Ben Bernanke Bestrides Our Narrow World Like A Colossus Draft

Ben Bernanke Bestrides Our Narrow Economic World Like a Colossus J. Bradford DeLong Professor of Economics, U.C. Berkeley Research Associate, NBER [email protected] September 18, 2008 DRAFT Ben Bernanke bestrides our narrow economic world like a colossus, the closest thing to a central economic planner we have ever had in the United States. Unelected—he was appointed by president George W. Bush and confirmed by an overwhelming majority in the Senate. Unaccountable—unless the congress decides that it wishes to amend the Federal Reserve Act and thus open itself up to blame for whatever else goes wrong with the economy, a thing that congress has shown no sign of wanting to do for a decade. Responsible only to his conscience—and his open market committee of himself, the other six governors of the Federal Reserve, and the twelve presidents of the regional Federal Reserve Banks. He is a figure out of Plato's Republic: a moral philosopher-prince to whose judgment we have entrusted a remarkable share of control over our destiny. How did an ivory-tower academic whose specialty is the details of the collapse of the U.S. economy into the Great Depression get to this position? What does he do all day? How did we, collectively, get to this institutional state? And what consequences does this set of institutional arrangements have for our likely future? The time to pick up the story is 1844. The place is London, England. The occasion is the debate in Britain's House of Commons over the terms on which the Bank of England's charter—the document allowing it to function as a corporation—is to be renewed. The Bank of England was

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then the British government's bank. The British government was then the largest economic institution the world had ever seen: more money flowed in as taxes and out as spending than had ever been seen before, and the Bank of England processed that flow. The British economy was then the fastest-growing economy the world had ever seen: it was the age of the original Industrial Revolution, with the first large-scale automated factories, the first steamships, the beginning of the throwing of the first net of railroads across the world, and the first time that any national economy had developed the chronic disease that we call the industrial business cycle. Before the nineteenth century the causes of times of economic distress were obvious: war, or famine—a large-scale harvest failure—or disease—a plague—or a state bankruptcy—a government that decides that it is simply not going to pay its debts. You could see what was going wrong and what had caused it. The industrial business cycle was different—and mysterious. Factories would be shut, but not because of a lack of raw materials or of workers who wanted the jobs or of people who needed the products. Construction workers would be idle, but not because the country had enough railroads or buildings or ports. People would be much poorer than they had been a couple of years before, but not because an invading army had burned their cities or a plague of locusts eaten their crops or a fit of amnesia led them to forget how to make all the things they had made before. What seemed to be happening was that the flow of funds from individuals with savings into banks that promised to keep those savings safe and then out to companies that wanted finance to expand of even to maintain their operations… somehow dried up. Sometimes the flow of money into the banks dried up first, and so the interest rate the banks had to pay to attract funds and deposits rose, and so the interest the banks were receiving from the loans it had made was all of a sudden less than the interest they had to pay out on the deposits they had attracted—and the banks ran short of cash, couldn’t pay their obligations, crashed, went bankrupt. This further dried up the flow of funds from savers: why deposit your money in a bank that might crash next week? Sometimes the confidence of entrepreneurs in the expansion of their enterprises flagged and faltered, and the value that they paid each other for shares of ownership of factories and railroads and

