At the end of January 2014, Ben Bernanke will step down as chairman of the Federal Reserve Board. Bernanke’s eight-year tenure as the head of America’s central bank has been hugely consequential and unexpectedly controversial. Neither the consequence nor the controversy was anticipated when the scholarly Bernanke assumed the chairmanship of the Fed on Feb. 1, 2006, following the nearly two-decade tenure of Alan Greenspan.
Few suspected that Bernanke would face a crushing financial crisis and would be compelled to create a raft of new programs to prevent the American economy — and even the world economy — from unraveling.
And few would dispute that the 2008 financial meltdown fundamentally shaped Bernanke’s tenure at the Fed, which controls the nation’s money supply. Bernanke’s book explains what he did and why during this remarkable time. “The Federal Reserve and the Financial Crisis” is based on a series of lectures Bernanke delivered in the spring of 2012 at the George Washington University. It is a clear exposition of his views about the financial crisis and the challenges that America’s central bank still faces.
Bernanke has been an aggressive and innovative central banker. He is regarded by some as a dangerous revolutionary and by others as the savior of American capitalism. He was named Time magazine’s “Person of the Year” in 2009 and is frequently heralded on Wall Street and in financial markets around the world as a cool crisis manager and a strikingly creative Fed chief.
However, some Republicans in Congress are sharply critical of Bernanke, likening his easy money policies to a narcotic the American economy has become addicted to.
The passion he’s inspired among his critics is intriguing given the mild-mannered Bernanke’s rather staid (albeit impressive) intellectual background. Born in Georgia, raised in South Carolina, and educated at Harvard and the Massachusetts Institute of Technology, Bernanke came to the Fed with sterling academic credentials. He has taught at Stanford University, New York University, MIT and Princeton University. He took a leave from Princeton in 2002 to become a member of the Fed’s Board of Governors and served there until 2005, when he was appointed chairman of the Council of Economic Advisers by President George W. Bush. When Bernanke accepted the chairmanship, there was widespread speculation that he was auditioning to succeed Greenspan, whose reign at the Fed was winding down. Bush did appoint Bernanke and he has served memorably as America’s preeminent central banker.
As one might expect from a former chairman of Princeton’s Economic Department and a renowned scholar of the Great Depression, Bernanke explains central banking and the financial crisis he confronted in a clear, deliberate way. Each of the book’s four sections is based on a lecture that Bernanke delivered at George Washington. He carefully builds a foundation that describes central banking, the 2008 financial crisis, the subsequent recession and the gradual recovery of the American economy. There are few rhetorical flourishes and no name-dropping or juicy accounts of policy debates. He strives to describe the financial and economic crisis in concise, jargon-free language.
In the first section of the book, Bernanke discusses the role of central banking and the early history of the Federal Reserve. He argues that a central bank has two central responsibilities. First, it’s mandated to achieve macroeconomic stability with sound economic growth and low inflation. The main tool to achieve this is with monetary policy, usually through adjustments in the federal funds rate, which is the overnight rate the Fed charges banks to lend them money. Low interest rates are designed to spur growth while higher interest rates slow growth and contain inflation. The second role of a central bank is to maintain financial stability by the provision of liquidity through short-term credit to financial institutions. This is a central bank’s “lender of last resort” responsibility.
Central banks, Bernanke notes, have been around for a long time. Sweden set up its central bank in 1668 while the Bank of England was established in 1694. The United States is, of course, a much younger nation and its central bank is a relative infant.
The Federal Reserve was born out of financial panics in the United States in the late 19th and early 20th centuries. In the aftermath of a serious economic crisis in 1907, Congress contemplated whether an American central bank was needed. It commissioned what turned out to be a 23-volume study about central banking practices but no immediate action was taken. Finally, after intense lobbying by President Woodrow Wilson, Congress passed the Federal Reserve Act of 1913, which created the Federal Reserve to serve as a lender of last resort, ease financial panics, and manage the nation’s gold standard. The law created a seven-member Board of Governors in Washington led by the Fed chairman, and it also set up 12 regional bank districts, each of which elected its own president.
