In FED We Trust (12 page)

“At that time,” he added, “there was a tendency to think that to prove you were a star, you had to write a thesis that was difficult and mathematical.” Bernanke didn’t. “I used to say that the more work I had to do on a thesis, the worse the thesis. I didn’t have to do much work on Ben’s thesis.”

At MIT — then widely regarded as having the strongest economics department in the world — Bernanke occasionally crossed paths with another wunderkind, the child of two economists and the nephew of two Nobel Prize winners, Lawrence Summers, who earned his undergraduate degree at MIT in 1975 and an economics Ph.D. at Harvard. While at MIT, Bernanke also met Anna, then a Wellesley senior; the two were married the week after she graduated.

In 1979, the couple moved to Palo Alto, California, where Ben took up teaching at Stanford’s Business School while Anna pursued a master’s degree in Spanish. MIT classmate Jeremy Bulow invited them and another young economist, Mark Gertler, to share a house he had rented from Stanford economist Robert Hall. “My first reaction was how shy and unassuming he was,” Gertler said. “If I hadn’t heard he was a superstar, I would have thought he was just a good guy. Once you start talking about economics, though, he got animated — or about baseball.” It wasn’t just the game; it was the stats, the sort of sports minutiae made popular at the time by Bill James and his
Baseball Abstract
.

The late 1970s and early 1980s were a time of ferment in academic economics and in economic policy in Washington. In academia, a school of thought
known as rational expectations was arguing that Fed moves to raise or lower interest rates didn’t have much impact on the economy if they were anticipated by the public and the markets, as they often were. At the Fed, Volcker wasn’t worrying about models. He was exercising the Fed’s monetary muscle, raising interest rates to double-digit levels to bring down inflation at the cost of a severe recession.

At Stanford, seminar rooms and coffee rooms were thick with talk about the ways markets work or don’t work when one side has much better (“asymmetric”) information than the others and about the divergence of the interest of principals (such as shareholders) and those of their agents (corporate executives), especially when the agent has more information than the other. Bernanke applied that theory to the way banks and borrowers work, making his initial mark with the
American Economic Review
article on the causes of the Depression that was published in 1983, a couple of years after Bernanke finished it.

The conventional textbook explanation of the Fed’s influence on the economy is simple: the Fed raises interest rates, which makes borrowing more costly for businesses — so they borrow and invest less — and more costly for consumers, too, so they borrow and spend less, particularly on houses, cars, and appliances. Lowering interest rates has the opposite effect: more borrowing, more investing, more spending. The uncomfortable secret among economists, though, was that they had a hard time documenting this story. Something was missing.

Working with Gertler, Bernanke built on his initial 1983 paper on the Depression and claimed to have found the missing link: the functioning of banks and financial markets. It was a subject that macroeconomists for a couple of generations had treated as intriguing, but not crucial to understanding booms and busts. Bernanke and Gertler emphasized the expertise, information, and relationships on which banks relied to decide to whom to lend. When this “credit channel” got clogged — because banks were closing (the Depression) or because they were trying to rebuild their capital cushions (the Great Panic) — the economy suffered.

Eventually, Bernanke and Gertler broadened their thinking and came up with the notion of a “financial accelerator” to describe the way shocks were
transmitted — through the credit channel, among other ways — from the economy to the financial system and then back to the economy. A quarter century later, the Great Panic became a frightening illustration of the phenomenon Bernanke and Gertler had described. As the housing bubble burst, falling real estate prices reduced the value of houses (the collateral families had used to get mortgage loans) as well as the value of the mortgage-linked securities that banks held. The first phenomenon made borrowers much less appealing to lenders. The second ate into banks’ capital cushion; with less capital and the prospect of even more losses in the future, banks grew reluctant to lend. That further weakened the economy. Inevitably, looking at this unraveling through the lens of his early work shaped Bernanke’s response.

