President Obama has decided to reappoint Fed Chairman Ben Bernanke to a second term. On balance, I think this is the right move. In many ways, his reappointment makes more sense than his original appointment.
The worst marks against Bernanke’s record come from when he was serving on the Fed board under Alan Greenspan, did nothing to stop the bubble forming and was almost willfully blind in seeing it coming. While as Chairman, he was a little slow off the mark in addressing the crisis, once engaged he took the needed steps to pull the world back from the brink of the abyss.
The role of Fed Chairman has two major components. First and foremost, he (along with the board of Governors) is responsible for monetary policy. This is the raising and lowering of the Fed Funds rate and regulating the overall money supply.
On that front, I think he has done an excellent job under the most trying of circumstances. He faced a raging wildfire of deleveraging in the financial system after the demise of Lehman Brothers and the near collapse of several other major financial institutions, including American International Group
(AIG - Analyst Report
) , Fannie Mae
, Freddie Mac
, Merrill Lynch -- now part of Bank of America
(BAC - Analyst Report
) and Citigroup
(C - Analyst Report
He responded by quickly lowering the Fed Funds rate to almost zero, and then going a few steps further by engaging in quantitative easing, or buying mortgage-backed securities and long-term T-notes. These actions dramatically increased the size of the Fed balance sheet and with it the size of the monetary base. He responded with a slew of innovative alphabet soup programs, such as the TALF program, to stabilize the system.
At the core of the problem is that deleveraging dramatically slows the velocity of money, or the rate at which it moves from one hand to another. Banks want to hold onto as much cash as possible and do not want to lend it out.
Since nominal GDP can be defined as the supply of money times the rate at which it turns over, if the money supply is not increased, then GDP will fall precipitously. This comes from the basic monetarists equation of M*V = P*Q, where M is the money supply, V is the velocity, P is the price level (inflation) and Q is the quantity produced (real output).
Once engaged, Bernanke saw the scope of the problem and unleashed a fire hose of liquidity on the problem. While the economy is clearly not in good shape, I shudder to think about the condition we would be in had he not taken these actions. Most people fail to appreciate just how close we came to financial Armageddon last fall. It was the economic equivalent of the Cuban Missile Crisis.
Sopping up all that liquidity is going to be extremely tricky, and the timing is going to have to be just right. If it is removed too soon, then the economy will slip right back into its downward trajectory.
The actions of the Fed prevented a second Great Depression, but that does not mean the threat has totally disappeared, just that the medicine is working. Stopping the medicine too soon would cause a relapse.
The best example of this in history was in the 1930’s. Few people realize that the greatest growth in GDP and industrial production in U.S. peacetime history was from 1933 through 1936. Unfortunately, worried about the potential for inflation and unprecedented budget deficits, both Monetary and Fiscal policy turned concretionary in 1937, resulting in a very nasty recession, a relapse that took WWII to cure.
On the other hand, if velocity starts to pick up and all that monetary base is still out there, then the movement on the other side of the equation will be as much or more from the P, inflation, as it is from the Q, a pick up in real economic activity. If Bernanke does not act quickly enough, inflation could easily return to mid-1970’s levels or worse.
Bernanke is betting that right now real activity is depressed enough that when V starts to pick up, the bulk of the adjustment will be in real output, or Q. With capacity utilization at near record lows, there is a very good justification for this view.
Certainly recent inflation reports have been not been on the too-hot side. Heck, we just saw the biggest year-over-year drop in producer prices on record! Changing horses in midstream is not a good idea, and until this river of liquidity is removed, we will not get to the other side.
The other major role of the Fed Chairman is to be one of the most important bank regulators. Here I would give him much weaker marks. The banks acted outrageously leading up to the crisis. They used taxpayer-backed deposits and effectively went to Las Vegas with them. Their casino of choice was highly leveraged bets on exotic forms of mortgage-backed securities.
Another favorite table game were derivatives, most notably Credit Default Swaps (CDS) which were essentially life insurance contracts on companies. When they were winning the bets, they paid out bonuses that were beyond lavish. They did not set aside sufficient reserves for when the bets turned bad.
The Fed, along with the Treasury, simply threw money at the banks with very few strings attached. The taxpayer got very little in return. This was one of the greatest transfers of wealth -- welfare, if you will -- in human history. It did not go to the poor or the sick; it went to the wealthy and the powerful. In the process, it set up a moral hazard problem of epic proportions.
Bankers now know that they can make huge bets, and if they lose, the taxpayer will cover them. If they win, they get to keep it all. This will encourage banks and other financial institutions to be even more irresponsible in the future.
An overhaul of the financial regulatory structure would help, and the recent proposals by the Obama Administration are a decent first step in that regard. Unfortunately, the proposals are more likely to be watered down in Congress than strengthened. This is exactly the sort of issue where lobbyists hold the most sway -- dry and complicated issues where a very powerful group has a huge interest in the outcome.
The net result is that down the road -- not next year or the year after, but maybe in a decade -- we will face another massive crisis in the financial system. And where the actions of the last administration with regard to the banks were beyond scandalous, the actions of the current administration towards the banks have been a huge disappointment. "Change we can believe in" has, at best, become change around the edges.
In his second term, Bernanke will have to become a much tougher regulator. Part of the regulatory reform would put even more power in the hands of the Fed as a systemic risk regulator. I agree that such a regulator is needed, and the Fed is one of the two obvious candidates for the job (the other being the FDIC).
The opposition the Fed has shown in giving up part of its regulatory power -- the consumer protection part -- is extremely disappointing, and smacks of more interest in bureaucratic turf than the interests of the American people or the economy. The Fed has done a lousy job in protecting the consumer from predatory practices at the banks, and a separate agency is desperately needed.
The experience of Alan Greenspan should warn us loudly about the lionization of a Fed Chairman. For most of his tenure, Greenspan was lionized as the “Maestro. Now it is clear that he truly was a failure whose actions led to the near total collapse of the entire world economy.
Thus, I have no desire to lift Ben Bernanke up to Mount Olympus. Still, given his excellent handling of monetary policy during the most difficult of times, Bernanke deserves to finish the job he started, and Obama is making the right move in reappointing him.With more than 25 years' experience as an analyst and portfolio manager, Dirk van Dijk is Zacks’ Chief Equity Strategist. He also manages the new long-term investing service, Strategic investor.