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office buildings fell, and they could no longer sell shares in the properties they had built for enough money to pay back the banks from which they had borrowed—and the banks ran short of cash, couldn’t pay their obligations, crashed, went bankrupt. This further dried up the flow of funds from savers: why deposit your money in a bank that might crash next week? This had not happened before the Industrial Revolution. It has happened irregularly but frequently every five years or so on a varying scale of severity ever since. It was in this context in the first half of the nineteenth century that the Bank of England developed a custom: in a panic, during a crash, in a depression, when the other smaller banks are running short of cash, the Bank of England would print some up and lend it out to the other banks. Nobody thought that Bank of England notes were bad because nobody thought the Bank of England would crash: it was too useful to the British Empire which would never let it fail. And so the Bank of England lent to smaller banks that could not meet their obligations, wishing for repayment only after the crisis had passed. This lending would (a) keep smaller banks from crashing, (b) lower interest rates somewhat because the banks were no longer so desperate to attract deposits, and (c) raise asset prices somewhat because banks were no longer so desperate to sell off collateral to get cash. And, indeed, the crises did pass. Savers reappeared and the interest rates banks had to pay to attract deposits fell. Entrepreneurs returned from rest cures for nervous exhaustion and recovered their confidence so asset prices rose again. And the Bank of England got repaid—or at least got repaid enough of the time to keep the system going. All of this was illegal. The notes the Bank of England printed were supposed to be backed by good gold in its vaults. So in 1844 the British Parliament debated whether the Bank of England’s charter should be amended to make legal what the Bank was already doing. Prime Minister Robert Peel said no: if the Bank of England has the legal power to print up extra notes to rescue banks in a crisis, he said, then the banks will get into more crises: making more extra-risky loans will be extra profitable if the luck is running in, and everybody will know that the Bank of England will rescue them. But, said Robert Peel, if the governor of the Bank of England decides, in a crisis, that this time the banks should be rescued and lent money—that the risk of creating “moral hazard” and encouraging feckless

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financiers is less than the damage that would be done to the country’s livelihood by allowing the panic to snowball into a crisis and then into a depression—then we, the government, will not prosecute the Bank of England for breaking the laws that govern it. As my teacher Charlie Kindleberger put it in his book Manias, Panics, and Crashes, the principle was that the central bank should always show up when it was really needed, but beforehand and especially in normal times its appearance should always be in doubt. As the nineteenth century passed, the Bank of England’s role experienced some mission creep. There had always been a “bank rate”—a rate at which other banks could borrow from the Bank of England. At the start that Bank of England would periodically adjust “bank rate” to follow the general price in the free money market in normal times, but it found that the other banks were waiting for it before they would change their own lending rates. By the end of the nineteenth century the short-term interest rate in Britain was an administered rather than a market price all the time—not just in the panics when the Bank of England lent money in emergency rescue operations. The United States did without a central bank in the nineteenth century. The United States had the severest panics and the deepest depressions of anyplace in the nineteenth century—1857, 1873, 1884, 1893, 1896, 1907. In 1907 the financier J.P. Morgan said “enough” and constituted himself as a pick-up central bank because nobody doubted that his and his partners’ fortunes were so large that their credit was good. And in 1913 congress created the Federal Reserve. The Federal Reserve did not acquit itself well during the Great Depression: Milton Friedman and Anna J. Schwartz always blamed that on the untimely death in 1928 just before the crash of the Federal Reserve’s leader, New York Federal Reserve Bank President Benjamin Strong, and the lack of competent replacements. Other central banks also did not acquit themselves well during the Great Depression: they all seem to have decided that maintaining the gold standard was more important than rescuing banks, which is why we no longer have a gold standard. After World War II the Federal Reserve found its footing. Eight times a year plus emergencies the Federal Open Market Committee met to assess

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the levels of the federal funds rate and the Federal Reserve discount rate—the American equivalents of British “bank rate.” The Federal Reserve set its interest rates with an eye, first, to maintaining price stability (because without low inflation all other tasks become much more difficult); second, to minimizing the danger of a future financial crisis; and, third, to keeping the economy’s level of growth as high and unemployment as low as possible given the other two objectives. In the first post-World War II generation the Federal Reserve came under heavy political pressure: members of congress who would denounce the Federal Reserve for keeping interest rates too low and thus triggering inflation; members of congress who would denounce the Federal Reserve for keeping interest rates too high and thus creating high unemployment and low real wages; presidents anxious that the Federal Reserve lower interest rates in time to produce a thorough-going economic boom just when they were running for reelection. But the 1970s taught members of congress that criticizing the Federal Reserve is likely to backfire because if it takes your advice you cannot then blame it for what has gone wrong in the economy. The 1980s taught presidents and their staffs that getting into a fight with the Federal Reserve is likely to shake business confidence and risk either higher inflation or higher unemployment or both. And the memory of the 1970s and the 1980s created a culture inside the Federal Reserve of resistance to political pressure: a belief that the root cause of our only post-World War II depression, 1982, had been then Federal Reserve Chair Arthur Burns’s willingness to bow to pressure from his political patron Richard Nixon to create a high-pressure economy for Nixon’s reelection campaign in 1972. The last even semi-serious political effort to pressure the Federal Reserve came in 1991, when George H.W. Bush’s White House delayed Alan Greenspan’s reappointment as Chair and threatened to find a replacement if Greenspan and his committee did not lower interest rates far and fast enough to suit John Sununu, Sam Skinner, Jim Baker, and company—what then White House counsel C. Boyden Grey told me were “counterproductive and pointless games.” Since Paul Volcker’s appointment as Chair in 1979, the Federal Reserve has been effectively independent from the rest of the government. And whenever it makes a