After six years at Stanford, Bernanke, then thirty-one, took a tenured position at Princeton, and he and his wife moved to New Jersey, where they raised two children, Joel, now at Weill Cornell Medical College in New York, and Alyssa, who graduated from college in the spring of 2009. Bernanke seemed destined to live out his career in the world of academia, looking at the Fed from the outside. In 1996, Bernanke became chairman of Princeton’s economics department, a post that often offers more hassle than honor. When Bernanke returned to Princeton for a speech early in his Fed tenure, Alan Blinder noted that he had spent six years as chairman. “Six
and a half,”
Bernanke said, wanting credit for every month. In Bernanke’s own speeches, the term stretched to seven years.

By all accounts, Bernanke was good at the administrative job. He helped strengthen the economics department by courting prominent names in the field — including Paul Krugman, who later won the Nobel Prize in economics. (Bernanke might have had reason to regret the Krugman coup; he proved generally unpopular with students and colleagues and occasionally used his popular
New York Times
column to snipe at his former colleague for, among other sins, propping up “zombie” financial institutions.) Bernanke
was an aggressive fund-raiser and found a way to establish a successful and lucrative center on finance, overcoming resistance from some economics professors who feared it was a stealth business school. Despite his successes, though, Bernanke was passed over for provost, the top academic management post at Princeton, in favor of political scientist Amy Gutmann, who later became president of the University of Pennsylvania.

In early 2002, the Bush administration had two vacancies to fill on the seven-member Fed board, now one of the very few politically safe ways a president can try to influence the Fed. Lyndon Johnson and Richard Nixon openly pressed their Fed chairmen to keep interest rates down, while President George H. W. Bush made no secret of his displeasure with what he considered Greenspan’s stinginess prior to the 1992 election. Although nothing in the law demands it, recent presidents have taken a hands-off, mouth-shut approach to the Fed. Both Bill Clinton and Bush the younger made a fetish of respecting the Fed’s independence on interest rates; Barack Obama shows signs of doing the same. This approach reflects the international consensus that a politically insulated central bank is the best way to counter inflation.

By 2002, confidence in the U.S. government’s management of its economy rested almost exclusively on the reputation and health of the aging Greenspan, then seventy-six years old. Greenspan’s allies at the Clinton Treasury, Robert Rubin and Lawrence Summers, were gone. Greenspan was the only remaining member of what a
Time
magazine cover famously called “The Committee to Save the World” for a story that described how the trio had “prevented a global meltdown — so far” during the financial crisis that enveloped Asia in 1999. Bush’s other economic advisers saw an urgent need to put some economic heavyweights on Greenspan’s board in case the old man slipped in the shower.

Glenn Hubbard, then on leave from Columbia University’s Graduate School of Business to chair Bush’s Council of Economic Advisers, had his eye on Bernanke, a longtime acquaintance. Fearing that Greenspan might be
uncomfortable with a Princeton professor — the last one, Clinton appointee Alan Blinder, chafed at Greenspan’s dominance of the institution — Hubbard assured the chairman that Bernanke would be less confrontational. To sweeten the deal, Hubbard proposed packaging Bernanke with the promotion of Greenspan loyalist Donald Kohn. That part, the chairman liked.

Bernanke had thought a lot about the Fed, particularly about the post-Greenspan era. He coauthored a
Wall Street Journal
op-ed in 2000 with the provocative headline: “What Happens When Greenspan Is Gone?” His answer: “Fix the roof when skies are sunny” and declare an explicit, public, numerical target for inflation “to ensure that monetary policy stays on track after Mr. Greenspan.” Given his interests, Bernanke had thought about — but never pursued — a Fed job; thus, when Hubbard called a few months after September 11, he was intrigued and made several trips to Washington for interviews.

“All I had in mind,” he said, “was taking a couple of years off from the university and doing some public service. It was still in the penumbra of 9/11…. I had never been in the military, and so I felt I needed to do something. The best thing I had to offer was my knowledge of monetary economics and monetary history.”

Indeed Bernanke, who once described himself as an “academic lifer,” had seen precious little of life outside of the university. To academics, he was among the best and brightest: degrees from Harvard and MIT, teaching posts at Princeton and Stanford, editorships of prestigious journals, and a catalog of academic writings that put him among the twenty economists most often cited by peers, according to the Research Papers in Economics database. But Bernanke had barely tasted politics and never the high-stakes Washington flavor.

