The Bernanke conundrum

Why did Ben Bernanke, widely respected among economists as both a scholar and gentleman, support a rescue plan that very few of his colleagues considered “first-best” or even “second-best”? While there was no firm consensus among economists about precisely what ought to have been done, a plan based on no-strings-attached purchases of difficult-to-value assets by taxpayers was particularly surprising. Here’s Greg Mankiw being politely puzzled. Paul Davidson quotes correspondence with Chris Carroll, in which the Hopkins economist admits he wants to

spur Bernanke to try to provide his own views… My suspicion …is that he [Bernanke] thinks buying the toxic assets is a bad idea …. I think Bernanke believed all along that a recapitalization was the only effective thing that could be done, but he could not persuade Paulson of that.

Cynics can easily find reasons for Secretary Paulson to have favored the original TARP proposal. But why did Dr. Bernanke play along?

Here’s a possibility: Sometime in the middle of September, the Fed hit its balance sheet constraint. Dr. Bernanke could not have provided liquidity on the scale he thought necessary to support the financial system without injecting unsterilized new cash into the banking system and potentially sparking inflation or a run on the dollar. At that moment, the U.S. Federal Reserve lost its independence entirely. In order to pursue the policy its technocrats thought best, it required large-scale funding from the US Treasury. Dr. Bernanke had to negotiate with Secretary Paulson, whose nickname “The Hammer” is not a tribute to his love of carpentry. A deal was struck, and the Supplementary Financing Program was born.

Undoubtedly, inside both the Fed and the Treasury, a variety of options were considered on how to intervene as credit conditions continued to deteriorate. Perhaps the Treasury settled upon the TARP approach, while the Fed might have preferred something different. Perhaps the Fed had to give a little to get a little. Perhaps that’s why the Paulson Plan emerged as what Greg Mankiw terms the “new Washington consensus”.

The Fed has now regained some of its independence. The “stabilization act” included a clause that gives the Fed authority to pay interest on bank deposits, which permits the central bank to partially sterilize cash injections without having to sell securities from its much depleted portfolio.

But in mid-September, events were spiraling, and the Fed was cornered. Even a gentleman and a scholar might have decided that acceding to a proposal that could do little immediate harm and might do some good was better than having his hands tied and watching the banking collapse he was born to prevent unfold before his tired eyes.

Update History:
  • 11-Oct-2008, 11:15 p.m. EDT: Added a missing “his” to the concluding sentence.

16 Responses to “The Bernanke conundrum”

  1. winterspeak writes:

    i’ve wondered the same thing myself. i put it down to the personality and calibre of paulson and bernanke. paulson was the ceo of goldman sachs, which is kind of like becoming the head of the kgb. you know how to get things done, and you don’t mess around. bernanke was an academic economist, a cut throat environment to be sure, but nothing like the Nietzche-fest that characterizes the executive floor in the most competitive investment bank on the planet. bernanke had no chance. this is paulson’s show.

    and given how riven the treasury is with ex-GSers, a changing of the guard in the oval office will have no impact. this will be a status quo bank driven process.

  2. BSG writes:

    Hmm, I wonder about this.

    Long before the Fed hit its balance sheet constraints, it accepted – no, *invited* banks and others to submit dubious collateral for temporary – no, indefinite loans. I recall statements at the time declaring that it’s important to consider the “real” value of the securities, not the fire-sale price. Does that sound familiar?

    I also recall undisputed reports that the Fed was “working closely” with the Treasury.

    So, while I don’t doubt that Paulson rolled over Helicopter Ben, I think he did so quite some time ago. It also doesn’t seem like the sage from Princeton offered any resistance to anything coming from the Street, including Paulson.

    As far as the balance sheet constraints, they don’t seem to have prevented the Fed from a huge recent expansion of its various facilities. Not to mention the elastic loan to AIG – after the $85 Billion was gone, the Fed said with a straight face that it borrowed securities from AIG, providing $37+ Billion in cash as collateral. Whatever it is and whatever the merits of the approach used, integrity it isn’t. It also doesn’t inspire confidence.

    I wonder if you give Dr. Bernanke too much credit.

  3. I agree with BSG. Fed independence is nonsense. The Fed is a political tool of Uncle Sam. At times, like during the Fed-Treasury “Accord” which ended in 1951, I believe, it is explicit. The Fed exists to facilitate the sale of Treasury debt, Humphrey-Hawkins, et. al., notwithstanding. I noticed the monetary base increased 8.1% from 10 to 24 September 2008. What Fed constraints? Hyperinflation, or at least 10-15% measured inflation, here we come. Imagine, people hold long-term Treasury bonds. Hahahahaha. Zimbabwe Ben would never admit he’s jealous of Gono, Zimbabwe’s chief central banker. It takes a special someone to engineer 231 million percent inflation on an annualized basis last month.

