The Improviser

Ben Bernanke, the consensus-building academic who toiled in Alan Greenspan's shadow, is emerging as the most powerful--and inventive--Federal Reserve chairman in the 95-year history of the central bank. Paul Volcker says he's overreaching.

By Steve Matthews
Bloomberg Markets June 2008

The event was a 2002 conference at the University of Chicago to celebrate the Nobel laureate Milton Friedman's 90th birthday. When Ben S. Bernanke rose to speak, he said that the Federal Reserve, of which he was then a governor, had come around to Friedman's view that the central bank's blunders were to blame for the Great Depression. "We're very sorry," Bernanke said, prompting laughter. "But thanks to you, we won't do it again."

Bernanke, a longtime scholar of the 1929-to-1933 panic, now has the unwelcome task of trying to keep a new financial calamity from turning into a full-blown depression. What started as a meltdown in the market for subprime mortgages has turned into a worldwide credit and economic crisis. Bernanke, now the Fed chairman, has responded with the most-aggressive expansion of the Fed's power in its 95-year history. Since last August, Bernanke, 54, has twice cut interest rates by 75 basis points, made Federal Reserve loans available to investment firms for the first time since the 1930s, lowered the rates at which banks can borrow from the Fed and launched an unprecedented rescue of Bear Stearns Cos., the struggling investment bank. (A basis point is 0.01 percentage point.) To prevent a wider crisis, the Fed risked the U.S. government's money by lending $29 billion backed by Bear's risky mortgage-backed securities. The loan was an incentive to JPMorgan Chase & Co. to buy the 85-year-old bank. (See "The House of Dimon," also in this issue.)

While Bernanke's attack on the U.S. economic malaise has been fierce, friends say the Fed chairman himself is anything but. "He is very even keeled, with a pleasant demeanor, a level temperament," says Richard Newell, an economist at Duke University who studied under Bernanke at Princeton. "He's not inclined to hit one over the head with the depth of his knowledge--that makes him an effective communicator."

Bernanke's rate cuts were followed by the release on March 31 of a sweeping proposal by U.S. Treasury Secretary Henry Paulson to revamp government supervision and regulation of the financial system. Paulson endorsed the Fed's moves to stabilize the economy and proposed the central bank be given a permanently expanded role as watchdog over the entire financial system, including commercial and investment banks, insurance companies, hedge funds and mutual funds. "The Fed would have the authority to go wherever in the system it thinks it needs to go for a deeper look to preserve stability," Paulson told the press.

At a press briefing in Miami on April 7, Paulson said the plan--which would abolish the Securities and Exchange Commission--may take several years to implement, and the Democrats, who control Congress, say no quick action is likely. Even so, Bernanke's Fed has already grabbed some of the power the Treasury proposes to give it by inserting itself into the back offices of the investment banks. "Since we've begun lending to dealers, including the remaining investment banks, we have put examiners on the ground in those firms, and we've established off-site teams that coordinate with them," Bernanke told Congress's Joint Economic Committee in testimony on April 2.

Bernanke, an academic from rural South Carolina, took office in February 2006 in the shadow of former Fed Chairman Alan Greenspan, who held sway at the central bank for 18 years. Bernanke, a Republican, is now well on his way to becoming the most powerful Fed chairman ever. "One interpretation of the Paulson report is that the Fed is handed any authority to do anything it wants," says former Fed Governor Lyle Gramley, now a Washington-based senior economic adviser for Stanford Group Co., a wealth management firm in Houston. "It assigns the Fed overall responsibility for any financial institutions that might be a source of systemic risk."

Former Fed Vice Chairman Alan Blinder says Bernanke's actions are justified. Paulson and President George W. Bush have done little to address the mortgage crisis, he says. "The Fed has been extremely creative and is fighting this war almost exclusively by itself."

The Bernanke Fed may have already seized too much power and has abandoned historical principles, says Paul Volcker, who was Fed chairman from 1979 to '87. "The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers," Volcker, 80, told the Economic Club of New York on April 8. "A direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in times of crisis: lend freely at high rates against good collateral. It tests it to the point of no return."

Bernanke says the gravity of the crisis is extraordinary. Until the beginning of this year, he had looked for consensus among his fellow Fed governors--a departure from the chairman-dominated regime of Greenspan, says Gramley. Then, in a Jan. 10 speech, he laid out a more dour view of the country's economic prospects and promised to lower interest rates to address the unfolding credit crisis. The speech signaled that Bernanke was shaping policy rather than following the view of the group, Gramley says. "That was when Bernanke realized the idea of letting a consensus develop sounded good, but in times like we were going through now would no longer be effective. He put his foot down. That is what we have been seeing since then."

