December 15, 2013 2:51 pm

US Federal Reserve: The Bernanke years

Assessing the chairman’s legacy has to start with a hard look at his culpability for the crisis
Ben Bernanke©AP

It was a drizzly day in Washington when Ben Bernanke went to his confirmation hearing in November 2005, but all seemed bright for the US economy. Growth was on track to hit 3 per cent. House prices had another five months left to rise.

The assembled senators felt indulgent towards the modest academic – variously described by the media as bearded, or sometimes whiskered – seated in front of them. “A superb appointment,” said Richard Shelby, the Republican committee chair. “Tremendously impressive,” agreed Chris Dodd, his Democratic counterpart.

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In just a few years as a policy maker on the Fed’s board of governors, Mr Bernanke had made his mark. He had promised the Fed would never allow another Great Depression and made some bold speeches taking the Bank of Japan to task for deflation. The senators were happy to confirm him.

There was just one prophetic moment. “I hope you will not be confronted with a crisis to manage, but I know you will be,” said Mr Shelby. Replied Mr Bernanke: “I will certainly make every effort to be prepared for whatever may come my way.”

Just 18 months later, Mr Bernanke was plunged into a financial crisis and recession that tested both his pledge to avert a new depression and his belief that a central bank can always stimulate the economy, even when interest rates are stuck at zero.

It will be years before history can render a final judgment on Mr Bernanke’s tumultuous term – and with a possible tapering of asset purchases on the agenda this Wednesday, it is not quite over yet. But as he prepares to depart – Janet Yellen will take over in February – it is time for a preliminary assessment of whether Mr Bernanke met his goals.

The US economy is still far from full employment, but a fair reading of the data, which recognises the depth of the financial crisis, will give Mr Bernanke much credit for the economy’s stabilisation and recovery.

“Monetary policy has contributed, I think, massively to the recovery,” says Carmen Reinhart, professor of economics at Harvard, whose work on past financial crises helps to set the benchmark for their aftermath. “If you compare the magnitude of the initial decline relative to previous US crises, we put a high floor under it. I give the Fed high marks.”

Mr Bernanke’s place in history is likely to depend on that comparison. The crisis was and still is agonising for the US and the world – but could anyone have managed it better?

Monetary policy has contributed, I think, massively to the recovery. If you compare the magnitude of the initial decline relative to previous US crises, we put a high floor under it. I give the Fed high marks

- Carmen Reinhart, Harvard Kennedy School

The first issue to consider is whether the Fed chairman was himself culpable for the crisis. If so, any glory earned in its management is much diminished. Mr Bernanke was active in economic policy from 2002-06 as the housing and financial bubbles built up. And the Fed was in charge of regulating some of the banks that later got into trouble.

Historians will carry out a full reckoning of the guilty when all the files are open. Mr Bernanke did express concern about house prices: in 2005, he gave a presentation to President George W Bush setting out the economic consequences of a house price crash, people who were there say.

But, like the vast majority of economists, Mr Bernanke missed the knock-on dangers that housing posed to the financial system and for that much he is culpable. He was not involved in the big financial deregulations of the 1990s – but nor did he warn against them.

At present, it seems most likely Mr Bernanke will be regarded as one of a cohort of policy makers who failed to prevent the crisis, but did not actively cause it. The blame for that failure will be widely shared.

A second issue is the crisis itself, and there Mr Bernanke’s star shines brightly. One simple set of numbers tells the tale. For the first year and a half of the financial crisis the data for asset prices, economic output, international trade and bank failures closely track the Great Depression. The world was staring into the abyss.

But from the middle of 2009, they diverge. Whereas in 1930-31, the US plunged into another downward leg of bank failures, credit contraction and deeper recession, in 2009, the US began a steady recovery. That reflects the Fed’s – and Mr Bernanke’s – success in stabilising the banks and the financial system.

“Ben Bernanke deserves great credit for acting with skill during the crisis itself,” says Marvin Goodfriend, a former Fed official and now an economics professor at Carnegie Mellon University in Pittsburgh. To recognise the problem of broken private credit markets, and then fix it by risking the Fed’s balance sheet on an unprecedented scale, “required skill and courage that shouldn’t be underestimated”, says Mr Goodfriend.

One action in the crisis remains controversial: on September 15 2008, the Fed and the US Treasury let Lehman Brothers fail. That is the moment the “credit crunch” turned into a panic. For critics it was a defining error of the financial crisis.

Mr Bernanke’s defence is that Lehman was deeply insolvent and that the Fed wanted to rescue it but only the Treasury could spend public money. Furthermore, if the Fed had bent all the rules and used its balance sheet to keep Lehman afloat, Congress would most likely not have voted funds for the troubled asset relief programme, in which case it would have been the next bank – maybe Citigroup, Merrill Lynch or Wachovia – that went to the wall.

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By the end of 2009 it was clear that Ben Bernanke, student of the depression, had passed his exam. But his second term, which began in 2010, posed a different challenge. It was a test of Ben Bernanke, monetary theorist.

“I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States,” Mr Bernanke said in 2002. “A central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition.”

