"Courage to Act," published by W.W. Norton & Co., was released this month, and it is the antithesis of the Washington tell-all. Those looking for anything juicier than Bernanke's decision to go gluten-free will be sorely disappointed. Rather, it is a careful, detailed and exceptionally clear justification for the Fed's aggressive actions to avert another Great Depression and resuscitate the American economy.
In a wide-ranging discussion, Bernanke explained why fear was the real culprit behind the recession, the state of the recovery now and the advice he gave current Fed Chair Janet Yellen before she took office. The transcript below has been edited for length and clarity.
Wonkblog: Throughout your book you argue that the real problem was panic. The housing bust was clearly painful and economically damaging, but it was really fear that turned that into a much broader and deeper slowdown. Can you explain that argument?
BB: Take subprime mortgages, for example. One reason why we underestimated what the effect would be is because it’s a pretty small asset class. The losses on subprime mortgages looked to be comparable to a bad day in the stock market in terms of lost wealth. So the question was how could those losses lead to such a major crisis? The answer was that it was a close analogy to what was seen in financial panics 100 years or 125 years ago. A big panic can sometimes be triggered by a relatively modest trigger.
The subprime loans were packaged in these securitized assets, and investors, once they began to understand that the subprime loans would go bad, they began to fear anything that was wrapped up in these securitized assets. That created panic and fear, and that led to runs. The runs took place not on the part of ordinary depositors lining up on the street as they would have in the 19th century. They were electronic runs from wholesale funders like commercial paper investors and repo investors. It was very much like the traditional panics.
The previous six months [before Lehman Brothers failed], the economy had been growing, house prices had fallen moderately. After Lehman, the economy just went into a death spiral. The fourth quarter of 2008 and the first quarter of 2009 was among the sharpest declines in the economy in U.S. history. Once the crisis went into a new gear, house prices started falling more quickly, and that had a feedback mechanism. Absent the broad-based panic that froze credit markets, caused asset prices to drop sharply and punctured confidence, we wouldn’t have had nearly so bad a recession.
Wonkblog: Does that analysis have implications for regulation? Can you regulate away fear?
BB: You can’t regulate away fear, but you can make things safer. One of the most important developments since the crisis is that banks, particularly big banks, have to hold a lot more capital. If they’d had as much capital before the crisis as they have now, investors would’ve been confident that they would not be in so much danger, and they would not have been so inclined to run.
Another major change is that before the crisis a lot of these institutions didn’t have an effective regulator. So the investment banks like Bear Stearns and Lehman, they had a voluntary regulatory arrangement. Now we have a much more comprehensive regulatory scheme, including a provision that allows the Fed to regulate a systemically important firm.
Wonkblog: Do you feel these tools are enough?
BB: There’s always a tradeoff between eliminating the risk of a crisis on the one hand versus getting rid of all risk-taking, which would be bad for growth on the other. You’ve gotta find a balance. We’re groping our way forward.
We made a lot of progress, no question. The risk of a crisis and the impact of a crisis are no doubt less than they were before 2007. But we still need to continue to be vigilant and continue to improve oversight.
There’s really two types of macroprudential policy. There’s “through the cycle,” which makes the system more resilient. And I think the system is a lot more resilient. The other kind of macroprudential policy is more reactive. It tries to identify specific threats and tries to address them. In the United States, we haven’t reached the ability to do that very effectively. That’s something they should keep working on.
Wonkblog: You also talk a lot in the book about moral hazard, acknowledging that as a concern in the Fed’s decision to create emergency lending facilities and to rescue Bear Stearns and AIG. But you put that question aside while the economy was still in the emergency room. If moral hazard is always a question to be settled later, does it ever get addressed?
BB: The moral hazard is that if you bail out firms that they will imagine that they will always be bailed out and they won’t have any incentive to be cautious or take risks. I think we’ve dealt with that in two ways. In real time, we weren’t generous to the firms that were bailed out. They got very tough deals: Shareholders lost most of their equity. Creditors took a hit in some cases. Some workers lost their jobs. It wasn’t a pleasant experience. I don’t think many firms would voluntarily choose the fate of Bear Stearns.
The other is, after the fact, to try to deal with the too big to fail problem. I would point you to the orderly liquidation authority that gives the Fed and other authorities to wind down a failing firm in a way that’s less dangerous for the system as a whole. That is still being developed. There is meaningful progress.
The firms have to report to the Fed and FDIC every year a plan for how they would unwind themselves in the event of failure. The FDIC and the Fed have to approve those plans, and if they don’t approve them, they can order many different kinds of changes. Over time, with sufficiently attentive regulators, that should not only give the Fed and the FDIC ex-post powers to deal with the firms, it should force the firms to simplify themselves.
This ad-hoc approach [toward bailing out firms] that we used in the crisis is no longer available. That’s actually a good thing because it takes away from moral hazard. Instead, it would use this preset procedure that Congress approved.
Wonkblog: When you look at where the economy is now, and you look at the number of years it’s been since the financial crisis actually occurred, is there anything you could’ve done differently that could have yielded significantly better results now?
BB: We weren’t fortune tellers, you know. I think it is important to note that the U.S. recovery, while not all we would like, looks pretty good compared to the rest of the world.