According to Bernanke, the Fed had an uncertain role in its first decades because the United States was on a gold standard. This is a monetary system in which the value of the currency is fixed in terms of gold and sharply limits policy discretion.
The Great Depression, which extended from 1929 to 1941, was a shattering event in the United States and President Franklin D. Roosevelt created a raft of initiatives to respond to it. But the Fed was not very helpful; in an initial attempt to preserve the gold standard, it kept interest rates high. This made a bad situation worse and by the end of the 1930s, unemployment remained stubbornly high at about 13 percent. Bernanke argues that Roosevelt made plenty of mistakes but was innovative and aggressive. Unfortunately the Fed at that time was neither, and its policies hampered recovery from the Depression.
In the second section of the book, Bernanke describes American economic policy from World War II until the first signs of the financial crisis in 2006. During this time, two Federal Reserve chairmen were towering figures: Paul Volcker and Alan Greenspan. Volcker was appointed Fed chairman by President Jimmy Carter in 1979 with the near singular mission of wringing skyrocketing inflation out of the economy. When Volcker began his tenure at the Fed, the consumer price index was nearing an astonishing 13 percent. Volcker dramatically tightened monetary policy, increasing key interest rates to nearly 20 percent. Between 1980 and 1983, Volcker drove inflation down from 13 percent to 3 percent, but his policies also triggered a serious recession. Despite the disruption and economic hardship caused by tight monetary policy, high interest rates and the resultant recession, Volcker is still credited with rescuing the U.S. economy during a perilous time.
President Ronald Reagan appointed Greenspan to succeed Volcker as Fed chairman in 1987. He served until 2006 and his tenure has been called the Great Moderation. The American economy grew steadily, job growth was robust, and inflation was low. Some in Congress touted Greenspan as the greatest central banker in history. After the housing bust and financial crash, though, Greenspan’s decision-making, particularly when it came to financial deregulation, came under harsher scrutiny.
Without disparaging Greenspan, Bernanke observes there were imbalances that built up in the U.S. economy during the later years of Greenspan’s leadership that helped precipitate the financial crisis of 2008. For example, from the late 1990s to early 2006, housing prices in the United States jumped about 130 percent. As that was happening, lending standards for new mortgages sank. Millions of new homebuyers got loans without making significant down payments or documenting their finances. Many of those subprime loans were further repackaged into risky, opaque mortgage-backed securities that were sold on the stock market.
The American housing bubble collapsed in 2006, when housing prices plunged 30 percent. For about one quarter of all mortgages, the amount of money owed was greater than the value of the house. Mortgage delinquencies soared. Bernanke observes that the amount of wealth destroyed by the collapse of the housing bubble was comparable to the amount lost during the dot.com bust in 2000 and 2001. However, the housing sector is integral to the American economy, partly because Wall Street bundles trillions of dollars in residential mortgages into exotic securities that are sold around the world. So the collapse of the American housing sector rocked the global financial system.
Bernanke describes how the Fed tackled the financial crisis that exploded during the fall of 2008 with the failures of Fannie Mae, Freddie Mac, Lehman Brothers, the American International Group and other firms. Bernanke defends the Fed’s massive loan to AIG, arguing that the insurance giant was integral to the functioning of the U.S. and global financial systems. “In our estimation, the failure of AIG would have been basically the end…. We were quite concerned that if AIG went bankrupt, we would not be able to control the crisis any further,” he writes.
Bernanke said he reflected on the Fed’s policy failures during the Great Depression as he formulated his actions in 2008 and 2009. He was determined to stabilize the banking system and push interest rates down to near zero. Bernanke details how the Fed provided short-term funding to commercial banks and created special liquidity and credit facilities that allowed it to make loans to other kinds of financial institutions such as investment banks, commercial paper borrowers and money market funds.
