The Courage to Act

Ben Bernanke’s reputation needs revising.

The public imagines the former Fed Chairman as a disciple of Milton Friedman, monetary activist, and advocate for the power of the printing press.

In an essay lecturing the Japanese on how to escape deflation, written back in 1999, he urged the Bank of Japan to “issue money” to finance an intervention against the yen to achieve greater trade competitiveness. If that did not work, his advice was to print money to finance either large scale asset purchases (LSAPs) or a major fiscal expansion via the “hoary” mechanism of helicopter drop.

In 2002, now speaking as a Governor of the Federal Reserve, he explained how the Fed could easily prevent Japanese-style deflation from coming to the US.  He listed roughly the same set of remedies as he had offered the Japanese, although only as failsafe in the US case, and thereby won himself the nickname Helicopter Ben, an outcome he could hardly have failed to anticipate.

As Fed Chairman, he oversaw the development of the Fed’s LSAPs, which came to be known fondly as QEs 1, 2 and 3. So there is good reason Bernanke is known as a monetary policy activist and advocate of resort to the printing press when conditions warrant.

His recently-published account of his time at the Fed, The Courage To Act, then, can be viewed as a helpful correction of that misperception.

In Courage, Bernanke explains that when in charge he relied much more on Bagehot than on Friedman or his predecessor Hume. That is, the Chairman saw the Fed’s primary duty during the Financial Crisis as being the prevention of liquidity runs that would take down the financial system and plunge the US economy into depression.  Compared to the overwhelming importance of that objective, and the many liquidity and bailout programs the Fed developed (or participated in) to achieve it, QE appears secondary and, almost literally, an after-thought.

Bernanke’s book is certainly not so reductive, but the monetary economics here could be distilled down to a simple point.  When the private sector’s demand for liquidity surges, the central bank needs urgently to meet that demand, or collapse will ensue.  In contrast, efforts to foist excess liquidity into a financial system no longer in crisis are secondary, although not pointless, in Bernanke’s view.

In fairness to those with a different take and to Bernanke himself, I went looking for that lesson, because it fits my own priors, as anyone who has been following this blog will have noticed.  But it is easily found within Courage, if one looks.. I do not impose it.

Smart early and a good story teller

The book is written as a straight chronology and could actually be read as an autobiography, although one with very heavy emphasis on the twelve years ending with Bernanke’s retirement from public life in early 2014.  Bernanke provides some detail on his family’s history in South Carolina, his youthful discovery of his own academic prowess, his move north to join the academic elite, his success there, and his eventual entry into policy circles.

In 2002, he was successfully nominated by President Bush to a position on the Fed’s Board of Governors – and immediately set out to attach the word “helicopter” to his name.  In 2005, he replaced Greg Mankiw as the Chairman of President Bush’s Council of Economic Advisers (CEA). And his service there is presented in part as establishing enough credibility with the President to win successful nomination to the Fed Chairmanship in early 2006, just as the air was beginning to escape the housing and credit bubbles of the mid-2000s.  The meat of the book is about how the Bernanke Fed responded to that deflation, and why.

Bernanke peppers his account with enough fly-on-the-wall story telling and score settling to keep the general reader interested.  Somewhat amusingly, to me anyway, the New York Times’ initial review of the book, by Michael Kinsley, obsessed over the score settling and seems to have missed or not even to have cared about the economics involved.

The fly on the wall tells us: that Bush teased Bernanke about his clashing socks, what it was like for Bernanke to chair his first FOMC meeting, that Barney Frank can be pretty funny, and that Bernanke had been warned by his press officer that his 2002 anti-deflation speech would be taken the wrong way.

Bernanke also mentions that he developed an nom de plum to avoid hacking of his email exchanges while Chairman at the Fed. For the purposes of obscurity, he chose Edward Quince, listed in the phone book as working on the “security” team. Oh, how EQ would become QE, as the Fed bought massive volumes of “securities!”

In settling score, Bernanke is much more direct when praising an associate than when critical.  And in the latter case, he often feigns the role of stenographer, allowing his associate to undermine himself with his own words taken from the record.

It is not so obvious that former Dallas Fed President Dick Fisher made a major contribution to monetary policy formation during his time at the Fed, so Bernanke’s account of Fisher’s    dissent against a 50 bps rate cut in early 2008, as the US economy was sinking into deep depression and risk of deflation seems particularly amusing:

The vote was 9-1.  Richard Fisher told us he had prayed over his decision, but couldn’t join the majority.  He was worried about inflation, which had ticked up in the second half of 2007, even when volatile food and energy costs were excluded. And he didn’t want to react to financial turmoil.  “When the market is in the depressive phase of … a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt – doing so is fruitless, if not dangerous, because it will simply insist upon more,” he said.

