Ben Bernanke launches a New Deal at the central bank.
By Michael Brendan Dougherty
Ben Bernanke doesn’t look like a revolutionary. The Federal Reserve chairman has the dry, affectless manner of a timid researcher even as he rings in sweeping changes to monetary policy. He makes his actions seem qualified, tentative, easily revisable. But make no mistake: Bernanke is remaking the Fed from a mere central bank into an all-purpose policy tool.
All it took to send the dollar plummeting below parity with its Australian namesake on Oct. 15 was a few bland words from Bernanke, delivered at the Federal Reserve Bank of Boston. After agreeing that there should be “limitations” on the Fed’s “nonconventional” strategy for zero interest rates, and allowing that his critics have “understandable concerns” about inflations, he announced flatly, “there would appear—all else being equal—to be a case for further action.”
That set financial pundits squawking—“it’s what the market wants!”—and prompted goldbugs to hit “publish” on their “Gold $2,500?” articles. Fed watchers began to contemplate what it meant for the largest holder of American debt to announce that it will be in the market for even more debt. Bernanke had effectively proclaimed that the emergency measures the central bank employed during the crash of 2008 would now be standard practice. A New Fed was being born.
The old Fed was charged with keeping employment high and prices stable. Traditionally it attempted this by controlling interest rates and through the “printing press”—the Fed’s ability to make loans to member banks through the discount window. But in the 2008 crisis, the Fed moved dramatically to keep home and securities prices up by buying assets directly. What’s more, by putting its own purchase price on financial instruments that were rapidly being deemed “worthless” on the market, the Fed helped prop up the value even of securities it did not purchase. The central bank also involved itself deeply in the affairs of nonbanks like the investment house Bear Stearns and insurance giant AIG.
Bernanke admitted that the Fed was tottering into dangerous territory. “One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public,” he said.
The New Fed is the offspring of statutes dating to the early 1990s and a changing cultural shift among the central bank’s governors and staff. It has new tools, new prerogatives, and a new perspective. In the person of its chairman, Bernanke, the New Fed also has found its personality—experimental, academic, able to seem cautious while improvising wildly, and deathly afraid of deflation.
Bernanke, who taught economics at Stanford and Princeton, made his name for groundbreaking research into the Great Depression. In part he blamed the extended crisis on a Fed that had “passed into the control of a coterie of aggressive bubble-poppers.” Bubbles shouldn’t be popped because, he argued, banks were not just institutions that moved money from savers to borrows, they were vital to the entire economy in their role as discoverers of market information. Financial institutions were experts in gathering data about industries, and the loss of that data could lead to a vicious downward spiral.
Bernanke laid out his thoughts in the 1983 American Economic Review, in which he argued that bank failures meant that households, farms, and small firms found credit “expensive and difficult to obtain” and that the “credit squeeze helped convert the severe but not unprecedented downturn of 1929-1930 into a protracted depression.” Even sound businesses could not get access to necessary credit because the infrastructure of knowledge that would have made their worthiness plain had contracted along with the banking sector. The result was a credit crunch more severe than necessary. In public life Bernanke would vow to protect the economy from another wave of bank failures.
By the late 1990s, Bernanke also positioned himself as an aggressive foe of deflation. In a stinging 1999 paper, he lashed out at the Japanese central bank for that country’s “self-inflicted” economic torpor. “[The Bank of Japan’s] responses, when not confused or inconsistent have generally relied on various technical or legal objections—objections that, in my opinion, could be overcome if the will to do so existed. Far from being powerless, the BOJ could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism,” he wrote.
In short, the Bank of Japan was not willing to take extraordinary measures beyond settings its effective interest rate at zero. Bernanke urged firing every cannon against deflationary forces, even if new cannons had to be invented with the help of Japan’s government. He suggested setting aggressive inflation targets of 3-4 percent and urged “substantial currency depreciation.” Or, failing adequate debasement of the yen, he recommended a “helicopter drop”—his words—which, if it didn’t kick-start inflation, would at least increase “the real wealth of the population… as they are flooded with gifts of money from the government.”