In 2002, Mr Bernanke’s outré ideas – such as buying long-term assets or putting a cap on bond yields – were just the theorising of the Fed’s “wonkiest” board member. But by the summer of 2010, the threat of US deflation was grave. The unemployment rate was still 9.5 per cent. Consumer price inflation was falling relentlessly.

In the years that followed, the Fed rolled out round after round of quantitative easing, as central bank asset purchases are known, with the nicknames QE2, QE3 and Operation Twist. It promised low interest rates until mid-2013, then late 2014, mid-2015 and finally until unemployment hit 6.5 per cent as the Fed pursued Mr Bernanke’s vision of effective policy with rates at zero.

. . .

I would give them not such a good grade for after the crisis. The things they’ve done look large in terms of how many billions of dollars are moved around but they’ve been quite inadequate for restoring full employment

- Laurence Ball, Johns Hopkins University

The Fed’s policies earned criticism from all sides and still do. Hawks predicted inflation. To date, their predictions are wrong, but the Fed still has to exit from its $4tn balance sheet before their concerns can be fully dismissed.

The dovish critics are more interesting. They include a number of Mr Bernanke’s fellow monetary economists, such as Paul Krugman, who argue the Fed chairman’s actions did not live up to the aggressive course outlined in his 2002 speech; and others, such as Columbia’s Michael Woodford, who argue that the Fed used the wrong tools.

“I would give them not such a good grade for after the crisis,” says Laurence Ball, professor of economics at Johns Hopkins. “The things they’ve done look large in terms of how many billions of dollars are moved around but they’ve been quite inadequate for restoring full employment.”

Part of the reason is the natural caution of a central bank using innovative new tools. But it is also worth considering the constraints Mr Bernanke was under – both within the rate-setting Federal Open Market Committee and with a hostile Congress – and how he moved the Fed into steadily more aggressive action.

“There is a committee. There are 19 individuals at the table,” says Richard Fisher, president of the Dallas Fed, who is one of the longest-serving members of the FOMC and opposed QE. “I think there’s a limit to what he could have gotten done if he had wanted to do more.”

But perhaps the fairest way to judge Mr Bernanke is to look at the numbers. One, in particular, is striking: for his eight-year term, and despite a colossal financial crisis, the average rate of inflation was 1.8 per cent compared with the Fed’s goal of 2 per cent. If his pledge was to avert deflation, then he succeeded.

The US has also outperformed most of the world’s other advanced economies even though it was the epicentre of the financial crisis. Output per capita in the US is higher than it was in 2007. It remains substantially lower in the UK, France and Italy. The US is performing roughly in line with Canada, which suffered much less during the crisis.

How much of that is due to monetary policy is difficult to say. A series of sovereign debt crises hobbled the eurozone. Fiscal policy tightened later in the US than elsewhere, though the destructive budget battles in Congress after 2010 were a constant frustration for Mr Bernanke. It is probably no coincidence that the US did better after running a more aggressive monetary policy than any other country.

A final test is to look at past financial crises and ask if this time was different. In August 2010 Mr Bernanke gave a speech that laid the ground for the Fed’s $600bn QE2 round of asset purchases. The next speaker that day was Ms Reinhart, who presented a paper called After the Fall. The paper showed that in the decade after a financial crisis a rich country would, on average, suffer unemployment 5 percentage points higher than in the years before it. Six years into the US crisis, the unemployment rate averages just 3.3 percentage points higher. That should improve further before the decade is complete.

On the other hand, in the six years after a crisis, per capita growth was 1.5 percentage points lower in the average country, whereas it is 2.1 percentage points lower so far in the US. That is a weaker performance, but the countries in the sample were smaller.

It has turned out that monetary policy, and Ben Bernanke, cannot work magic. But when, seven weeks from today, he walks out of the Fed’s marble palace on Constitution Avenue, he can do so with his head held high.

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Transparency: Revolution set to endure

Ben Bernanke set out one goal when he came to the Federal Reserve in 2006: he wanted to increase transparency and, in particular, set a numerical goal for inflation.

There were numerous false starts in the past eight years and endless debates about communication policy, but together with Janet Yellen, his deputy, Mr Bernanke has achieved a gradual revolution in how the Fed explains itself.

Changes include the publication of extensive economic forecasts, the introduction of press conferences, guidance about future policy, and – after many years of debate – a formal 2 per cent goal for inflation.

All of those innovations are likely to endure and mean a permanent structural change in how the Fed operates. Ms Yellen is expected to continue and expand them.

Mr Bernanke also brought a change of tone to the Fed’s deliberations. Whereas Alan Greenspan would say what the Fed should do, and then solicit opinions, Mr Bernanke did it the other way round. There was a flowering of – sometimes confusing – speeches by Fed officials.

“I think [Mr Bernanke] brought to a highly refined level the preservation of civility in the discourse that takes place at the Federal Open Market Committee,” says Richard Fisher, president of the Dallas Fed. “I think Ben is exemplary in that he listened to everyone at the table.”

There is now a tension between the dissent encouraged by Mr Bernanke and the Fed’s tradition of making decisions by consensus.

But a return to the Greenspan days is unlikely.

“There’s this constant drumbeat about more transparency and more transparency,” says Mr Fisher. “I don’t see how you put that back in the bottle.”

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Letter in response to this article:

Successful economic expeditions include the journey home / From Prof Ira Sohn

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