Wednesday, September 3, 2014

One Hand Clapping for Ben Bernanke

WASHINGTON, DC – President Barack Obama’s nomination of Ben Bernanke to a second term as Chairman of the United States Federal Reserve represents a sensible and pragmatic decision, but it is nothing to celebrate. Instead, it should be an occasion for reflection on the role of ideological groupthink among economists, including Bernanke, in contributing to the global economic and financial crisis.

The decision to nominate Bernanke is sensible on two counts. First, the US and global economies remain mired in recession. Though the crisis may be over in the sense that outright collapse has been avoided, the economy remains vulnerable. As such, it makes sense not to risk a shock to confidence that could trigger a renewed downturn.

Second, Bernanke is the best among his peers. He did eventually come to understand the nature and severity of the crisis, and then took decisive steps that contributed to halting the economic freefall. That record, combined with doubts that any of his peers would have done better, means replacing him with another mainstream candidate makes little sense.

These two factors justify Bernanke’s reappointment, but the faintness of praise is indicative of the deeper problems that his leadership has exposed. Those problems concern the state of economics and economic policy advice.

One such problem is Wall Street’s implicit veto over the Fed. After all, a major reason for reappointing Bernanke is to avoid rocking financial markets. This also explains why Bernanke’s only rivals are from his peer group – the only people whom financial markets would be willing to accept.

In the 1990’s, placating financial markets was also invoked to justify the reappointment of Bernanke’s predecessor, Alan Greenspan, and it is now perennially invoked to block change at the Fed and other central banks. In effect, financial markets have established an implicit veto over much of economic policy and the people who can hold top policymaking positions, and it is time to think how we can escape that hold.

A second problem concerns the state of economics. Though Bernanke may be the best in his peer group, the fact is that the economic crisis decisively proved him and his peers to have been wrong. As a group, they joined in the adulation of Greenspan, whom one leading economist proclaimed “the greatest central banker who ever lived.” Almost without exception, mainstream economists failed to foresee the crisis, and even the few who did get the logic and unfolding of events wrong.

For his part, Bernanke led the intellectual charge toward inflation targeting by central banks, arguing that setting a target for annual inflation was a full and sufficient framework for monetary policy. Such thinking contributed to neglect of asset and credit markets, promoted intellectual disregard for regulation, and fostered laissez-faire excess, because macroeconomic belief in the sufficiency of inflation targeting paired logically with microeconomic belief that credit markets would take care of themselves. In Greenspan’s words, the “self-interest of lending institutions” would protect shareholders and the economy from lending excess.

This thinking explains why the Fed under Bernanke’s leadership was so slow to respond to the crisis, which began in August 2007 yet did not elicit a coherent and comprehensive response until November 2008. The Fed certainly would have reacted sooner had it not been attached to a model of banking more appropriate to the 1950’s.

Oblivious to the role of the shadow banking system, the Fed did not understand how its implosion would undermine the traditional banking system. The Fed simply failed to comprehend the significance of traditional banks’ large holdings of mark-to-market assets and their own engagement in shadow banking via off-balance-sheet “structured investment vehicles.”

Any dispassionate assessment of the Fed’s thinking before and well into the crisis shows that it failed to understand the economics of its own bailiwick, banking and financial markets. Moreover, the Fed promoted broader economic views about deregulation and the self-stabilizing nature of markets that the crisis has discredited.

Though circumstances dictate that Bernanke is the best candidate and should be reappointed, the real challenge is to ensure a thorough intellectual housecleaning at the Fed in order to open space for alternative economic views. The great danger is that reappointing Bernanke will be interpreted as a green flag for a flawed status quo .

That is where public debate and Bernanke’s Senate confirmation hearings enter the picture. Those hearings should be an occasion for critical examination of what went wrong, and why. If that happens, Bernanke’s reappointment can serve as a trigger for constructive change rather than an endorsement of a discredited paradigm.

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