Samuelson: The Bernanke Era Has Begun

Last week the Fed shifted its emphasis from fighting inflation to preventing panic. Was that the right call? Certainly it was the popular call.

It's Ben Bernanke's moment of truth. The Federal Reserve—the economy's symbolic command center—has now truly passed to him. Yes, he replaced Alan Greenspan as Fed chairman in early 2006. But until now, Bernanke had faced no crisis and his policies had shadowed Greenspan's. With the Fed's decision last week to cut its key interest rate to 4.75 percent, down half a percentage point, he's on his own. The cut stirred much excitement; global stock markets jumped sharply. But only history will ultimately judge whether he made the right move.

Government central banks like the Federal Reserve have two critical responsibilities. The first is to control inflation, which can be hugely destabilizing. The rise of U.S. inflation from 1 percent in 1960 to 13 percent in 1979 caused four recessions of increasing severity. The other job is to prevent financial panics. These can devastate confidence and credit flows. Bank runs in the 1930s worsened the Great Depression, when unemployment peaked at 25 percent.

Unfortunately, these tasks can collide. The standard antidote for a bank run (people demanding their money back) is for the Fed to lend liberally to besieged banks so they can repay terrified depositors and quell the fear. But if the Fed is too lax with money and credit, it may feed inflation—resulting in the proverbial "too much money chasing too few goods." Last week the Fed shifted its emphasis from fighting inflation to preventing panic. Was that the right call?

Certainly it was the popular call. The housing market is imploding; new building permits are at their lowest point since 1995. Fear of recession is in the air. In August, payroll employment dropped. Last week's interest-rate cut could affect some consumer rates: on home-equity loans, for example. But the rate declines aren't large enough to change the first "resets" on adjustable-rate mortgages that had introductory "teaser" rates, says Mark Zandi of Moody's He estimates that almost $900 billion of these mortgages will be reset in 2007 and 2008, with average monthly payments rising from $1,200 to $1,550.

The Fed is trying to prevent a fear-driven breakdown of credit flows: the modern equivalent of a bank run. Through the 1970s, banks dominated the credit system. They were the largest source of business and consumer loans. Now many loans (home mortgages, credit-card debts, auto loans) are "securitized" into bonds that are sold to U.S. and foreign investors: pensions, mutual funds, hedge funds. In 2006, U.S. nongovernment bond issuance totaled $3.8 trillion. But the "subprime" mortgage crisis has traumatized this credit system.

When the subprime mortgages—loans to weaker borrowers—began to default in large numbers, so did the bonds into which they'd been packaged. Rattled investors revolted; they stopped buying other securities whose value seemed unclear. From July to mid-September, outstanding U.S. commercial paper (a type of short-term business loan) dropped by $308 billion, says Brian Bethune of Global Insight. "This credit crunch is one of trust," says economist Roger Kubarych of UniCredit Global Research. "People who had been buying things on trust—rather than their own due diligence—went on strike."

Enter the Fed as strikebreaker. In effect, it supplies banks with more credit at a lower cost (a.k.a. a lower interest rate). Banks then find it more profitable to increase their lending to fill the vacuum left by skittish investors. The economy and financial markets don't spiral downward as less lending weakens the economy and leads to more losses. Confidence returns.

Sounds sensible, but it could be short-sighted. "The unemployment rate is 4.6 percent. Is that a crisis? Suppose it goes to 5 percent. It's still not a crisis," says economist Allan Meltzer of Carnegie Mellon University and author of a history of the Fed. "It sure looks like they're responding to pressures from the markets, from Congress." Implicit in this view is that the economy and financial markets must periodically suffer setbacks. These remind investors to be prudent; they also check price and wage increases. A falling dollar last week (against the euro and the yen) suggests that inflation anxieties are not entirely abstract.

It must be counted in Bernanke's favor that the consumer price index for August showed only a 2 percent increase in prices over the past year. But like much of the information the Fed weighs, this good news came with caveats. The subdued inflation mainly reflected a recent drop of gasoline prices that, with oil hovering around $80 a barrel, could be reversed.

The Fed isn't all-knowing or all-powerful. It operates with limited tools in financial markets that are increasingly complex and globalized. Its actions are only one of many that influence a nearly $14 trillion economy. Almost everything of importance that it does involves personal judgment. There was a telling symbolism last week. Monday marked the publication of Greenspan's autobiography. On Tuesday, the Fed cut interest rates. An era ended. It's Bernanke's judgments that now matter.