The Bernanke Doctrine
In a speech this week to celebrate the Federal Reserve’s 100th birthday, Chairman Ben S. Bernanke said one of the central bank’s greatest strengths is its willingness, “during its finest hours,” to stand up to political pressure and make tough decisions. To remind him that those pressures aren’t new, Bernanke keeps in his office one of many two-by-fours that construction industry workers mailed to Paul Volcker to protest the former Fed chairman’s double-digit interest rates.
To tame runaway inflation, Volcker had to crush the construction business. That culture of political independence freed Bernanke -- who conducted what may be his last news conference as chairman this afternoon, and whose eight-year tenure ends next month -- to break the central-bank mold just as Volcker had done. He established what might be called the Bernanke Doctrine, a two-part philosophy. First, use the Fed’s balance sheet to do whatever it takes to stimulate a faltering economy. With this new tool of monetary policy, he maneuvered the U.S. away from another Great Depression. Second, put financial stability alongside the Fed’s existing mandates of price stability and full employment.
Along the way, he spurned the free-market, deregulatory thinking of his predecessor, Alan Greenspan, and startled his Republican political sponsors. Yet he earned the admiration of colleagues and central bankers worldwide, many of whom are now copying his moves. Underwater homeowners, underemployed workers and underpaid savers may not see Bernanke as a heroic figure. History most likely will.
Bernanke didn’t arrive at the Fed in 2006 intent on revolutionizing central banking. Just the opposite: The economy seemed strong, with unemployment at 5 percent and annual growth of 3.3 percent. The housing bubble, however, was inflating rapidly. The smartest economists, Bernanke included, failed to see that the combination of undercapitalized financial institutions, subprime loans, securitizations and exotic derivatives could produce the lethal mix that crashed the global economy. Bernanke’s Fed was responsible for regulating large banks and home loans, and it failed.
What happened next redeems him. Bernanke recognized that an economy running on credit would succumb unless the Fed fixed broken credit markets, revived consumer demand and avoided deflation. Using his deep knowledge of the mistakes of the 1930s, Bernanke set up one lending facility after another to finance everything from commercial paper to auto loans. He helped persuade Congress to adopt the Troubled Asset Relief Program to bail out hundreds of banks. He made sure dollar loans were available to overseas banks. He brought interest rates down to near zero, and promised to hold them there indefinitely. To make that commitment more credible, he put more of the Fed’s deliberations on the record.
Granted, mistakes were made. Letting Lehman Brothers Holdings Inc. fail was a big one. Bernanke and Treasury Secretary Hank Paulson wanted to make an example of Lehman and end the moral hazard that bailouts cause. That turned a liquidity crisis into a full-blown panic.
By the end of 2009, the emergency had abated, but the economy was still sick. So Bernanke’s Fed got even more creative. With inflation hawks -- Republican lawmakers, conservative economists and even some of his Fed colleagues -- screaming bloody murder, he started the first of three phases of quantitative easing. The Fed bought enormous quantities of Treasury bonds and mortgage-backed securities to depress long-term interest rates and induce investors to shift into other assets. The Fed’s balance sheet grew from $1 trillion in 2008 to almost $4 trillion, where it stands today -- greater than Germany’s gross domestic product.
Today, as many had expected, Bernanke announced that the pace of QE would be slowed -- though modestly, from $85 billion a month to $75 billion a month, with further “measured steps” to follow if the recovery continues as the Fed expects. He stressed that while the Fed is still adding to its balance sheet, it isn’t tightening monetary conditions: It’s still adding stimulus, but from now on at a gradually diminishing rate.
The policy worked. It energized the stock market, lowered long-term interest rates, supported the interest-rate-sensitive housing and auto markets, and cut unemployment -- not a lot, but enough to quiet many critics, especially once they saw that inflation remained tame.
Bernanke, meanwhile, backed the Dodd-Frank Act’s many financial reforms. He agreed that large banks shouldn’t get taxpayer subsidies in the form of lower borrowing costs because of their “too big to fail” status. To prevent that, he required the largest banks to hold more capital to absorb future losses. He also required them to submit to rigorous stress tests. More recently, the Fed threw its weight behind a stronger Volcker Rule (to limit banks’ proprietary trading) than most observers had expected.
The Fed chief also had the temerity to criticize Congress for failing to devise a long-term deficit reduction plan coupled with short-term stimulus. As the congressional dysfunction worsened after 2010, QE was the only stimulus in town -- again, to the chagrin of Republicans, who all but accused him of aiding the enemy. He was right, and they were wrong.
Under Janet Yellen, the next Fed chief, the Bernanke Doctrine is certain to prevail. The central bank will take its mandate to reach full employment as seriously as the order to keep inflation in check -- and will reach for new instruments, if necessary, to do it. The Fed will strive with equal determination to assure financial stability -- recognizing, in effect, the third part of its new triple mandate.
Bernanke, scholar of the Great Depression, would not have wished that expertise to be called upon. But it was, and the U.S. can consider itself fortunate he was there.
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