Bernanke's Test: Ben Bernanke, Alan Greenspan, and the Drama of the Central Banker

Table of Contents

Title Page

Epigraph

Introduction

PART ONE - THE STAGE IS SET: THE HISTORY OF THE FED AND THE UNDERTAKER’S ...

Chapter 1 - The accidental creation of a powerhouse

Chapter 2 - Volcker’s inflation-fighting crusade

Chapter 3 - High praise for a controversial chairman

Chapter 4 - The education, private life, and ascent of Alan Greenspan

Chapter 5 - The principles behind the rules

Chapter 6 - Avoiding deflationary paralysis

Chapter 7 - Regulatory refusal

Chapter 8 - Consumption gets out of hand

PART TWO - BEN BERNANKE AND HIS INTIMATE KNOWLEDGE OF THE GREAT DEPRESSION

Chapter 9 - Bernanke begins

Chapter 10 - The bubble controversy

Chapter 11 - A genuine free marketer

Chapter 12 - A controversial governor

Chapter 13 - The subprime crisis sets in

Chapter 14 - A once-in-a-generation event

Chapter 15 - The odd twins

Chapter 16 - Falling like autumn leaves

Chapter 17 - Europe collapsing

Chapter 18 - Crisis drivers

Epilogue

Acknowledgements

Bibliography

Endnotes

Index

Copyright Page

MILITARY HISTORY IS WRITTEN BY THE VICTORS. ECONOMIC HISTORY IS WRITTEN, TO A LARGE EXTENT, BY CENTRAL BANKERS. IN BOTH CASES, YOU HAVE TO TAKE OFFICIAL ACCOUNTS WITH A LARGE DOSE OF SALT.

—Steve H. Hanke, 2008

LIKE A GOOD NOVEL, EACH PHASE IN ECONOMIC HISTORY HAS ITS VILLAINS, HEROES, AND DEFINING MOMENTS. OFTEN, IT IS ONLY WITH HINDSIGHT THAT WE CAN IDENTIFY THEM.

—Claudio Borio & William White, 2004, p. 1

I BELIEVE THAT BANKING INSTITUTIONS ARE MORE DANGEROUS TO OUR LIBERTIES THAN STANDING ARMIES.

—Thomas Jefferson, 1802

Introduction

ON MONDAY, JANUARY 21, 2008, AS MOST AMERICANS enjoyed the Martin Luther King, Jr. Day holiday, Ben Bernanke was hard at work. Bernanke, chairman of the American central bank, the Federal Reserve Board (Fed), was toiling away in his office in the majestic Fed building on Constitution Avenue in Washington, D.C.

Bernanke was worried about the ongoing fall in equity prices all over the world. The U.S. markets were closed, but U.S. stock futures still being traded indicated that a sharp downturn was on the horizon. Bernanke feared that on top of the ongoing credit crisis caused by the collapse of the subprime mortgage market in August 2007, a major crash in the stock markets was developing. The consequences of such a scenario were nightmarish, not only for the United States but also for the entire world. The former Princeton University professor, an authority on the American Great Depression of the late 1920s and 1930s, decided that urgent, bold action—a dramatic rate cut—was needed.

That day, Bernanke contacted his two most senior colleagues: Don Kohn, the Fed’s vice chairman, and Tim Geithner, the president of the New York branch (the Fed is headed by a chairman, and each of the twelve branches has a president). The three men were in agreement that prompt reaction by the Fed to short-term market gyrations might have adverse consequences, but they concluded that the bold monetary action they were considering for the next regular meeting (January 30) of the major decision-making body of the Fed, the Federal Open Market Committee (FOMC), should be brought forward immediately instead, and they quickly organized a videoconference of the FOMC for 6 p.m.

During the videoconference, Bernanke argued forcefully for his proposal with several FOMC members, voicing strong reservations about the idea of a drastic rate cut. By the end of the day, Bill Poole, president of the traditionally hawkish St. Louis branch of the Fed, refused to go along with the idea. Nonetheless, Bernanke gathered a strong enough majority to push through his proposal.

At 8:20 a.m. on Tuesday, January 22, the Fed slashed its main policy interest rate, the federal funds rate, by 75 basis points—the largest single cut since the 1980s, when the Fed began to use the federal funds rate as the cornerstone of its monetary policy. The markets reacted positively and reversed the downward trend—at least temporarily. A bit of a shock to world markets occurred later that week, when it was revealed that Jérôme Kerviel, a trader at the French banking house Société Générale, had piled up financial trading losses to the tune of $5 billion. Hence, the Financial Times declared it the week that shook the world.¹ At the time, few expected that even worse weeks were to come.