Ben Bernanke, the son of a small-town drugstore owner, has been preparing his entire adult life for the fight against what Greenspan has called the "most wrenching" economic crisis since World War II. A former Princeton University economics professor who was appointed to a four-year term as Fed chairman and 14-year term as a Fed governor by Bush in 2005, Bernanke has been studying the causes of the Great Depression since he was a graduate student at Massachusetts Institute of Technology.

In 1989, he wrote an article with Mark Gertler, a New York University economics professor, for the American Economic Review in which they presented a detailed model that helps to explain the cascade of events that led to the collapse of markets in the years after the 1929 crash. The research showed for the first time that, in a financial crunch, as borrowers' net worth declines, their financing costs increase. That brings about an "accelerator effect" that can make a downturn more severe. Since it was published, the research has been cited about 400 times in other economics journal articles, says Gertler.

A weakening of borrowers' balance sheets results in further credit tightening, creating a vicious circle, Bernanke wrote. That process, he told the House Financial Services Committee on Feb. 27, is behind the continuing credit crisis today. "There's an interaction between the economy and the financial system, and perhaps even more enhanced now than usual, in that the credit conditions in the financial markets are creating some restraint on growth," he said.

Bernanke's approach to the current financial troubles has been shaped by his scholarship, says Gertler, 57. "The Fed let financial markets go, and that caused the depth and duration of the Depression," Gertler says. "He has taken that conviction to heart. There is no one on this planet who has a better understanding of financial crises, and better intuition, and that is what is driving Fed action." In 2000, Bernanke published a book, Essays on the Great Depression, the introduction to which includes this statement: "To understand the Great Depression is the Holy Grail of macroeconomics." Princeton University Press initially printed 1,500 copies of the 320-page tome; it has since gone through five additional printings and sold a total of 6,500 copies. By contrast, Greenspan's book The Age of Turbulence: Adventures in a New World had sold 488,000 copies as of March 30, according to Nielsen BookScan.

Lee Hoskins, who was president of the Cleveland Federal Reserve, one of 12 Federal Reserve banks, from 1987 to '91, says Bernanke has been ill served by his preoccupation with the Depression. "The Fed has shown a hint of panic," Hoskins, 67, says. "The solution should not be to bail out institutions or run around with all sorts of new programs. The Fed is overreacting to fears."

Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh, agrees that Bernanke is swatting a fly with a sledgehammer. "In monetary policy, he has not been good," Meltzer, 80, says. "It is a silly policy designed to head off a recession that may come but hasn't come yet."

Meltzer says the Fed, by ignoring the inflationary potential in its latest rate cuts, is creating the possibility of negative real interest rates. He also says the Fed should never take credit risks, especially to save floundering banks. "We can't have a system that continues to work well if the bankers make the profits and the public, the taxpayers, take the losses," he says. "That is not a viable system."

Meltzer says Paulson's plan for expanded Fed oversight of the financial industry is both overreaching and impractical. "It's hard to see how the Fed is going to do it," he says. "The Fed's record of anticipating and heading off crises is poor. Now they are going to go out and examine investment bank portfolios? Most of the people who are buying and selling this stuff don't fully understand it. How is some Fed auditor going to figure it out?"

Former Fed Governor Gramley says the Fed chairman knows what he's doing. "The innovativeness of the Bernanke Fed has no precedent," he says. "Bernanke understands the implications of having credit markets seize up. He is well aware the Fed has to be as aggressive as possible."

Gramley is one of a band of Bernanke loyalists who have followed his career from Princeton to the Fed, to the White House, where he served as head of the Council of Economic Advisers from June 2005 to January '06, and back to the Fed. "From my work with him, I know that he's exceptionally levelheaded," says Mark Watson, who was associate chairman of the Princeton economics department when Bernanke was chairman. "He was always able to keep his cool dealing with crises here at Princeton, even when others, like me, were going crazy."

That quality carried over to the White House, says John Anderson, who worked with him there. "He was an incredibly quick study," says Anderson, now an economics professor at the University of Nebraska-Lincoln. "It didn't matter what the policy issue was. He was easygoing, easy to communicate with. He had a lot of credibility in the West Wing, with the president."

Bernanke was thinking in terms of his Depression scholarship as early as June 2007, though it was not yet clear how quickly the mortgage meltdown would ripple through the broader economy. In a speech at an Atlanta Fed conference, he said both the failure of banks and declining creditworthiness of borrowers played a role in the Depression. And he added that last year's decline in home prices could have a greater impact than expected. "If the financial accelerator hypothesis is correct, changes in home values may affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect, because changes in homeowners' net worth also affect their external finance premiums and thus their costs of credit," Bernanke said.

