In FED We Trust (42 page)

By early summer 2009, the Fed had purchased more than $550 billion of mortgage-backed securities and more than $150 billion in U.S. Treasury bonds. But the bond market pushed up interest rates anyhow, prompting tension inside the Fed. Some wanted to step up the bond-buying to help the economy. Others worried the more bonds the Fed bought, the more difficult it would find “the exit strategy,” the timely retreat from intervention.

The Fed’s actions may have saved the U.S. economy from catastrophe but an increasingly vocal band in Congress found it uncomfortably undemocratic to head off future crises by making the Fed the overarching overseer of financial stability and monitor of the nation’s biggest financial companies, as Obama proposed in June 2009. “We should not ignore that the Fed has had some responsibility for systemic risk regulation under the current structure” and thus the current crisis, said Senator Mark Warner, Democrat of Virginia, on the Senate floor, making a case heard with growing frequency at the time. The Fed and the Treasury, he complained, had struck “private deals” that put “smaller, less powerful but often better run institutions at a competitive disadvantage.” The answer to the Great Panic, he said, was not to make the Fed more powerful, but to diffuse its regulatory powers in a grand council of regulators. Geithner thought that a dangerous idea, akin to running a firehouse by committee and calling meetings before responding to alarms. But Obama did propose amending the law to require the Fed to get the Treasury secretary’s written approval before exercising its authority to lend to nearly anyone in “unusual and exigent circumstances.” The Democratic and Republican leaders of the Senate Banking Committee sponsored a nonbinding resolution calling for “an evaluation of the appropriate number and the associated costs of Federal Reserve banks,” a flare
across the bow of the Fed and regional Fed presidents who are neither appointed by the president nor confirmed by Congress. Even if those efforts fizzled, Congress was likely to reopen the Federal Reserve Act as it renovated the financial regulatory apparatus. As Greenspan had warned privately for years, once the law was reexamined, the Fed was vulnerable to changes that it might not welcome.

Bernanke, like Greenspan and Volcker before him, subscribed to the view that the best way to protect a democratic society from undesirable rates of inflation was to keep control of interest rates and the supply of money away from elected politicians. Politicians need the frequent approval of voters and are naturally tempted to settle for a little more economic growth today and defer the fight against inflation until after the next election; the only case for an independent central bank in a democracy is that it can take a longer-term view and do what is in the interest of the people in ways that elected politicians cannot. By going directly to the politicians’ constituents, the voters, through the nonfinancial press, Bernanke was seeking to build public support to resist any changes to the Federal Reserve Act that would curtail the Fed’s ability to fight inflation.

Sitting on a bench on Main Street in Dillon, South Carolina, Bernanke made a pitch that would have done a congressional candidate proud. “I come from Main Street. That’s my background,” he told
60 Minutes
. “I’ve never been on Wall Street. And I care about Wall Street for one reason and one reason only: because what happens on Wall Street matters to Main Street.”

BERNANKE’S DASHBOARD
June 12, 2009

*   *   *

So, with the benefit of a bit of hindsight, what did the Bernanke Fed get right and what did it get wrong? What lessons have been learned so far?

The Fed failed to see the problems percolating under the surface of a prospering economy. Once the housing bubble and credit bubble began to burst, the Fed’s diagnosis was wrong. It saw risks, but not their full dimensions. It thought the housing bust would be “contained,” and it wasn’t. The Fed was hardly alone; plenty of others made the same mistakes. But as Congress moves toward designating the Fed to be the guardian of the nation’s financial stability, the Fed’s inability to see the Great Panic coming is worrisome. Unless it understands what it failed to see then, it will not be any better at seeing the approach of the next crisis in time to avoid it. Bernanke himself remains reluctant to criticize Greenspan publicly. He continues to argue that the single most important factor in creating the credit bubble was something over which the Fed had no control: an inflow of foreigners’ savings to the United States that led banks and other financial institutions to compete aggressively for borrowers, which in turn led to increasingly lax lending standards.

“Regulators,” he said at Morehouse College in April 2009, “did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation.” Yes, but by using the Fed’s existing authority to put new restrictions on subprime mortgages, Bernanke demonstrated that the Fed could have done more than it did and earlier. And the absence of full-throated warnings in the years just before the housing and credit bubbles burst undercuts the argument that the Fed did all that it could.

All that was largely history by the time Bernanke took over as Fed chairman in February 2006. While every one of Bernanke’s subsequent decisions can be second-guessed and criticized, and most have been, he cannot be fairly criticized for not anticipating every bizarre turn that the crisis took. Or the bad luck that led nearly everything that could go wrong to go wrong. Or the shortcomings of a U.S. financial regulatory regime woefully ill equipped for a crisis like the Great Panic. Or the unpopularity of a lame-duck president or the missteps of a new Treasury secretary or the
shortsightedness of some high-profile actors on Wall Street who badly misread the public mood.

All decisions aren’t created equal. The fair question is whether Bernanke got the big ones right.

