Beat up Bernanke if You Want, Senators, but Please Reconfirm Him

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

December 11, 2009

The U.S. Senate is in the process of deciding whether to reconfirm Ben Bernanke as Chairman of the Federal Reserve Board (the Fed.) Despite a great deal of anger in the Senate and the public at large toward the Fed, I concur with most observers that he will in fact be reconfirmed. I also believe this would be the smart decision. It is true that he has made mistakes, particularly during the bubble years, but it would be extremely difficult to find anyone in a position of real power around the world during that time who was free of error.

The focus needs to be on the Chairman’s ability to perform the crucial tasks that will face him going forward, principally the need to unwind the Fed’s support for the financial sector and the economy without throwing us into a second recession or allowing persistent inflation to rear its ugly head. This will be a difficult mission, but one that he seems particularly well qualified to take on. In addition, changing chairmen at this point would bring real risks, since it would throw into doubt the assumptions of investors and business people about the likely actions of the Fed, which will be so important to the overall performance of the economy. This would not be a good time to encourage investors to sell U.S. assets and the dollar itself or businesses to freeze their investment and hiring plans.

Senators will need to express the anger that they and their constituents feel about the terrible recession and to insist that the Fed and its chairman bear a noticeable portion of the blame for the problems. They are right to be angry and they are right to affix some of the blame on our central bank and its head. I hope, however, that after they have made their sentiments clear they will still vote to reconfirm Chairman Bernanke. In my view, the senators need to weigh the following arguments for and against reconfirmation, which I believe clearly balance out to support a vote for Bernanke.

The Case Against Bernanke

The bubble. Bernanke was Fed Chairman as the bubble grew toward its most inflated point. He was in charge long enough to have taken action. It may not have made sense to raise interest rates, thereby slowing down the entire economy, in order to fight the asset bubbles – you find good economists on both sides of this issue. However, there were regulatory actions that could have been taken and a lot more use of the Fed’s ability to warn against dangers to the economy. Internally, contingency plans could have been developed that would have allowed quicker and more coherent action once the bubble burst.

Bank supervision. The Fed supervises the parent companies of all the major banks, as well as supervising many of the smaller banks directly. None of our nation’s regulatory bodies, including the Fed, covered themselves with glory regulating the banks during the bubble and in the early days of the crisis. It is probably unnecessary to cite the litany of mistakes made by the financial sector. Many of these mistakes were made at institutions at least partially regulated by the Fed. The Fed often did not recognize the problems and many times did not act as effectively or urgently as it should have even when it was aware of the troubles.

Consumer protection. Part of the Fed’s responsibility as a bank regulator was to protect consumers against products that were mismarketed or unreasonably risky. The Fed had authority to take action against some of the worst products and lenders associated with subprime mortgages, but did not do so in a timely manner.

The financial bailouts, particularly AIG. Much of the anger against the Fed relates to its central role in rescuing the financial system. The Fed provided financial support for the rescues of Bear Stearns and AIG, as well as providing guarantees for Bank of America and Citigroup. There are two levels to the accusations against the Fed. Those who feel that the rescues saved the bankers and other elites at the expense of the ordinary taxpayer are angry with the Fed for being an integral part of this. I personally do not fault the Fed for this, as I believe that we did indeed need to take strong action to aid the financial sector in order to avoid a far worse recession. At a more detailed level, mistakes were definitely made in the process of dealing with AIG and some of the other rescues and there are still other actions that appear reasonable to me but are viewed by others as mistaken.

Turf warfare. It has been sad to see the extent to which each of the country’s financial regulators has fought to preserve their power bases as the administration and Congress look to craft a sensible reform of our regulatory structure. The Fed under Bernanke appears to be guilty of this along with the others. It is possible that he and his colleagues have made their arguments solely out of a sincere desire for the public good, unsullied even by unconscious self-protection, but the nearly perfect alignment between their positions and the self-interest of the organization leads me not to believe this. If my fear is true, it is a less grievous sin than the other arguments against reconfirmation, but it ought to have some weight. We are in the equivalent of wartime and it is incumbent on those in positions of power to stay focused on the national interest.

Inflation. I do not personally agree, but there are many observers who fear that the Fed has pumped too much money into the economy and that we will inevitably face a bout of serious inflation. Senators who believe this would have a legitimate reason to consider voting against Bernanke, because he clearly disagrees with them about the appropriate monetary policy at this point in the recovery.