Bernanke ended his paper by commending “Rooseveltian Resolve,” writing, “Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment … Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done.” Settled doctrine and legal limits were just failed paradigms and technicalities. For Bernanke, the work of escaping economic Depression is a matter of improvisation, trial, and will.
By the time Bernanke found himself at the Fed in the 2000s, America’s central bank had undergone a transformation that set the stage for his experiments. The DNA of long dead New Deal programs had been surreptitiously grafted onto the Fed. This was quite a change, since institutions such as the Reconstruction Finance Corporation and the Federal Housing Administration had been created in the first place only after Treasury Secretary Andrew Mellon and various Fed governors made it clear that the central bank of the 1930s should not be involved in securing mortgages or bailing out nonbank entites.
The extension of governmental credit directly to nonbanks has historically been a fiscal operation carried out by the Treasury Department, not a monetary-policy maneuver undertaken by the Fed. Restrictions on the Fed’s loaning power under section 13.3 of its charter meant that few nonbanks or business could ever qualify for an infusion of cash or easy lending. Fed governors had to vote that “unusual and exigent” circumstances existed. And the collateral offered by borrowers had to consist of “real bills” and certain Treasury obligations “of the kinds and maturities made eligible for discount for member banks under other provisions of [the Federal Reserve] Act.”
These limitations were undone in a little-noticed amendment of the Fed’s lending authority nearly 20 years ago—the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The law significantly revised the emergency liquidity provisions of the Federal Reserve Act, including Section 13. In particular, FDICIA permitted all nonbanks to borrow at the discount window for emergency purposes under the same collateral terms afforded to banks.
The key language was inserted by Sen. Christopher Dodd and written by a securities industry lawyer, Rodgin Cohen, dubbed by the New York Times the “Dean of Wall Street Lawyers.” In the 1980s Cohen was the leading mergers and acquisitions lawyer in the financial industry. He worked for Goldman Sachs and AIG, though he insists he was not acting on their behalf when he drafted the language.
In a speech before the bill was passed, Dodd announced that he wanted to give the Fed power “to respond in instances in which the overall financial system threatens to collapse” as he believed it had in 1987. The language he added to the legislation allowed the central bank to accept anything to its “satisfaction” for collateral. The revision anticipated the very terms used 18 years later to justify these powers. Loans could only be made to “systematically important institutions” that in an emergency couldn’t obtain private credit. Five members of the Federal Reserve Board were required to vote on approving this emergency borrowing.
Potential problems with FDICIA were noted in the Fed itself. Walker Todd, an economist at the Cleveland Fed, submitted a paper to the central bank’s Economic Review warning of the dangers ahead. He wrote:
How could a new element of taxpayer risk arise? One possible source is derived from the moral hazard aspects of the increased availability of Reserve Banks’ loans to nonbanks during financial emergencies. Nonbanks lacking eligible collateral or eligible purposes for borrowing must manage their affairs and conduct their relations with creditors and clients so as to be able to survive financial market emergencies. Now, with increased potential for assistance during emergencies, nonbanks’ managers might have less incentive to avoid recourse to the Federal Reserve. Although nonbanks still have strong incentives to run their firms prudently, their managers now have potential access to another funding source during financial crises. Whether this potential access alters non- banks’ business decisions—so as to make their calling upon that funding source more likely—remains to be seen.
In other words, investment firms and insurance companies—nonbanks—might come to see themselves as too big to be allowed to fail.
Todd had to revise and resubmit his paper to the Fed governors 22 times before it was published. “They knew I was right, they just wanted to run me around or prevent the fact from being discussed,” he says. Even as Todd’s article finally went to press, the Fed Board called again to try to stop publication. He was fired from the Cleveland Fed later that year and eventually became a research fellow and instructor for the American Institute for Economic Research. Todd now calls the 1991 revisions to Section 13 “the greatest abuse of the Federal Reserve’s monetary policy powers in recent decades.”
