In FED We Trust, page 6
As Bernanke retold the story, the post-Strong Fed “passed into the control of a coterie of aggressive bubble-poppers,” the most determined of whom was Adolph Miller, an economist who was among the first members of the Fed board and served for twenty-two years into FDR’S presidency. Herbert Hoover — a neighbor and friend of Miller — was a fervent foe of “speculation” and encouraged him. Under Miller’s influence, the debate inside the Fed shifted from whether to try to stop stock market speculation to how to stop it. The Washington faction threatened to cut off loans to New York City banks as a way to stop them from lending to stockbrokers. It also favored rhetoric, the sort of jawboning that Alan Greenspan tried with his warnings about “irrational exuberance” in 1996.
Strong’s successor at the New York Fed, George Harrison, a Harvard-trained lawyer who had been the Washington board’s general counsel, argued that the brokers would get money elsewhere and that rhetoric would do nothing. His solution was to raise interest rates in an economy that had hardly recovered from a recession that began in November 1927, and was experiencing no inflation. He prevailed, and the Fed’s discount rate on loans it made to banks went from 3.5 percent in January 1928 to 6 percent by August 1929, higher than at any time since 1921.
The Fed tightened credit again in 1931 at just the wrong moment, responding with then-conventional tactics when gold flowed out of the United States. By 1932, with Congress shouting for relief, the Fed reluctantly opened its spigot for a few months, and the economy responded. But when Congress went home in July, the Fed reversed course with Harrison’s support, and the economy collapsed. “The monetary policy of the ’30s led to a deflation of about 10 percent a year, so it was extraordinarily tight monetary policy, which created, among other things, the greatly increased value of debts, which therefore led to more defaults and bankruptcies,” Bernanke said.
Friedman and Schwartz argued the key to the Depression was that the Fed had been too stingy with credit. Bank failures were “important not primarily in their own right” but because they were the vehicle for the “drastic declines in the stock of money,” they wrote. Bernanke contended that that wasn’t the whole story. In seminal research done while he was still in his twenties, Bernanke emphasized the devastating impact that the collapse of the banking system had even beyond its depressing effect on the money supply. Bank failures and the weakness of surviving banks, he wrote, meant households, farms, and small firms found credit “expensive and difficult to obtain.” In turn, the “credit squeeze … helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression.”
As happened in 2008, confidence in financial institutions evaporated. A toxic combination of depression and deflation made borrowers insolvent. Nearly half the banks that existed in 1929 had collapsed or been merged into other banks by the end of 1933. Those that survived suffered massive losses and often could not or would not lend. When they did, they often charged outrageous rates.
As with lesser panics, worries about the safety of banks prompted runs in which depositors pulled out their money. Runs, or even the anticipation of them, forced banks to sell securities or call in loans to raise cash. Dumping assets at the same time other banks were doing so pushed down the market price of virtually all assets, generating losses that actually caused banks to fail. “Thus, expectation of failure, by the mechanism of the run, tends to become self-confirming,” Bernanke wrote. The words could have been used to describe Bear Stearns or Lehman Brothers.
“THE FINANCIAL ACCELERATOR”
In seeking to understand why the economy had a disturbing tendency toward growth spurts followed by recessions, panics, and depressions, many economists discounted the financial markets as a sideshow. They believed that financial markets reflected and predicted what was going on in the underlying economy but weren’t an independent driver of the business cycle. It was a reflection of much of the profession’s amazing proclivity for assuming away reality at times and understating the importance of institutions. Ben Bernanke didn’t see the world as they did. The health of banks and other financial institutions and their attitude toward lending was a major driver of the business cycle — and could amplify the impact of Fed policies on the economy, he said. He called it “the financial accelerator,” and the Great Depression became his leading case study. His research on this subject provided the lens through which he would later view the Great Panic.
Beginning with an article published in 1983 in the prestigious American Economic Review and in subsequent research, Bernanke emphasized banks’ role in the economy, employing concepts that later brought Nobel Prizes to Joseph Stiglitz and George Akerlof for their insights into the functioning of markets when one side has more information than the others.
Bernanke, among others, contended that banks and other financial intermediaries were “special” because they did more than funnel money from savers to borrowers; they developed expertise in gathering information about industries and borrowers and maintained ongoing relationships with customers. “The widespread banking panics of the 1930s caused many banks to shut their doors,” Bernanke told a 2007 audience. “Facing the risk of runs by depositors, even those that remained open were forced to constrain lending to keep their balance sheets as liquid as possible.” The economy, thus, was denied the benefits of banks’ unique knowledge and ability to discern the creditworthy borrower from the less desirable. Stingier banks inhibited consumer spending and capital investment and made the Depression worse. His determination to avoid repeating that mistake drove Bernanke during the Great Panic to do whatever it takes to resuscitate the financial system.