The historic January 22 move by Bernanke and the FOMC figured prominently on the front page of newspapers around the world. Pundits and analysts by the dozens proclaimed that something extremely important had happened at the world’s most important central bank. The extensive media coverage devoted to the January 22 rate cut and the personalities behind it highlight the ways in which the role of the Fed chairman has changed. Over the last two or three decades, Fed chairmen have gone from being nearly anonymous bureaucrats working in fortress-like buildings to something approaching pop stars. They have, in fact, become household names. This switch can to a large extent be attributed to Bernanke’s predecessor, Alan Greenspan.

Greenspan served as chairman of the Fed for more than nineteen years, and it was from him that Bernanke inherited the credit crisis and related problems in the U.S. economy. During his tenure, Greenspan became as well known as some Hollywood celebrities. His counsel was sought on all manner of economic issues, and even though his comments were usually vague and restrained, what little he did say was taken very seriously, both in the United States and abroad.

While the public perception of central banking has changed dramatically over the last few decades, the core issues of central banking have hardly changed at all. The two most significant issues are the Fed’s mission and its position within government. Bernanke very eloquently described the first of these issues, the mission of a central bank, in a speech at a conference organized by the Atlanta Fed:

Economic growth and prosperity are created primarily by what economists call real factors—the productivity of the work force, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. But extensive practical experience, as well as much formal research, highlights the crucial supporting role that financial factors play in the economy … Healthy financial conditions help a modern economy realize its full potential.²

Central banks bear the primary responsibility for creating and maintaining those healthy financial conditions. This requires price stability and a sound and efficient financial system. Arguably, central bankers’ most important role among these responsibilities is their ability to act as lender of last resort—their power, in other words, to create money.

One of the most important phrases Bernanke used in his speech is a reference to banks playing a supporting role: central banks can create a positive environment, but they cannot singlehandedly create growth and prosperity. To put it another way, they can mess things up terribly for growth and prosperity by instituting policies and/or tolerating developments that jeopardize healthy financial conditions.

Bill Poole, the aforementioned former president of the St. Louis Fed, once remarked, The most serious employment disaster in U.S. history was the Great Depression, which was a consequence of monetary policy mistakes.³ These mistakes are often cited as primary causes of the Great Depression,⁴ but other factors, such as the spread of trade protectionism, also contributed to the event. On the other hand, when central bankers do their job properly and keep healthy financial conditions in place, other forces often get the credit; the contribution of the monetary authorities is all too often taken for granted.

The second core issue regarding central banking is the authority and accountability central banks have in the democratic societies in which they exist. Renowned economist Milton Friedman once quipped that central bankers’ main goals are avoiding accountability on the one hand, and achieving public prestige on the other.⁵ Both history and economic research show quite unequivocally that a central bank can only create healthy financial conditions if it is given real and substantive independence from political authorities. Many recent economic calamities can, in fact, be traced back to politicians abusing monetary policy for political reasons.

But if central banks are given complete independence from elected governments, how can they be held accountable? That’s a difficult question to answer, and it’s one that democratic governments all over the world are struggling with, as many other countries have adopted the U.S. model of a central bank. Obviously, increased transparency is crucial, but the exact formula for balancing accountability and independence is still a work in progress. You could call it a democratic deficit: a structural flaw built into the modern idea of central banking. However, it’s a flaw that, many economists would likely agree, greatly benefits society as a whole. As The Economist recently declared, Central banks have done more than enough to justify the argument that monetary policy should be run by technicians rather than by elected politicians.⁶

In addition to this lack of accountability, central bankers often further obscure their work behind the spectacularly complex (or at least esoteric) language they use to communicate with the outside world. In this arena, Alan Greenspan was the master of masters, as illustrated by the following quote: Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said. Even more to the point is this statement, also from Greenspan: I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant.⁷

Given utterances like that, it is hardly surprising that Greenspan is often criticized for being obtuse, with a penchant for sentences more akin to James Joyce than John Keynes.⁸ Greenspan’s obfuscations bred a proliferation of analysts who specialize in deciphering what central bankers really say when they speak.