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decision, the word comes down to all executive branch officials to stay on message: Our role at the Treasury Department was to support the independent regulators…. The Treasury Department supports the actions taken by the Federal Reserve Bank of New York and the Federal Reserve. We believe the actions taken were necessary and appropriate… Thus after one and three quarter centuries we have our current system. We have a market economy—in all other sectors social democracy with government ownership, control, and regulation of at least the “commanding heights” of the economy has been in retreat for a generation. But in the middle of this market economy is this immense island of central planning: the Federal Reserve. In normal times, it—not the market—decides what the short-term interest rate is. Think of it: The interest rate is perhaps the key price in the economy. It determines the terms on which we trade wealth in the present off for wealth in the future. When the interest rate is low, our focus is on the future which is valuable in terms of the present. When the interest rate is high, our focus is on the present because far-future promises of cash are not worth very much in today’s dollars. You might think that if there were ever a decision to be left to the market and its wealth weighting of individual preferences it would be the terms on which we trade present comfort off for future wealth. But we don’t. We leave that decision to the discretion of the moral philosopher-prince who is Ben Bernanke, and his committee. And in extraordinary times, when the flow of funds through financial markets dries up, we leave the decisions of which banks to nationalize, which to close down, which to forcibly merge, and which to rescue and on what terms to our financial overlords in the Eccles Building on Washington’s Mall. We do this for essentially conservative reasons: our system was not designed, it simply grew as less bad at each stage than the alternatives open. The Bank of England did not start out thinking its job was to rescue the banking sector in crisis, it just found there was a crisis and thought it could do so good. Robert Peel did not set out to create a central bank, but

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prosecuting the Bank of England for charter violations seemed a mistake at the time. The Bank of England did not set out to supplant the market and turn the interest rate into a centrally-planned and administered price, but monetary management in extraordinary times led to monetary management in unusual and then in ordinary times. The U.S. congress in 1913 did not set out to turn Ben Bernanke into a moral philosopher-prince, but the absence of an American central bank was blamed for the every decade dire panics and depressions that struck between the Civil War and World War I. And post-World War II presidents and congresses did not set out to cede all effective powers of national macroeconomic management to the moral philosopher-princes of the Federal Reserve; it just seemed like the least-bad idea at the time. To the extent that we are all Burkeans now, the fact that all of the countries in the world large enough to have truly independent economic policies have groped toward and now settled on modern independent central banking practices as their institutions for macroeconomic management suggests that there is some wisdom, or at least some avoidance of unwisdom, But just because central banking is independent of politics does not mean that politics is independent of central banking. “You may not be interested in the dialectic,” Leon Trotsky once said, “but the dialectic is interested in you.” That we now have independent central banks run by technocratic moral philosopher-princes like Ben Bernanke, and that we have these central banks because elected legislator and executive-politicians do not want to challenge their authority or change their charters—these have powerful implications for the freedom of action and the choices that elected governments can make. Let me give three examples: First, we saw this most strongly back at the start of the Clinton administration, in 1993. Alan Greenspan as Federal Reserve Chair was firmly and genuinely convinced that further increases in the budget deficit or even the maintenance of the federal budget deficit at its then current level was inflationary. Deficits raise debt. One of the things governments do to get from under the burden of a high national debt is to inflate the currency. Financiers are smart enough to understand the government’s incentives. Back in 1993 Alan Greenspan was firmly convinced that if he wanted to maintain price stability—and he wanted to maintain price stability—then he had to offset the upward pressure on inflation coming