The Fed not only acquired new powers in the 1990s, it developed a new intellectual culture as well. The Federal Reserve’s traditional mindset was captured in 1973 when Howard Hackley finished revising his monograph, Lending Functions of the Federal Reserve Banks: A History. The book is a historical study long on technical and legal analysis of the central bank’s lending practices, with extensive examination of the reasons for its powers. Hackley’s book was both the product and a guarantor of a central bank mindset steeped in history and restrained by settled doctrine. It was the most cited text in Federal Reserve publications in the decade and a half after its publication.
But now Hackley’s influence is almost gone—what remains of the Old Fed mentality is to be found only in soon-to-be retiring Kansas City Fed President Thomas Hoenig or Richmond hardliner Jeffrey Lacker. As for the rest, “They’re beyond Hackley now,” says Todd.
The younger Fed presidents and staff prefer a central bank that takes its policy cues from advanced mathematical models rather than history. Fed watchers over the last two decades have had to familiarize themselves with esoteric systems such as the “New Keynesian” technique of “dynamic stochastic general equilibrium modeling,” which passed into and out of fashion within the Fed in just the last decade. The intellectual climate is more technical and adventuresome than before. Even if the New Fed’s policies backfire, the urge to innovate will be indulged.
And as with Bernanke himself, fear of deflation has become an obsession at the New Fed. In 2003, after Greenspan had cuts interest rates for the 13th time, the central bank continued to worry about how it might combat deflation even as home prices rocketed beyond all reason. That summer, the Dallas Fed published a paper titled “Monetary Policy in a Zero-Interest-Rate Economy,” which presented an argument for arresting deflation even after the Fed has slashed interest rates to nothing. The paper proposed, among other things, the possibility of the Fed buying real goods and services. But the most shocking idea it contemplated was a savings tax.
The paper’s authors, Evan Koening and Jim Dolmas, formulated a “stamp fee” or “carry tax” whereby currency would have to be stamped periodically, at a price, “in order to retain its status as legal tender. The stamp fee could be calibrated to generate any negative nominal interest rate the central bank desired.” The authors mooted rates of perhaps 1 percent a month. In other words, Fed economists were contemplating penalties for saving money—effectively a government charge of 12 dollars for every 100 dollars you didn’t spend in a year.
Bernanke’s response to the 2008 crash didn’t involve anything quite like that. But he made extensive use of the powers the Fed obtained from FDICIA. And 17 years after drafting the language that empowered the Fed to lend to nonbanks, Rogdin Cohen was the very man Bear Stearns CEO Alan Schwartz would call as his investment house reeled. Cohen’s recommendation: call the Fed. The central bank not only crossed the Rubicon to save a “systemically important” financial house from extinction, it gave Bear Stearns enough life to allow Treasury Secretary Henry Paulson to call Deutsche Bank CEO Josef Ackermann and plead with him to take on the ailing Bear. Bernanke’s Fed would go on to order the purchase of undreamed of forests of rotting financial timber, barely pretending to comply with the its own rules about sound investments.
With a second round of asset purchases and quantitative easing to begin after the Fed’s November meetings, Bernanke has announced that the New Fed lives on. The old central bankers derived their policies from the data of history—often imperfectly, but almost always with caution. The New Fed tears through constraint and custom, emboldened by the latest econometric theories. Whereas Fed Chairman William McChesney Martin warned the Senate in 1957 that “there is no validity whatever in the idea that any inflation, once accepted can be confined to moderate proportion,” Bernanke today defines price stability as hitting inflation targets no matter what it takes. And now that the New Fed has grown accustomed to using powers once wielded only by the Treasury, there is little to stand in the way of its chairman’s “Rooseveltian resolve.”
Michael Brendan Dougherty is a TAC contributing editor and a 2009-10 Phillips Journalism Fellow.
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