With similar finesse and detachment, Bernanke hoists the tedious gold bug and grifter Ron Paul for not understanding how the Gold Exchange Standard actually worked. And he is clear that John McCain is careless about economic policy and that Harry Reid puts politics ahead of it. He lumps together hard-right Jim Bunning and hard-left Bernie Sanders as two peas in a pod, paranoid of different people, but equally susceptible to bizarre conspiracy theories. Bernanke does this without seeming harsh or resentful.  In most cases, he just let’s their own words and deeds do the dismantling.

In contrast, he speaks quite highly of Barney Frank and Tim Geithner. At points he seems to show a preference for Democrats over Republicans, and he states flatly that his experience in politics forced him to abandon his self-identification as Republican. But he became an Independent, not a zealous convert.

What I found most surprising (and is separately evidence of political balance) in Bernanke’s score settling was his very favorable account of the contribution Kevin Warsh made to policy while serving as a Governor during the Financial Crisis and its early aftermath.  In following the Fed from a distance, I had viewed Warsh as a bit of poseur and lightweight, more interested in fostering a political career than in contributing to monetary policy. I really disliked this op-ed from the Wall Street Journal, which seemed incoherent and mostly an effort by Warsh to establish bona fides among the Republican base as a monetary hair shirt.  Worrying about the bond market just autonomously freaking out over inflation, in late 2010? Really?

I had assumed Bernanke was more miffed by the piece, but was wrong about that. Bernanke mentions the episode in Courage, and is clear that he disagreed with Warsh on the substance. But he also points out that he had approved Warsh’s wish to speak independently and that were no hard feelings, even though (I would say) Warsh’s comments were calculated to lead to an unhelpful tightening of financial conditions.

More substantially, I was impressed by how important Bernanke viewed Warsh’s role as eyes and ears on the capital markets and contributor to the design of the various liquidity programs and firm-specific rescue efforts. I cannot provide a single citation to drive the point home, but Warsh’s name comes up very often as important counsel. And Bernanke leaves the impression that he was one of four members of the crisis-managing inner sanctum, which included also Tim Geithner and Vice Chairman Don Kohn.

Priority is to meet a surge of liquidity demand

Away from the story telling and score settling, it seems that the main policy message of Courage is that — in crisis — a central bank must take decisive steps to meet a surge in liquidity demand to prevent the financial system collapsing and the economy spiraling down into depression.  As I read Bernanke’s account, the liquidity provision programs and bail-out efforts were far more important than QE, although Bernanke does end  up defending the efficacy of the LSAPs.

The primacy of liquidity provision into a panic is telegraphed early in the book when Bernanke emphasizes that Walter Bagehot had established the intellectual foundations for the very creation of the Federal Reserve:

As the financial experts understood well at the time (of the Fed’s creation), central banks can help end financial panics by lending cash to banks that are threatened by depositor runs, taking the banks’ loans and other assets as collateral. The classic description for central banks facing a panic was provided in 1873 by Walter Bagehot, the British journalist economist, and longtime editor of the Economist magazine, in his short book, Lombard Street: A Description of the Money Market.  To calm a panic, Bagehot advised central banks to lend freely at a high interest rate, against good collateral, a principle now known as Bagehot’s dictum.

In a panic, depositors and other providers of short-term funding withdraw out of ear that the institution will fail and  they will lose their money.  Even a bank that is solvent under normal conditions can rarely survive a sustained run. …  By lending freely against good collateral during a panic – that is, by serving as a “lenders of last resort” – a central bank can replace the withdrawn funding, avoiding a forced sale of assets at firesale prices and the collapse of otherwise solvent institutions.  Once depositors and other short-term lenders are convinced that their money is safe, the panic ends, and the borrowing banks repay the central bank with interest. 

That passage seems like a pretty good playbook describing how the Bernanke Fed would try to protect the US economy from the runs that threatened systemic collapse during the roughly 18 months between the liquidity crisis at BNP in the summer of 2007 and the Fed-supported rescue efforts in the winter of 2008-09.

Bernanke returns to Bagehot when giving a personalized account of his rise to the Chairmanship and the office that came with it:

My new desk was a nineteenth-century antique donated by the late John Laware, a former Board member.  Computer screens, a Bloomberg terminal, and a television screen would soon surround the scarred wooden desk, giving my work area the ambience of a cockpit. Built-in bookcases held my small library, including many books brought from my office at Princeton, such as Bagehot’s Lombard Street.

No other book or speech is mentioned. He did not install a scale replica of Gutenberg’s printing press or a bust of Hume caught expounding on the specie flow mechanism.  Bernanke’s reference to Bagehot is probably conditioned by his experience at the Fed.  Having faced the need to apply Bagehot, of course he would remember his foresight in installing a visual cue to do so!  But that is the point. Bagehot is who Bernanke chooses to recall as his most important intellectual influence.

