By David Ignatius
Thursday, May 28, 2009
Sometime this summer, President Obama will have to start thinking about one of the big decisions of his presidency -- whether to reappoint Ben Bernanke as chairman of the Federal Reserve when his term expires next January. What complicates the choice is that the other obvious candidate is Lawrence Summers, the White House economic czar.
Bernanke has emerged as one of the few heroes of the financial crisis, widely praised for his innovative stewardship of the Fed. He's still something of a sleeper in Washington, so low-key that the frequent descriptions of his "soft-spoken" manner don't do justice to just how quiet he is. But in fixing the financial breakdown, he has been a veritable tiger. The Bernanke Fed is so much more powerful than its predecessors that it's almost a different institution.
Bernanke agreed to sit down for a luncheon interview last week to talk about lessons learned. Behind him through the picture window of his private dining room was a majestic view of the Mall, but the Fed chairman was as reserved and fastidious as ever -- even as he described his battle to contain the greatest financial crisis of the past half-century.
I asked him what message he might leave for his successor to explain what these two tumultuous years have taught him. Bernanke offered a surprising answer: For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic. Investors thought their money was parked in securities that were as safe as bank deposits. When these securitized assets proved to be riskier than expected, investors panicked.
"We were seeing variants of classic panic behavior," Bernanke said, remembering the wild days of 2007 and 2008, when supposedly safe markets suddenly locked up as frightened investors rushed to get their money out.
Bernanke recommended studies by Gary Gorton, a Yale economist who has analyzed the ways the recent panic resembled those of the late 19th century. In his latest paper, "Slapped in the Face by the Invisible Hand," Gorton explains that the long-ago panics typically came at the height of the business cycle and involved new information that frightened depositors into withdrawing their money. Such bank panics disappeared for nearly 75 years after the enactment of federal deposit insurance in 1934.
The panic psychology returned with stunning force in 2007, when Wall Street suddenly lost confidence in new instruments created by the shadow banking system, such as mortgage-backed securities. It's hard to imagine now, but these exotic instruments were embraced by risk-averse investors such as money-market funds, pension funds and corporate treasuries. When that safety proved illusory, people rushed for the exits.
As Fed chairman, Bernanke scrambled for innovative ways to pump money and confidence back into these markets. If one tactic didn't work, he quickly tried another. When the panic first hit in August 2007, Bernanke took the unusual step of sharply cutting the discount rate for lending directly to banks. Banks proved wary of using the discount window, so Bernanke created a less-stigmatizing "Term Auction Facility."
Next came special Fed facilities to bolster money-market funds, the commercial-paper market, mortgage-backed securities and asset-backed securities -- all with complicated names and strategies. But the mission was consistent: to lend into the panic, and to reassure the markets that the Fed was really, truly committed to maintaining liquidity, no matter what. Gradually, the panic eased.
More jury-rigged rescue programs may be on the way. Barney Frank, chairman of the House banking committee, is drafting a bill to provide federal insurance for the municipal bond market, which could add hundreds of billions of dollars in new federal obligations. The Fed hasn't objected, saying this is a fiscal problem for Congress, not a monetary issue. A muni bailout would increase the immense debt hanging over the economy and the risk of future inflation.
The challenge ahead for the Fed is to clean up the debris -- including all the special structures created to contain the crisis. Obama will want a Fed chairman who can convince the markets that the central bank will crush inflation, regardless of the short-term pain or the howls from politicians. He will need someone who can reverse gears in a hurry and who can say no convincingly.
Is that person likely to be the quiet radical, Bernanke; or the outspoken, market-savvy former Treasury secretary, Summers; or some dark-horse candidate? Each would have strengths and liabilities at a post-crisis Fed, but there's a strong argument for not changing what, right now, looks like a winning team.
The writer is co-host of PostGlobal, an online discussion of international issues.
His e-mail address is email@example.com.