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INEFFICIENT MARKETS - Hapless Policymakers

Why Bernanke is as much to blame as Greenspan.

When asset prices fall the maestro becomes fair game. Former Federal Reserve Board chairman Alan Greenspan presided over two of the greatest bubbles in U.S. history. But despite more than two decades in the public spotlight, he remains an elusive figure. On matters relating to monetary policy, it’s difficult to know where he really stood. Ben Bernanke is more thoughtful, articulate and consistent than his predecessor. If you want to understand where the Fed went wrong over recent years, it’s better to examine Bernanke’s theory than Greenspan’s practice.

Before coming to Washington, Greenspan earned his keep as an economic forecaster, far from the ivory tower. At the Fed his public views were generally opaque and sometimes changeable. In the late 1990s he flip-flopped between denouncing “irrational exuberance” and embracing the New Economy. After the housing boom took off, Greenspan first denied the possibility of a real estate bubble, then later saw “froth” in regional housing markets. By contrast, the current Fed chairman is less prone to shifting positions. Everything Bernanke says about monetary policy is rooted in theory, as befits a former head of the Princeton University economics department.

Bernanke’s perspective on Wall Street is limited by the tunnel vision of economic theory. At heart Bernanke is a rationalist. In his Essays on the Great Depression (Prince­ton University Press, 2000), he displays a reluctance to depart from “the assumption of rational economic behavior.” In a footnote he adds: “I do not deny the possible importance of irrationality in economic life; however, it seems that the best research strategy is to push the rationality postulate as far as it will go.” That may be a useful exercise in the classroom, but it’s another matter when you are running the world’s central bank.

His belief in rationality probably explains why Bernanke has long maintained that it is impossible to identify asset bubbles before they pop. It follows from this that the central bank shouldn’t attempt to prick a bubble; rather, Bernanke argues, the Fed should step in to deal with the aftermath. His academic work on this subject helped provide a justification for Greenspan’s failure to rein in the dot-com mania at the turn of the century. In 2002, Bernanke was appointed a Federal Reserve governor.

It turned out that the Fed’s attempt to handle the burst tech bubble had the unfortunate side effect of inflating an even larger one. Naturally, Bernanke failed to recognize the appearance of a massive housing bubble, arguing instead that rising home prices simply reflected increasing prosperity. He also suggested that the growth in consumer debt was no concern because rising home prices had improved household balance sheets.

Bernanke, in his academic work, is preoccupied with the problem of deflation. In November 2002 he delivered a celebrated speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” The newly appointed Fed governor told his startled audience that “deflation is always reversible under a fiat money system.” Helicopter Ben had taken off. In the same speech he asserted that in extremity the Fed might manipulate long-term rates to keep them from rising. Wall Street woke up. Bernanke appeared to be guaranteeing the profitability of the carry trade, which involves borrowing short and investing in longer-dated securities. The “Bernanke put” revived debt markets. Bonds climbed in value, spreads narrowed, and the credit bubble started to inflate.

The trouble with Bernanke’s views about deflation is that he doesn’t clearly distinguish between the “bad” deflation that damages the economy and the “good” deflation that comes from rising productivity and other supply-side improvements. He is not the first to make this error. The Federal Reserve in the 1920s also followed a policy of price stability at a time when consumer costs would otherwise have declined because of technological advances. As a result, interest rates were set so low that they encouraged excessive credit growth and stimulated a real estate boom. The Bank of Japan pursued a similar course in the late 1980s, with disastrous consequences. The Fed under Greenspan and Bernanke replicated this error. In recent years the good deflation was prevented from occurring, but at the cost of a wild credit expansion.

Bernanke seems to believe that bad deflation derives from poor policies, such as adherence to the gold standard in the early 1930s.There is something in this, but he underplays the effect that a bursting credit bubble has on promoting deflation. His essays on the Great Depression contain remarkably little on the growth of credit in the late 1920s and the role that excessive debt played in the subsequent bust. In his view the banks didn’t fail in the 1930s because they had made poor loans. Rather, Bernanke blames the Federal Reserve for preemptively trying to prick the speculative bubble in 1928.

In short, Bernanke thinks about money and price stability, but appears to focus too little on credit and its contribution to financial instability. He suggests in one of his essays that the collapse of the debt pyramid in the early 1930s was “connected very indirectly (if at all) with the path of industrial production in the United States.” This is a surprising conclusion. Researchers at the European Central Bank recently found that “high-cost” recessions tend to occur after periods of strong credit growth and real estate booms.

Greenspan’s critics tend to see Bernanke as the patsy who was handed a poisoned chalice on assuming the Fed’s chair. That’s probably too generous. After all, Bernanke rationalized the recent expansion of credit as a reflection of economic and structural improvements to the financial system. He hailed the “Great Moderation” (the result of improved policymaking, in his view) but failed to recognize the increasingly reckless behavior on Wall Street. The greatest excesses of subprime and leveraged-buyout lending occurred after Bernanke took office on February 1, 2006.

Bernanke also excused the debt-fueled consumption binge in the U.S. as a by-product of a so-called “global savings glut.” Countries with trade surpluses reinvested their money in the U.S. because, he said in a 2005 speech, it was a more attractive “investment destination.” He failed to note that the recycling of foreign export dollars had created an indiscriminate demand for U.S. securities, including subprime loans. After the housing market turned down, Bernanke was slow to observe the dangers posed by the fallout. He initially held that subprime problems were “contained,” and he vastly underestimated likely losses.

When the credit crunch hit last summer, Bernanke didn’t seem at first to grasp the seriousness of the problem. But as the crisis has dragged on, that has changed. Not only did Bernanke cut rates by 1.25 percentage points in January, but the Fed is now lending to banks against a broader range of collateral, including securitized loans containing subprime mortgages.

Writing about the Great Depression, Bernanke describes “hapless policymakers trying to make sense of the events for which experience had not prepared them.” Having provided an intellectual rationale for just about every mistaken move by the Fed over the past decade, Bernanke is now the “hapless policymaker” who must get us out of the hole that he and Greenspan dug for us.

Edward Chancellor is the author of Devil Take the Hindmost and a senior member of GMO’s asset allocation team.