Wessel Answers Questions on the Changing Fed

QUESTION: Did Ben Bernanke himself admit to you any kind of regrets or mistakes while you were doing research for the book?

DAVID WESSEL: Ben Bernanke, by personality, doesn’t pretend to (have) papal infallibility. He thinks, on the whole, he did a great job under trying circumstances. There were mistakes, and he admits to them.

He also admits to misjudging the damage that the housing bust was doing to the U.S. economy in 2007 when both he and Treasury Secretary Henry Paulson described the housing damage as “contained.” He thought strength elsewhere in the U.S. economy, and abroad, would limit the harm that the subprime housing mess would cause. He was wrong, and he admits it. In January 2008, Mr. Bernanke realized that the economy was in a lot worse shape than he had anticipated. That’s why he and his Fed colleagues rushed to cut interest rates by a steep 1.5 percentage points in January 2008. They were trying to catch up. Moreover, he and others didn’t realize that the entire financial system rested on a single and flawed proposition: housing prices would never fall across the country. I think of that as a failure of imagination, and I think Mr. Bernanke sees it similarly.

Mr. Bernanke does not admit error in the now infamous decision to let Lehman Brothers go into bankruptcy. He insists today that there was simply no legal way for the Fed to lend money to Lehman because Lehman had no collateral or security to offer the Fed. He does allow that had he and Mr. Paulson persuaded Congress to give them $700 billion to shore up the banking system earlier, he would have argued for using that money to save Lehman. So why didn’t he ask for the money earlier, perhaps after the Fed had to come up with $30 billion to subsidize the purchase of Bear Stearns by JPMorgan Chase? He says Congress wouldn’t have approved the money any sooner, but does wonder aloud if asking for money (and new legal authority) earlier would have made some sense.

On a broader question — Should the Fed try harder to let the air out of asset bubbles before they grow so large? — Mr. Bernanke is changing his mind. He used to be an articulate and forceful advocate for the proposition that preemptive bubble bursting was somewhere between impossible and dangerous. But seeing the damage done by the bursting of this housing and credit bubble has prompted him to say that view needs to be rethought.

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QUESTION: How did Bernanke’s research on the Depression inform his handling of this crisis?

DAVID WESSEL: Enormously. Milton Friedman and Anna Schwartz, in their Monetary History of the United States, blamed the Fed for the Great Depression, arguing that it had been too stingy with credit and choked the economy. They saw bank failures as a consequence of that. Mr. Bernanke’s subsequent work argued that bank failures actually were also an independent cause of the depth of the Great Depression. Bank failures clogged what Mr. Bernanke called the “credit channel” of the economy. That greatly influenced his determination to do whatever it takes to save big financial institutions from imploding in the midst of the panic.

His work also demonstrated how during the Depression, a weak economy pushed down financial markets, and that falling markets then produced an even weaker economy and so on in what is sometimes called “adverse feedback effect.” He deemed it crucial for the Fed to intervene to prevent that from happening. But on top of all those specific lessons, Mr. Bernanke admires FDR’s trial-and-error approach during the Depression, and adopted a similar approach — a willingness to try new things, even if they didn’t work as intended, and then to pursue those that appear successful. The Fed, after all, was following economic orthodoxy in the ’20s and ’30s, and it got it wrong. That was a lesson Mr. Bernanke absorbed and never forgot.

QUESTION: You talked on the NewsHour about how the Federal Reserve has, in essence, become the fourth branch of government. Many lawmakers say the central bank holds too much power and should be exposed to occasional audits by the GAO. Chairman Bernanke argues that the Fed is plenty open. Where do you fall in this debate?

DAVID WESSEL: I’m not in the business of favoring or opposing bills, but here are some facts. The Fed’s actions have revealed how much power it has, the power to create trillions of dollars in credit without getting anyone else’s OK and the power to lend massive sums when it deems it necessary (and to withhold such loans when it chooses.) It was the first responder to this financial conflagration; no one else had the ability.

That raises legitimate questions in a democracy, and that’s why Congress has been summoning Mr. Bernanke so often to explain what he did and why (and even publishing his e-mails.) In most capitalist democracies, however, the politicians have decided that they don’t want to have their hands on the interest-rate lever; they know that they have to face the voters frequently, and that will tempt them to juice the economy a little more now at the expense of more inflation later. So they’ve set up a central bank, insulated it somewhat from politics, and instructed it to raise interest rates even when it is unpopular to avoid unwelcome inflation.

