President Obama can’t let a week go by without getting on nationwide TV. Even a vacation with his family at Martha’s Vineyard didn’t keep him from announcing the reappointment of Ben Bernanke as Fed chairman.
Wall Street reacted positively to the reappointment, largely because Bernanke shepherded us through the Great Panic of 2008, which could have left us in a depressed state for years. His aggressive and innovative “quantitative easing” kept us from a 1930s-style financial collapse.
But let us not forget the many blunders Bernanke created in his first four years as chairman, and the mess he faces in the future.
His sins of commission are substantial:
1. It was on Bernanke’s first two years watch that the worst excesses of the real estate boom and the lax subprime lending rules took place.
In January, 2007, I was at Bernanke’s first major address before the American Economic Association on the subject of “bank regulation.” The Fed, he pointed out, is in charge of regulating the banks, yet he failed miserably to control their excesses at this critical time. It was a standard boring speech, except that Bernanke uses the words “panic” and “crisis” 37 times. He subconsciously knew what was coming but did nothing about it.
2. He significantly raised the “moral hazard” problem with financial institutions. “Moral hazard” is a term used by economists and policy analysts referring to the willingness for banks, insurance companies, and other financial institutions to take excessive risks knowing that the government will bail them out if they fail. It’s a serious danger, and one reason we continue to have lots of bank failures in the United States.
Bernanke raised the “moral hazard” risk when he and Treasury Secretary Hank Paulson engineered a rescue of Bear Stearns in March, 2008. But then fearing “moral hazard” concerns, he and Paulson decided not to bail out Lehman Brothers in September, 2008. They had no idea how big and important Lehman Brothers was in the global banking system, and the next week, because Lehman was allowed to fail, AIG suddenly became vulnerable. AIG was deemed too big to fail and has received about $180 billion (almost $2,000 for every American household) in federal assistance.
3. In less than six months, the Fed more than doubled its balance sheet from $800 billion to over $2 trillion, and has taken on $600 billion worth of Fannie, Freddie, and Ginnie mortgage-backed securities. During this time, the money supply (M2) grew at a double digit rate.
4. The worst mistake was Bernanke’s call to Treasury Secretary Paulson insisting that the financial crisis was too big for the Fed to handle, and his demand that Congress and the Treasury get involved. The result has been over $1 trillion in TARP and various sorts of stimulus packages, creating the worst deficits in U.S. history. This year’s deficit is expected to exceed $1.6 trillion.
What about the future under Bernanke? Here are his challenges:
1. How to maintain a stable monetary policy in the future? Bernanke’s Fed has already put the breaks on quantitative easing and the money supply. The Fed’s balance sheet has stopped growing this year, and the money supply (M2) is actually starting to shrink. The Fed is pursuing a boom-bust easy-money/tight-money policy. That kind of stop-go monetary policy can’t be good for the U.S. economy.
2. How long will interest rates stay low? Long-term rates and mortgage interest rates are already moving back up to 5% level, a more natural rate. But keeping short-term rates between 0-1% for long periods can re-ignite another round of inflation and asset bubbles. We’re already seeing a commodity boom again, with oil back up to $75 a barrel and copper at $3 a pound. If Bernanke allows short-term rates to climb to their natural level, this could spell trouble for financing the monstrous deficits. In short, Bernake is between a rock and hard place.
3. How will the Fed be able to maintain its independence? For the first time since World War II, Bernanke’s Fed bought Treasury bonds directly from the Treasury. Bernanke is now part of the Obama team, making decisions about holding government-guaranteed securities (Freddie, Fannie, and Ginnie mortgages). The Fed’s independence has been compromised, and it will be hard to earn back.
4. Finally, what about the banking system? How does Bernanke avoid “moral hazard” when banks and other financial institutions know that the government will bail them out? Perhaps the US will spend some time looking at the banking systems in Canada, Australia, New Zealand, Hong Kong, and elsewhere to see how they avoided the financial crisis almost entirely.
How well Bernanke and the Fed operate can best be judged by the value of the U.S. dollar and the price of gold. If the dollar keeps falling against the euro and the yen, and the price of gold (and oil) continues to rise, watch out. We are in trouble. But if the dollar strengths and gold (and oil) gradually decline, Bernanke will be rewarded as a financial magician.