The Case for Bernanke

Saving the world. If one is to focus on Bernanke’s actions over the four years of his first term, I believe it is critical to recognize that he redeemed many of his past errors by acting boldly and intelligently from at least October of last year. He recognized that we were in danger of a meltdown of the financial system that could have led to a depression and would almost certainly have led to at least a far more severe recession than the ugly one we have experienced. He initiated an extraordinary series of unprecedented policy responses to reassure the markets and the world that our system would hold together. They worked. It is true that stepping back from these extraordinary measures will take great expertise and some luck, but his actions were critical in saving us from being in a much worse situation today.

Common mistakes; uncommon boldness. The mistakes that Bernanke and the Fed made in running the economy, supervising banks, and protecting consumers were unfortunately mistakes shared by the great bulk of those in power. In contrast, the bold and, at times, brilliant emergency responses since October 2008 are more closely associated with Bernanke and a small handful of others. To my mind, the broad extent to which his errors were shared makes them somewhat more forgivable, since it is hard to escape the zeitgeist and see the mistaken assumptions that are embedded in societal “wisdom.” On the flip side, he clearly led with his vision of how to respond once the crisis deepened.

Expertise on financial and economic meltdowns. I believe that the skills needed at the Fed for the next four years are much closer to those Bernanke demonstrated in the last year than those that he arguably failed to demonstrate in the first part of his term. We are fortunate that Bernanke is one of the world’s leading experts on the Great Depression, a period which has a disturbing number of parallels with today’s situation even acknowledging the many differences. A chairman without this background might have held back from the bold emergency measures the Fed has taken since October. We are not yet out of the woods and it is likely that this expertise will remain very useful. For example, he has written extensively on the Fed’s error in 1937 of withdrawing monetary support too quickly, which appears to have led to the severe second leg of the Great Depression. Understanding the constraints around withdrawing emergency support for the economy will be important as the economy recovers.

Exit strategies. Most of the Fed’s actions over the next couple of years will be focused on withdrawing the extraordinary levels of monetary and credit support that the Fed has been providing the economy and the financial system. It will be very tricky to get this right. At the big picture level, it will be difficult to know at what pace to move toward normal monetary conditions. The right movement is unlikely to be steady, but will need to slow down and speed up in response to developments. At a more detailed level, there will be a series of critical decisions to be made. For example, the Fed has taken on a much more significant credit allocation role than it has ever had, directing funds toward mortgages, both residential and now commercial, securitizations of consumer loans, etc. Unwinding this too quickly risks hammering these key sectors of the economy. Moving too slowly risks all the problems that can occur when the government becomes embedded in detailed credit allocation, including the risk that emergency measures may slowly become permanent ones. Bernanke is intimately familiar with all of these programs and the larger issues and is more likely to handle them well than would someone new.

Don’t switch horses in mid-stream. Such an argument can be galling when the horseman has helped create the problems that require fording the stream in the first place, but it remains no less a valid argument than when Lincoln used it to argue for his own re-election in the middle of the Civil War. Changing Fed chairmen at this point in the crisis/recovery would be perilous and we ought to give the incumbent a strong benefit of the doubt. Business people and investors have embedded their assumptions about Fed policy into a myriad of decisions they have taken. Businesses might freeze their new investments and defer hiring until they can see the new Fed chair in action. Investors may sell U.S. assets and the dollar in order to reduce their exposure to this new unknown variable. Further, much of the world would fear that a new Fed chair would be less independent of the politicians. This is a particular concern since a significant number of global investors fear that the U.S. will eventually choose to deal with its large budget deficits by inflating its currency. The actions that could lead to such inflation would likely be quite popular politically in their early stages, which is a key reason that we and other developed countries try to maintain central banks that are fairly independent of current governments.

Personal characteristics. I normally shy away from discussing personalities, but it must be noted that Bernanke appears to be an excellent public servant by nature. His focus seems to be primarily on advancing the general good; it does not feel as if power or money were the main drivers of his ambition. His career has been almost entirely in academics and public service despite the temptations that must have existed to earn a fortune on Wall Street. He has also made significant efforts to foster a more collegial and transparent Fed, rather than relying on the chairman’s historical ability to dominate the Fed and to make decisions somewhat opaque so as to avoid interference from politicians.