Ron Paul, the Republican congressman from Texas, opposes that set up and is explicit about that. He’s the one pushing the bill to expand the Government Accountability Office’s power to audit the Fed. The GAO now audits much of what the Fed does — the loans to Bear Stearns, its bank regulatory activities, etc. But current law prevents the GAO from auditing interest-rate and other monetary policy decisions. That reflects the view that monetary policy makers need to be independent of politicians if they are to do their jobs. Mr. Bernanke says that if the GAO starts auditing monetary policy, it’ll inevitably lead to second-guessing the Fed and weakening its ability to do that part of its job.

QUESTION: There’s not much attention paid to Bernanke’s own role in providing some intellectual foundation to some of Greenspan’s policies, including the housing bubble, subprime, etc. What can you say about Bernanke’s role in the lead-up to the economic crisis?

DAVID WESSEL: Well, I do talk about that in my book. With hindsight, and that’s an important caveat, Alan Greenspan kept interest rates too low (for) too long earlier in this decade, a time when Mr. Bernanke was serving as a Fed governor. It made sense at the time. Both Mr. Greenspan and Mr. Bernanke saw an uncomfortably large risk that the United States would slide into Japan-style deflation and they were determined to prevent that.

They succeeded. But those low interest rates contributed to an orgy of borrowing and speculation. Mr. Bernanke provided an important intellectual foundation, as you suggest, for those policies. Before he was appointed to the Fed and as a Fed governor, Mr. Bernanke also argued that the Fed shouldn’t use interest rate increases to burst a bubble in asset prices. Rather, he said, the Fed should use its regulatory and supervisory muscle to control bubbles. But he didn’t follow up on that while sitting alongside Mr. Greenspan at the Fed before becoming chairman.

QUESTION: You write that of the three principal players involved in the Lehman decision, it was Hank Paulson who ultimately drew the hard line. Why did he do that? And did he tell you why he did so? Did he regret it?

DAVID WESSEL: Paulson is not a man who shares his regrets readily. I’m curious to see how he reflects on the Lehman decisions in his own book, which is supposed to come out at the end of this year.

From my conversations, he thinks he did everything he could to get Lehman to raise capital before the crunch and did everything he could to sell it — and, despite his assertions at the time, was prepared to approve putting Fed money, which in the end is taxpayer money, into a deal along with other Wall Street firms to make a sale happen. The only bidder, Barclay’s, the British bank, couldn’t do the deal because regulators there wouldn’t go along. In the end, he says he didn’t believe the Treasury and Fed had the legal power to lend money to Lehman.

But it’s clear to me that he didn’t come into that weekend with a Plan B to keep Lehman out of bankruptcy even if there wasn’t a bidder: If he had, some way might have been found to prevent the calamitous bankruptcy. Why is that? Well, for one thing, he — and Mr. Bernanke — thought that the markets were well-prepared for Lehman’s collapse since it had received so much attention, and there was a sense in the Treasury that Wall Street needed to learn that not every institution would be bailed out. So that’s a strategic or principled explanation. (That rationale has dropped from the Paulson and Bernanke explanation in the wake of what happened.) Mr. Paulson says he knew a Lehman bankruptcy would have ripples; he didn’t realize those ripples would be tsunami-sized. So that’s a misreading-the-situation explanation.

QUESTION: What are the odds that President Obama will ask Ben Bernanke to serve another term as Fed chairman?

DAVID WESSEL: I’d put them at 70 percent right now. Changing drivers when the road is so rocky and curvy is risky. Any new appointee would have to prove his or her inflation-fighting credibility and that probably implies higher interest rates than Bernanke would pursue, which I’m sure the president wouldn’t welcome. Or uncertainty might lead the bond market to bid up long-term interest rates — which means higher mortgage rates — another development that the president wouldn’t welcome. And even though an Obama appointee would strive to be independent of the White House, there would be a perception abroad that the president had replaced a Bush appointee with his own person and might lead foreign investors — the Chinese and others — to be suspicious of his motives. That could hurt the dollar and also lead to higher interest rates.

But — and this is a big but — if the economy tanks in the coming months, the president might decide that he needs to have his own person in place at the Fed to show that he is doing everything he can to speed the economy’s health.

David Wessel is economics editor for the Wall Street Journal and writes the weekly Capital column about how economic forces affect lives around the world. He has shared two Pulitzer Prizes. Read more about his latest book, “In Fed We Trust.

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