Commentary - Ben Bernanke

By Scott Boyd - October 24, 2007

It is said that you can tell a great deal about a person by how they handle themselves in times of crisis. For the U.S. economy, the recent subprime mortgage meltdown – which has dominated the news for much of the past eighteen months - can certainly be categorized a financial crisis. Ben Bernanke was no economic neophyte when he assumed the Chairmanship of the U.S. Federal Reserve Board of Governors on February 1, 2006, but even he must have had second thoughts as the full impact of the subprime mortgage fallout started to emerge around the time he assumed the top spot at the Fed.

Indeed, just replacing the iconic Alan Greenspan – who had served as the country’s “chief economist” when he first became the Fed Chairman way back in 1987 – was in itself a daunting task. But to add the growing subprime mortgage turmoil into the mix could only add to the pressure Bernanke already faced as he took over the Chair of the Board of Governors.

Biography - Ben Bernanke

Ben S. Bernanke was born in 1953 in Augusta, Georgia and grew up in South Carolina. He earned a Bachelor of Arts in Economics from Harvard and then completed a Ph.D. in Economics at MIT in 1979. Shortly afterwards, he accepted a teaching position at Stanford University’s Graduate School of Business.

In 1996, Bernanke became the Chairman of Princeton University’s economics department, a role he filled until joining the Federal Reserve Board of Governors on a full-time basis in 2002. While a member of the Board of Governors, Bernanke also served on President Bush’s Council of Economic Advisors where he provided advice to the President and assisted with the preparation of the Economic Report.

Bernanke has published a wide range of articles on monetary topics but is especially interested in the Great Depression of the 1930s and the role – that he feels – the Federal Reserve played in making a bad situation worse. In a speech at the H. Parker Willis Lecture in Economic Policy at Washington and Lee University in Lexington, Virginia on March 2, 2004, Bernanke stated that the most important lesson of the Great Depression was that “price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy”.^[1]

Bernanke’s Communication Style

Bernanke has a reputation for fostering a clear understanding of economic policy that can be understood by fellow-economists and the general public alike. In comments he made prior to a meeting of the Group of Seven industrialized countries in Washington on Oct, 19, 2007, he stated that “Predictability is critical in building credibility. It is critical in reducing uncertainty, in making long term interest rates respond in appropriate directions to Fed actions.”^[2]

He also touched on the topic of adopting a specific inflation target: “My idea of being predictable is on the one hand to use benchmarks…but also to provide information to the public what our outlook is, what our forecast is, how we see the risks and how we plan to proceed. That communication, and providing adequate information, is really the only way to be adequately predictable in a world of uncertainty.”^[3]

Prior to his confirmation as Chairman of the Board of Governors, Bernanke stated that he will continue to maintain the same policies and strategies of the outgoing Greenspan. However, those that know Bernanke have gone on record as saying that while the policies may not change materially, the message and the reasoning will be much clearer than experienced under the previous administration.

Former Fed Governor Lyle Gramley highlighted the communication style differences by saying, “I think Ben’s style is a bit more open than Greenspan’s. This is a guy who will be very careful about his choice of words. He’ll be cautious, but he won’t be obscure.”^[4]

Bernanke’s Voting Record

From June 2004 until the end of Greenspan’s tenure on January 31st, 2007, the federal funds rate had fourteen successive one-quarter point increases in a bid to curb inflation. As the new Chairman, Bernanke – true to his word of maintaining current policy – called for a quarter point increase in the first Open Market Committee meeting he chaired.^[5]

However, as the subprime mortgage concerns grew during the fall of 2006 and into 2007, Bernanke quickly signaled that due to the economic slowdown, inflation was no longer a concern. Consequently, in the May and August meetings of the FOMC, Bernanke voted to maintain the federal funds rate at 5 ½ percent. As the crisis deepened, Bernanke argued for a reduction in the federal funds rate in order to boost spending and help the economy recover from the effects of the subprime-related problems.

At a meeting in August 2007 to set the discount window lending rate, Bernanke voted in favor of reducing the rate by fifty basis points. He further confirmed his commitment to reducing interest rates by voting in favor of reducing the federal funds target to 4 ¾ at the September 2007 meeting of the FOMC.

Bernanke’s Comments on the Subprime Crisis

Former Chair Alan Greenspan stated that while he was aware that there were questionable lending practices in the mortgage industry, he “had no notion of how significant they had become until very late.” He added, “I really didn’t get it until very late in 2005 and 2006.”^[6]

This is a very telling statement in that Greenspan is essentially admitting that it was not until the very end of his term at the head of the Federal Reserve, that the problems with the subprime mortgage industry were recognized. If this is indeed the case, then Greenspan – and by extension the Federal Reserve itself – essentially did nothing to address the economic turmoil prior to Bernanke taking over the Chair.

Perhaps this can simply be chalked up to timing, but on one point we can be clear – Bernanke has been extremely up front with regards to the subprime mortgage collapse. At a time when markets were falling and several large financial institutions were – and still are – facing bankruptcies, Bernanke re-affirmed his commitment to open market policies. In testimony before the Committee on Financial Services, Bernanke stated that “markets do tend to self-correct”.^[7]

This clearly demonstrates his belief in allowing free markets to react naturally to economic conditions, and while he does understand that there are many homeowners who are in financial distress, he does not advocate a “legislative quick fix”. Instead, he suggests that the Federal Housing Administration (FHA) “collaborate with the private sector to expedite the refinancing of credit-worthy subprime borrowers”.^[8]

“Other changes could allow the agency more flexibility to design new products that improve affordability through features such as variable maturities or shared appreciation. In addition, creating risk-based FHA insurance premiums that match insurance premiums with borrowers’ credit profiles would give more households access to refinancing options.”^[9]

Clearly, Bernanke favors a policy that takes into account the borrower’s risk and credit profile, but still stays true to basic economic principles as the most prudent approach. To ensure that the Committee is clear on his position, he adds:

The risk of moral hazard must be considered in designing government-backed programs; such programs should not bail out failed investors, as doing so would only encourage excessive risk-taking. One must also consider adverse selection; programs that provide credit to only the weakest eligible borrowers are likely to be more costly than those that serve a broader risk spectrum. Risk-based insurance premiums or tighter screening and monitoring by lenders can mitigate adverse selection. But ultimately such mechanisms have their limits, and no government program will be able to provide meaningful help to the highest-risk borrowers without a public subsidy. Whether such subsidies should be employed is a decision for the Congress.^[10]

Related Links

United States Federal Reserve

Federal Reserve Website

References

1. ↑ Speech to the H. Parker Willis Lecture in Economic Policy, Washington and Lee University, March 2, 2002
2. ↑ Reuters News - October 19, 2007
3. ↑ Reuters News - October 19, 2007
4. ↑ Interview with Lyle Gramley - CNNMoney.com
5. ↑ Federal Reserve website
6. ↑ Bernanke interview in the Financial Post - September 14, 2007
7. ↑ Testimony before the Committee on Financial Services, U.S. House of Representatives – September 20, 2007
8. ↑ Testimony before the Committee on Financial Services, U.S. House of Representatives – September 20, 2007
9. ↑ Testimony before the Committee on Financial Services, U.S. House of Representatives – September 20, 2007
10. ↑ Testimony before the Committee on Financial Services, U.S. House of Representatives – September 20, 2007