Lack of accountability and the use of strange language reinforce the impression that central banks specialize in secrecy, or at least in obscurity. Historically, writes author and banking expert Martin Mayer, no occupation has been more secretive … Bank secrecy is in the bones of central bankers.⁹ Economist and current governor of the Bank of England Mervyn King illustrates this point further:

When I joined the Bank of England in 1991, I was fortunate enough to be invited to dine with a group that included Paul Volcker. At the end of the evening, I asked Paul if he had a word of advice for a new central banker. He replied—in one word—mystique. That single word encapsulated much of the tradition and wisdom of central banking at that time.¹⁰

The late Karl Brunner, a highly respected monetary economist, saw central banking as traditionally surrounded by a peculiar and protective political mystique … The mystique thrives on a pervasive impression that central banking is an esoteric art. Access to this art and its proper execution is confined to the initiated elite.¹¹

And it’s an elite that does a very important job. A poorly managed central bank can seriously harm a country’s growth and prosperity and, as Harvard professor Benjamin Friedman has persuasively argued, economic growth in turn is a very important determinant of the moral qualities of a society.¹²

In recent decades, important work has been done in the fields of monetary theory and policy. The theoretical basis supporting the work of central bankers has expanded dramatically.¹³ Nevertheless, a lot of questions and unsettled issues remain. Echoing similar remarks by economist and Princeton faculty member Alan Blinder from the 1990s, Fed governor Frederic Mishkin noted in 2007: Monetary policy will always have elements of art as well as science.¹⁴

Despite all the magic or complicated wisdom surrounding central banking, the people in charge of monetary policy and supervision remain flesh-and-blood men (unfortunately, women in leading positions in the world of central banking have been extremely rare, so far). Their job performance is affected by their personalities, intellectual and ideological convictions, and assumptions about the economy, monetary processes, and the specific circumstances of the times in which they serve. To understand central bankers and to come to a balanced judgment on their track records, one must take all these elements into careful consideration.

This book closely examines the two most recent chairmen of the Federal Reserve Board, Alan Greenspan and Ben Bernanke. It is no exaggeration to say that these two men are the central figures in the dramatic developments since financial crisis emerged in August 2007 as the American subprime mortgage market collapsed.

Much of the first part of this book focuses on Greenspan. After a (very) short overview of the history of the Fed, with some attention paid to Greenspan’s predecessor, Paul Volcker, I’ll explore Greenspan’s personality, but most of the attention is on Greenspan’s record as the captain at the helm of America’s monetary ship. Until recently, Greenspan’s tenure was widely considered to have been exemplary. Recently, though, there has been a considerable reevaluation of some of his decisions.

This book takes a nuanced position in this discussion, concluding that, with respect to interest rate policy, criticism of Greenspan’s record with hindsight is perhaps legitimate—but a little bit facile. However, in terms of the regulatory duties of the Fed, Chairman Greenspan put in a performance that can at best be described as mediocre. In this sense, the man bears direct responsibility for the subprime crisis and its aftermath.

The second part of the book focuses on Ben Bernanke, the man who now finds himself in the eye of the worst financial storm since the Great Depression. Bernanke was in a sense born to be at the helm of the Fed at this time. This book’s overview of his life and career as an outstanding academic economist shows that there is probably no other person alive today with a more intimate knowledge of the economics and mechanics of the disastrous period known as the Great Depression, which hit the United States and the rest of the world in the late 1920s and the 1930s. Bernanke, more than any other living economist, has focused intensely on this period in his research.

Much of Bernanke’s research has centered on the financial accelerator—which this book discusses in detail—and two specific transmission mechanisms of monetary policy: the balance sheet channel and the bank lending channel. Because so much of Bernanke’s academic work examines and presents insights into different aspects of central banking, they will also be discussed in some detail. Next, I explore two of Bernanke’s most hotly debated positions—that is, on deflation and on the global savings glut as the driving forces behind the huge deficit on the current account of the American balance of payments.

When the financial crisis hit in August 2007, Bernanke realized immediately that strong and decisive action was needed, and the policy tools he used to respond showed remarkable inventiveness. In order to extensively cover the policy Bernanke has pursued at the helm of the Fed, I must also provide a detailed look at what caused this major financial crisis to erupt in the first place. Intense financial innovation, regulatory shortcomings, risk and risk evaluation, securitization, leverage, derivatives, capital norms for banks, major changes in the world economic landscape, and several other issues are placed in a global context. More specifically, I develop a framework based on macropillars and micropillars to get to the fundamental causes of this devastating financial turmoil. Additionally, we will examine what is new, and what is not new, in this crisis.

The epilogue analyzes the Fed’s policy during the financial crisis, asserting that the Fed performed remarkably well during this difficult period. Much attention is given to the crucial role played by Chairman Bernanke, whose intimate knowledge of the mechanisms behind the Great Depression of the 1930s proved to be of immense value.

I conclude with some remarks on the future of central banking and the financial sector in general. My intention is to argue against the temptation to throw the baby out with the bathwater. Financial markets and financial innovation remain extremely valuable contributors to the general welfare, but they need a well-considered regulatory framework in order to function optimally. This will remain true, I believe, even after the worst financial crisis since the Great Depression is behind us.

