Ev Ehrlich's Everyday Economics

Person of the Year

Hey!  Anybody remember me?

I apologize for taking a ten week powder – my last post was in late October, just before the World Series.  But lots of stuff was going on.  First, I did some hanging out with Judge Crater and Jimmy Hoffa – what a pair!  Then, I was leaving my house in my Escalade at three in the morning and I drove into a fire hydrant and my wife, Nancy, had to extricate me by smashing in the rear window of the car with a golf club and she doesn’t even play golf!  Then, I got engaged and it turned out I was my ex-girl friend’s baby daddy!  Then, NBC cut my much-ballyhooed prime time television program!  And then Time magazine made me Person of the Year!  Man, with all that going on, I barely know how I kept it together, let alone post a blog!

Well, OK, that’s not all 100 percent true.  Time magazine did not make me Person of the Year,  which is what they now call Man of the Year, even though the three women who have won the honor alone – Wallis Simpson (the Duchess of Windsor), Queen Elizabeth II (yes, two royals), and Cory Aquino – all won as “Men.”  (Madame Chiang and Melinda Gates won it with their partners.)  Instead, they gave the honor to an economist of all people, Ben Bernanke.

Bernanke deserved it.  And he deserves it, not just for taking prompt action in the face of a potential economic cataclysm, but for having the courage to admit that he was flat-out wrong about how the world worked.  His apostasy is perhaps the real story.

When Bernanke was first confirmed as Fed Chairman in 2007, he seemed to regard the Chairmanship as the ultimate class project.  He was enchanted with formulae such as the then-famous “p-star,” which calculated underlying inflation and guided monetary policy in addressing it, as well as the “Taylor Rule,” a similar approach to the same problem.   This rule- or equation- driven approach to determining monetary policy was favored by the academic supposition that a “mechanical” rule – similar to putting policy on autopilot -- was the best way to convince markets that the Fed was serious about reaching those targets, and if markets became so convinced, the target rate of inflation would be reached all the more quickly.

And, in contrast to Alan Greenspan’s economic Stengelese, Bernanke embraced “transparency,” his thinking being that being straightforward with the market (meaning its participants) was the best way to get them to, again, move to where the Fed wanted them to go.  The only problem was that Bernanke’s light seemed to shine on a different measure of inflation or economic activity with every passing week, and as he continually shifted “what he was watching,” the only thing that became transparent was his diffuse focus.

At the root of Bernanke’s theorizing was his belief that the world worked in the way that the monetarist school of economics described it.  Transparency and “p-star” type guiding mechanisms were important because, as Bernanke then appeared to believe, the supply of money determined the rate of inflation, as in the old saw about inflation being caused “by too much money chased too few goods."  And this was a perfectly reasonable explanation of the dynamics of inflation, so long as you lived in 15^th century Venice.

I remember sitting with the rest of middle management behind my then-boss, Alice Rivlin, who was the Director of the CBO in 1981, when the Reagan Revolution swept Republicans to control of the Senate.  It was her first appearance in front of the newly-constituted and fairly hostile majority on the Senate Budget Committee.  And one member – let’s not go into who – decided to challenge Alice on economics.  “If I had an economy with only ten gold coins,” he lectured, “would it be possible to have any inflation?”  His answer of choice was, “Of course not,” and his point was that if we similarly fixed the money supply, we would eliminate inflation, which was then running strong.

It was a perfect example of understanding a problem by ignoring its complexity.  Beyond the issue of how fast those coins turn over, there’s the larger question of whether those gold coins are the only form money takes.  In today’s world, money takes a burgeoning variety of forms – credit cards, zeroes-and-ones in electronic commerce, all manner of credit instruments, and so on.  The issue is not how many gold coins or dollar bills there are, but rather, how much credit the economy is providing to itself and on what terms.

And this was the lesson that hit Bernanke on the forehead in 2008 and 2009.  The rate at which the “money supply” grew was irrelevant.  Banks had money – there was plenty of money around, but there was no lending.  Manipulating the availability of money to drive the interest rate – the cost of money – to zero had no effect.  (In fact, banks today have close to a trillion in reserves sitting around, doing nothing.)  Instead, the Fed would have to wade into markets right up to its waist and take matters into its own hands – buying assets or otherwise guaranteeing their value, making banks whole after losses they incurred through their own cupidity, and trying to calm the outright panic that pervaded markets by giving the impression, through deeds more than words, that it was prepared to do anything to assure the flow of credit and the survival of the institutions that provided it.

There are still carpers today who argue that Bernanke’s his Orphean journey into the forbidden netherworld of financial activity – was arbitrary, improvised, and inconsistent.  They are perfectly right -- it was all those things.  And we should be grateful that it was so.  Bear Stearns was bailed out but Lehman was allowed to die, and while there were good reasons for both decisions, one’s moral claim to a seat in the lifeboat was no better than the other’s.  Rather than engage in a foolish consistency, these decisions were made on the fly, with one eye on resurrecting the orderly functioning of financial markets and the other on getting through one day with an eye to the next.

Similarly, Bernanke quickly and dramatically threw away pre-existing notions about central banking.  The Fed would buy whatever assets it had to, and lend to whomever it had to, whether they were an investment bank usually at arm’s length from the Fed or a commercial one used to its embrace.  It would discard academic ideas about the growth in the money supply and the possibility of future inflation and instead focus on the desperate here-and-now.  (There’s not enough time here to talk about the future of inflation, but give me a week or two.)  It is hard to imagine that the architect of this improvised, pragmatic, and close-to-the-vest program was only two years before concerned about “transparency” and fixed policy rules that would lead self-governing markets to adopt most rapidly.

The old saw has it that a conservative is a liberal who has just been mugged.  But an interventionist is a laissez-faire practitioner who must preside over a crisis.  It was true of Alan Greenspan in 1987 when, only months into his job, he was confronted with a stock market collapse and reacted by intervening quite decidedly to maintain liquidity in equity markets.  It was true of President Bush, who knew some Sunday school economics but quickly initialed the memo when it was time to throw $700 billion at Mammon.

And so it was with Bernanke.  By breaking all the rules and walking away from his underlying beliefs about the economy, he became a legendary Fed Chairman.  The question is whether he has internalized the lessons of the experience.  Does he still think economic crises are the exception to the rule, or are they an outcome to be expected in market driven by frail human psychology?  Is the money supply the only way to manage the flow of credit, or can we use regulation to rein in excess, as the late Fed Governor Ned Gramlich futilely urged Greenspan to do when he saw the mortgage bubble coming?    Can the Fed watch the prices of stocks and other financial assets for signs of excess, just as it does the prices of oil, haircuts, and peanut butter and jelly?

There’s an argument that Bernanke will never get to get “back to normal” during his tenure – that we’re in for a Japanese-style decade of stagnation – and that he’ll never get past “crisis mode.”  I don’t buy that.  The economy is going to get back to something looking like “normal” (I didn’t say “good”) quicker than most people think.  And then we’ll see what Chairman Bernanke learned.  Being a Person of the Year is a good thing.  But a person who learns from experience and discards old, outdated beliefs is something even better – a Person.