    I have been wondering what really ails the market. It may be the prospect of an Obama victory and 60 Democrats in the Senate. The market may be concluding such a combination will produce large tax increases and pyramid building which wastes capital. In looking at the market’s panic last week, it reminded me of the market’s reaction to the debate in Congress over the Smoot-Hawley tariff.

  4. fusion writes:

    If Bernanke disagreed, he could have said something. This would have put tremendous pressure on Paulson and congress.

    >>I have been wondering what really ails the market. It may be the prospect of an Obama victory and 60 Democrats in the Senate.>>

    People always say this when it looks like Democrats will win, yet the economy and market almost invariably does better under D administrations than R.

  5. I’d have to agree, as a student of the great depression, Bernanke knows full well what willand what will not whip back the forces of deflation and depression. Certainly Bernanke knows TARP is not it.

    Fortunately, Paulson is at least paying attention to his overseas counterparts and watching them take equity stakes in the companies they are recapping.

    I feel mildly encouraged at this sign, no matter how small it might be. Could turn out to be an acorn of an idea that if it takes hold will grow into an oak tree

  6. JKH writes:

    The balance sheet constraint is one of size, not composition. Treasury financing has been necessary up until now (payment of interest on reserves) to increase the size when targeting specific reserve levels.

    The Fed is not independent when it comes to matters of obvious interdependence between monetary policy and fiscal policy – such as extraordinary Treasury financing for the Fed balance sheet. That’s just common sense.

    It is independent when it comes to functional responsibility for setting the target rate. But even functional responsibility hardly outlaws listening to advice.

    As far as Bernanke’s personal independence is concerned, the man is neither an intellectual nor a political idiot. I would think that when the world’s financial system is threatened, collaboration and compromise is a reasonable approach. He may well have thought that TARP was neither necessary nor sufficient, but the path of least systemic risk at the time was to support it rather than reject it. And the final Congressional record included (written and verbal) that TARP be interpreted as allowing capital injections. Ever think he might have had something to do with that subtle adjustment?

  7. Ben writes:

    “People familiar with the early planning efforts for a systemic bailout said the chairman of the Federal Reserve, Ben S. Bernanke, argued that it would be easier and more efficient to inject capital directly into banks. But Treasury officials balked, in part because they were ideologically opposed to direct government involvement in business.”

  8. Ben writes:

    The above quote is from th NY Times article White House Overhauling Rescue Plan

  9. egc writes:

    With urgings from Volker and Gross there was CYA in September for buying bad assets, but none for recap.

  10. eurolander writes:

    At the risk of being repetitive, I beg to differ. There was no balance sheet constraint all along. The Fed could have created reserves out of thin air, bought Treasuries with them on the open market while at the same time the Treasury could have issued new debt. The outcome would have been the same. In my opinion, they chose the Treasury-capitalizing-the-Fed path because it lend itself better to disguise the huge increase in reserves (and thus in the monetary base) that they engineered, although it’s fair to say that this newly added reserves would have been hold by the Treasury. And where’s the sterilization in replacing reserves with short-term government debt that yields nearly nothing?

    JKH: it’s high time you start a blog of your own! Many of your points are too complex to fit in the comments section of other blogs. I can assure you at least one faithful reader.

  11. eurolander — “The Fed could have created reserves out of thin air, bought Treasuries with them on the open market while at the same time the Treasury could have issued new debt.”

    Yes, but that would still have required coordination with the Treasury to sterilize the central banks currency issuance. Which box the account lives in is not the issue. The Fed could not have nearly doubled the size of its balance sheet without surrendering control of the Federal Funds rate, unless someone was willing to sterilize. BB had to negotiate.

  12. groucho writes:

    “But Treasury officials balked, in part because they were ideologically opposed to direct government involvement in business.”

    Ha, ha, ha….”sure” King Tut was worried about govt rigging! What Paulson cares about is “keep on keepin’ on” and counting the roadkill along the way.

    Bear, Lehman? Gotcha..GS, JP, Citi, MS…keep on by unloading the crap onto the taxpayer.

    “what a country!”

    “BB had to negotiate.”

    That’s the ticket. I think Bernanke played his cards right(even though bailing out these scumbags is the last thing I would recommend)

    Steve, the greatest bubble of all time is now quickly developing. The exploding T-rate scheme. Future claims against taxpayers were already in default mode before the recent hi-fi implosion.

    The taxpayer scheme is equivalent to the exploding ARM scheme during the housing bubble.

    The flight to “safety” in treasuries allows the total US debt to grow exponential up until the rates explode when the safety trade fades.

    While Bernanke still has the keys to the printing press and claims he is not afraid to run it at full speed; Peer pressure(Volker, Issing, etc.)will stop him from fulfilling his Great Depression fantasy game.

    In reality the FED will print less than Japan and the US will renege on it’s promises.

