The Investor

Failure Rewarded

The case against reappointing Ben Bernanke.

By 8.26.09

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The Federal Reserve's purpose, beyond monitoring the money supply, is to ensure the safety and stability of the financial system and to manage systemic risks.

Is there any doubt that the Fed has failed -- spectacularly -- to fulfill these duties?

Ben Bernanke, as the Fed's chairman, should not be allowed to fail on the job without any consequences, as if he were more an economic planner-for-life than a public servant. For that general reason, President Obama should not have commited to reappointing Bernanke for a second term.

There are also more specific charges against Bernanke. Although mainstream economists are right to say that Bernanke's aggressive monetary policies avoided a repeat of Great Depression-style deflation, he should answer for preventable mistakes he made in the wake of the housing crash that threatened regime stability and damaged business confidence.

Bernanke, a Great Depression expert before his public service, himself provided the justification for aggressive monetary expansion. He helped build on the narrative that after the financial crash of 1929, the Fed allowed the money supply to contract rapidly, which led to the steep decrease in investment and output that lasted over a decade. The seminal book in this line of inquiry was Milton Friedman and Anna Schwartz's 1963 A Monetary History of the United States. In 2002, on the occasion of Friedman's 90th birthday, speaking as a Governor of the Federal Reserve, Bernanke admitted the Fed's negligence, apologizing to Friedman, "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

And he lived up to that promise. Between August and November 2008, the Fed increased its balance sheet from roughly $900 billion to over $2.2 trillion -- an unprecedented expansion that involved many inventive liquidity programs. Clearly the Fed acted to avoid the specific mistake it made during the Great Depression.

But that does not excuse Bernanke's other, serious missteps along the way. Indeed, although he averted the kind of deflation that kicked off the Depression, he copycatted some of the mistakes that '30s economic officials made. Specifically, his errors lay in measures that increased what Depression historian Robert Higgs calls regime uncertainty. His Fed misidentified the root causes of the financial meltdown, and failed to stem the contagion early on. More importantly, he aided Treasury Secretary Hank Paulson in the disastrous bailouts, overstepped the limits of his office and the law in dealing with the banks, and undermined the Fed's sacrosanct independence.

John Taylor, a Stanford economist famous for the "Taylor Rule" that describes the Fed's interest rate policy, argues in his 2009 monograph Getting Off Track that Bernanke fundamentally misdiagnosed the cause of the financial panic as illiquid banks when in fact it was counterparty risk -- banks afraid of lending to institutions that might collapse overnight. Instead of massive targeted liquidity programs, Taylor demonstrates, Bernanke should have, early on, taken the feared subprime loans and other toxic assets off of the banks' books or injected equity. In doing so, he could have begun the process of rehabilitating the fragile credit system even before the near-collapse in September.

If only our financial overseers had tried such a structured, calm approach. Instead, the tag team of the Fed and the Hank Paulson-led Treasury, charged with regulating the banks, launched a flurry of ad hoc measures with no regard for precedent, policy continuity, or even the Constitution. Hank Paulson cannot bear all the blame for these terrible false starts and mixed signals. What else would one expect from a former investment banker but to make deals and be overly aggressive?

For the economist Bernanke, however, there are no such excuses. Surely during his studies he must have come across the work of Robert Higgs, and learned his explanation for the failure of private investment throughout the '30s and into the '40s. Higgs's insight on regime uncertainty is that the activist government, in its haste to "do something, anything," confused the private sector as to the rules of the game and ended up discouraging long-term investment, which relies on stable conditions. Higgs drew on the insights of Depression-era economists like Joseph Schumpeter as well as modern econometric studies of investment under uncertain conditions to demonstrate that it was the Hoover and FDR administrations' capriciousness that retarded investment until after WWII.

In his seminal 1997 paper, "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed After the War," Higgs outlined all of the various property rights encroachments, changes to the tax code, giant spending programs, and threatening promises that FDR's government inflicted on private investors. Although the Bush and Obama administrations have not embraced anything like FDR's anti-market rhetoric -- Higgs presents a 1941 poll that found that 40 percent of businessman believed that the U.S. would become a fascist or at least semi-socialist economic system after the war -- otherwise they have copied FDR's missteps very closely, with Bernanke complicit all the while. A review of the events from the fall of 2008 to today clearly shows a pattern of the Fed introducing all kinds of instability into the economic mix.

The first monumental blow to regime stability was the Fed's inexplicable decision to let the investment bank Lehman Bros. go bankrupt in mid-September when it had already committed to rescuing systemically important financial companies with the Bernanke-blessed nationalizations of Fannie Mae and Freddie Mac just a week earlier, and the Fed-facilitated fire sale of Bear Stearns all the way back in March. The very next day after Lehman's collapse, the feds turned around and bailed out the giant insurance firm AIG to the tune of $85 billion. These inconsistent measures sent a clear signal to the market that the government was not operating according to any set procedure, but instead arbitrarily picking winners and losers.

