Bernanke's Burden

Amid the hoopla over Barack Obama's economic team, it's worth remembering that Federal Reserve Chairman Ben Bernanke is America's most powerful economic policymaker and will probably remain so after Obama's inauguration. The decisions he makes—or doesn't make—will decisively influence the outcome of the present economic crisis. Will it surpass the brutal 1981-82 recession (peak unemployment: 10.8 percent) as the worst since World War II? Might it lapse into a more savage global collapse justifying comparisons with the Great Depression?

Bernanke's Fed has hardly been passive. Already, it has invented more economic tools than was done in any comparable period of the Fed's 94-year history. The object: to prevent a broad credit collapse. Since late 2007, the Fed has found novel ways to lend to banks, former investment banks, money market funds and issuers of commercial paper. It has dramatically increased dollar loans, called "swaps," to other government central banks, which then lend the dollars to their commercial banks.

All told, the Fed's new loans and credits easily exceed $1 trillion, which dwarfs the $335 billion committed by the Treasury Department under the better-known Troubled Asset Relief Program (TARP). Until recently, most of these loans, including those used to rescue Bear Stearns, AIG and Citigroup, have been justified as fulfilling the Fed's traditional role of "lender of last resort." To prevent panic, government central banks prop up financial institutions deemed "too big to fail" or acquire securities in markets where a stampede of sellers overwhelms buyers.

Now, even this justification is being jettisoned. In November, the Fed announced more new credits: purchases of up to $600 billion of securities related to home mortgages and $200 billion of securities consisting of auto, credit card, student and small-business loans. There was no pretense that these markets verged on panic. The purpose was simply to pump more credit into the economy.

The Fed's new lending occurs through programs with such baffling names as the ABCP MMMF Liquidity Facility. The mumbo jumbo aside, the Fed is lending in new ways because the old ways aren't working. Traditionally, the Fed has reduced interest rates by cutting one short-term rate (the Fed funds rate, on overnight bank loans) and assuming that, by making credit more abundant and cheaper, other rates on consumer and business loans would follow. Since September 2007, the Fed has cut the Fed funds rate from 5.25 percent to 1 percent. But some other rates have actually increased (high-quality corporate bonds were a percentage point higher in November than at the start of 2007), and some loans are unavailable at any rate.

Parts of the credit market have simply shut down. Traumatized by losses on "subprime" mortgage securities, many investors shun all forms of "securitized" lending—loans packaged into bond-like instruments. In 2006, "securitized" auto loans averaged almost $7 billion a month; last month, they totaled $500 million. Without ample car loans, fewer cars will be sold. For a while, greater bank lending partly offset collapsing "securitization." No more. Fearing higher losses on consumer and business loans, banks have tightened lending standards and are hoarding cash. From late October to mid-November, bank lending dropped by $162 billion.

So Bernanke faces a rare, if not unprecedented, situation. Despite the Fed's frantic efforts to relax credit, it seems to be tightening in the midst of a harsh recession: the opposite of what's wanted. Private behavior is neutralizing public policy. Lenders are terrified by losses and the fear of what they don't know; the sudden failure of Lehman Brothers in September compounded their anxieties. Having once had too little appreciation of risk (i.e., subprime mortgages), lenders may now have too much. The danger is that tight credit and consumer pessimism combine to lower spending, raise joblessness and cause more defaults.

The Fed is struggling to mitigate this sort of spiral. There are offsetting forces. Lower oil prices bolster consumer purchasing power. The Fed's latest announcement on buying mortgages pushed rates down, stimulating more demand to refinance old loans, thereby reducing consumer debt burdens. It's widely expected that Bernanke will ultimately cut the Fed funds rate to zero and then, by buying long-term Treasury bonds, try to push down longer-term interest rates.

All this is a vast and daring monetary experiment, global in scope and fraught with hazards. The new money and credit issued by the Fed are created out of thin air. If the Fed is too timid, it may deepen today's slump; the financial magazine Barron's—hardly a socialist bastion—suggested the Fed should balloon its credit to an astounding $6 trillion. But too much money and credit might someday boomerang as higher inflation. Considering the consequences of being wrong, Bernanke faces an enormous intellectual challenge and no less an agonizing personal burden.

© 2008