Love him or hate him, it’s hard to understate the magnitude of Ben Bernanke’s role in the Great Experiment. He has served as chairman of the U.S. Federal Reserve during one of the most financially turbulent and politically dense periods of American history. The 2008 financial crisis was both severe and uniquely challenging, and Bernanke has helped the Fed navigate through the economic and financial wreckage that was left in the wake of the crash.
Speaking at the annual IMF Economic Forum on Friday, Bernanke said, “The challenge for policymakers is to prevent crises when possible and to respond effectively when not.” Bernanke underscored this sentiment in his usual way, with a mix of historical perspective and modern context.
Speaking at an event in Cambridge to mark the centennial anniversary of the Fed, he discussed the institution’s history and how three key aspects of Fed policy making — “the goals of policy, the policy framework, and accountability and communication” – have evolved over time. He covered a lot of the same ground at the IMF conference, using the banking crisis in 1907 as a springboard to discuss the way present-day policymakers are thinking about the future of monetary policy.
The goals of Fed policy
“The financial crisis and the ensuing Great Recession reminded us of a lesson that we learned both in the 19th century and during the Depression but had forgotten to some extent, which is that severe financial instability can do grave damage to the broader economy.”
At its inception, the Federal Reserve was established to “provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped.” Bernanke pointed to this comment by Robert Latham Owen, one of the authors of the Federal Reserve Act of 1913, in his July speech in Cambridge. As originally imagined, the means by which the Fed was to “stop” (an overly optimistic directive) period panics was to provide monetary elasticity.
Bernanke punctuated Owen’s statement by saying that the original goal of the Fed was the “preservation of financial stability,” which is very much in line with the idea that bank action (over-lending) or inaction (liquidity hoarding) can exacerbate crises. Keep in mind that the Fed was established in 1913, just six years after J. P. Morgan led a coalition of bankers in the impromptu bailout of the entire U.S. banking system. The memory of financial crisis, its massively devastating consequences, and what caused 1907 Bankers’ Panic (hint: it’s in the name), was fresh in the minds of the authors of the Federal Reserve Act.
But 22 years later, the Federal Reserve System had failed to anticipate, prevent, or mitigate Black Tuesday and the economic ruin that followed in its wake. The Banking Act of 1933 — which, among other things, established the Federal Deposit Insurance Corporation — was still just a good idea buried somewhere in the subconscious minds of Sen. Carter Glass and Rep. Henry Steagall when the Federal Reserve Act was passed.
So the Fed was established with a directive of financial stability, and the fact that the trigger for the Great Depression was financial in nature solidified — for a while — the goal of the Fed as the preservation of financial stability. But speaking in Cambridge, Bernanke outlined the evolution of the objectives of Fed policy. Over time, this evolution shifted the focus of Fed policy from the preservation of financial stability to employment — as codified in the Employment Act of 1946, which helped place the burden of the maxim of full employment on the Federal Reserve.
Ostensibly, the transition was a function of the Great Depression itself. Rampant unemployment left the nation all but crippled, and it took World War II to get America’s economic engine started again. The Employment Act of 1946 was passed in part because of concerns that without federal action, unemployment would return to the U.S. economy in the post-war era.
In an effort to save time, we’re going to fast-forward about 30 years, to the late 1970s. This period was marked by some Fed successes and many failures, but there were no catastrophic economic collapses. And in many ways, the Fed’s biggest failures during this time — arguably two rounds of double-digit inflation — served to push Fed thinking further away from financial regulation.
By 1977, employment and price stability dominated the Fed’s attention. This is when the Fed’s dual mandate as we know and love it today was added to the Federal Reserve Act: Section 2A, Monetary Policy and Objectives:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
The establishment of this mandate pretty much marked the beginning of what Bernanke has popularized as the Great Moderation — a decline in the volatility of business cycles and economic growth between the mid-1980s and mid-2000s — in which consideration for financial risk seemed to evaporate from Fed thinking.
There are any number of reasons for this neglect. Bernanke has pointed at “the so-called Modigliani-Miller theorem, an implication of which is that the details of the structure of the financial system can be ignored when analyzing the behavior of the broader economy” as a contributor.
Others would sum it up as laziness from a central bank that had grown soft during the Great Moderation. Many attributed the increased output stability of this period on “good monetary policy,” a side effect of which is overconfidence in one’s current tools to address future problems.
Critics of the Fed have cited this evaporation of concern for financial details as a contributing factor to what may best be described as its short-sightedness ahead of the late-2000s financial crisis. In many ways, the Fed was blind to what was going on in the financial sector. Not only did it not see the crisis coming, it lacked the tools to respond in a maximally effective way.
This is the lesson that Fed learned in the wake of the crisis: That it must be a robust and dynamic mechanism to preserve financial stability.
The framework of Fed policy
Central banking in the United States was initially established as a “Great Experiment,” one that was necessary to tackle the new and increasingly complicated financial challenges facing the nation 100 years ago. At one point, all monetary tools were experimental, and only through use and aggregate effectiveness have they become traditional. The discount window and its lending rate were among the first of the Fed’s tools, shortly followed by open-market operations in the 1920s.
The emergence of open-market operations — the purchase and sale of securities in the open market — as a tool came almost by happenstance. The Fed began purchasing government securities first to finance itself, but in the 1920s realized that its participation in the market had a broad impact on the supply and cost of bank reserves. The Fed had discovered a means by which it could influence financial markets, and it has honed this tool ever since.
But the toolset of central bankers around the world has expanded in the wake of the financial crisis. The monetary tools developed to address the economic problems of this and previous decades are increasingly irrelevant in an increasingly complex global financial system. Central bankers have been forced to expand their thinking and adopt unconventional tools and strategies in their efforts to competently regulate financial markets and guide monetary policy. Central bankers have been forced to innovate at the zero bound and figure out how to affect the economy when traditional measures have exhausted themselves.
Some observers have described this change as the latest fad in central banking: A fashionable shift toward experimental macro-prudential policy.
Speaking in May 2011, Bernanke took a crack at defining macro-prudential policy in the context of the Dodd-Frank Wall Street Reform and Consumer Protection Act. He highlighted features of the act that are aimed at helping the regulatory system adapt over time to changes in the market, “an approach that supplements traditional supervision and regulation of individual firms or markets with explicit consideration of threats to the stability of the financial system as a whole.”
In this context, Dodd-Frank is perhaps the most significant way in which the Fed’s policy framework was shifted in order to address a new — or rather, old and revisited — goal of Fed policy: financial stability. In May, Bernanke said:
“The financial crisis demonstrated clearly that supervisory and regulatory practices must consider overall financial stability as well as the safety and soundness of individual firms… For our part, the Federal Reserve has restructured its internal operations to facilitate a macro-prudential approach to supervision and regulation and to monitor systemic risks… The explicit incorporation of macro-prudential considerations in the nation’s framework for financial oversight represents a major innovation in our thinking about financial regulation, one that is taking hold abroad as well as in the United States.”