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Thursday, August 27, 2009

Galbraith questions whether Bernanke saved the economy

James K. Galbraith - "President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen."

Two pieces are reproduced and linked below. The first is the day after comment on Bernanke's reappointment. The second is a review of David Wessel's In Fed We Trust, with Galbraith's questioning of the received wisdom that Baffled Ben rescued the economy. (emphasis below added)
Resist False Optimism
James K. Galbraith

Odds are, Mr. Bernanke’s second term will not be as interesting as his first.

Ben Bernanke came to the Federal Reserve imbued with academic notions. One of these was that central banks should concentrate on “inflation targeting.” Another was that we were living in a Great Moderation, that efficient financial markets would provide for stable economic growth evermore. Ha, and ha-ha-ha. Both of these ideas, Mr. Bernanke had to chew and swallow. His merit is that he did so, quickly, when the time came.

In the crisis, he cut interest rates to zero, nationalized the commercial paper market, lent with abandon here and abroad –- and kept the financial system afloat. He deserves credit for this. But President Obama overstated matters when he said that Mr. Bernanke had kept us out of a Great Depression. This remains to be seen.

One challenge will be to overcome fixed ideas on deficits -– ideas sadly shared in Washington.

Keeping big banks alive is not the same as restoring credit flows. Credit will not recover until the housing crisis subsides. Right now, with record inventories, collapsed cure-rates, and a flood of foreclosures we’re far from that. The jobs picture remains grim. Low interest rates alone can’t fix these problems, nor can “quantitative easing.” Mr. Bernanke’s first challenge, going forward, will be to recognize these facts — and his own limited power.

His second challenge will be to overcome fixed ideas on deficits -– ideas sadly shared throughout Washington. Fiscal expansion remains necessary. More is needed, especially to sustain state and local public services. This is no moment for people who are made nervous by a big government debt. With the private sector still flat, the public sector has to grow, or the economy will not.

A third challenge will be to resist deceptive optimism. In July, 2007, Mr. Bernanke was still testifying that our housing problems could be managed. I don’t believe that he didn’t see the impending collapse. But he didn’t want to precipitate it — understandable, but bad policy. He should now beware of cheerleading for a recovery that may, at best, leave millions behind.

Ben Bernanke is smart and capable, honorable and honest. Yet his renomination signals continuity in policy from the late Bush era, through this year and onward. President Obama passed up a chance to reorganize his economic team. When the moment comes that the policy has to change, the task will not be easier, because of this.

Fed Up
Did Ben Bernanke really save America's financial system?

By James K. Galbraith
In Fed We Trust:
Ben Bernanke's War on the Great Panic
by David Wessel
Crown, 336 pp.
David Wessel’s new account of the Great Crisis, In Fed We Trust, has many merits: it is timely, well written, and informative. The protagonists—Ben Bernanke, Henry Paulson, and Timothy Geithner—were faced in September 2008 with a supreme challenge. Wessel gives us, without judgment, a narrative of what they did. As history, this is first-draft stuff, but it’s as good a first draft as one could hope for, less than a year after the events it describes.

Wessel begins with the collapse of Lehman Brothers, as the crisis climaxed. We see the government acting as the ultimate investment banker, an uber-manager for the too-big-to-fail. Bernanke, Geithner, and Paulson shuttle between New York and Washington, send signals, urge Lehman to find a buyer, court Bank of America and then Barclays, and pressure other Wall Street CEOs to join a deal. It is all in direct line of descent from J. P. Morgan’s epic rescue of the Trust Company of New York in the panic of 1907—a comparison Wessel does not neglect to draw.

Bernanke, Paulson, and Geithner could not repeat Morgan’s achievement. They did try. Ben Bernanke, the academic economist, had no sympathy with the oft-stated view that such matters should be left to the market; in Wessel’s words, he “thought that was idiocy.” And though Paulson “made what sounded like an unambiguous declaration that he had been unwilling, not unable, to save Lehman,” Wessel contradicts him: “That was not true.” At the time (later statements revealed) they doubted the government had legal authority to rescue—with public funds—an investment bank whose assets were largely pledged or worthless, and so could not be used as security for a public loan. Two days later, when AIG failed, they paid for this judgment. After that, lesson learned, whatever powers were needed would be found, and no other large financial institution would be permitted to fail.

From this opening, the story turns to the Federal Reserve, the institution whose face for so many years was Alan Greenspan, secular oracle, the man who believed in markets. As Wessel documents, Greenspan did not miss the housing bubble. He saw the crisis coming. He was warned of the impending crash, notably by the late Fed Governor Edward Gramlich. He knew what he would have to do. But he elected—he chose—not to do it.

Greenspan’s reputation is now shattered, not least by his own confessions, but it is still useful to read here of the cult of obsequy that surrounded the Federal Reserve chair in his time. Wessel quotes a cringe-inducing 2005 assessment by economists Alan Blinder and Ricardo Reis: “No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although both may come in time as the legend grows.” The chapter on Greenspan is aptly titled “Age of Delusion”—a phrase borrowed from a manuscript Ben Bernanke had been working on at Princeton. Bernanke’s subtitle: “How Politicians and Central Bankers Created the Great Depression.”

