This column was written by Ethan Harris, co-chief U.S. economist for Barclays Capital (BCS) - Get Report and author of the new bookBen Bernanke's Fed: The Federal Reserve After Greenspan.
It is often said that the
chairmanship is the second most important job in America. And yet, while there are many books about Alan Greenspan, there have been no books written about Ben Bernanke -- until now.
Contrary to popular belief, Bernanke is not Greenspan with a beard. Indeed one of the big mistakes investors have made in the last two years is to view Bernanke through Greenspan glasses. Bernanke's policies are shaped by a very different background than his more famous predecessor.
Consider the most important questions of the day: How should the Fed behave if it suspects an asset bubble, and what should it do if that bubble bursts? While there is intense soul-searching going on, the consensus at the Fed is that
should take an "asymmetric risk management approach" to suspected bubbles. That is, it should not react to bubbles as they develop, but should react strongly when they pop to avoid serious collateral damage to the economy.
Why not react to a suspected bubble? Bernanke and others see three problems with preemptive strikes against asset bubbles. First, bubbles are hard to identify in real time. Specifically it requires that the Fed believe it can outguess the collective wisdom of the market. Second, even if a bubble is identified, policy lags make it hard to counter. By the time Fed policy kicks in, the bubble may be deflating of its own accord. Third, monetary policy is the wrong tool for popping a bubble. Aggressive actions may be required, causing serious damage to the economy. Bernanke likens it to doing "brain surgery with a sledgehammer."
I would add a fourth reason for stepping aside in the face of a potential bubble: Attempting to stop a bubble could expose the Fed to severe political criticism. The Fed does not want blood on its hands when the markets retrench; it would rather the markets suffer self-inflicted wounds.
Frankly, I've never found the Fed's arguments convincing. There is no question that asset bubbles pose a difficult challenge to central banks. However, all of the problems the Fed faces in countering asset bubbles also apply when the Fed is countering an overheating economy.
In both cases the Fed must grapple with imprecise models, policy lags and political risks if mistakes are made. If the Fed can take away the punch bowl when
threatens, surely they can water down the punch bowl when asset market parties get out of hand. Leaning against bubbles should be part of the Fed's risk management strategy. When Greenspan started to suspect "froth" in the housing and credit markets he should have abandoned the super-slow 25
rate hikes and tightened monetary and regulatory policy.
So much for the inflation phase of the bubble. What about when the bubble pops?
A look at Bernanke's background makes it clear why he has been so aggressive in battling the
crisis. Bernanke is an expert on the financial accelerator model: He believes it is impossible to understand the business cycle without a clear understanding of the linkages between credit and the economy.
He is an expert on the Great
. What is his main lesson from that period? Here is what he said to Milton Friedman about the Fed's role in the Depression: "You're right, we did it. We're sorry. But thanks to you, we won't do it again." Specifically, by stepping aside and allowing the collapse of the banking system the Fed was a major factor in the Great Depression.
Third, Bernanke is a close student of Japan's deflation of the 1990s. As a Fed Governor in 2003 Bernanke went over to Tokyo and essentially called for a nonviolent revolution. Here was nothing less than an official of the Federal Reserve urging Japanese economists to "speak out and present clear, persuasive arguments that will help guide the policy debate and urge leaders to effective action."
For Bernanke, the lesson from Japan was simple: Move decisively before confidence and
seep out of the system.
The battle plan he laid out for Japan sounds just like what we are seeing today. Step one: Push short-term rates down to zero. Step two: Drive down long term rates by buying longer-dated debt. Step three: Push down interest rates on private securities. Step four: Have a coordinated easing of monetary and fiscal policy. Finally (and this is where Bernanke got his "helicopter Ben" nickname), step five: Argue for "a money-financed tax cut," which is like Milton Friedman's famous "helicopter drop of money."
While there have been some missteps along the way, I think Bernanke has been just as aggressive as I would have expected. However, he has made some tactical errors. Like most economists -- including yours truly -- he initially greatly underestimated the scope of the financial crisis. Like most central banks the Fed was head-faked by the inflation scare this summer. At least Bernanke bended, but did not break, refusing to follow the hawks on his committee and in Europe and hike rates. And the Fed and other central banks clung to the "moral hazard" argument too long.
Looking ahead, my motto is: If they have proposed it, it will probably happen. The Fed and Treasury will continue to hit the financial accelerator until the markets respond. Sitting back is not in Bernanke's DNA. This does not mean a quick turn in the economy, but it does mean the job will get done.
Ethan Harris is a Managing Director and co-chief U.S. economist for Barclays Capital. A former research officer at the Federal Reserve Bank of New York, he has taken top honors in the
Wall Street Journal's
economic-forecasting rankings for 2007 and is regularly one of the top fixed income economists in the
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