A few colleagues at Princeton knew he was a Republican, but he hadn’t flaunted it or publicly advised any candidate. His only political experience was on a local school board. “On the administrative side,” he once joked, “I served seven years as the chair of the Princeton economics department, where I had responsibility for major policy decisions such as whether to serve bagels or doughnuts at the department coffee hours.” Bernanke had never worked on Wall Street, in government, or in business. But the White House wasn’t
looking for a Renaissance man; they wanted to strengthen the brainpower at the Fed.

As is the custom for significant presidential appointments, Bernanke’s ultimate interview was in the Oval Office with Bush. “He talked a bit about his own economic goals — Social Security privatization at the time — but the thing I remember the most was, he asked, ‘Do you have any political experience?’” Bernanke recalled later.

“I said, ‘Mr. President, it won’t count for much in this office, but I’ve served for two terms as the elected representative on Montgomery Township’s school board.’

“And he said, ‘No, no, I think that counts for a lot in this office, and I think that’s really terrific.’”

Bernanke was a solid citizen on the Greenspan Fed, but few governors had much impact on Greenspan’s decisions. Colleagues confided privately that Bernanke’s interventions at the Fed’s policy meetings were undistinguished — though several incidents illustrated his dry, if sometimes nerdy, sense of humor.

In August 2002, Bernanke noted that revised government data showed the 2001 recession to be worse than initially reported. “We were always pessimistic about
forecasting
, and now
backcasting
seems to be a problem as well!” he said. “I have a modest proposal … if the BEA [Commerce Department’s Bureau of Economic Affairs] can restate GDP figures and firms can restate their earnings, the Fed should have the option to go back and restate interest rates from last time.” The wonks around the table laughed, according to the transcript of the meeting.

Four months later, at a December 2002 meeting, Greenspan skipped his usual lengthy soliloquy preceding the discussion of interest rates and recommended that the Fed leave interest rates unchanged. Bernanke told him: “I support your recommendation, Mr. Chairman. But if your brevity is going to be a habit, though, I would like to get my tuition back.”

An advocate of relaxed academic dress codes, Bernanke joked that one of the biggest changes in his life that came with working at the Fed was wearing a suit to work every day. Wearing uncomfortable work clothes, he once said, is a way that people signal that they take official responsibilities seriously. He lamented that his proposal that Fed governors wear Hawaiian shirts and Bermuda shorts had gone unheeded.

His speeches, however, were tightly reasoned, influential, and closely read, both inside and outside the Fed. Among Bernanke’s most visible roles was promoting, explaining, and defending Greenspan’s strategy of keeping interest rates very low. This was, in part, a deliberate campaign to reduce the risk of deflation — a generalized decline in prices, which can lead to a debilitating disease that makes it ever harder for borrowers to pay back debts. Deflation was a major feature of the Great Depression, and most economists thought it had been eradicated until it reappeared in Japan in the 1990s. As U.S. inflation rates fell in early 2002, the Fed saw deflation as a possibility for which it had to prepare.

So in November 2002, to a group of economists in Washington, Bernanke delivered a talk titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” The speech described all the ways the Fed could fight deflation, a mix of standard textbook talk and speculation about innovative maneuvers the Fed might undertake if interest rates fell so low they couldn’t go any lower. (When a similar threat emerged in late 2008, the earlier speech was revived and scrutinzed because it was such a useful guide to the options he was putting before the Fed.)

Bernanke clearly meant for his November 2002 speech to be reassuring. But the reaction to it underscored the differences between a professorial lecture and words spoken by a Fed governor. Bernanke argued that even if the Fed cut interest rates all the way to zero — then an almost unimaginable event — it wasn’t out of ammunition. Obviously, it couldn’t cut the price of borrowing below zero, but it could increase the supply of credit by simply pumping money into the economy. The government might, he suggested, cut taxes, increase the federal deficit, and issue bonds that the Fed would buy by printing money. This, he said, was “essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.” (Friedman used the line in 1969 to argue that depression and deflation were avoidable. If nothing else worked, the Fed could send a helicopter to drop dollar bills to get people spending.)