Bernanke and other Fed governors also discussed the notion of a chain-reaction financial crisis at meetings of the Federal Open Market Committee, which sets interest rates, in December 2007 and January and March 2008, according to minutes of those meetings. "Several participants noted that the problems of declining asset values, credit losses and strained financial market conditions could be quite persistent, restraining credit availability and thus economic activity for a time and having the potential subsequently to delay and damp economic recovery," according to the minutes of the March 18 meeting.

From Bernanke's standpoint, there are two major lessons to be learned from the Fed's reaction to the market crash of 1929 that are relevant today. The first is that the Fed should lower rates, not raise them, in the face of an economic contraction. The second is that the Fed must pay careful attention to the health of financial institutions, as lending plays a big role in economic growth.

In July 1928, when financial markets were still booming, the Fed raised its benchmark interest rates to 5 percent, the highest since 1921, effectively cutting the money supply, in order to reduce what it saw as excess speculation on Wall Street. It did so even though there were no signs of inflation, Bernanke said at the conference honoring Friedman. In October 1931, after the market crashed and GDP had begun to nosedive, the Fed raised rates again to prevent the dollar from falling in international markets. That made it harder for companies and individuals to borrow even as the economy was contracting 30 percent and deflation was setting in. A series of bank failures further reduced credit throughout the economy.

While the United States moved to protect the dollar, the Bank of England, faced with depleted gold reserves backing the pound, in 1931 let the value of the currency float freely. The decision to abandon the gold standard allowed Britain and the Scandinavian countries to recover from the Depression earlier than the rest of Europe.

All of this is front-of-mind for the current Fed chairman, who is weighing the falling U.S. dollar among the factors he considers in making policy decisions. "We will address financial issues and try to maintain the integrity and stability of the financial system," Bernanke told the Joint Economic Committee of Congress on April 2. "We will not let prices fall at 10 percent a year. We will act to keep the economy growing and stable."

Bernanke started his term in February 2006 by trying to stamp out some of the growth in an overheated economy. Following Greenspan's example, he raised interest rates three times, on March 28, May 10 and June 29, to counter a threat of inflation. By the time the credit meltdown began in July and August, the federal funds rate was at 5.25 percent, a six-year high.

Bernanke at first resisted pressure from Wall Street and the housing industry to begin ratcheting rates down. Instead, on Aug. 17, 2007, he reduced the discount rate at which the Fed makes loans to banks by half a percentage point and extended the maximum term of such loans to 30 days from overnight. By September, though, it was clear to Bernanke and his backers at the Fed that more-dramatic action was necessary. The Fed then took a series of actions:

• On Sept. 18, the Fed cut interest rates half a percentage point, the first of six cuts that moved the rate to 2.25 percent in mid-March from 5.25 percent in August. When the central bank reduced rates 75 basis points on March 18, Dallas Fed President Richard W. Fisher and Philadelphia Fed President Charles Plosser dissented, saying they preferred "less-aggressive action."

• On Dec. 12, the Fed created the Term Auction Facility, a new lending vehicle to make 28-day credit available to banks as an alternative to direct borrowing at the Fed's discount rate, which may carry a stigma. The U.S. also moved to increase the supply of dollars in Europe. The action was coordinated with the European Central Bank and three other central banks in the biggest act of international economic cooperation since the Sept. 11 terrorist attacks.

• On March 11, through the Term Securities Lending Facility, the Fed for the first time loaned Treasuries in exchange for debt that includes mortgage-backed securities.

• On March 16, the Fed cut the rate on direct loans to commercial banks to 3.25 percent and opened up borrowing at the same rate to nonbank securities firms. The move, taken on a Sunday, represented the Fed's first weekend change in borrowing costs since 1979, when former Chairman Volcker was fighting inflation.

• On that same Sunday, the central bank announced its unprecedented arrangement with JPMorgan to take control of a collapsing Bear Stearns. In his testimony on April 2, Bernanke said that Bear Stearns advised it on Thursday, March 13, that without additional financing it would be forced to declare bankruptcy on Friday, March 14. The Fed announced the deal to let JPMorgan buy the bank on Sunday. "Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain," Bernanke said.

In helping finance JPMorgan's purchase of Bear Stearns and its mortgage-backed securities, the Fed for the first time created the possibility that taxpayers will take significant losses from a Fed action. "I don't think there is anybody at the Fed who wanted to do that," says William Isaac, a former Federal Deposit Insurance Corp. chairman, who led the FDIC takeover of the failing Continental Illinois National Bank & Trust Co. in 1984. "Sometimes you do things you don't want to do. We had to stop the contagion."

