Courage to act, failure to understand
Entering the greatest financial crisis since the 1930s, the United States was fortunate to have Ben Bernanke at the helm of the Federal Reserve. The former Princeton University professor was a self-proclaimed “Great Depression buff.” He understood like few others how the Fed’s mistakes led to economic catastrophe. As the title of his newly published memoir suggests, Bernanke also possessed “The Courage to Act” in the aftermath of the Lehman Brothers bust. The central bank helped prevent another severe depression and set the U.S. economy on the road to recovery.
This, at least, is the official narrative, reproduced at great length in Bernanke’s 600 page narrative. It is certainly true that when the financial crisis hit, the former Fed chief was prepared to act boldly: taking over Bear Stearns’ securities portfolio, lending to the near-bankrupt AIG, reducing interest rates to zero and later launching successive bouts of quantitative easing. The more important question is whether Bernanke’s actions before, during and after the crisis did more harm than good.
Bernanke’s great intellectual weakness is his failure to understand the relationship of monetary policy, credit creation, asset price bubbles and economic crises. His view of the Great Depression derives from Milton Friedman and Anna Schwartz’s influential 1963 work “Monetary History of the United States”, which maintained that the Fed caused the 1930s economic debacle by allowing the money supply to collapse and deflation to take hold. This reading ignores the role of the speculative boom on Wall Street in the late 1920s.
An alternative reading of history starts with the Fed’s excessively low policy interest rates in the 1920s. The easy money, justified at the time by quiescent inflation, led to a credit boom which fuelled speculative bubbles – in real estate markets from Florida to Chicago and on the New York Stock Exchange. Low rates also encouraged massive capital flows into central Europe and South America, where yields were higher. In the late 1920s, the Fed increased rates. International capital flows reversed, real estate and property bubbles collapsed, and the way was paved for financial crisis, followed by depression.
Bernanke, like his predecessors at the Fed in the 1920s, believes that the central bank should aim to control inflation and ignore asset price bubbles. He maintains that the latter cannot be identified before they burst. He certainly had a problem with spotting speculative froth. He did not see a housing bubble in 2005 in the United States, ignoring prices which were more than two standard deviations above their long-term trend.
There’s an inconsistency here. Bernanke seems to believe that the Fed can use monetary policy to inflate asset prices – one of the prime purposes of the post-crisis quantitative easing policy – but that any subsequent decline in asset prices is both unpredictable and unrelated to monetary policy.
Bernanke argues that monetary policy shouldn’t be used to pop bubbles. He used to argue that it was easier to deal with the aftermath. Given the severity of the late real-estate bust, Bernanke now thinks that financial regulation can do the job instead. Yet he admits the Fed and other U.S. regulators failed to understand the increasing fragility of the global credit system prior to 2008. If the goal is to dampen animal spirits and promote financial prudence, nothing is as effective as stringent monetary policy. Interest rates, as the former Fed Governor Jeremy Stein says, “get into all the cracks”.
During the Lehman crisis, Bernanke was criticised by his Fed predecessor Paul Volcker for taking the central bank “to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.” Bernanke wasn’t too concerned with the finer points of moral hazard and the theoretical limits of central banking. “There are no ideologues in financial crises,” he told his Bank of England counterpart, Mervyn King, in those dark days. The Fed’s unconventional policies were justified by success. They eventually succeeded in quieting the markets.
It is harder to justify the continuation of extraordinary monetary policy long after the panic had passed. Bernanke does not acknowledge that ultra-low interest rates have potentially corrosive effects. The Fed’s policies have resulted in yet another bout of asset-price inflation. After the financial crisis, the value of U.S. household wealth, as reported in the Fed’s flow of funds statements, quickly rose to a record high level relative to gross domestic product.
History is repeating itself. Low rates have forced investors into another desperate search for yield. Corporate credit quality has deteriorated with the return of “cov-lite” loans, “toggle notes” and vast issuance of junk bonds. Cheap money has dampened price volatility and encouraged investors to reduce liquidity in their portfolios. Once again, low rates have fuelled a multitrillion-dollar global carry trade exporting financial fragility to emerging markets.
On stepping down from the Fed in early 2013, Bernanke commented that having sailed an uncharted path, the central bank was “at least nearing known waters.” This seems remarkably complacent. We simply don’t know how much damage low rates have inflicted on emerging markets or what the consequences of normalising rates will be in the United States, or how the Fed will shrink its bloated balance sheet.
Rather than considering the ill effects of low rates on the global financial system, Bernanke prefers to focus on the benefits that low rates bring to the “real” economy. Yet here too, easy money has had unintended consequences. The global financial crisis was followed by a tepid U.S. economic recovery and lingering high unemployment. Low rates have kept weak companies out of bankruptcy, dampening productivity growth. Corporate zombies stalk the planet.
Wall Street and Main Street are deeply interconnected, as Bernanke himself admits. If monetary policy increases financial fragility and promotes asset price bubbles, the wider economy cannot remain immune forever. This was the lesson of the Great Depression and also of the global financial crisis. It is a lesson that Bernanke has yet to learn.