PART ONE

THE STAGE IS SET: THE HISTORY OF THE FED AND THE UNDERTAKER’S RISK-MANAGEMENT APPROACH

THE LATE ECONOMIST CHARLES KINDLEBERGER AND his coauthor Robert Aliber recognized four distinct asset price bubbles in the last 15 years of the 20th century. The first was in real estate and stocks in Tokyo in the second half of the 1980s and the second, at about the same time, was in real estate and stocks of three of the Nordic countries—Finland, Norway, and Sweden. The third was in Bangkok, Kuala Lumpur, Jakarta, and Hong Kong and nearby national financial centers in the mid- 1990s, and the fourth was in U.S. stocks in the second half of the 1990s.¹

As these bubbles burst, they caused great damage, but the most recent one to burst—that of the U.S. housing market—will undoubtedly be remembered as the worst of all. It was this bubble that in August 2007 caused the subprime crisis to erupt, an event described by Yale professor and finance specialist Robert Shiller as an historic turning point in our economy and culture.²

This crisis mushroomed into a worldwide credit crisis that quickly spread through the entire financial system, driving the American economy into recession along with many other parts of the world economy. Financial networks around the globe were seriously affected, and markets and economies became increasingly nervous and uncertain. Ben Bernanke, who inherited the chairmanship of the Fed from Alan Greenspan early in 2006, became arguably the central figure in the management of the most serious financial crisis since the Great Depression.

Before discussing Bernanke and his chairmanship of the Fed during this time of great crisis, it is imperative to present some historical perspective, which is the subject of the first part of Bernanke’s Test. I will begin with the creation of the Federal Reserve System and then move through the disastrous policies the Fed pursued during the Great Depression of the late 1920s and 1930s. I will then present significant events of the evolution of the Federal Reserve System up to 1951, when then–Fed chairman William McChesney Martin brokered a historic deal between the Fed and the Treasury.

Next, I will discuss the period from the Great Inflation of 1965 to the mid-1980s and the roles played by four different Fed chairmen: William McChesney Martin (1951–70), Arthur Burns (1970–78), G. William Miller (1978–79), and finally Paul Volcker (1979–87), the architect of the Great Disinflation.

Last, I will analyze the life and career of Alan Greenspan and will attempt to deliver a balanced judgment of Greenspan’s tenure at the Fed. On a number of occasions, Greenspan argued that he followed a risk-management approach to monetary policy. In trying to counter highly disruptive economic developments—even those with a low probability of occurrence—the risk-management approach gives at least the impression of being discretionary. Nevertheless, the policies of the Fed under Greenspan tended to be remarkably rules based, at least until 2001. More specifically, the interest rate policy the Fed followed prior to 2002 can be described by what economists refer to as a Taylor rule, a policy rule that links the conduct of monetary policy directly to the evolution of inflation and economic growth.

Broadly speaking, there are two styles of monetary policymaking. First is what economists define as a rules-based approach: policymakers base their decisions on clearly defined rules, such as the Taylor rule. Second is a freestyle method, where policymakers enjoy much more freedom in setting monetary policy. In this case, policymakers’ actions are rather discretionary—they can base monetary policy purely on the way in which they judge the specific circumstances of the moment. This book will discuss how and why the policy of the Greenspan Fed drifted away from the Taylor rule after 2001.

I conclude this first part of Bernanke’s Test by tracking Greenspan’s record in more detail. As he later admitted,³ Greenspan’s dogmatic belief in the inevitably beneficial working of free financial markets contributed to several adverse developments in the American economy.

Chapter 1

The accidental creation of a powerhouse

THE FEDERAL RESERVE SYSTEM WAS CREATED IN 1913 during the Wilson administration.¹ Two previous attempts to establish a central American bank had failed. The major reasons for these failures were, in the words of Ben Bernanke, the

perceived conflicts of interest between (on the one hand) the farmers and tradespeople of Main Street America, who believed that they were most advantaged by policies of easy credit, and (on the other hand) the financial barons of Wall Street, who, as creditors and bondholders, preferred hard money, low-inflation policies.²

The designers of the 1913 system hoped that the Fed would facilitate commerce through a better organized payment system and the provision of an elastic currency; reduce financial instability by avoiding banking crises; and act as the government’s banker. The importance of the provision of an elastic currency is made clear when you consider the wild and all-too-frequent fluctuations in interest rates that existed before the Fed’s creation. Since demand for credit was seasonal—in large part because of the nature of agricultural activity, which was the primary cornerstone of the American economy at that time—and supply was essentially