Bryan Caplan  

Bernanke Mea Culpa Redux

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Don Boudreaux's open letter to Ben Bernanke reminds me how badly I overestimated my former teacher's practical wisdom:

Dear Mr Bernanke:

I had to down an extra mug of coffee this morning to be certain that I read your op-ed in today's Washington Post correctly.  Sure enough, you claim to be worried about a recent House-committee vote to, as you say, "repeal a 1978 provision that was intended to protect monetary policy from short-term political influence."

Ummm....  What guided Fed "policy" over the past couple of years if not short-term political influence?

Working hand-in-glove with the political branches, you now have the Fed performing activities - such as direct lending to what, in an April 2009 speech, you called "ultimate borrowers and major investors" - that are utterly outside of the Fed's traditional role.

[...]

Sorry, Mr. Bernanke, any independence that the Fed might have once had from "short-term political influence" has already been trampled to death - chiefly by you.

Several economists I know argue that you have to be in Bernanke's shoes to understand his conduct.  Back in September of 2008, for example, Mankiw wrote:
I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs and editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.
I don't write such blank checks to people with power.  Lord Acton had it right:
I cannot accept your canon that we are to judge Pope and King unlike other men, with a favourable presumption that they did no wrong. If there is any presumption it is the other way, against the holders of power, increasing as the power increases. Historic responsibility has to make up for the want of legal responsibility. Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men...
The life lesson I take away: Acton's admonition remains true even if you personally know the "great man."  It should be obvious, but it's all too easy to forget.


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COMMENTS (13 to date)
Ryan Vann writes:

Nice appeal to authority by Mankiw; it is made all the more ironic by addressing other Economists (authorities). Truly amazing work.

CJ Smith writes:

Bryan:

As I'm sure you are aware, its easy to be critical when you are not in the hot seat. While I have no great confidence that Bernanke did the absolutely best thing, I also have no confidence that doing nothing would be the best course of action. Perhaps from an economic standpoint, letting the market self-correct would be efficient, but would it be equitable?

If we take the position that efficiency is the end all and be all of policy, we ignore the real human costs of that efficiency. Bernanke had to consider the human costs and attempt to somehow alleviate the negative impact of the crisis. The problem is, as in most economic analysis, attempting to quantify this human cost. Does your critique of Bernanke build a human cost into its analysis, and if so, how do you quantify it?

I freely admit lack a way to quantify human costs for the purpose of analysis.

Scott Wentland writes:

This post would be a great opening (or conclusion) to a public choice course...with emphasis on a crucial point from public choice that policymakers are not special.

fundamentalist writes:

Hayek wrote in Fatal Conceit that intelligence is highly overrated, especially by intelligent people. Bernanke may be everything that Mankiw claims (though I doubt it), but that doesn't make his policies correct. In fact, it has nothing to do whatsoever with whether his policies are correct or not. He could be the smartest man ever to live and still prescribe the wrong policies.

Tom Dougherty writes:

"While I have no great confidence that Bernanke did the absolutely best thing, I also have no confidence that doing nothing would be the best course of action."

The alternative to the unconventional tools of monetary policy used by Bernanke (such as the bank bailouts, paying interest on reserves, direct lending to corporations) was not nothing or no action, but rather using the conventional tools of monetary policy of expanding the money supply by using open market operations. In hindsight, the unconventional tools proved to be a failure. Aggregate demand plunged beginning in the 4th quarter of 2008, which Bernanke failed to prevent using his unconventional methods. Not only is Bernanke a failure, but by working directly with the Treasury he threw away any notion of an independent Fed.

wm13 writes:

Intelligence is doubtless overrated by intelligent people. Also, academic theorists tend to overrate, you know, academic theory. The fact that central banking authorities in developed countries have for two hundred years considered it necessary to intervene during financial panics in order to stabilize markets and protect major institutions should tell us something, and not be sneered at by academics who say "That may be fine in practice, but it doesn't work in theory."

Even stranger are academic types (admittedly not found outside the confines of this blog) who cheer for the Paultard loons who want to abolish banking entirely.

Nick writes:

Bernake's groveling is comical. The Fed shoulders most of the responsibility for causing the current meltdown ( deregulation, thwarting effective regulation, poor oversight , poor monetary policy decisions) and add to that they bungled the clean up too. It seems that congress is more justified in stripping them of power. Economy melted down on your watch ben deal with it.

CJ Smith writes:

@Tom Dougherty:

Over the period October 2007 to December 2008 the Fed funds rate droped from 4.25% to 0.00-0.25% - see http://www.ny.frb.org/markets/statistics/dlyrates/fedrate.html

While we might argue whether this was a quick enough response or could could have been more agressive, I don't think it qualifies as not utilizing open market operations.

My point to Bryan was more directed to his opening comment - "Don Boudreaux's open letter to Ben Bernanke reminds me how badly I overestimated my former teacher's practical wisdom:..." I was trying to point out that Bernanke was in fact taking a practical approach, as opposed to theoretical approach, because he had to consider and respond to the political and human cost consequences of the situation.

Tom Dougherty writes:

CJ,

How anyone can make the case that monetary policy was expansionary in the 4th quarter of 2008 given that we now know their was a dramatic fall in aggregate demand is beyond me. Money was too tight relative to the fall in velocity which caused a drop in aggregate demand. An expansionary monetary policy would have prevented the drop in aggregate demand. Bernanke had the tools to prevent the drop, but instead was too busy trying out his new toys and with the bailouts. Frederick Mishkin writes in his monetary textbook that one of the lessons of monetary policy is, “It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.” In this case, it certainly was dangerous to assume the rate cuts were associated with an easing of monetary policy.

