If there was any doubt that the Greenspan era was over, Ben Bernanke’s rough day on June 25 dispelled it. The Federal Reserve chairman endured hours of grilling by the House Oversight and Government Reform Committee, a stunning contrast to the deferential treatment long accorded to his predecessor. With Bernanke’s four-year term winding down, the debate over whether President Obama will reappoint him is getting a lot louder.
The committee’s sharp questions focused on the role the Federal Reserve played in Bank of America’s takeover of Merrill Lynch last year. But Fed watchers have recently been focusing on important new evidence of Bernanke’s actions in the early part of the decade. The Federal Open Market Committee (FOMC) meets eight times a year to plan various aspects of monetary policy, including interest rates. It releases verbatim transcripts after a five-year lag. Fed members often make speeches and give interviews, but the transcripts show exactly what goes on behind closed doors.
2003 was a pivotal early bubble year. The war drums had been beating for months, which suppressed economic activity in the early part of the year. But by the middle of 2003, Iraq was an apparent success. With “Mission Accomplished” as the national mantra and Saddam in the market for spider holes, American consumers let out a collective sigh of relief. Third quarter GDP growth was a stunning 7.5 percent. The fiscal and monetary jets were on full blast. George W. Bush’s tax cuts passed that May, and in June the Fed cut the fed funds rate to 1 percent and kept it there for the next year. The great national binge was underway.
But the FOMC transcripts show that Bernanke, then a Fed governor, was feeling a bit grumpy. With the economy gathering speed and the fed funds rate already at a historic low, he searched for reasons to cut interest rates even further. The text of the meeting on Aug. 12, 2003 evidences his concern:
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. My concern is focused on the behavior of inflation both in the short term and in the long term. Regarding the short term, though I can see that output gaps are extremely hard to measure, the most reasonable guess is that the current gap remains substantial. Moreover, because of rapid productivity growth, the gap may close very slowly in coming quarters even if output growth is quite strong. That’s bad news for workers, and it poses some risks to consumer spending. More to the point, a persistent output gap implies that additional disinflation over the next year remains a distinct possibility. Even if we consider actual deflation to be too remote to worry about, further disinflation poses important risks.
Bernanke’s caveat about output gaps was appropriate. The output gap is the difference between the actual output of an economy and the output it could achieve at full capacity. As economic statistics go, it is notoriously unreliable. Actual GDP is hard enough to measure and is habitually revised. One can imagine the pitfalls of a group of statisticians in Washington trying to estimate the collective potential of the entire U.S. economy. Beyond that, some larger dynamics affect the utility of the output gap as a statistic. If Detroit makes cars that consumers don’t want, leaving large parts of the automobile industry and its associated national supply chain fallow, the output gap will reflect that. So too if a U.S. company outsources manufacturing to China or India. These are long-term, structural changes in the economy, influenced by forces such as globalization, demographics, and consumer preferences. They cannot be solved through monetary policy.
But Bernanke’s solution is to monetize them. And using the output gap to predict inflation, as he did in that 2003 meeting, is particularly risky when it justifies easy monetary policy. Carnegie Mellon economics professor Allan Meltzer has noted that there are “lots of examples of countries with underutilized resources and high inflation. Brazil in the 1970s and 1980s.” The problem is that employment and other output-gap components can remain intractably weak in the face of rising prices. For Bernanke, however, rising prices are subordinate to the output gap. This can create a cycle in which commodity inflation saps money from the broader economy and causes deflation, which the Fed in turn fights with ever easier money. At the FOMC meeting on Dec. 9, 2003, Bernanke made his position clear:
The odds that we have begun a strong and sustainable expansion have risen significantly. … [T]hose on the Street and elsewhere who lately have been worrying about inflation have tended to point primarily to raw materials prices, which have been rising, and to the dollar, which has been falling. … [E]ven very large movements of raw materials prices—which are quite common by the way—appear to have muted effects on intermediate goods prices and, most important, no discernible effects at all on final goods inflation. … [A]lthough output gaps are of course very hard to measure, the weight of the evidence continues to support those who believe that considerable slack remains in the economy.
