laboring under the unforgiving strictures of an academic model known as the Phillips curve, which held that low inflation and economic growth were incompatible opposites. If you wanted to raise employment, you had to permit more inflation. And that’s what Burns did.
By the late ’70s, inflation was as much a psychological condition as an economic one. As prices rose, unions scored automatic cost-of living hikes, and so businesses raised prices even more. With inflation in double digits, Jimmy Carter finally nominated Volcker, an aloof, 6-foot-7 career public servant, who seemed to garble much of what he said through a half-chewed cigar. From the intelligible part, it was clear that Volcker intended to break the inflationary cycle. Volcker tightened the money supply so much that the fed funds rate soared to 20 percent. This led to a brutal recession, which was especially tough on workers and businesses in interest-rate-sensitive industries like real estate. … Idle builders were so enraged that some sent him two-by-fours in the mail. High interest rates took a terrible toll on President Carter. In September 1980, with Carter and Ronald Reagan in a close race, Volcker administered the coup de grâce by hiking the discount rate. A decade later, President George H. W. Bush blamed Alan Greenspan’s tight money policy for his own defeat.
For Bernanke’s generation, the great inflation served as a bookend to the 1930s. It was an object lesson on the dangers of creating too much liquidity. Once again, Milton Friedman changed the profession’s understanding, this time by deciding that, in the long run, the Phillips curve was wrong. Printing money (or as Friedman famously quipped, dropping bundles of bills from a helicopter) would spur the economy only temporarily. At first, as the money supply expanded, businesses would hire more workers and produce more goods. The economy would be “tricked” into operating at a higher gear. But after a while, workers would insist on wage hikes, and companies would jack up prices. The higher prices would cool off the economy again. So the net result of printing money would be just inflation — no gains in production. In the long term, neither the Fed nor anyone could spur an economy to grow faster than its “natural rate” — which is determined by all those other factors: productivity, population changes, technological advances, demand for exports and so forth.
Thus the dictum that inflation would lead to jobs was out. According to the new thinking, low inflation is consistent with, and even a prerequisite for, reaching whatever the economy’s potential is. That means that Fed chiefs and presidents are on the same side. Bill Clinton bought into the idea, which is to say he broke with precedent and left Greenspan alone. Only in the very short term — say, when a stimulus is needed — are the Fed’s two mandates in conflict. Of course, since elections are decided in the short term, the potential for political infighting remains. More