Ben Bernanke was a member of the US Federal Reserve Board in the tumultuous period from 2002 until 2014 and Chairman from 2006 to 2014. His version of this period is told in The Courage to Act, his 600-page meeting-by-meeting account. This degree of detail would overload a reader who just wanted to know what the lessons were, and where we are now. This is Bernanke writing for history, and he spells out the detail of how, on each of the many decisions, he got it pretty much right.
He joined the Federal Board with the right background for the times ahead: he is an expert on the 1930s Great Depression. This gave him a head-start over most central bankers, whose mindsets were formed (and perhaps scarred) by the 'stagflation' of the 1970s. While their focus was on inflation, Bernanke had the deflationary experience of the 1930s on his mind.
Does his dovish bias explain what many would see as the Federal Reserve's initial mistake – keeping interest rates too low in 2001-2006, encouraging the housing bubble that initiated the crisis? Not really. While 'Maestro' Alan Greenspan chaired the Fed, his views dominated. He had faith that the market would sort things out. In any case the Federal Reserve could not identify bubbles beforehand and could clean up after the bubble burst. Bernanke did not differ.
Bernanke's chairmanship covers two connected but separable phases. First, the unravelling of financial stability as the knock-on effects of the bursting of the housing bubble spread. Then the aftermath, as the US (and most mature economies) struggled to recover.
The excitement starts in 2007, when the collapse of the housing bubble sets off a slow-motion chain reaction. The beginning was hardly noticed: Bear Stearns bailed-out two of its subsidiary funds in 2007, which put it on the path to failure in May the year after. One by one the pins tottered and some fell, culminating in the bankruptcy of Lehman Brothers in September 2008 and the rescue of AIG the following week.
Beginning in 2007, the Fed and the Treasury were busy putting their fingers in the many leaking dykes. The Fed added liquidity (base money) to the financial sector, guaranteed the money-market funds, allowed investment banks such as Goldman Sachs to change their status so that they were protected by government guarantees, facilitated mergers of failing banks and saved Citibank with guarantees and capital injection. Critical to financial stability overseas, the Fed made US$600 billion of loans to foreign central banks to allow them to on-lend to dollar-short foreign commercial banks.
Ingenuity prevailed, with many late-night and weekend sessions cobbling together solutions. Read More
The result was a mish-mash of ad hocery, with consistency taking second place to force majeure. The Fed lends to some insolvent banks while others are taken over; Lehmans goes under but AIG is saved. If you want the minute-by-minute version of these dramtic events, read this book. You will sense the lack of preparedness and the unnoticed vulnerabilities that had evolved over the previous decade as profit-hungry financial firms pushed the risk frontier outwards. You will also hear Bernanke condemn the dysfunctional nature of the US political system.
The financial system had become inextricably interconnected and complex. The bursting of the housing bubble – not in itself catastrophic – triggered contagion, reaching to the whole globe. Each of these interconnections was fragile because everyone had borrowed up to the hilt. It was all held together by confidence that the sun would go on shining. When confidence was lost, depositors and lenders wanted their money back; risk perceptions swung from mindless optimism to deep pessimism overnight. The credit rating agencies, always assessing risk by looking in the rear-vision mirror, belatedly downgraded tottering institutions, ensuring they would topple.
Meanwhile, the US supervisory system was so compartmentalised that coordination was lacking. The huge risks on AIG's balance sheet were supervised by an obscure and understaffed regulator. Much of the shadow banking system was under the oversight of the corporate regulator. Deposit insurance was not in the hands of the Fed but a different agency with different priorities.
Whenever the problem interfaced with the political system, ideology (in particular, free market non-interventionism) dominated. Congress was uncooperative, hobbling and delaying necessary action. The public was stunned and angry that the richly rewarded 'masters of the universe' in the financial sector turned out to be inadequate for the task.
The second phase of the Bernanke period began in 2009, when the financial sector had regained some composure. The crisis had left a legacy of over-leveraged home borrowers and chastened banks, pushing the economy into recession followed by a feeble recovery.
The shift of interest rates as the crisis unfolded was dramatic, with the policy rate taken almost to zero. Bernanke was ready to do more. In his 2002 speeches, he had recalled Milton Friedman's idea of 'helicopter money': the authorities could give the public extra money to spend, financed by the central bank. In fact Bernanke did not implement 'helicopter drops'. Instead, quantitative easing (QE) was deployed, which the Japanese had tried earlier in the decade to little effect. The Fed flooded the banking system with reserve money to encourage banks to lend and to push down the longer end of the yield curve.
A Friedmanite helicopter drop would have provided a powerful fiscal stimulus (similar to the Australian 'cash splash' in 2009). QE, however, is a much weaker instrument. Instead of directly providing the public with additional spending power, its aim is to lower the longer-term bond rate in the hope that this will encourage spending. It also provides a psychological message which weakens the exchange rate and pushes up equity prices, both helpful for a frail economy.
Whatever the effectiveness of QE, it is a poor substitute for adequate fiscal stimulus. This was made worse by Congress' threats to impose a debt limit on government spending. Bernanke was left to face a problem which monetary policy alone was not powerful enough to solve.
A reader might come away with the feeling that these serious deficiencies have been resolved. That would be too sanguine. Perhaps the new laws, higher capital requirements and rescue techniques pioneered in this period could do the job when needed. Macro-prudential measures are the new panacea, as yet untested. Much is made of the Fed's greater transparency, without much acknowledgment of its inability, so far, to give a clear message to financial markets, whose instinct was always to panic first and think later.
Bernanke and his colleagues can take credit for preventing an even more serious financial melt-down and recession, but the narrative of the crisis and its lackluster recovery needs a more critical vantage-point, more ready to contemplate the possibility that mistakes were made. More important still, the structure of the financial sector needs a more fundamental re-think, without pressures from Wall Street to get back to business as usual.