The U.S. Senate Finance and Banking committees are reviewing the taxpayer-backed sale. "You have a lot of smart people working at the Federal Reserve," Republican Senator Sam Brownback of Kansas told Bernanke at the April 2 hearing. "I am concerned when the taxpayers' money becomes the skin in the game to rescue supposedly sophisticated investment and commercial banks from the results of their own poor decision making."

In his April 2 testimony, Bernanke pointed out that the Federal Reserve was created in 1913 in response to another market meltdown, the Panic of 1907. On March 14 of that year, exactly 101 years before the Fed's Bear Stearns intervention, the stock market fell 8.3 percent, touching off a number of bank failures. Financier John Pierpont Morgan, who founded what later became J.P. Morgan & Co. in 1871, helped to save the day by calling together the heads of the largest U.S. banks and locking them in a room until they agreed to supply financial backing to the Trust Company of America, which was threatened with bankruptcy.

One cause of the panic was a depleted money supply. "There was a state of credit anorexia--what we would call a credit crunch today," says Sean Carr, co-author of The Panic of 1907: Lessons Learned from the Market's Perfect Storm (John Wiley & Sons, 2007). The Fed was created to serve as a lender of last resort in times of crisis and to monitor and stabilize currency markets through manipulation of interest rates.

The Fed has had just six chairmen since 1951: William McChesney Martin, who served for almost 20 years, Arthur F. Burns, G. William Miller, Volcker, Greenspan and Bernanke. The 6-foot-7-inch Volcker is best known for his successful battle against the high inflation of Jimmy Carter's and Ronald Reagan's presidencies. The consumer price index rose 14.8 percent for the year ended on March 31, 1980. Volcker's Fed responded by raising the fed funds rate as high as 20 percent. By July 1983, inflation had been reduced to a tame 2.5 percent.

During Greenspan's 18 years in charge of the Fed, the U.S. endured only two recessions, both lasting less than a year, and enjoyed the longest economic expansion in U.S. history. "He has a legitimate claim to being the greatest central banker who ever lived," wrote Princeton economist Blinder, who spent 19 months as the Fed's No. 2 in the mid-1990s, in a paper presented in August 2005 at a Fed conference devoted to the "Greenspan Era."

Greenspan had been Fed chairman for just a few months when he faced his biggest challenge, the stock market crash of Oct. 19, 1987. The Dow Jones Industrial Average plunged 23 percent that day amid concern that a falling U.S. dollar could lead to Fed tightening. The decline was worsened by failed trading strategies among financial firms and resulting margin calls. Greenspan responded by pumping money into the banking system. The economic expansion continued. Greenspan built a reputation as a man who could navigate crises: He put off a planned rise in interest rates after the Asian currency crisis of 1997. He cut rates following the Russian debt default in 1998. And he helped pull together a bailout plan after the failure of a big hedge fund, Long-Term Capital Management LP, that same year, threatened to trigger a broader crisis.

Critics say Greenspan was also partly responsible for speculative bubbles, first in tech and Internet stocks in the late '90s, then in housing prices. The housing bubble swelled as Greenspan kept the fed funds rate at 1 percent in 2003 and '04. "One of the reasons we are in this particular predicament is because for 20 years the Fed has been trying to suppress the downside of the business cycle and has been proposing bailouts and easing money whenever money needed easing," says William Fleckenstein, president of Fleckenstein Capital Inc. in Seattle, Washington, and co-author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve. Greenspan, in a Financial Times commentary on April 6, said low long-term interest rates, rather than the Fed's manipulation of short- term rates, were the cause of the housing speculation.

Bernanke, with his sharp interest rate cuts and rescue of Bear Stearns, has kept up the Greenspan practice of intervening to stimulate economic activity. Such emergency action would not be necessary if Fed governors, including Bernanke, had had more foresight, says former Fed Governor Martha Seger, a Reagan appointee who served from 1984 to '91. "In general, the Fed is very late to get onto things, and by that time, it's a full-fledged roaring disaster about to happen," Seger says. "The Fed is prone to ignore problems as they're building up, and by then you not only get the fire trucks but ambulances and everything else."

Bernanke has seen poverty close up. Born in Augusta, Georgia, in December 1953, he grew up in Dillon, South Carolina, a textile-and-farm town in an especially poor part of one of the U.S.'s poorest states. His father, Philip, owned a drugstore with his uncle; his mother, Edna, was a schoolteacher. The Bernankes were among the few Jewish families in the area.

