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Helicopter Ben and the Hapless Policymakers

11 March 2008 By Edward Chancellor

When asset prices fall it becomes fair game to maul the Maestro. Greenspan’s Bubbles (McGraw-Hill) by Bill Fleckenstein and Frederick Sheehan is the latest indictment of the former Federal Reserve chairman, who presided over two of the greatest bubbles in US history. The trouble with attacking Alan Greenspan is that, despite more than two decades under the public spotlight, he remains an elusive figure. On matters relating to monetary policy it’s difficult to know where he really stood. Ben Bernanke is more thoughtful, articulate, and consistent than his predecessor. If you want to understand where the Fed went wrong over recent years, it’s better to examine Bernanke’s theory than Greenspan’s practice.

Before coming to Washington, Greenspan earned his keep as an economic forecaster, far from the ivory tower. At the Fed, his public views were generally opaque and sometimes changeable. In the late 1990s, he flip-flopped between denouncing “irrational exuberance” and embracing the New Economy. After the housing boom took off, Greenspan first denied the possibility of real estate bubbles, then later saw “froth” in regional housing markets. The current Chairman of the Board of Governors of the United States Federal Reserve is less prone to shifting positions. Everything Ben Bernanke says about monetary policy is rooted in theory, as befits a former head of the Princeton economics department.

Bernanke’s view of Wall Street is limited by the tunnel vision of economic theory. At heart, Bernanke is an economic rationalist. In his Essays on the Great Depression (Princeton, 2000), the Fed chairman displays a reluctance to depart from “the assumption of rational economic behavior.” In a footnote, Bernanke adds: “I do not deny the possible importance of irrationality in economic life; however, it seems that the best research strategy is to push the rationality postulate as far as it will go.” That may a useful exercise in the class room, but it’s another matter when you are running the world’s central bank.

His belief in rationality probably explains why Bernanke has long maintained that it is impossible to identify asset prices bubbles before they pop. It follows from this that the central bank shouldn’t attempt to prick a bubble; rather, Bernanke argues, the Fed should step into deal with the aftermath. His academic work on this subject provided a justification for Greenspan’s failure to rein in the dotcom mania at the turn of the century. In 2002, Bernanke was appointed a Federal Reserve governor.

It turned out that the Fed’s attempt to handle the burst tech bubble had the unfortunate side-effect of inflating an even larger one. Naturally, Bernanke failed to observe the appearance of a massive housing bubble, arguing instead that rising home prices simply reflected increasing prosperity. He also suggested that the growth in consumer debt was no concern since rising home prices had improved household balance sheets.

Bernanke’s academic work is obsessed with the problem of deflation. In November 2002, he delivered a celebrated speech entitled ‘Deflation: Making Sure ‘It’ Doesn’t Happen Here.’ The newly appointed Fed governor told his startled audience, assembled in a Chinese restaurant in Washington, that “deflation was always reversible under a fiat money system.” Helicopter Ben had taken off. In the same speech, he claimed that in extremity the Fed might manipulate long-term rates to keep them from rising. Wall Street woke up. Bernanke appeared to be guaranteeing the profitability of the carry trade, which involved borrowing short and investing in longer-dated securities. The “Bernanke put” revived the debt markets. As bonds climbed in value and spreads narrowed, the credit bubble started to inflate.

The trouble with Bernanke’s views about deflation is that he doesn’t clearly distinguish between the “bad” deflation which damages the economy and the “good” deflation which comes from rising productivity and other supply-side improvements. He is not the first to make this error. The Federal Reserve in the 1920s also followed a policy of price stability at a time when consumer prices would otherwise have declined due to technological advances. As a result, interest rates were set so low that they encouraged an excessive credit growth and stimulated a real estate boom. The Bank of Japan pursued a similar course in the late 1980s with disastrous consequences. The Fed under Greenspan and Bernanke replicated this error. In recent years, the good deflation was prevented from occurring, but at the cost of a wild credit expansion.

Bernanke seems to believe that bad deflation derives from poor policies, such as adherence to the gold standard in the early 1930s.There is something in this, but he underplays the role that a bursting credit bubble plays in promoting deflation. His essays on the Great Depression contain remarkably little on the growth of credit in the late 1920s and the role that excessive debt played in the subsequent bust. In his view, the banks didn’t fail in 1930s because they had made poor loans. Rather, Bernanke blames the Federal Reserve for preemptively trying to prick the speculative bubble in 1928.

In short, Bernanke thinks about money and price stability, but understands little about credit and its contribution to financial instability. He suggests that the collapse of the debt pyramid in the early 1930s”connected very indirectly (if at all) with the path of industrial production in the United States.” This is surprising conclusion. Researchers at the European Central Bank recently found that “high-cost” recessions tend to occur after periods of strong credit growth and real estate booms.

Greenspan critics tend to see Bernanke as an unfortunate stooge who was handed a poison chalice on assuming the Fed’s chair. That’s probably too generous. After all, Bernanke rationalized the recent expansion of credit as a sign of economic and structural improvements to the financial system. He hailed the “Great Moderation” (the result of improved policymaking, in his view), but failed to observe the increasingly reckless behavior on Wall Street. The worst of the subprime and leveraged buyout lending occurred after Bernanke took office on 1 February 2006.

Bernanke also excused the debt-fuelled consumption binge in the US as a by-product of a so-called “global savings glut.” According to his view, countries with trade surpluses reinvested their money in the US because it was a more attractive “investment destination.” He failed to note that the recycling of foreign export dollars had created an indiscriminate demand for US securities, including subprime loans. After the housing market turned down, Bernanke was slow to observe the dangers posed by the fall-out. He initially held that subprime problems were “contained” and vastly underestimated likely losses.

When the credit crunch hit last summer, Bernanke didn’t seem to grasp the seriousness of the problem. But as the crisis has dragged on that’s changed. Not only did Bernanke cut rates by1.25 percentage points in January. The Fed is now lending to banks against a broader range of collateral, including securitized loans containing subprime mortgages.

Writing on the Great Depression years, Bernanke describes “hapless policymakers trying to make sense of the events for which experience had not prepared them.” Having provided an intellectual rationale for just about every mistaken move by the Fed over the last decade, Bernanke is now the “hapless policymaker” who must get us out of the hole that both he and Greenspan dug for us.


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