Which Bernanke? Whose Bubble?

August 25, 2009 2:00 PM

Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve. But which Bernanke are we getting? There are at least three.

  1. The Bernanke who led the charge to rescue the US (and world's) financial system after the Lehman-AIG collapse. If you accept that the choice from late September was "Collapse or Rescue," this Bernanke did a great job.
  2. The Bernanke who argued for keeping interest rates low as the housing bubble developed. This Bernanke was part of the Greenspan Illusion—the Fed should ignore bubbles and "just clean up afterwards." Is that still Bernanke's view? Surely, he has learned from that experience.
  3. Then there is Bernanke-the-reformer. Given number 1 and number 2 above, shouldn't he be pushing hard for tough re-regulation of the financial system—particularly those dodgy parts where markets meet banking? But is there any sign of such an agenda, even with regard to recently trampled consumers—let alone "too big to fail" financial institutions?

Most likely, we're in for another bubble.

The Fed will keep interest rates low for the foreseeable future. This will make sense given continued high rates of unemployment in the US economy. But unemployment indicates average economic outcomes—high unemployment is completely consistent with some parts of the financial sector expanding at record rates; this is part of the two-track story.

The big banks have access to large amounts of Fed-provided funding at very low rates. We'll see this reflected in speculative market activities (think oil).

We'll also see this in global capital flows (i.e., gross flows, perhaps also net flows—but the new global imbalances may not be so obvious in the pattern of current account surpluses/deficits around the world). The United States is increasingly a cheap funding environment if you are a big player (definition: anyone regarded as an important client by Goldman). Rates now begin to rise in emerging markets as their economies turn around. The Asia story will be compelling fundamentals and a great carry trade (borrow cheaply in dollars, lend at higher rates in Asian currencies) and the exchange rate risk is for appreciation against the dollar.

Everyone involved knows this is unsustainable, but also that it can last for a while—and they can get out before everyone else. Or, alternatively, that—as major financial players—they can't afford to sit on the sidelines (talk to Chuck Prince: what has changed, in ideology, policies, and people at the top since his day?).

Presumably, commodity prices also get dragged up—or perhaps they jump up in anticipation of the coming Asian boom. Now this might lead Asian central banks to tighten, but probably not if these economies can continue to keep wage costs under control. And it might lead the Fed to tighten, but probably not as the mantra of focusing on "core inflation" (without food and energy prices) remains intact—however anachronistic it may seem to the rest of us. It's hard to see Bernanke number 2 doing anything different, except perhaps at inconsequential margins.

So then we really bubble—and perhaps we even mistake it for a boom.

When the big crash comes, there'll be another moment of decision: "Collapse or Rescue." And we know what Bernanke number 1 will do. This is, of course, why this administration is reappointing him—and not seriously re-regulating big finance.

Also posted on Simon Johnson's blog, Baseline Scenario. Following is a previous post on Baseline Scenario.

Waiting for the Federal Reserve's Next Apology (August 14)

In November 2002, Ben Bernanke apologized—for the Fed's role in causing the Great Depression of the 1930s. "I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again" (conclusion of this speech).

Bernanke's point, of course, is that the Fed tightened monetary policy inappropriately—and allowed banks to fail—in 1929–33. And much has been made of his strong focus over the past year on avoiding a repeat of those or closely related mistakes (including here).

But today we need a different kind of apology, or at least a statement of responsibility, from Ben Bernanke and the Fed.

From the Federal Open Market Committee (FOMC) meeting transcript of August 2003, we know that Bernanke said, "Despite the good news, I think it's premature to conclude that we should not consider further rate cuts, if not at this meeting then at some time in the near future depending on how the data play out" (p.63).

He was concerned not just to keep interest rates low for a prolonged period but also to signal this to financial markets, "To the extent that we can sharpen our message that economic growth no longer implies an immediate and automatic policy tightening, we should make every effort to do so" (p.65; see also his role in the broader discussion around p.93).

This was, of course, at a time that the speculative fever and outright malpractice in the housing market was really taking off. The build-up of financial market risk was starting to head towards system-threatening dimensions. And many consumers were being set up for a trampling of epic proportions. It is striking there is barely a mention of these issues in the FOMC transcripts.

And that's the issue. We can argue for a long time about whether the Fed should have tightened earlier. Defenders of the Fed will say the data were ambiguous and will point to the serious discussion of these issues in the FOMC transcript.

We can also dispute whether or not the Fed should have said anything in public about the impending housing-financial-consumer-taxpayer doom, or tried to tighten regulation. "It's not our job" or "we don't have the powers," or "the politicians wouldn't have supported us" is what senior Fed people now whisper around Washington.

But this and other FOMC transcripts make it clear that the senior Fed decision makers were not even thinking about the first order financial sector issues. They weren't aware of what the big investment banks were really doing—show me the intelligence reports before the FOMC or the analytical discussion that indicated any degree of worry. No doubt someone somewhere in the Federal Reserve system was thinking critically about finance—feel free to send me any relevant details—but from the point of view of evaluating the institution, it only counts if the top decision-making body at least has the issues on the table.

We have transcripts so far through the end of 2003. Others should be forthcoming soon; there is supposed to be only a five-year lag in their publication. Given their historic importance, the Fed should make sure to release them on time and not withhold them to avoid embarrassment.

At this moment of potential regulatory reform, who within the Fed really wants us to know that their leadership in the Greenspan era completely framed the problem wrong, didn't understand what was happening, and repeatedly, brazenly, and callously ignored the damage being done to consumers?

I fully understand that financial market considerations are not the established focus of central bank interest rate deliberations. But the scope and nature of such deliberations has changed a great deal since the founding of the Fed almost 100 years ago. As the economy changes, central banks have to adapt their conceptual frameworks and our broader regulatory frameworks need to change also. We've done this many times before, and we need to do it again.

Huge problems were missed by people using anachronistic conceptual frameworks. Those frameworks should change. This was the assessment of Ben Bernanke, building on Friedman and Schwartz, for 1929–33, and this should be our assessment today.

Our top monetary policymakers completely missed the true nature of the great bubble and its consequences until it was far too late. They should apologize for that and we can start work on redesigning the institution, its decision making, and how financial markets operate to make sure it won't happen again. And it would also be nice if the Fed could avoid adding insult to injury and stop opposing the administration's consumer protection proposals.

Hopefully, this time the Fed's apology won't take 70 years.