Bernanke rode his obsession with the output gap and his disdain for raw materials up to $145-a-barrel oil, while Americans stopped spending on anything that didn’t come with an octane level—including mortgage payments and credit-card bills.
The transcripts from the most recent FOMC meetings won’t be made public for five years. But it’s easy to guess what they contain. After June 24, 2009, the committee justified keeping the fed funds rate between 0 and 0.25 percent with this press release:
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.
In the days before that FOMC meeting, oil traded in the $70s, up from the $30s earlier in 2009. The new surge in prices at the pump helped stir speculation about the potential for a double-dip recession. The output gap threatened to get wider.
As an important part of Bernanke’s dovish monetary philosophy, the output gap issue is reflected in his voting record. For eight straight meetings of the FOMC, from June 2003 to May 2004, Bernanke voted with Greenspan to keep rates at 1 percent. While builders swarmed over Tampa and Las Vegas, and bidding wars started to break out in the suburbs of Boston and New York, Bernanke hit the lecture circuit in support of Greenspan’s policies. In a high-profile paper he presented in early 2004 with senior Fed official Vincent Reinhart, Bernanke wrote, “There seems to be little reason for central banks to avoid bringing the policy rate close to zero if the economic situation warranted.” When Greenspan championed a laissez-faire approach to Wall Street regulation, including on financial derivatives, Bernanke joined the charge. At the hearing in November 2005 to confirm him as Greenspan’s successor, he had the following exchange with former senator Paul Sarbanes:
SARBANES: Warren Buffett has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?
BERNANKE: I am more sanguine about derivatives than the position you have just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced, and diced, and given to those most willing to bear them. They add, I believe, to the flexibility of the financial system in many different ways. With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk in their institutions.
After Bernanke offered a quick defense of the hedge-fund industry, Sarbanes said, “Well, I commend this area to you as one that should have some focus of your attention. Otherwise, it may well come back to haunt you.”
A Fed chairman’s job has two broad parts: performance and predictive ability. The former depends in large measure on the latter. The existence of “green shoots” is still open to debate. Bernanke’s prescience is not. Consider his track record:
March 28, 2007: “The impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.”
May 17, 2007: “We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
Feb. 28, 2008, on the potential for bank failures: “Among the largest banks, the capital ratios remain good and I don’t expect any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.”
June 9, 2008: “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.”
July 16, 2008: Fannie Mae and Freddie Mac are “adequately capitalized” and “in no danger of failing.”
If Obama reappoints him, Bernanke’s judgment will determine when and how the Fed reverses its massive monetary stimulus and starts to shrink its balance sheet. Oil, the dollar, and the U.S. consumer hang in the balance.
At Intrade, a website that lets the public wager on the likelihood of certain events occurring, the probability of Obama keeping Bernanke was 75 percent in early June. After the House committee’s grilling, it dropped to 57 percent. But the betting activity was more a reaction to the tough new tone in Congress than a referendum on Bernanke’s technocratic skills. He deserves recognition for overseeing the design and implementation of various liquidity and credit facilities that helped stabilize the financial markets. It was an immense task—albeit one made easier by a tall stack of blank checks on his desk.
But that accomplishment merely shows Bernanke’s proficiency at navigating the quotidian guts of the financial system. It says nothing about his judgment or competence in the broad strokes of policy. For years, Bernanke was Greenspan’s intellectual hatchet man, a deceptively even-keeled advocate of policies that even some ardent Fed defenders now admit contributed to one of history’s most spectacular and destructive boom and bust cycles. He has been involved with the Fed since the 1980s, when he was a visiting scholar at several Fed banks. The system of risk and regulation and oversight, the interconnected web that failed so epically, is one he has had a role in shaping for decades. What else has to happen for someone to be judged unfit to run monetary policy? Arguing that Bernanke deserves another four-year term based on a few months of relative calm is like admiring how fast the fire department got to a five-alarm blaze after its chief failed to enforce building codes.
Wilson Burman is the pen name for the New York City investment professional who writes The Cunning Realist blog.
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