The methodical former professor gives a clinical rundown of his intervention, but in its profile of Bernanke, Time magazine was far more blunt in describing just how far the Fed chairman went to save the financial system: “[W]hen turbulence in U.S. housing markets metastasized into the worst global financial crisis in more than 75 years, he conjured up trillions of new dollars and blasted them into the economy; engineered massive public rescues of failing private companies; ratcheted down interest rates to zero; lent to mutual funds, hedge funds, foreign banks, investment banks, manufacturers, insurers and other borrowers who had never dreamed of receiving Fed cash; jump-started stalled credit markets in everything from car loans to corporate paper; revolutionized housing finance with a breathtaking shopping spree for mortgage bonds; blew up the Fed’s balance sheet to three times its previous size; and generally transformed the staid arena of central banking into a stage for desperate improvisation,” Michael Grunwald wrote. “He didn’t just reshape U.S. monetary policy; he led an effort to save the world economy.”
Bernanke argues that the programs he instituted helped the United States avoid another Great Depression but could not prevent a deep recession.
In the final section of his book, Bernanke discusses the Fed’s response to the recession. He acknowledges the central bank has adopted unconventional policies but says the Fed’s aggressive response to the economic crisis was in line with the historic role of central banks to provide liquidity to stem panic and stabilize the economy.
Bernanke says the Fed realized that its conventional monetary policy tools, such as adjusting the federal funds rate, were insufficient for the crisis it faced. By December of 2008, the federal funds rate was down to almost 0 percent and the central bank needed to take other steps to boost the economy. The Fed commenced large-scale asset purchases of Treasury bonds and mortgage securities to reduce long-term interest rates. This is often referred to as quantitative easing. The first round of quantitative easing was announced in March of 2009, the second in November of 2010, and the third round began in September of 2012.
Bernanke rejects criticisms that this program has insinuated the Fed into the realm of fiscal policy. He argues that quantitative easing is simply monetary policy by another name. Bernanke also defends a program called Operation Twist to drive down long-term interest rates and the Fed’s announcement of its future interest rate plans as important steps to revive the economy.
Bernanke notes that the recession in the United States officially began in December of 2007 and ended in June of 2009. But he acknowledges the recovery has been frustratingly slow, with the housing market strengthening only gradually and unemployment remaining stubbornly high. Bernanke says there are several different tools the Fed can use to unwind its aggressive monetary policy when the economy is stronger.
“The Federal Reserve and the Financial Crisis” is a valuable book. Bernanke provides an excellent primer on monetary policy. He is clear, organized and persuasive. This is an excellent guide for those seeking to understand Bernanke’s thinking and will be an essential document for historians seeking to understand his tenure as Fed chairman.
He acknowledges the Fed made important mistakes before the crisis by failing to use its powers to better regulate mortgage lending practices. Bernanke probably should have been more critical about his own slow reaction to the financial crisis. As the subprime mortgage crisis was intensifying in 2007, Bernanke made public remarks that downplayed the severity of the situation in an assessment that ultimately turned out to be flat wrong. He said in May 2007 that “we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
“The Federal Reserve and the Financial Crisis” would be even more valuable if Bernanke had described in more personal terms what it was like to be at the epicenter of a global financial crisis and if he had reflected on the difficulty of operating under great pressure with imperfect information. Those kinds of revelations may not seem characteristic for a quiet academic who shuns the political spotlight, but Bernanke has become one of the most important voices in Washington, despite his unassuming nature. Hopefully, these insights will be part of a memoir that he will likely write after leaving the Fed.
Bernanke does not indicate how the Fed will eventually climb down from the unprecedented steps it took to stanch the financial bleeding, but he insists the central bank has plenty of mechanisms to do so. His decision not to begin this process of “unwinding” has left many in financial markets worried that Bernanke does not have a plan to return monetary policy to a more normal stance.
So it will fall to his successor, Janet Yellen, to gracefully exit from the policies that Bernanke was compelled to initiate.
About the Author
John Shaw is a contributing writer for The Washington Diplomat.