Martin Wolf: The very model of a modern central banker

In their patter song in The Pirates of Penzance, Gilbert and Sullivan satirised the notion of an educated “modern major-general”. Today they might satirise academic central bankers, of which Ben Bernanke – soon to be ex-chairman of the Federal Reserve – is the very model. As a distinguished scholar, he brought to the Fed a brilliant and well-informed mind. His knowledge of economic history helped him halt a terrifying panic. But he also made mistakes. History will probably judge him kindly. But there is much to be learnt from his time at the Fed.

Mr Bernanke was hugely influential even before he became chairman, in 2006. As governor from 2002, he made notable contributions, including his 2002 “Making Sure ‘It’ [Japanese-style deflation] Doesn’t Happen Here”, and his 2004 celebration of the “Great Moderation”. Before this, not least in a 1999 paper co-authored with Mark Gertler of New York University, he had argued that “the best policy framework for attaining [price and financial stability] is a regime of flexible inflation targeting”. This is the core dogma of modern central banking.

In a valedictory this month, Mr Bernanke started with “transparency and accountability”, pointing to the fact that, in January 2012, the Federal Open Market Committee “established, for the first time, an explicit longer-run goal for inflation of 2 per cent”. He added that the Fed’s transparency and accountability proved “critical in a quite different sphere – namely, in supporting the institution’s democratic legitimacy”. He was surely right. Central banks wield great power. Transparency and accountability are vital if its exercise is to be both effective and legitimate.

Another area on which Mr Bernanke focused was financial stability. Here, in the run-up to the crisis, he made two mistakes.

First, in his 2004 praise for the great moderation, the vainglorious label given to the performance of the US economy before the largest financial and economic crisis for 80 years, Mr Bernanke claimed that “better monetary policy may have been a major contributor to increased economic stability”. In this, he displayed the blinkers of his profession. As the disregarded economist Hyman Minsky tried to tell us, stability destabilises. An active and enterprising financial system creates risk, often by raising leverage dramatically in good times.

Second, he missed the implications of subprime mortgages. Thus, in May 2007, he remarked that “we believe the effect of the troubles in the subprime sector on the broader housing market will probably be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system”.

Fortunately, when it became evident that this judgment was in gross error, the Bernanke Fed acted decisively and effectively, slashing interest rates and sustaining credit. As panic-fighter Mr Bernanke followed the guidance of the great Victorian economic journalist Walter Bagehot, who urged unrestricted lending by central banks to solvent institutions in times of crisis. This is a world of manias and panics. Happily, Mr Bernanke knew this.

Having prevented the seizure of financial markets, the Fed focused on the moribund economy. As Mr Bernanke explains, “to provide additional monetary policy accommodation despite the constraint imposed by the effective lower bound on interest rates, the Federal Reserve turned to two alternative tools: enhanced forward guidance regarding the likely path of the federal funds rate and large-scale purchases of longer-term securities for the Federal Reserve’s portfolio”.

Such actions were widely condemned for risking hyperinflation or thwarting a desirable liquidation of pre-crisis excesses. These criticisms were nonsense. Fear of hyperinflation was based on a mechanistic model of the links between central bank reserves and bank lending, which is irrelevant to contemporary banking. Banks are constrained not by reserves but by their perception of the risks and rewards of additional lending. The former had soared and the latter collapsed in the crisis, which is why the central bank had to intervene. The calls for liquidation failed to understand that an unchecked panic could cause mass bankruptcy and another Great Depression.

Many have also expressed concern over the exit from these exceptional policies. Again, this concern is misplaced. Tools exist for managing or eliminating excess reserves. Many complain, too, about over-reliance on monetary policy. But the determination of Congress to impose a grotesquely ill-timed fiscal squeeze left the Fed the only actor.

In all, the Fed managed to deal with the crisis and its aftermath in fraught circumstances. For this, Mr Bernanke deserves great credit.

Where, however, does Mr Bernanke leave finance and monetary policy? The answer is: in great uncertainty. There are two huge challenges, both related to pre-crisis errors.

The first is how far it will be possible to combine inflation-targeting monetary policy with financial stability. Pulling this off depends on making a new idea – macroprudential policy – effective. Nobody really knows whether this can be made to work.

The second is whether enough has been done to make the financial system less fragile. I remain concerned. Yes, regulation and oversight have improved. But, in essence, today’s financial system is the same as before. Worse, it is yet more dominated by a small number of thinly capitalised, complex, global behemoths. The notion that such institutions could be “resolved” in a panic without triggering panic remains untested and, partly for this reason, government promises not to bail them out are not credible. This is a highly troubling legacy.

Mr Bernanke will surely be regarded as one of the Fed’s most significant chairmen. Yet the fact that such hyperactivity was needed to save the world from economic ruin tells us how fragile was the bright new global financial system and how ill-judged the confidence in its stability. Mr Bernanke saved the day. But he also leaves behind unresolved questions about the future of central banking, money and finance. We should not forget them. They matter.


Martin Wolf


FT