The other way that financial disturbances exacerbated the rest of the economy in the 1930s, Bernanke said, was through the creditworthiness of borrowers — and, particularly, through the value of the collateral that they could offer as a way to assure lenders that a loan would be repaid. Bernanke viewed the collapse of home prices during the Great Panic primarily through this lens: a decline in the value of American families’ best collateral would inevitably make it harder for them to borrow. This reading of economic history also led him to press earlier and harder than Paulson did for the government to take steps to avoid “preventable foreclosures” and reduce the size of mortgages that exceeded the value of the homes on which they were written.
In his dissection of the Fed’s mistakes in the 1930s, Bernanke also cited the Fed’s misreading of interest rates as a gauge to the availability of credit.
At times of panic and uncertainty, bankers and others rush to the security of the safest securities, especially the debt of the U.S. Treasury. This pushes down the interest rate that the Treasury has to pay to borrow money, a measure that ordinarily is a useful gauge for the Fed. More important, though, are the rates that consumers and businesses have to pay to borrow, if they can borrow at all. If the gap — known as the “spread” — between the rates the Treasury pays on supersafe borrowing and the rates that ordinary borrowers pay widens (if they can borrow at all), then that becomes a much more important gauge of financial distress.
Bernanke found that the gap between medium-grade Baa corporate bonds and supersafe U.S. Treasury bonds widened from 2.5 percentage points in 1929 to 1930 to nearly 8 percentage points in mid-1932. That was more than double the spread recorded during the deep recession of 1920 to 1922. “Money was easy for a few safe borrowers, but difficult for everyone else,” he concluded. Exactly the same was true during the Great Panic, and many of Bernanke’s innovations at the Fed were aimed at reducing that same spread, which widened sharply from about 1.6 percentage points in December 2006 to over 6 percentage points in December 2008.
INTERVENTIONISTS VS. LIQUIDATIONISTS
In the wake of the Depression, Congress made the only substantial changes to the Federal Reserve Act it has ever made. In 1935, it removed the Treasury secretary and comptroller of the currency from the board in Washington, renamed it the Board of Governors of the Federal Reserve System to emphasize its primacy over the district banks, and changed the title of the heads of the regional banks from “governor” to “president.” Even more significant, Congress diluted the power of the regional Fed banks to set interest rates by creating a Washington-dominated committee, the Federal Open Market Committee. All seven governors in Washington have a vote at all times, but only five of the twelve regional bank presidents vote in any one year, serving in a rotation dictated by statute. (The New York Fed president is always one of the five voting presidents.)
That institutional change would prove important during the Great Panic, giving Bernanke the power to act despite the resistance of the presidents of some regional Fed banks. But the broader consequence of the Depression was the nature of received wisdom. Today, the notion that the government should or would stand by as the stock market crashed, credit markets stalled, and the economy tumbled over the abyss seems implausibly bizarre. The public, politicians, professors, and the press have been shaped by searing memories or photographs from the Great Depression, the years in which the unemployment rate rose to 25 percent and the country’s output of goods and services declined by 29 percent over four years. The lasting lesson — taught by economists with views as different as John Maynard Keynes and Milton Friedman, the leading economic minds of the twentieth century — is embraced almost universally by politicians and economic policy makers: government can and should act to prevent such a dangerous downward financial and economic spiral. Indeed, during the Great Panic, the Fed took interest rates to zero, and President Barack Obama signed into law a package of tax cuts and spending increases that amounted to $787 billion in fiscal stimulus over ten years, $185 billion of which was to hit the economy in the first year and another $399 billion in the second year.
This notion of the government’s role was not universal in the 1930s. In his memoirs, Herbert Hoover described tension within his own administration, putting words in Treasury Secretary Andrew Mellon’s mouth that are routinely reported as something Mellon actually said.
In one camp were the “leave it alone liquidationists” headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He insisted that, when the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. He held that even a panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”
Several Fed officials saw the financial debacle unfolding around them much as Mellon did: as an avenging angel sent to purge a slack system and fallen people. George Norris — a lawyer and early overseer of a federal farm-mortgage agency who was president of the Federal Reserve Bank of Philadelphia from 1920 to 1936 — attacked the Fed for interfering “with the operation of the natural law of supply and demand in the money market,” an argument not far from that made by some dissenting Federal bank presidents during the Great Panic.
History has cast Hoover as the do-nothing president who stood firm on conservative principles as the economy crashed and burned, as opposed to his hyperactive successor, Franklin Roosevelt. Hoover wasn’t as callous or delusional as his modern caricature suggests, and he believed in the power of government to do good. Some of the seeds of the New Deal were planted in his presidency as he realized that “volunteerism” wouldn’t suffice, just as some parts of Obama’s recession-fighting policies of 2009 had their beginnings in the Bush years. Hoover created the Federal Home Loan Bank System to rescue savings banks and savings and loans, and to offer sustenance to the beleaguered mortgage market, but Congress watered down his proposals to his bitter regret. He created the Reconstruction Finance Corporation to provide emergency loans to banks, railroads, and other companies. But he was hung up on balancing the budget. He disagreed with, but didn’t fire, Mellon as Treasury secretary. And he did not — despite some of the claims in his 1952 autobiography — see how big a government response it would take to conquer the Great Depression.