Bernanke developed an interest in mathematics and economics at an early age. Calculus wasn't offered at Dillon High School, so Bernanke learned it on his own, his uncle Mort Bernanke, 79, says. Bernanke played saxophone in the high school band and was an above-average talent, says band mate John Braddy, who still lives in Dillon (population, 6,800). In 1966, the Fed chief appeared at Dillon High in a four-boy band called Fancy Pants in which all wore plaid trousers, according to the Dillon Herald. Later, he and Braddy played in a nameless rock band that belted out The Doors' "Light My Fire" on the talent show of a local TV station. "We probably butchered it to the point it wasn't recognizable," Braddy says. Bernanke has since given up playing the sax.

Bernanke was the winner of the state spelling bee in 1965 and the valedictorian of his senior class. In 1971, he went off to Harvard, in Cambridge, Massachusetts, after scoring 1590 out of 1600 on his SAT exam. He used the proceeds of a $1,000 National Merit Scholarship to help pay his tuition. "You knew Ben was smart, but he never intimidated you or made you feel he was different than anyone," says Braddy. During college breaks, Bernanke worked six days a week at South of the Border, a village of souvenir shops along I-95 near Dillon.

The Fed chairman earned a bachelor's degree in economics at Harvard in 1975, winning the Allyn Young Prize for best Harvard undergraduate economics thesis. (It was called "An Integrated Model for Energy Policy.") He then went on to MIT, where he earned a Ph.D. in economics in 1979. "He was the smartest guy in our class, and it wasn't a class of dumb people," says Alexander S. Kelso Jr., principal of Great Oak Development, a New Orleans- and Boston-based property development firm, who shared an MIT office with Bernanke.

"Ben was quiet and serious," says Robert Solow, 83, an economics professor at MIT and Bernanke adviser who won the Nobel Memorial Prize in Economic Sciences in 1987. "I don't think you got to appreciate Ben until you read his exam or talked to him one-on-one."

Bernanke taught economics at Stanford University and New York University before taking a tenured professorship at Princeton in 1985.

Bernanke's ascension to head of the world's most important central bank has not changed him, says his Uncle Mort. "I'm sure Ben is under pressure now, but he never shows it," his uncle says. Bernanke visited his parents, who now live in Charlotte, North Carolina, in March, and the family attended a Harlem Globetrotters game. "He seemed very relaxed," says Mort Bernanke. "He has a sense of humor--a wry sense of humor, not boisterous."

Bernanke's demeanor has been a factor in the way he runs the Federal Reserve system. Under Greenspan , the FOMC, which sets interest rates, had been dominated by the chairman, according to Vincent Reinhart, who was the Fed's chief monetary-policy strategist from 2001 until September 2007. Bernanke has made the FOMC a more democratic group, with more decisions made by consensus. He has extended the length of meetings, scheduling four two-day meetings a year, to allow for more discussion, Reinhart says. His speeches and testimony reflect committee forecasts rather than his personal views. He doubled the number of forecasts by the FOMC as a whole to four a year.

"It is an important point that Bernanke is trying to depersonalize monetary policy, which is an unselfish act," says Reinhart, now a scholar at the American Enterprise Institute in Washington. "In terms of style, Alan Greenspan came from the corporate world, where he had been a director of many boards. He viewed the Fed chairmanship from that corporate perspective, which is formal. Ben Bernanke came from academia, where he had been chairman of the Princeton economics department. That's much less formal and involves frequent give-and-take."

There has been less of that give-and-take since March 18, when the Dallas Fed's Fisher and Philadelphia's Plosser registered their unusual dissent from the Fed's latest rate cut. William Niskanen, chairman of the libertarian Cato Institute and a former member of Reagan's Council of Economic Advisers, says that Bernanke's dramatic lowering of interest rates will have unintended consequences. "The actions people take in difficult times tend to be what creates the next bubble," Niskanen says. "This is a very dangerous situation."

Equally dangerous was Bernanke's rescue of Bear Stearns, says Seger. "I hate to say this, but this is sort of typical for the Fed," she says. "It has this New York, Wall Street bias. They get special treatment."

Bernanke denied any such bias in his April 3 testimony before Congress. "The issues raised extended well beyond the fate of one company," he said. "The sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence." Having moved out of the shadow of Greenspan, Bernanke is improvising, trying to find a formula--even in the face of criticism by Volcker and others--that will ease the financial system out of danger and prevent history from repeating itself.

Steve Matthews covers the U.S. economy and Federal Reserve at Bloomberg News in Atlanta. smatthews@bloomberg.net With reporting by Vivien Lou Chen in San Francisco and Thomas R. Keene and Michael McKee in New York.

May/02/2008 18:13 GMT

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