By Randall Holcombe • Wednesday August 26, 2009 10:08 AM PST •
President Obama announced that he will reappoint Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve Bank (Fed), and I’m more than OK with the president’s decision. Bernanke’s policies over the past year and a half have put the Fed in a precarious position, but Bernanke says he has an “exit strategy” and it’s just as well that he’s staying to try to implement it. If he was replaced now, his successor could, with some justification, blame the Fed’s difficult situation on Bernanke, and Bernanke could counter that he had an exit strategy his successor should have implemented. Now it will be Bernanke’s responsibility.
Perhaps the biggest legacy of Bernanke’s tenure as Fed chair, regardless of how long he stays, is his expansion of the Fed’s toolbox for dealing with economic downturns. Prior to Bernanke’s tenure, the Fed’s primary activity was controlling the quantity of money through open market operations, which was undertaken by buying and selling Treasury securities. Bernanke greatly expanded the Fed’s asset portfolio by purchasing securities from private and semi-private issuers. It bought from money market funds, and still owns a substantial amount of securities issued by Fannie Mae and Freddy Mac. This goes well beyond the Fed’s policy pre-Bernanke. Also prior to Bernanke’s tenure, the Fed made “discount” loans to banks that were members of the Federal Reserve System. Bernanke expanded the use of discount loans, making them available to financial institutions that not only were not Fed members but weren’t even commercial banks. Again, this goes well beyond the Fed’s pre-Bernanke policy. And, the Fed stepped in to rescue AIG as it was collapsing, also unprecedented.
This is all history now, and would be Bernanke’s legacy whether he stayed or was replaced. This expansion in the activities of the Fed sets a precedent—I think, a bad one—for future Fed action in the face of economic downturns. Essentially, the Fed was engaging in industrial policy as it was propping up the financial system, deciding that some firms would survive (Goldman Sachs), some would go under (Lehman Brothers), and some would be taken over by other institutions (Bear Sterns, Merrill Lynch). It’s worth a remark, and probably even more extensive discussion than I’ve given here, because with all the attention focused on the Fed’s expansion of the monetary base, I’ve seen little written about the discretionary policy the Fed followed as it expanded its set of policy tools to deal with the downturn. For this reason, I’m not a Bernanke fan.
Now, with the Fed holding a massive amount of excess bank reserves, the Fed must keep those reserves from being lent and entering the money supply, or inflation will skyrocket. Bernanke knows this, and his exit strategy, not explained in detail, would mop up these reserves to hold inflation in check. The problem is, any method of mopping up these reserves would cause interest rates to rise, and as long as the recovery is fragile, Bernanke will be reluctant to do this. There is the real risk that Bernanke won’t want to see higher interest rates until inflation starts to appear, and that by then it will be too late to stop a more substantial inflation.
This problem is a result of Bernanke’s policies, and I support leaving Bernanke in charge of the Fed to deal with the problem. To put someone else in at this point would allow the new Fed chairman to put the blame on Bernanke; to leave Bernanke in charge clearly locates all the responsibility with him. He says he has an exit strategy, and while I hope it works, I’m concerned enough to think that it won’t. Bernanke is a smart guy, and very knowledgeable, so I have no complaint with him on those grounds. I do believe, however, that he is overly ambitious in his view of the Fed’s agenda. Keeping inflation in check should be the Fed’s first priority, and Bernanke’s more expansive view of the Fed’s role is likely to distract him from that primary goal.
Another problem I see with Bernanke’s tenure is the close relationship that has developed between the Fed and the Treasury. Bernanke is helping the Treasury finance it’s huge deficit, and that too will prove inflationary if it keeps up. To keep inflation in check, Bernanke should reestablish the Fed’s independence from the Treasury and make it clear that as the recovery progresses, the Fed will design monetary policy to prevent inflation, and the Treasury will be on its own to finance the deficit. Bernanke is in the best position to do this, because he can say that his actions of the past two years were designed to deal with an extraordinary situation, and with the recovery underway the Fed will be turning its attention back to price level stability, which should be its first priority. A new Fed chairman could be accused of turning his back on the “successful” Bernanke policies if he were to try to reassert the Fed’s independence.
While I’m not a Bernanke fan, I do think he is in a better position than any other plausible candidate to steer the Fed on the right course, and if he fails to do so, it will be easier to identify who’s to blame than if someone else stepped in at this point.