But in contrast to the Great Panic, Hoover did not have anyone with Bernanke’s stature at the Fed pushing him to be bolder. Only a minority of Fed officials, Hoover wrote, “believed with me that we should use the powers of government to cushion the situation.”
Bernanke knew this history well. He faulted Hoover for overoptimism and for listening too much to Mellon, among other things, but thought Hoover — a smart, well-intentioned man who was hardly opposed to using the power of government — had been given a “bum rap.” The bigger culprit, he said, was Woodrow Wilson, the father of the Fed, because he had so badly botched the Treaty of Versailles after World War I, which produced the global economic and political conditions that led to the Great Depression.
“After Strong’s death …,” Bernanke said, “the Federal Reserve no longer had an effective leader or even a well-established chain of command. Members of the Board in Washington, jealous of the traditional powers of the Federal Reserve Bank of New York, strove for greater influence; and Strong’s successor, George Harrison, did not have the experience or personality to stop them. Regional banks also began to assert themselves more. Thus, power became diffused; worse, what power there was accrued to men who did not understand central banking from a national and international point of view, as Strong had. The leadership vacuum and the generally low level of central banking expertise in the Federal Reserve System was a major problem that led to excessive passivity and many poor decisions by the Fed in the years after Strong’s death.”
Or as Herbert Hoover put it, the Fed became “a weak reed for a nation to lean on in a time of trouble.” Ben Bernanke was determined that his Fed would not be a weak reed. “I optimistically think that, while we could still have financial crises and bad outcomes in the world economy, policy makers know enough now to short circuit the impact before it becomes anything like the severity of the 1930s. Certainly that’s the hope anyway,” he said.
In November 2002, the University of Chicago honored Milton Friedman as he turned ninety years old. Bernanke, then in his fourth month as Fed governor, turned to Friedman and Schwartz and said: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
A half decade later, faced with the Great Panic of 2008, Bernanke would struggle to keep that promise.
BEYOND “ONE-MAN LEADERSHIP” — OR NOT
As for J. Pierpont Morgan, the man who saved the nation in the Panic of 1907, the glory of his triumph would be subsumed in the shifting sentiments of the times. When he died at the end of March 1913, the nation was more relieved than sad.
“We may look upon Mr. Morgan’s like again — there were great men before and after Agamemnon, but we shall not look upon another career like his,” the New York Times editorialized on April 1. “The time for that has gone by. Conditions have changed, and Mr. Morgan, the mighty and dominant figure of finance, did more than any other man to change them. …
“The growth in his time was prodigious, and now Wall Street is beyond the need or the possibility of one-man leadership. There will be co-ordination of effort, the union of resources, but Mr. Morgan will have no successor; there will be no one man to whom all will look for direction.”
The New York Times editorialist, of course, could not have known about Alan Greenspan.
Chapter 3
AGE OF DELUSION
In the morning cold of February 6, 2006, President George W. Bush made his way by armored limo to the Federal Reserve’s Beaux Arts building, only the third time on record that any U.S. president had visited the Fed’s headquarters. The official occasion was the public swearing-in of Ben Bernanke as the chairman of the Federal Reserve, but everyone knew Bernanke’s ascension wasn’t the main event. What really was being celebrated was Alan Greenspan’s departure after nearly nineteen years as Fed chairman, the Maestro. To laughter and applause from the invitation-only crowd, Bush said, with substantial accuracy, “Alan Greenspan is perhaps the only central banker ever to achieve … rock-star status.”
Indeed, Bush gladly would have done what he had four years earlier, and what his father and Bill Clinton had done before him: extend Greenspan’s term as chairman and avoid the search for a successor who would satisfy both financial markets and the president. Bush had plenty of other problems — notably the war in Iraq — and in the years following the September 11 attacks, Greenspan had steered the economy to a place where Bush hardly had to worry about it. But Greenspan was seventy-nine years old, ready to retire and cash in on his celebrity. He rebuffed a quiet White House plea to stay for a while beyond the January 31, 2006, expiration of his term.
BERNANKE’S DASHBOARD
February 6, 2006
Dow Jones Industrial Average: 10,798
Market Cap of Citigroup: $224.6 billion
Price of Oil (per barrel): $65.13
Unemployment Rate: 4.7%
Fed Funds Interest Rate: 4.5%
Financial Stress Indicator: 0.09 pp
NOTE: The financial stress indicator, given in percentage points (pp), is the gap between the rate banks charge one another for three-month loans and the expected Fed rate. The bigger the gap, the more stress.
So, in front of a crowd that included Greenspan and his predecessor, Paul Volcker, Bush celebrated Greenspan’s successes. The final report card looked impressive. Unemployment was below 5 percent. Inflation was low. The United States had been in recession for only 16 months in Greenspan’s 211-month tenure. The housing bubble had yet to burst. The very worst of the subprime mortgages were yet to be written. The Great Panic was unimagined except by a few Cassandras who were routinely dismissed as cranks.
