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08.25.09

Bernanke Vs. Summers?

Nominating Ben Bernanke to a second term as Fed chairman may have been politically expedient for Obama, but it will leave Larry Summers seriously disappointed. Jeff Madrick on the ruffled feathers and future fiscal course.

Nominating Ben Bernanke to a second term as Fed chairman may have been politically expedient for Barack Obama, but it will leave Larry Summers seriously disappointed. Jeff Madrick on the ruffled feathers and future fiscal course.

It is by no means obvious that President Obama should have nominated Ben Bernanke to a second term as chairman of the Federal Reserve. But it is surely politically expedient, and this administration seems dedicated to ruffling as few political feathers as possible in almost all policy matters, from international affairs to defense, the health-care debate, and financial re-regulation.

How long Summers will be satisfied being the head of the White House economics team will now be an intriguing question.

Not that Bernanke should automatically be rejected. He is unusually bright, forthright compared to former chairmen, and he has been innovative and courageous. But it took him too long to understand how serious the cascading crisis was, in part because he carried so much ideological baggage with him. He did not understand, in fact, until his failure to cut rates in early August 2007 was greeted miserably by the markets. Then he changed tune, adopting moderate rate cuts. Only by early 2008, however, did the Fed start cutting rates aggressively. And only by March 2008, along with the Bear Stearns bailout, did Bernanke open the discount window wide to commercial banks and to the large investment banks like Morgan Stanley and Goldman Sachs, so that the besieged bankers could borrow at will.

This was late in the game for someone who had at his disposal the Federal Reserve’s investigatory authority and enormous, intelligent Fed staff to delve deeply into and digest the books of the financial community. By the fall of 2005, delinquencies on mortgages were rising rapidly and getting worse throughout 2006. By early 2007, a major bank in Europe warned about its earnings. By the spring of 2007, many on Wall Street were already worried about full-scale “meltdown,” judging by internal emails. Bernanke did not wake up until the late summer.

Once he did act in 2008, however, Bernanke was aggressive, creative, and determined. But even here there were blemishes, in particular he and Treasury Secretary Henry Paulson allowing Lehman Brothers to go bankrupt in September. But again, Bernanke recovered quickly with new programs. The achievement is not a small matter, and I think he will be rewarded with a gold star in economic history. Should he be reappointed for this reason?

Not necessarily. There will be life after this crisis, and the question is whether Bernanke will retreat to the same policies he so heartily believed in and helped promulgate before the ship sank. I would be comforted to be told that Obama or someone on his team discussed future policy with Bernanke, as well as his past mistakes, and learned that there has been a change in thinking or at least a newfound humility. That would presume, of course, the administration also had a clear understanding of past ideological errors, misplaced faith in markets, and the need to regulate firmly. I haven’t read or heard of any such discussions.

The leading candidate for Bernanke’s job had long been thought to be Larry Summers, the former Treasury secretary, Harvard president, and current head of the White House National Economic Council. Summers was quicker than Bernanke to recognize recessionary possibilities back in 2007. It was easier for him, of course, as a Democratic critic of the Bush administration. He may be less of an inflation hawk than Bernanke as well, but probably only marginally so. He was an undiluted supporter of Greenspan during the Clinton presidency and a leading advocate of financial deregulation.

How long Summers will be satisfied being the head of the White House economics team will now be an intriguing question. The administration claims he remains the right-hand man of the president on economic matters. But in terms of prestige and perhaps influence, Bernanke is now at least his equal. This will require patience and self-effacement from a man accustomed to dominating the economic-policy discussion. Is he prepared to wait another four years? Or perhaps he has his eye on the chairs of the World Bank or the International Monetary Fund. The World Bank post, at least, still seems to go to Americans. This, he knows, is second-best choice for the Democrats’ key economic man. Or perhaps the Bernanke reappointment means it’s the end of the Washington line for Summers. Bernanke not only will have to handle economic uncertainties but also a disappointed and powerful rival.

