By ANNA JACOBSON SCHWARTZ
July 26, 2009
SourceAS Federal Reserve chairman, Ben Bernanke has committed serious sins of commission and omission — and for those many sins, he does not deserve reappointment.
Let me begin with the former. It is standard practice for a central bank like the Federal Reserve to ease monetary policy to combat a recession, and then to tighten it as recovery gets under way. Mr. Bernanke so far has only had to do the first half, and has conducted a policy of extreme ease. The Fed’s Open Market Committee cut the federal funds rate in October to 1 percent from 1.5 percent, and then in December to a range of zero percent to 0.25 percent.
What drove down the funds rate was the Federal Reserve’s decision to increase its depository bank reserves. Bank reserves have been rising since Sept. 17, as the Fed purchased securities and financed loans. When the Fed committee cut the rate to zero, it was merely ratifying the de facto rate.
Mr. Bernanke seems to know only two amounts: zero and trillions. Before 2008 there were only moderate increases in the Federal Reserve’s aggregate balance sheet numbers, but since then the balance sheet has exploded by trillions of dollars. The increase was spurred by the Fed’s loans to troubled institutions and purchases of securities.
Why is easy monetary policy such a sin? Because in such an environment, loans are cheap and borrowers can finance every project that they dream up. This results in excesses, and also increases the severity of the recession that inevitably follows when the bubble bursts.
Let’s move on to the sins of omission. After 2007, the Federal Reserve clearly observed that the mortgage loan industry was being transformed into an issuer of securities backed by a pool of mortgages of varying quality. Yet the Fed at no point clearly warned investors that these new instruments were difficult to price. (These securities were backed by everything from top-quality mortgages to subprime ones, and it was difficult to determine what value to assign to different mortgages.)
Partly as a result of the Fed’s silence, investors who loaded up their balance sheets with these securities were ignorant of the great risks of trying to sell assets that are difficult to price. Other new instruments, like derivatives, were not risk-free, although the market became enamored of them.
The Fed is the manager of markets. There is thus every reason to expect that it would see the problems that these new instruments were likely to create for normal transactions, and speak up about them.
The Fed delivered plenty of rhetoric about the importance of transparency, yet failed to articulate its own goals. The market was thus bewildered when the Fed rescued certain firms and not others. Mr. Bernanke should have explained the principles behind these decisions. The market could not understand why the Fed rescued Bear Stearns and then permitted Lehman Brothers to die.
As a consequence, there was volatility in the credit and equity markets and a general sense of turmoil that demonstrated that participants were at a loss to understand the functioning of the Fed.
Last year, when the credit market became dysfunctional and normal channels for borrowing broke down, the Fed misread the situation. It persisted in believing that the market needed more liquidity, even though this was not a solution to the market disturbances. The real problem was that because of the mysterious new instruments that investors had acquired, no one knew which firms were solvent or what assets were worth. At the same time, these new instruments were being repriced in the market. The firms that owned them then needed to restore their depleted capital. When big firms experienced enormous losses, the Fed did not respond in a way that calmed markets. Most of all, Mr. Bernanke ultimately failed to convince the market that the Fed had a plan, and was not performing ad hoc.
I am certain that there are economists whose reputations for outstanding academic work in monetary policy are every bit as distinguished as Mr. Bernanke’s, and who have good judgment and experience within the Federal Reserve System. President Obama should choose one of them.
Anna Jacobson Schwartz is an economist at the National Bureau of Economic Research and the author, with Milton Friedman, of “A Monetary History of the United States, 1867 to 1960.”