By August 2007, Bernanke understood that the economy was at risk, yet from today’s perspective his initial efforts seemed timid. It wasn’t until December 2007 that the Fed began experimenting with new ways to lend to banks, and not until January 2008 did the Fed get serious about cutting interest rates aggressively. But once Bernanke and the other Musketeers realized the risks, they were creative and bold. To his credit, Bernanke managed to hold the FOMC together as he pushed the Fed to places it had never gone before, or at least to places it hadn’t visited since the Great Depression.

Bear Stearns was a shock to the Fed. Helping JPMorgan Chase buy the failing investment bank was prudent. But the Fed’s response immediately afterward was flawed. It was clear at the time that Bear Stearns was a big deal. “The past ten days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse,” I wrote in the
Wall Street Journal
of March 28, 2008. “On the Richter scale of government activism, the government’s recent actions don’t (yet) register at FDR levels. They are shrouded in technicalities and buried in a pile of new acronyms. But something big just happened. It happened without an explicit vote by Congress. And though the Treasury hasn’t cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess.”

Yet neither Bernanke, nor Geithner, nor Paulson took the six months between Bear Stearns and Lehman to prepare adequately. They did not use Bear Stearns as a lever to try to get Congress to act quickly to provide emergency authority, even if temporary, to handle the collapse of a major financial institution. They did not hint that they anticipated that taxpayer money would be needed to shore up the banking system. They did not turn the bare-bones April 2008 “break the glass” plan into a contingency plan ready
to be implemented if needed. Bernanke and Paulson argue that Congress wouldn’t have acted in the spring and summer of 2008 because members didn’t perceive the Main Street economy to be at risk. Perhaps. But Bernanke and Paulson didn’t
try
. Had they done so, they might have had more credibility later when they needed it. If the two men had a game plan, they didn’t explain it.

When Lehman weekend arrived, the Fed had left itself only two options, or allowed the Treasury to narrow its options to two: either sell Lehman as Bear Stearns had been sold, or let it go into bankruptcy. Bernanke and Paulson convinced themselves the system could withstand the latter course because the warning signs had been so many and so visible. They were wrong about that. They didn’t realize the lesson that many people had drawn from Bear Stearns: the Fed would somehow find a way to keep Lehman going. They didn’t appreciate the tidal wave that a Lehman bankruptcy would cause. Had they realized how much damage Lehman’s bankruptcy would wreak, they might have had a third option ready, one that showed some of the same creativity they exercised at other points in the crisis as they stretched law to do
whatever it takes
to protect the system from clear and present danger. Whether AIG’s collapse was caused by Lehman’s or whether it was inevitable is a question that defies a simple answer. The reaction to Lehman’s collapse reasonably led Bernanke and Paulson to rush to keep AIG from following Lehman into bankruptcy. But the form it took was flawed, unsuccessful, and expensive in taxpayer dollars and in damage to the Fed’s reputation.

Paulson and Bernanke did seize that September 2008 moment to get Congress to come up with $700 billion, even though getting the legislation through Congress proved so tortuous that it undermined confidence in the ability of American democracy to cope with a major financial crisis. (At the Fed, there was more than one conversation about the advantages of parliamentary systems, where the prime minister can count on his party to do whatever he deems necessary at the darkest hour.) But in the weeks and months that followed, neither Paulson nor Bernanke nor Geithner laid out a coherent plan for using the $700 billion to restore the banking system to health. They made mistakes of substance and mistakes of communications. Their plan was seen as, and may have been in retrospect, too generous to Wall
Street and the banks, Citibank in particular. That perception contributed to an uncomfortable political reality in the spring of 2009: Congress appeared unwilling to approve more taxpayer money for the banks, even though Bernanke, Geithner, and White House economist Larry Summers all knew that it probably would take more than the $700 billion already approved to repair or, as they put it, “recapitalize” the banking system.

Professors make the what-if game respectable by calling it “counterfactual.” It is tempting. What if Bernanke had moved more swiftly to attack the Great Panic in August 2007? What if Bear Stearns had become the catalyst that generated legislation focused on coping with the collapse of a big financial institution? What if Congress had approved more money sooner to recapitalize the banks? What if the initial bank rescue plan had been more coherently structured, implemented, and explained? What if Geithner had stayed at the New York Fed, his tax returns sheltered by scrutiny and his stature undiminished, and someone with more gravitas had been installed at Treasury? What if someone in the Treasury or the Fed had persuaded AIG not to pay those retention bonuses before they became so public? Things might have been better, of course. It’s hard to know for sure.

But there is another side to the what-if game. What if Ben Bernanke had not been a student of the Great Depression? What if he had not resolved to do
whatever it takes
to prevent a second Great Depression? What if he had been timid or cowed by the resistance inside the Fed? Those questions are easier to answer: the economy would have been even worse than it is now, and this book would have been an account of how the Fed had dithered and delayed, as an earlier generation of central bankers had. It would have been a book about Ben Bernanke’s failure to keep his November 2002 vow to Milton Friedman: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”