Peter G. Klein writes:

Bryan, I too found the Mankiw post you link above preposterous, writing at the time that Mankiw's prescription ignores (1) differences in theoretical frameworks or models, (2) the distinction between theoretical and applied economics, (3) private interests, and (4) concerns other than economic efficiency. I lost a lot of respect for Greg's judgment that day.

CJ Smith writes:

Tom:

Appreciate the response and the comments.

I think the way we might address the problem is by looking at the aggregate dollars put into the system via open market operations over the period October 2007 to December 2008. I don't have that data, but would greatly appreciate it if you on anyone else can provide it or a link to it.

While I can accept and understand your (and Mishkin's) premise that rise or fall in in short interest rates may not always be indicative of monetary policy, I think the converse is equally dangerous - in many situations, the short term interest rate IS indicative of tightening or relaxation of monetary policy. We might find that a combination of the two effects has led to the reductions, with reduction in demand combined with increase in supply causing to the result.

I think and hope that if we can review the numbers on open market operations, we can resolve the question of whether the policy was expansionist or not. On the question of whether it was too little, too late, I concede your point.

That being said, my point was not that Bernanke utilized open market operations to effectively respond to the situation, but that he did utilize that tool, along with anything else he could come up with. I think that Bernanke was flailing at the problem, and many of his tools failed or had little success for a variety of reasons: too little, too late; too free a hand in doling out money to AIG, BoA et al, not allowing the market to self-correct. But the justification I posit for this behaviour is diametrically opposed to Bryan's proposition - Bernanke was acting in a pragmatic fashion in an attempt to deal with the very real crisis facing the U.S. monetary system, and abandoned theory because it would take time neither he nor the system had, and the resulting damage would have had a disasterous effect on the financial industry, employment markets, and a host of other market failures echoing from the financial crisis. As economists, we can blithely bandy about a 10%+ unemployment rate or a 4% decrease in the Fed funds rate, and giving the market time to reset. Bernanke had to respond to the concerns and demands of the public, the electorate, and the politicians who saw three of the largest financial institutions in the U.S. go belly up in under a week, with the real possibility that another dozen would follow in the next two weeks. Nobody was lending money, even on perfect credit, fully secured propositions. The echo effects of the housing crisis on unemployment were just beginning to be felt and written about. No politician or quasi- politician (including the Chairman of the Fed) could have kept their jobs without doing something that appeared to attempt to address the crisis. From a realpolitck standpoint, neither Bernanke or anyone else would have survived on what would have been perceived as a "stay the course" philosophy.

But that's the real world as opposed to the theory. In theory, the Fed should be immune from political pressure, but so should the Supreme Court, the Attorney General's office, and any number of other agencies that in the real world are rife with politics. The Fed's monetary policy isn't purely theoretical, and I can't understand how anyone would make the case that it is.

Now for something complete different. In response to your belief that expansive monetary policy might have provided the cure:

In a way, TARP was expansionist monetary policy, albeit a very weird, unconventional sort of policy. Bernanke injected billions into the financial system with restrictions that basically amounted to "here's a boatload of money, get back to business." The government either took equity positions with the stated intent to let the organizations continue business as usual, or provided loans that also had no real restrictions on use. What was the effect? Almost every organization hoarded the cash and continued to tighten credit.

If you accept that most markets had shut down, and that there was little or no market growth going on, what would be the effect of pumping huge amounts of additonal money into the system? With no corresponding increase in real market wealth, you would just cause inflationary exacerbation of the problem.

Tom Dougherty writes:

CJ,

Final Sales of Domestic Product (aggregate demand) fell off a cliff so to speak beginning in the 4th quarter of 2008 with a year-on-year increase of 0.4%. In each of the first three quarters of 2009 aggregate demand’s year-on-year increase was negative with decreases of -0.5%,-1.5%, and -1.1% year-on-year. To put this in perspective, prior to the 4th quarter of 2008, the past 25 years aggregate demand’s year-on-year increase has averaged 5% with a low of 2.7% in the 2nd and 4th quarter of 2002 and a high of 9.8% in 1985.

See Bill Woolsey’s blog for a graph of Final Sales: http://monetaryfreedom-billwoolsey.blogspot.com/2009/11/sales-of-final-product.html

It is instructive to look at the growth in the monetary base relative to the decline in velocity. David Beckworth provides some very interesting data on the growth of the monetary base and the fall in velocity: http://macromarketmusings.blogspot.com/2009/09/does-equation-of-exchange-shed-any.html. He concludes that the fall in velocity was the main contributor to the fall in nominal spending.

So, although the Fed had increased its balance sheet from less than one trillion dollars to over two trillion dollars, in October of 2008 the Fed had started paying interest on excess reserves. So, much of the increase in its balance sheet ended up lying idle as excess reserves and not having the desired effect of increasing the money supply enough to prevent a fall in aggregate demand. In addition, the Fed, by lending to specific companies such as AIG and certain banks, is engaging in fiscal policy (targeting specific industries and companies) and not monetary policy (targeting all industries). The Fed has gotten away from the traditional tools of monetary policy, which should have been sufficient to stabilize aggregate demand, and decided to experiment with all types of new innovations which have failed.

CJ, I would also suggest taking a look at Scott Sumner’s very interesting blog for his views on the collapse of nominal spending and tight monetary policy beginning in the summer of 2008. http://blogsandwikis.bentley.edu/themoneyillusion/


CJ Smith writes:

Tom,

Thanks so much for all the information, I really appreciate it. I'm going through it and attempting to parse it out, particularly as it relates to my position and yours. On first pass, it seems like very valid support for your position. We may re-address this issue on another related blog posting, but I really want to get a good handle on your data and information.

Thanks again for sharing your thoughts and comments with me.

CJS

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