  13. KRE writes:

    Isn’t the ‘printing press’ argument a red herring? It is not the quantity of money in circulation but rather the backing that is the main determinant of its value.

    A cursory view of the Fed’s balance sheet shows that dollars are backed by a mix of assets, even though they are no longer convertible into gold or anything else. So, as long as the dollars are backed by assets of the same value (ratio of assets to liabilities is constant), then the value of the dollar should be constant.

    My concern with all of the new treasury/fed lending programs is that it allows assets of dubious value (in addition to outright crap in the case of fanny and freddy) onto the balance sheet. In many cases, what they call a ‘market dislocation’ is just their unwillingness to accept the market price. With the fed asset values increasingly questionable, dollars are now backed by increasinly questionable assets. I don’t care how many dollars Ben prints, as long as they are backed by assets of equal value. The problem now is that they are not.

    From October 11, 2007:

    Federal Reserve notes outstanding: $779,748

    Collateral Held against notes

    Gold certificate account $11,037

    Special drawing rights $2,200

    US Treasury and agencies $766,511

    From October 9, 2008:

    Federal Reserve notes outstanding: $811,692

    Collateral Held against notes

    Gold certificate account $11,037

    Special drawing rights $2,200

    US Treasury and agencies $516,710

    Other assets pledged $281,745

    1) What are the ‘other assets pledged’ ??? They have $70 billion of AIG crap on the balance sheet now, as well as $29.5 billion they call ‘Maiden Lane LLC’ which is the decomposing carcass of Bear Stearns. They also have $320 billion of ‘other assets’ which i am guessing is the crap shoveled into their term facilities and discount window. Is this good collateral?

    2) Agency debt, included in the $516 billion, is now of highly questionable value.

    Shouldn’t this pan out in the form of first, higher inflation and rates on US treasury auctions and second, increased volatility in the dollar forex market?

    Is literally ‘betting the dollar’ on this problem really the right thing to do? I think not.

  14. eurolander writes:

    SRW: “BB had to negotiate”.

    Conceded. But he had some bargaining power:

    a)He could have tinkered with required reserves ratios. Admittedly, not a good option in this environment. Incidentally, the total amount of reserves in the banking system (pre-crisis level) was ludicrously low and may well be one of the main factors when considering how quickly the systemic failure spread. Again, so much for deregulation.

    b)He could pay interest on reserves. This has been the preferred option, though was not available at the moment. But then again, why pay interest on required reserves? This seems an overt gift to the banking system and is tantamount to an stealth increase the public debt of some 40 billions (pre-crisis levels). In normal times it would have been a very controversial decision.

    c)The Fed could issue its own debt instead of new reserves. (Do you know if there is any provision in its charter that prevents this?). This would certainly be the ultimate risk-free debt and the Treasury would have faced a fearsome rival, so in the end they’d rather have sterilized the new reserves themselves.

  15. eurolander — he couldn’t pay interest on reserves, not without action by congress that he just got as part of the stabilization package. at that moment, in mid-september, M. Paulson had BB by the balls. now, the Fed has a lot more practical independence (although semi-sterilization of excess reserves in large quantity by attracting deposits is still a pretty much untried approach — the Fed will be gambling on bank risk-aversion if that adopt a “floor” model without increasing reserve requirements or otherwise regulating).

    lowering reserve ratios were not a practical option. reserve ratios are a fiction for large banks with sweeps programs in the US, the Fed has been self-consciously and deliberately moving toward a zero-fixed reserve ratio regime, expecting required clearing balances and eventually a “channel” or “floor” interest rate to fill in the gap. the Fed hasn’t adjusted formal reserve ratios in more than a decade, other than annual automatic adjustments. given the low start, and the uncertainty that would surround reviving a very creaky policy tool, lowering reserve requirements just aren’t an option.

    re issuing debt to the public, yes, but that would be at least as questionable as a legal matter as BB’s other, creative maneuvers (like Maiden Lane LLC), and defining a new risk-free security, Fed sterilization bonds, and getting them auctioned, would be logistically challenging. also might undermine confidence, as CB sterilization bonds tend to be associated with emerging economies.

    BB wanted to nearly double the size of the Federal Reserve’s balance sheet over a period of two weeks. he had no choice but to deal with Paulson. there may or may not have been serious disagreements between Paulson and BB — it could be a figment of my imagination that bargaining power was an issue here. but if it was, all the chips belonged to The Hammer.

  16. eurolander writes:

    SRW – Now that I come to think of it, the Fed does borrow money, and calls it Reverse Repos. And it’s been doing it a lot recently. Now take a look at this excerpt form Wikipedia:

    If the Federal Reserve is one of the transacting parties, the RP is called a “system repo”, but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a “customer repo”. Until 2003 the Fed did not use the term “reverse repo” – which it believed implied that it was borrowing money (counter to its charter) – but used the term “matched sale” instead.

    Unbelievable. Talk about bending the rules.