Ben Bernanke ascended to Greenspan’s post by dint of academic merit, low-keyed but clearly superior intelligence, and—most curiously—a largely apolitical appointment process within that most political of White Houses, that of George W. Bush. (Wessel explains that Fed Governor Kevin Warsh, “the networker,” acted as Bernanke’s link to high Republican politics. Will President Obama now give the Fed a comparable link to the Democrats? Don’t hold your breath.) Once in, Bernanke set out to shape monetary policy to his academic values: collegiality, transparency, more focus on what he imagined was the Fed’s core mission, namely “fighting inflation.” Clearly the Age of Delusion wasn’t over.

Bernanke’s merit, in these pages, was quick learning. By Wessel’s timetable, learning took hold in December 2007, when he first moved to cut rates in order to ward off, or anyway help mitigate, the oncoming recession. (The financial crisis had started the previous August, with the collapse of the interbank lending market.) Soon there would be the forced sale of Bear Stearns, which was at—or perhaps over—the limits of law and precedent in central banking. To Vincent Reinhart, a former senior Fed staffer, it “meant that the Fed would always be expected to bring money to the table when trying to arrange the rescue of a big financial firm.” With AIG, with TARP, and after, the commitments cascaded—dollars by the trillions went into commercial paper, into the banks, into foreign central banks—in processes neither collegial nor transparent. Thus, in the phrase that forms the second subtitle of this book, “the Federal Reserve became the fourth branch of government.” And the system survived.

Or did it?

There is a larger book, as yet unwritten, for which In Fed We Trust will prove a valuable source. That work will have to take on the questions that merely frame the narrative here.

The first question is: Did the system actually survive? It is true that checks still clear, that incipient runs on small banks and money markets were stopped, that neither the dollar nor the euro collapsed, and that the major commercial banks were not nationalized. But does all this add up to survival of finance capitalism as we knew it? Can we expect, with moderate passage of time, that households will resume borrowing, banks will resume lending, and that before long we will pick up the pattern of our economic lives as before?

Or does the fact that the Federal Reserve was prompted, in the heat of the crisis, to issue trillions of direct loans to private institutions fundamentally strip away the capitalist character of the system? Are we left with a system of large institutions of doubtful solvency, state dependent, unable to function without an implicit public guarantee, and therefore also needing government approval for their actions? If so, how is this system different from that in, say, the People’s Republic of China? Wessel notes that Chinese observers described the result as “socialism with American characteristics.” It’s not necessarily a joke.

Second, one must ask whether the Bernanke-Paulson-Geithner measures actually worked, not just in the sense of stopping bank runs, not just to put a floor under a deep slump, but in the larger sense of laying the foundation for a strong recovery and return to high employment.

Were the massive frauds that underlay the housing debacle rooted out, their perpetrators prosecuted and jailed? Not yet. Were foreclosures stemmed? Not yet. Have housing prices reached bottom? There is some evidence for that. Will housing construction recover? Not for years. Did “quantitative easing” get lending started again? Not in a way that would support new business investment or household borrowing.

And how could it? It was the borrowers, not the lenders, who last fall precipitated the economic downturn. Auto sales didn’t collapse because willing buyers could not get loans: they collapsed because people stopped buying cars. Without collateral, without home equity, without job security, householders decided, en masse and rationally, to save what they could. Without prospects for profit, businesses slashed their investment. And when tax cuts were injected by congressional conservatives into the stimulus plan, these too were saved, not spent. And so the housing crisis drags on, and the crises of state and local government finance, and the crisis of mass unemployment, show no signs, yet, of abatement.

Eventually stimulus funds will get spent. Eventually, households will start needing new cars and even new houses. But as the weeks go on, that moment seems to recede. Meanwhile the chorus of deficit hawks and “exit strategists” is swelling—and it looks like the next moves in macro policy will be toward contraction, not growth. It does not help that economic forecasters are always predicting a return to growth six months hence; such forecasts, though often wrong, serve to protect policymakers from pressure to action.

Perhaps, then, the Bernanke-Paulson-Geithner strategy was wrong? Perhaps the right thing to do would have been to put several large institutions through receivership, if not last September then from the start of Obama’s presidency in January 2009? Looking narrowly at monetary policy, perhaps Bernanke and company are wrong that their zero-interest policy helps stimulate activity: no one wants the cheap funds, while low rates reduce income from interest, cutting into spending power. Perhaps it would have been better to keep interest rates up, and to double or triple direct federal spending on investment, in support of state and local budgets and of private purchasing power. Perhaps the right thing would have been less focus on saving banks, and much more on saving jobs, families, and homes.

We will not know for sure, because our leaders did not take this path.

Finally, there is a question of character. David Wessel’s method is to treat each of his major protagonists as an upstanding public servant, hardworking and incorruptible. I do not criticize this approach; otherwise he could not have written the book, and anyway, Wessel is convinced that this view is correct, and there is plenty of evidence—long hours worked, hard decisions made—that supports it. In the history of George Bush’s presidency, no one will confuse Bernanke, Paulson, and Geithner with, say, Michael Brown of FEMA or Paul Wolfowitz and the others who planned the invasion of Iraq.

Still, historians will have a harsher task. Did Ben Bernanke’s academic commitment to Milton Friedman’s monetarist principles (including “inflation targeting”) render him unable to raise warnings, to see dangers, and to take action early enough? Do these ideas today still cause him to overrate monetary policy and underrate what is needed in new spending? Was Henry Paulson influenced, perhaps even driven, by loyalties to Goldman Sachs? Was Timothy Geithner too close to Wall Street—a deal maker, an investment banker—when an actual regulator was required? Is the Age of Delusion over yet?

Time, investigations, and greater detachment than found here will settle these issues, later on.

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