Course: The Federal Reserve and Its Role in Today’s Economy, George Washington University (Washington)
Guest Lecturer: Ben S. Bernanke
Lecture title: “The Federal Reserve after World War II”
Date: March 22, 2012
Missed the first few minutes of Prof. Bernanke’s second of four lectures. (The U.S. Senate was in the midst of passing a piece of legitimately bipartisan legislation. Too MOMENTOUS to ignore!!) But at least I made it! Only about 1,500 watched online Thursday. It was more than double that on Tuesday.
-- Big moment in Fed history – and economic history, period – came in 1951, when the Treasury agreed to let the Fed operate independently. During the Second World War, the Fed did its duty and kept interest rates low. Problem: the Treasury insisted the Fed keep on doing its duty even after the war was over. The Fed didn’t like this because it was worried about inflation. Now, almost all central banks operate at arm’s length from the government. The evidence is “quite strong” that the economy works better this way, Prof. Bernanke says.
-- 1950s and 1960s: Let the Good Times Roll! Fed had to do little more than “lean against the wind” to keep the party from getting out of hand. Korean War and couple of small recessions provided some bumps, but nothing to get excited about. Policy makers and economists start to become a little pleased with themselves. (So pleased, they left William McChesney Martin in charge of the Fed from 1951 to 1970!)
-- Turns out Mr. McChesney Martin wasn’t as good as he thought he was. He was wary of inflation, but apparently not wary enough. Inflation took off in the 1970s, peaking at 13 per cent at the end of the decade. Says Prof. Bernanke, policy makers in the 1950s and 1960s came to think that if they let the economy run just a little hot, they would create more jobs. That’s true, but it doesn’t last. Think of it like a candy bar, Prof. Bernanke says. “It gives you a burst of energy in the short run, but after a while it just makes you fat.”
-- Lesson of the 1950s and 1960s: “a little humility never hurts.” (Note to self: save this quotation in case ever asked to compare Prof. Bernanke to Alan Greenspan.)
-- Another important moment in history: October 1979, Paul Volcker appointed by Jimmy Carter to lead the Fed and extinguish inflation. As we all know, Mr. Volcker did so in legendary fashion. However, “nothing is free,” says Prof. Bernanke, who, after graduating in the early 1980s, would have liked to have bought a house. Only problem was mortgage rates were 18-plus per cent. Construction workers, farmers and others mailed Mr. Volcker chunks of 2x4 lumber in those years as a statement on what he was doing to the economy. Prof. Bernanke says he keeps some of those symbols on his desk as a reminder of why inflation is a concern and price stability is so important.
-- The Great Moderation, which coincided with Alan Greenspan’s reign from 1987 to 2006. Another period when policy makers got a little cocky. (Note to self: Mr. McChesney Martin served 19 years, leading to a period of complacency; Mr. Greenspan served 19 years, leading to a period of complacency. Maybe Congress should consider term limits at the Fed?! Just saying!) However, hard not to be cocky. See page 15 of Prof. Bernanke’s slides.
-- The Great Moderation wasn’t all about monetary policy. There were fewer oil shocks in this period. And just-in-time delivery helped level the business cycle.
-- But little did the Fed know the Great Moderation was building to the Great Recession. The housing market busted big time in 2007. The Fed and others weren’t totally asleep at the switch. They saw housing prices falling. But they predicted only a shallow recession because the loss of wealth in housing was similar to that which occurred during the dot.com bust of the 1990s.
-- So what was the difference between the tech bubble and the housing bubble? Important to distinguish between triggers and vulnerabilities, Prof. Bernanke says. The financial system was much more vulnerable in 2007 because households had piled up too much debt. Also, financial institutions’ risk management regimes had failed to keep up with the complexity of new financial products. And the final thing, banks were doing too much short-term funding. When the collapse came, they were left with no cash.
-- Prof. Bernanke doesn’t hide from blame. Regulators failed by sticking with rules that dated to the 1930s. The Fed failed by not forcing banks to bolster risk management and doing too little to protect consumers.
-- However, Prof. Bernanke isn’t prepared to say monetary policy caused the crisis. He points to three things: one, other countries had housing bubbles even though monetary policy was tight (Britain); two, the increase in U.S. housing prices was too big to be explained by the link of mortgage rates to the official lending rate; and three, the bubble appeared to begin before the Fed lowered rates, and prices kept rising after policy makers raised them in 2004. To his credit, Prof. Bernanke doesn’t insist that he is right. “I emphasize this is something that continues to be debated.”
One kid asks when central banks know it’s time to raise interest rates. “It’s challenging,” Prof. Bernanke says. Forecasting “is not very accurate,” which is why the Fed employs so many economists and uses so many models. The Fed is always updating its outlook. However, it’s become easier because inflation expectations are now anchored. That wasn’t the case in the 1970s.
Another guy wants to know why the Fed didn’t raise interest rates to cool the housing market. You need to use the right tool for the job, Prof. Bernanke says. Lifting borrowing costs to deal with the housing market is like “using a sledgehammer to kill a mosquito.” Monetary policy is meant to achieve overall economic stability. “Because monetary policy is such a blunt tool, if you can get a laser-like tool, that is much better for everyone.”
Questions start to drift off topic, and Prof. Bernanke shows a flash of annoyance. One student gets him to weigh in on the role government housing policy played in the crisis. “To put it all on the government is probably wrong,” he says. Private lenders made bad loans without any encouragement from the government, and Wall Street acted in its own interest when it bundled those loans into complex securities, Prof. Bernanke says.
“Thanks. Next week we’ll go into the crisis. Thank you very much.”