In The Fed We Trust

The past two years have been tumultuous ones for the financial markets and for the U.S. economy—and for the Federal Reserve, the institution charged with safeguarding both. As the subprime mortgage crisis mutated into a full-fledged global credit crisis, America's central bank, led by Chairman Ben Bernanke, responded with unprecedented actions, bailing out companies, slashing interest rates aggressively, propping up markets, and making direct loans to Wall Street firms. In his new book, In Fed We Trust: Ben Bernanke’s War on the Great Panic, David Wessel, a veteran Wall Street Journal columnist, chronicles the efforts to combat a financial meltdown. He spoke with NEWSWEEK's Daniel Gross.

A podcast of their conversation can be heard here. Listeners can also subscribe to Dan's "Every Day I Read the Book" podcast on iTunes.

You lead off talking about the Lehman Brothers bankruptcy in September 2008. What was so earth shattering about the events of Sept. 15, 2008?
In September 2008, Ben Bernanke and Hank Paulson, the Treasury secretary, and Tim Geithner, the New York Fed president, miscalculate. They think they will be able to sell Lehman Brothers to a British bank, just as they had sold Bear Stearns six months earlier to an American bank. But the British bank won't go through with the deal and they don't have a Plan B. They think at the time that the markets are kind of prepared for this to happen. But they're not. As one foreign central banker said to me, "In Europe we don't let dry cleaners fail, it never occurred to us that the Fed and Treasury would let a big investment bank go."

And that triggered a series of events that led the government to intervene in the financial markets in all sorts of new ways.
The financial system freezes up—and it's a little bit like the circulatory system in your body suddenly congealing and none of the blood is flowing anywhere. So the Fed, which was created at the early part of the 20th century in response to such financial paralysis, steps in, uses the extraordinary power it has. Without any legislative approval, it exercises this power that the law gives them to lend to almost anybody in what are called "unusual and exigent circumstances."

The tone of the book is highly critical of former Federal Reserve chairman Alan Greenspan. What were his big failures?
When you look back—with the benefit of hindsight—I think the Fed kept interest rates too low, too long. The more significant charge is that Greenspan really didn't believe that regulation was very effective and he chose not to use the regulatory muscle the Fed had had. His conviction that markets were better equipped to manage these risks than they actually were influenced a whole lot of other people in Washington to come to the same conclusion.

The central character in your book is really Bernanke. And it's partly the story of him coming onto this public stage in the shadow of Greenspan. Was that something that Bernanke thought about?
Yes. I think that Bernanke is by nature kind of introverted and shy but that belies a self-confidence. He'd spent his life thinking about central banking. He said at the time that he wanted to continue the Greenspan policies—to say anything else would have been heresy. But he was convinced that he could have a different style. He thought that Greenspan had made himself more the focus than the Fed as an institution. He wanted the Fed to be so open with its analysis and its forecasts that no one would much care what the Fed chairman said or thought. Once the crisis hits and he realizes there's a reason committees have chairmen, he totally changes his style and becomes much more visible, speaks more often and more emphatically about what's going on in the economy, to the point where now the guy's doing 60 Minutes.

You write that by the end of December 2007 and the beginning of '08, Bernanke realized he had misread the economy. How so?
Both he and Paulson deliberately used this word "contained." They saw the downside in housing, but they thought it would be offset by other things. They didn't understand how much the housing bubble had infiltrated the entire financial system and how much the entire world financial system rested on this wrong assumption that housing prices in the U.S. would not go down because they hadn't gone down since the Great Depression. At the end of 2007 and early 2008 Bernanke begins to say, "Oh I've seen this play before." He begins to think that if he doesn't do something to break the blockage in the arteries of the economy, we would have another Great Depression.

Of course he had written a series of essays and papers on the Great Depression—he's a historian of that era—and really seems to have internalized the lessons. Tell us about the comment he made at the event honoring Milton Friedman.
Milton Friedman, of course, is the Nobel Prize-winning economist who, with his colleague Anna Schwartz, made a diagnosis of the Great Depression: the problem was the Fed had been too stingy with credit and had turned a bad recession into a depression. At Friedman's 90th birthday, Ben Bernanke, then a governor of the Federal Reserve, turns to Milton Friedman and says, "You're right, we caused the Great Depression. We're sorry. But thanks to you we'll never do it again." I think he thought it was a joke because at the time—in the early 2000s—the notion that we could have another Great Depression was about as far out among mainstream economists as a bunch of scientists saying the dinosaurs were going to appear on the horizon. So, he's like an economic paleontologist: he'd been studying the dinosaurs and one day the dinosaurs show up and the guy who happens to be in charge of our economic defense is a guy who knows all about these animals and begins to experiment to try and fight back.

I think that helps to explain a lot of the motivation behind this extraordinary series of events. You have this phrase that you use over and over again: "unusual and exigent."
That's a phrase written by Congress that gives the power to the Fed—when the Fed itself determines that the circumstances are "unusual and exigent"—to lend to almost anybody, provided they provide some sort of collateral. That's the power the Fed used with Bear Stearns, with AIG. It is a polite way—or a legalistic way—of saying "Whatever it takes." And I think the Bernanke Fed decided to do whatever it takes to avoid another Great Depression and on that score I think we can judge them a success.

Bernanke's term expires next year. Is he, in effect, campaigning for reappointment? And will it be successful?
I think he would say he's not campaigning for reappointment. But as an observer I would say he is. I think if the president had to make a decision right now, he would be likely to reappoint Bernanke because the downside of changing horses in midstream are so great: the likely uncertainty in the markets that would lead to higher interest rates than we'd otherwise have, which would be very unwelcome at this time, and the suspicions that it would generate with our foreign investors that Bernanke was being replaced by an ally of Obama's who would be less independent and more likely to have inflation. But I think the president isn't rushing because he wants the option of getting rid of Bernanke if the economy tanks in the next couple of months.