Most important to know about Bernanke’s scholarly past—a prestigious full professor at Princeton—is that he fully believed markets clear efficiently and that when they reach equilibrium they do so at the optimum point and mostly price things right. Thus, mortgage brokers would not write absurdly risky subprime mortgages for very long. Prestigious investment banks would not gobble up securitized packages of these mortgages at prices that were too high given the risks of defaults. Perhaps he even believed the compensation packages were largely justified, set as they were by private enterprise. Bernanke could not fully imagine the size of the housing bubbles or the extent of bad investments on the Street.

Instead he complacently believed that because the Federal Reserve had defeated inflation, all was well with the economy. He called this “the great moderation” in a famous 2004 speech repeated in 2006. Bernanke had been a major advocate of inflation targeting—that the Fed should only worry about keeping inflation low. If inflation was low, the other pieces of the economy would fall into place because markets work more efficiently. He attributed less-volatile movements in U.S. output of goods and services and unemployment to just such policies.

To Keynesian traditionalists of an older school of thought, low inflation would lead to higher unemployment. Bernanke believed that low inflation would make the economy work so efficiently, inflation targeting could also lead to low unemployment. In fact, unemployment was not ideally low over the period he idealized, given the aging of the population and how many people withdrew from the work force. But, in fact, he had always moderated his view, yet still insisted a low inflation rate was by far the most important policy initiative a central government could take.

Is this the policy we will be returning to under Bernanke II? Low inflation coincided with enormous asset bubbles in equities in the late 1990s and housing in the 2000s, which actually propelled the economy to solid growth in those years by stoking consumer demand through borrowing. In the early 2000s, Bernanke claimed the housing bubble was manageable. He argued a burst in that bubble would not harm the rest of the economy. How did he miss forecasting all that followed? The answer is: He was ideologically blinkered.

So, today, the question is: What will he miss two years from now? Is low inflation still everything to him? In fact, Bernanke is a complex and flexible man, and if Summers is “brilliant,” a title the press has apparently conferred on him permanently, Bernanke certainly deserves the accolade, too. As an example of his flexibility, he imposed aggressive monetary loosening while fighting back the inflation hawks, Fed presidents like the singularly myopic Richard Fisher of Dallas and Charles Plosser of Philadelphia, who were warning about the imminent return of inflation well into 2008. He discussed at least as early as 2002 the use of regulatory and supervisory tools to combat asset bubbles, preferring these to raising interest rates, a very reasonable argument that former Fed chief Alan Greenspan had little use for.

My candidate for Fed chairperson would be Janet Yellen, who runs the San Francisco Fed. She would be less obsessed with inflation and more open to the failures of markets and regulatory needs. But such a choice, given the political climate, may not be practical. The inflation hawks, not least Fisher and Plosser, despite egg on their faces, will be laying in wait to pounce at any sign of life in the economy to call for higher interest rates sooner than later. They will also demand a reduction in the Fed’s loans to the financial community, no doubt prematurely. Bernanke is now in a strong position to fight them and will likely do so. The markets would not welcome, at least initially, someone like Yellen. I think the bond traders must be fought, but now may be too fragile a time for that.

We are perhaps only left with the Bernanke option. But Congress, if not the Obama administration, can question him about how or whether he has changed his views. He should be asked publicly about a wide range of matters, including those above. If he answers forthrightly and perhaps with more wisdom than in the past, it will at least be on the public record. If he muddles through, he doesn’t deserve the job again. He still has to prove he is what America needs in a new period.

Jeff Madrick is a contributor to The New York Review of Books and a former economics columnist for The New York Times. He is editor of Challenge magazine, visiting professor of humanities at Cooper Union, and senior fellow at the New School's Schwartz Center for Economic Policy Analysis. He is the author of Taking America, The End of Affluence (Random House) and The Case for Big Government.