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from expectations that someday the government would start printing money to ease its debt load. How would he offset it? By raising interest rates and so creating a supply imbalance in the labor market: you can’t have durable inflation without rising wages, and you can’t have rising wages when there is an excess supply of workers without jobs looking for jobs in the labor market. Thus the debate about the economic policy of the Clinton administration carried out in the fall and winter of 2002-2003—the proper balance between middle-class tax cuts, public investment expenditure increases, upper-class tax increases and economy to reduce the budget deficit, et cetera—was brought to a sharp and immediate halt by the Federal Reserve. Because Alan Greenspan credibly committed to keeping inflation low as job #1, any Clinton administration economic policy of benign neglect applied to the deficit would be very likely to produce a substantial recession. Greenspan, of course, said that he was not an unelected technocrat imposing his policy preferences on the elected president but was merely informing them of the reality that was the bond market—which generated James Carville’s crack about how he wanted to be reincarnated: I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody… Second, we saw a similar process at work in the opposite direction between 1995-2000. Federal Reserve Chair Alan Greenspan’s belief—over the objections of many if not most of the members of his committee—in the “new economy” computer-driven technological revolution of the internet led him to reduce interest rates below what standard Federal Reserve reactions found appropriate for the late-1990s levels of inflation and unemployment, and generated the high-productivity growth high-employment boom of the late 1990s that then turned into the dot-com bubble. Much of the political and policy success of the late 1990s was made not in the White House or in the Treasury but in the Federal Reserve’s Eccles Building, and as a result of this judgment call by Alan Greenspan.

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Third, the current financial crisis has its roots in Alan Greenspan’s decision to keep interest rates very low in 2002 and 2003 to head off the danger of a deflation-induced double-dip recession, and his subsequent decision that the costs of cleaning up after a housing bubble were likely to be less than the costs of the high unemployment that would be generated by a preemptive attempt to pop a housing speculation bubble before it really got started. Two years ago I would have said that Alan Greenspan’s judgment here was correct. Six months ago I would have said that his judgment was probably correct. Today—in the immediate aftermath of the largest nationalizations anywhere, anytime—I can no longer state that Alan Greenspan made the right calls with respect to the level of interest rates and the housing bubble in the 2000s. In all three of these episodes, the president and the congress—neither of them wishing to erode confidence by a public disagreement with the Federal Reserve—had about as much power to set or influence policy as the Queen of England does: they had the power to talk to the decider, Alan Greenspan, and nothing more. The coming of the great financial crisis of 2007-2008 does not weaken but rather strengthens the Federal Reserve’s independence in the short and medium run, no matter how one apportions blame among the Federal Reserve, the SEC, other regulatory agencies, and the overpaid princes of Wall Street. A strong economy is in the president’s policy interest: policy initiatives, especially expensive policy initiatives, cannot be enacted and implemented when the economy is weak. And a strong economy is in the president’s and the current congress’s political interest: weak economies lead to reelection defeats. The policy and political dangers of challenges to the Federal Reserve’s authority, independent status, and leading role are thus now unusually high and likely to remain unusually high for the duration of the current financial crisis and for a year or two thereafter. The next administration will find itself advising, warning, privately admonishing, and publicly partnering with an independent Federal Reserve that will see itself as rightfully and legitimately taking the leading role in economic policy. Cicero said that the problem with his ally Cato was that he thought they

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lived in the Republic of Plato while they really lived in the Sewer of Romulus. It is either our curse or our blessing, depending on how you look at it, that we live in the Republic of the Central Banker.

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