That being said, [the recovery] has been disappointing in several senses. One is the pace of recovery and the other is the overall average growth rate. On the former, the main problem is that other than in 2009, all the responsibility was put on the Fed. There was not a balanced monetary/fiscal mix. The Fed was asked to do more than it comfortably could because it was already down at zero interest rates. A more balanced approach could’ve gotten stronger results without as much reliance on the Fed.
The other issue was the overall rate of growth. The decline in the unemployment rate was actually faster than the Fed forecast. But growth was slower than the Fed forecast. And the reconciliation of those two facts was that productivity was very weak. The Fed cannot control productivity, so I don’t think you can blame the Fed for that.
Wonkblog: Fed officials have been trying to shift the focus of attention away from the first rate hike versus the overall path of interest rates. They argue it’s just a tiny quarter percentage point increase. But I was also struck in your book by you describing being really torn over quarter point moves and maybe wishing you had moved a quarter point faster here and there.
BB: It’s a signaling effect. All else equal, small changes don’t matter much. But when the markets and the public are trying to infer the Fed’s intentions and plans, individual moves can take on greater impact because they signal a certain plan. That’s part of the reason this move, which is intrinsically very small, has been the subject of so much debate and controversy. It involves the broader issues of what the overall Fed strategy is going to be and how they see the economy.
It implies, of course, that whatever action is taken, that communication will also matter a lot.
Wonkblog: There have been some people who say that the economy could fall into recession again in the next year or perhaps two years. If the Fed were to be faced with another downturn, what tools would it be able to turn to at this point in order to fight it?
BB: If that were to happen -- and we’re talking hypothetically here, of course -- the best approach would be a combination of monetary and fiscal policy.
Absent fiscal policy, the Fed has some tools. They could through communication suggest they could keep rates low for a long time. Secondly, they could consider negative rates, which we didn’t do when I was there.
Wonkblog: There’s one negative dot now!
BB: Third possibility might be something like an interest rate peg, hold short-term interest rates out to two years at a certain rate. And a fourth possibility would be to do more quantitative easing. So those are some options, but they’re not on the whole a super attractive set of options. So you would hope first that you avoid that situation, but secondly, that if you get there, you could find a partner on the fiscal side.
Wonkblog: How worried are you about the global economy right now?
BB: I’m not going to give you a good answer.
Wonkblog: Because you don’t have one or because you’d rather not say it?
BB: Because I don’t want you to infer a policy. It is slowing. It bears close watching. It is the main downside risk to the U.S. economy right now. The tradeoff is between a slowing global economy and a pretty solid domestic economy.
Wonkblog: Ok, this is not a backdoor policy question. But where would I look for exposure to China beyond trade?
BB: So far we haven’t seen any major financial disruptions anywhere, except for August, which was a little bit weird. The main effect so far has been the trade balance effect. But as August suggests, if there are financial disruptions arising because of unexpected problems in China or because you get capital outflows from some big emerging markets, and they have financial problems, then you could see stock values dropping in the United States and credit spreads rising and the dollar strengthening. All of those things are forms of financial tightening.
Wonkblog: As you worked on this book, did you have any epiphanies?
BB: You may not call this an epiphany, but I had the opportunity to go through the whole experience again. In real time, we were facing an awful lot of uncertainty, the fog of war. We were balancing different risks against each other and trying to find the best solution. There’s a lot of hindsight bias. But in real time, it was very difficult to understand exactly what was happening. I don’t know if that’s really an epiphany.
Wonkblog: That it was hard?
BB: In real time, the tradeoffs and the information gathering were very difficult.
Wonkblog: In the book, there were a few personal moments that you included, such as your wife cried when you received the nomination for the first time and not being able to be there when your father passed. What were the personal sacrifices of being Fed chair?
BB: It was a highly visible and highly stressful position. We were dealing with a lot of uncertainty every day and very high stakes. I guess I have two sets of lessons. One was personal, that I tried to maintain an even keel. I tried to give myself breaks. I tried to focus on the task of the day, the things that needed to be handled in the short term while trying to keep my eye on the big picture. I tried to make sure I could sustain the effort in what turned out to be a very lengthy crisis.
On the leadership side, I was an academic. I was used to collegial interaction. That’s how I tried to lead the Fed: by trying to get buy-in and input from other people at the Fed, I would both get better ideas, but I would also build up some capital, so in situations where I had to act quickly without full consultation, I would have some scope to do that.
I would also use the “blue-sky thinking” approach, where we would brainstorm, try to come up with ideas, try to shoot them down. We did come up with good ideas, but we also got senior staff and policymakers invested in what we were doing and committed to making these things work.
Wonkblog: Did you give Janet Yellen any advice when she took over?
BB: Other than not to take the job? Janet had considerably more experience at the Fed when she took over than I did. And moreover, we worked closely together. My style was to involve the vice chair pretty closely, so there’s a lot of continuity there. I don’t think she needed much more advice from me.
Wonkblog: How important do you think that continuity is for the markets and for the economy?
BB: It’s important for the Fed not to lurch every time the leadership changes. When I became chairman in 2006, I tried to maintain continuity with Greenspan. It’s important for a central bank to make plans -- and even make commitments on some occasions -- that extend beyond the term of the current chair. So continuity is very important, all else equal.
Of course, if the policy is wrong, you have to change it.
Wonkblog: So you’re assuming yours is right, of course.
BB: Well, I hope so.