Blaming Ben

Federal Reserve chairman Ben Bernanke has attracted a lot of criticism for his handling of the global financial crisis, but his greatest test may be yet to come.

You know you have a public relations problem when the New York Times Op-Ed piece making the argument for your retention as chairman of the Federal Reserve contains more pointed criticisms of your tenure than the Op-Ed arguing that you should be jettisoned.

Seriously. Nouriel Roubini writes the following devastating paragraph describing what Ben Bernanke did wrong at the outset of the financial crisis:

"He and the Fed made three major mistakes when the subprime mortgage crisis began. First, he kept arguing that the housing recession would bottom out soon (it has not bottomed out even three years later). Second, he argued that the subprime problem was a contained problem when in reality it was a symptom of the biggest leverage and credit bubble in American history. Third, he argued that the collapse in the housing market would not lead to a recession, even though about one-third of jobs created in the latest economic recovery were directly or indirectly related to housing. Mr Bernanke's analysis was mistaken in several other important ways. He argued that monetary policy should not be used to control asset bubbles. He attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the financial system played."

But after all that, Roubini believes that once the meltdown reached escape velocity, Bernanke demonstrated a flair for innovation and flexibility that saw the Fed pull out all the stops as it moved to increase liquidity, reduce borrowing costs, and prevent the financial system from freezing up beyond repair. Mild-mannered, cautious, and obsequious Clark Kent suddenly became a monetary policy Superman.

Fair enough. Congressional politicians may not agree, but I'd guess that the majority of economists would accept that once the true extent of the crisis became manifest, Bernanke acted aggressively to prevent another Great Depression. We will never know what would have happened if he had not pushed the Fed to take such a wide array of extreme steps, but maybe we should be thankful for exactly that. If Bernanke's decisions to buy vast amounts of US Treasuries, accept dodgy collateral from financial institutions in return for access to credit, and allow investment banks to borrow from the Fed's "discount window" actually did keep the global economy from going over the brink, then Obama's decision is a no-brainer. Of course Bernanke should be reappointed as chairman. If there's one accomplishment that should give you a lock on the job, it's preventing a seemingly imminent depression.

The pro case is strengthened further when you look at the anti position, presented by Anna Jacobson Schwartz, an economist most famous for being the co-author, with Milton Friedman, of A Monetary History of the United States.

Schwartz kicks off by arguing that Bernanke is guilty of serious "sins of commission." As example A, she writes:

"It is standard practice for a central bank like the Federal Reserve to ease monetary policy to combat a recession, and then to tighten it as recovery gets under way. Mr Bernanke so far has only had to do the first half, and has conducted a policy of extreme ease...

Mr Bernanke seems to know only two amounts: zero and trillions. Before 2008 there were only moderate increases in the Federal Reserve's aggregate balance sheet numbers, but since then the balance sheet has exploded by trillions of dollars. The increase was spurred by the Fed's loans to troubled institutions and purchases of securities.

Why is easy monetary policy such a sin? Because in such an environment, loans are cheap and borrowers can finance every project that they dream up. This results in excesses, and also increases the severity of the recession that inevitably follows when the bubble bursts."

Schwartz's pedigree is considered without reproach by many economists, but she is making very little sense here. Alan Greenspan was clearly guilty of excessively easy monetary policy, but if there was ever a time when a central bank should be keeping interest rates low in order to combat a recession, the last two years have been that time. So Bernanke, by Schwartz's own definition, is doing exactly what he is supposed to be doing. And while the recession may be nearing a bottom, there is scant evidence that a real recovery has actually begun, so the time is quite obviously not yet right for tightening.

Schwartz also accuses Bernanke of appearing to act in an ad hoc manner, and of confusing the market by coming to the rescue of Bear Stearns and not of Lehman. I very much doubt if there is an economist alive on this planet who would not have reacted in an ad hoc fashion to the crisis as it unfolded. We have just lived through an epic economic event and figuring out what happened will take generations (if it is ever actually accomplished, a point worth bearing in mind when we consider that we are still arguing about what caused and fixed the Great Depression).

There are many books yet to be written about what happened in the fall of 2008, but I wonder how much blame should be put on Bernanke for the Lehman fiasco, and how much belongs to the Bush administration, and specifically Paulson. I think there can be little doubt that the Bush White House was very uncomfortable, from an ideological perspective, about bailing out Wall Street. After Bear Stearns, the administration took considerable flak from both left and right for its intervention. At Lehman, the administration decided to draw the line, and in the process, instantly metastasized the crisis into a full-blown systemic event. Other than the theory that Goldman Sachs was simply orchestrating the execution of a competitor, that seems the simplest explanation for what happened.

Bernanke's real test will come as the economy starts to grow, and he seeks to extricate the Fed from its easy money stance and vastly overloaded balance sheet. He should get the chance to try.

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