The panic brought on by their own decision to let Lehman fail provided Bernanke and Paulson with fodder to fearmonger their way into the now famous TARP. The Economist described Bernanke's apocalyptic rhetoric best:

[Bernanke] "told us that our American economy's arteries, our financial system, is clogged, and if we don't act, the patient will surely suffer a heart attack, maybe next week, maybe in six months, but it will happen," according to Charles Schumer, a Democratic senator from New York. Mr. Schumer's interpretation: failure to act would cause "a depression."    

The duo didn't stop at words, they also used outrageous antics, such as Paulson getting down on his knees and literally begging Nancy Pelosi to help pass the bailout plan that he, Bernanke, and a few advisors had concocted the night before.

The bailout necessitated such heavy-handed tactics because it constituted a brazen power grab. The initial plan stipulated: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency." In other words, the plan granted Paulson $750 billion to spend in whatever way he should see fit and absolute power in the financial sphere. Luckily, key members of the Senate Banking Committee and House Republicans kept their heads and refused to give the bailout bill their votes in early drafts. But Bernanke persisted.

For all their insistence that only this plan could save the world if passed right now, Bernanke and Paulson all but abandoned the TARP strategy only two months later. By November 12, Paulson was saying that the best route was not a reverse auction of trouble assets, but direct capital injections into troubled banks. The market immediately tanked again on hearing this bewildering change in policy.

Even worse than constantly changing TARP policies -- the TARP would later be used to fund the auto bailout, be diverted to Obama Treasury Secretary Timothy Geithner's Public-Private Investment Partnership plan, and ultimately go more or less dormant -- Bernanke and Paulson also flouted the rule of law. Within days of the announcement that the TARP would be used for capital injections, word spread that Paulson had gathered the heads of the nine biggest banks into a room and coerced them into selling shares to the Treasury, whether they wanted to or not.

Later, it would come out that Bernanke and Paulson used similar strong-arm tactics to prevent Bank of America from walking out on its merger with the failing investment bank Merrill Lynch. BofA CEO Ken Lewis testified that Bernanke threatened to remove BofA's board if Lewis did not go through with the deal. Lewis also claimed that Bernanke promised him that "[the Fed] want to do something that when the public hears about it [the new government financing], your stock goes up." No wonder, then, that Lewis would complain before Congress that the regulators were "making up the rules as they went along." These events raise serious questions about the rule of law and property rights.

After Paulson's departure, Bernanke worked closely with Geithner to enact policies that prevented market reorganization. In June the president announced a number of financial services regulations reforms, the most important of which was increased jurisdiction over both bank and non-bank institutions for a systemic regulator. Geithner proposed that the systemic regulator should be a new Consumer Financial Protection Agency. Bernanke disagreed, claiming that the expanded powers should be given to -- of course -- the Federal Reserve. Lost in their very public disagreement was the fact that they were discussing whether or not the institution in charge of the money supply should also have final regulatory discretion over firms important in the credit system.

This development poses a subtle threat to the Fed's independence. The Fed has already acted in tandem with the Treasury in deciding which banks to save in crises, and added overlapping regulatory responsibilities with other regulatory agencies -- such as the CFTC and OCC -- bring the Fed even further under the executive branch's indirect power.

Furthermore, in September 2008, in order to improve specific banks' liquidity without introducing inflationary pressure, the Fed relied on hundreds of billions of dollars in loans from the Treasury to finance its liquidity initiatives. Although in practice those loans are harmless, in theory they make the Fed even more beholden to the executive branch. Central bank independence, it has been shown time and again, is crucial to maintaining a stable currency. An unstable currency is just one more regime uncertainty for the financial industry to deal with.

The Fed's inability to prick the housing bubble before a meltdown can be excused. The Fed chair cannot be omniscient. What we do expect is for them to increase the system's stability, not introduce needless volatility.

The Great Depression lasted into the '40s because the banking system never improved enough to finance a comeback in private investment. The crash could not have been avoided, but FDR's bouts of new taxes, undermining property rights, and bullying businessmen could have. For all the other lessons Bernanke has internalized, the lesson of regime uncertainty continues to elude him, as his recent complicity in repeating FDR's mistakes shows.

The U.S. economy is based on free enterprise and the rule of law, not the wisdom of one man. To suffer Bernanke's unlawful and damaging caprices without reprimand is to endorse them and to subscribe to his own cult of expertise. We are blessed with many brilliant economists other than Bernanke; appoint one of them.

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About the Author

Joseph Lawler, former managing editor of The American Spectator, is editor of Real Clear Policy. Follow him on twitter: @josephlawler.