Having enlivened this fore-runner, Bernanke proceeds meticulously in Section II through an account of every liquidity program and bailout effort in which the Fed was involved during “The Crisis.”  The public was against these efforts and many politicians, particularly the weaklings in Bernanke’s eyes, reflected that. But the Fed took advantage of its independence and spent the political capital required to do the right thing, in Bernanke’s account.

Force-fed liquidity is not quite pointless, but secondary

QE is discussed in Section III, “Aftermath”, which assesses the economy and monetary policy efforts once the main action was past.  It is not the only focus of the concluding section, which also discusses the state of the economy, the emerging “financial architecture”, and the inevitable trade-offs involved in regulatory policy.  If money printing and LSAPs are Bernanke’s main thing, he buries the lede and does a poor job of allocating space.

Bernanke’s initial references to QE are actually focused on distancing the program from the intellectual rationalization Bernanke had himself provided for the effort during his lecture to the Japanese in 1999 and his Helicopter Ben speech of 2002.

He refers to the lecture as arrogant pontification and notes that he has become “a little more sympathetic to central bankers”than he had been.   He leaves the impression that his sympathy relates to the  political pressures that central bankers face, but I suspect he has also lost confidence in his own turn-of-century reasoning.  He is certainly clear that it would have no application to the policy the Fed would actually pursue after 2008. Here he is describing his reputation as Helicopter Ben:

For my first speech as Chairman, on February 24, I returned to Princeton and spoke to an audience of faculty and students. To strengthen my credibility as an inflation fighter and dispel the Helicopter Ben nonsense, I focused on the economic benefits of low inflation – an easy topic for a central banker.

That passage seems like a fairly benign discussion, especially from a central banker, but it bears on the likely efficacy of QE more than may seem obvious and perhaps also more than Bernanke might himself admit.

As I explained in my earlier post on Bernanke’s Original Sin, there is actually no monetary aspect to QE, if the central bank’s inflation objective is independent of it and if the financing of the LSAPs is achieved with excess reserves paying a market rate of interest, making them debt not money.

It would be wrong to imply that Bernanke’s explicit abandonment of the original justification of QE, offered in 1999 and 2002, meant that the program was ineffective or pointless.  Bernanke is more optimistic about QE than I am, and he supports the conventional view that it worked by taking default-free duration out of private markets and thereby depressing Treasury (and related yields) via the portfolio balance channel.

But the portfolio balance channel is weak, not to mention theoretically dubious.  And in any event it is  small beer compared to the inexorable force of the printing press, which Bernanke ended up specifically excluding.

Moreover, I don’t think Bernanke’s heart is so obviously in it, when he defends the operation of this presumed portfolio balance channel.  For example, consider his discussion of the effects on markets of the initiation of the QE1 program:

A new era of monetary policy activism had arrived, and our announcement had powerful effects.  Between the day before the meeting and the end of the year, the Dow would rise more than 3,000 points – more than 40 percent – to 10,428.  Longer-term interest rates fell on our announcement, with the yield on ten-year Treasury securities dropping from about 3 percent to about 2.5 percent in one day, a very large move.  Over the summer, longer-term yields would reverse and rise to above 4 percent. We would see that increase as a sign of success.  Higher yields suggested that investors were expecting both more growth and higher inflation, consistent with our goal of economic revival. 

The tone of that passage is hardly defeatist.  He references a new era, which is no small thing. But it is just so unconvincing.  The portfolio balance channel argument claims that QE works by forcing long-term bond yields down for long enough to influence the economy. And yet, Bernanke notes that the enduring effect of QE1 (as in the case of QE2 and QE3) was to push bond yields up – against their underlying trend. He says that “we would see” the higher yields as sign of success, but that is forthrightly subjective and takes a rather odd view of success, given that the clearly stated purpose of QE was to depress bond yields.

A dispassionate observer, such as I fancy myself, would say that QE operated directly on risk tolerance in the equity market, probably for behavioral reasons, and that this dragged up bond yields. It is not a sign that QE was a failure or not worth trying, but it contradicts the claim that QE operated as indicated on the label when actually applied.

It is hard to believe that this would not have occurred to Bernanke, who is accustomed to intellectual rigor and logical consistency from his time as an academic. But he doesn’t bother to get into it, in the passage above or elsewhere in the book.

That is fine.  By now, that whole debate about QE is stale, as evidenced quite clearly by the fact that the Fed is now considering negative interest rates, rather than QE4, in the presumably-unlikely event that the economy stumbles and needs ease, rather than the gradual tightening planned.

But it is probably not too conspiratorial or too much an unwarranted reading of motives to assert that Bernanke is just not that interested in the debate, because Quantitative Ease was so obviously not his main contribution to the recovery of the US economy after the Financial Crisis.

Courage highlights this by putting heavy emphasis on the crisis liquidity provision programs and on the Fed’s participation in bailouts of various financial institutions. It is in those efforts that Bernanke et al made their main contribution and showed bravery.