Despite all that has been written about the summer credit crunch, the biggest mystery in the financial markets is still this: Who rolled Ben Bernanke?

In early August, as turmoil in the market for subprime mortgages generated big losses at hedge funds and other financial institutions, the Federal Reserve chairman and his colleagues pumped a bit more cash into the system but refused to be panicked into lowering interest rates—a stance that outraged some Wall Street traders.

For another couple of weeks, Bernanke stood firm. After a meeting on August 7, the Fed’s Open Market Committee kept interest rates steady. A week later, William Poole, the president of the St. Louis Fed, said only a “calamity” would justify a cut in interest rates before the committee met again in mid-September. “Nobody has called up and said the sky is falling,” he said.

And then, only two days later, everything changed. Bernanke abruptly reversed course, announcing a cut in the discount rate—the rate at which the Fed lends money to commercial banks—from 6.25 percent to 5.75 percent. In its statement, the Fed said it was “prepared to act as needed to mitigate” the impact of the subprime meltdown. Sure enough, on September 18, the Fed trimmed the federal funds rate—which banks charge one another for overnight loans—by a half of a percentage point, to 4.75 percent, a bigger cut than expected, and also cut the discount rate by another half a percentage point.

The mystery of why Ben Bernanke changed course will be debated for months. But the solution may turn out to be as simple as this: The Fed chairman found himself sandwiched between his academic beliefs and the real world. While he might have liked to teach investors a lesson about the theoretical costs of risk, in reality the economy was, and still is, shaky. So when Wall Street stood up to the chairman, he caved.

On August 21, he went to Capitol Hill, where he took part in a photo opportunity with Hank Paulson, the former Goldman Sachs C.E.O. who serves as Treasury secretary, and Christopher Dodd, who heads the Senate Finance Committee and whose faltering presidential campaign has received pots of money from hedge funds and investment banks. Both men had a direct interest in seeing the Fed cut rates. “Chairman Ben Bernanke looked more like a Taliban hostage than an independent central banker,” Willem Buiter, a London School of Economics professor who has served on the Bank of England’s monetary-policy committee, said on his blog.

Buiter has a point. Between them, Paulson and Dodd boast more than half a century of experience on Wall Street and in Washington. Bernanke’s entire policy career before he took over as Fed chairman in February 2006 consisted of three years serving under Alan Greenspan as a Fed governor and six months as chairman of the White House Council of Economic Advisers. Neither post conferred much executive authority.

To be fair, Bernanke, who has published dozens of academic papers on monetary policy and co-authored a lucid macroeconomics textbook, is a more than able economist and, by all accounts, a very decent individual. But academic learning, while arguably a necessary condition for being a successful central banker, is certainly not a sufficient one. The last Fed chairman with credentials similar to Bernanke’s was Columbia University’s Arthur Burns, who bowed to strong pressure from the Nixon White House and kept interest rates low, allowing inflation to get out of hand.

There is no evidence that Bernanke received a similar browbeating from the Bush administration. But more-subtle pressure can sometimes be just as effective. This summer, the Treasury Department, at Paulson’s instigation, convened a working group created after the stock market crash of 1987. Consisting of the secretary of the Treasury, the Fed chairman, the chairman of the Securities and Exchange Commission, and the chairman of the Commodity Futures Trading Commission, it provides a forum where the administration can make its views known to the Fed. Precisely what Paulson said to Bernanke may never be known; it is safe to assume, though, that he wasn’t advising him where to go on vacation. On Tuesday, August 14, a day after the Treasury secretary’s old firm announced it was bailing out one of its flagship hedge funds at a cost of $2 billion, Paulson told the Wall Street Journal, “Clearly we’re looking at all the policy levers available to us to increase liquidity in the markets.” Within 72 hours, the Fed had cut the discount rate.

Bernanke made his move amid a crisis in the overnight money markets, where many corporations finance their day-to-day operations. On August 16, Countrywide Financial was forced to tap an $11.5 billion credit line because it couldn’t find buyers for its short-term paper. That evening, Bernanke held a conference call with his colleagues and finalized his plan. In addition to cutting the discount rate, he extended the duration of the loans that banks could obtain through the discount window from a day to a month, as well as made clear that the Fed would accept mortgage securities as collateral.

Committing to cut the federal funds rate was going beyond standard crisis management; it was Bernanke overruling reluctant members of his own rate-setting committee—people like William Poole—and reversing monetary policy on the hoof.

There was nothing to prevent Bernanke from cutting the discount rate while leaving the funds rate alone. A week earlier, the European Central Bank had done just that. Bernanke clearly concluded that the situation was too dire for half measures. But why did he decide this? And was he right? 

Buiter, for one, is convinced that the cut was for “highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit-risk spreads. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them.”

Buiter is not alone in his views. A vocal minority of economists and commentators has long been warning about moral hazard—the danger that investors and financial institutions will take undue risks if they believe that the Fed will be there to bail them out in the event of a crisis. Bernanke was said to be sympathetic to this argument—“He takes moral hazard very seriously,” Alan Blinder, one of his former Princeton colleagues, said in August. Why, then, did Bernanke follow a course of action that, while not exactly a bailout, did give some careless institutions extra breathing room? Was he merely paying lip service to moral hazard?

Not entirely. Bernanke believes that concerns about rewarding irresponsible risk takers have to be balanced against the danger of problems in the financial sector spilling over to the rest of the economy. In 2000, when he was still at Princeton, he published a book of essays on the Great Depression in which he argued that one of the main reasons for its severity was that the banking system seized up, depriving consumers and firms of credit. “I am a Great Depression buff, the way some people are Civil War buffs,” he wrote. “The issues raised by the Depression, and its lessons, are still relevant today.”

Between 1929 and 1933, gross domestic product declined by almost a third, the stock market fell 80 percent, and a quarter of Americans found themselves thrown out of work. As the situation worsened, a growing chorus argued that the only way to purge the economy of its bad debts was to let insolvent institutions go bankrupt. On the other side of the debate, John Maynard Keynes urged the Fed to cut interest rates drastically in order to bolster the banking system and encourage lending.

George Harrison, the governor of the New York branch of the Fed, which in those days held sway over the Fed’s Washington-based board, had the unenviable task of deciding what to do. In some ways, Harrison resembled Bernanke. He was highly intelligent—he clerked at the Supreme Court for Oliver Wendell Holmes Jr.—but he didn’t have much financial experience. When the Great Crash of October 1929 happened, he had been in office for only 12 months, and his predecessor, Benjamin Strong, who held the job for 14 years, overshadowed him. Like Greenspan, Strong was a product of Wall Street: Before joining the Fed, he had run Bankers Trust. Whenever a crisis loomed, he didn’t hesitate to pump money into the financial system.

Harrison, by contrast, followed an uncertain course. At times, he seemed eager to bail out troubled institutions; on other occasions, he appeared content to see them fail. Milton Friedman and Anna Schwartz, in their 1963 opus A Monetary History of the United States, accused Harrison’s Fed of allowing a “contagion of fear” to develop, leading to countless bank runs. According to this reading of events, it was the Fed’s passivity that transformed a cyclical downturn into the worst economic calamity ever to befall the country. Bernanke is determined not to repeat Harrison’s mistakes, even if that involves rescuing some irresponsible financiers.

For now, the Fed chairman’s about-face has won him plaudits from investors, politicians, and homeowners. But the story is far from over. The financial system remains heavily leveraged. And even if the Fed manages to stabilize the credit markets and head off an election-year recession, can that really be counted as a triumph?

To bring an end to the boom-bust cycle, a Fed chairman is going to have to stand up to Wall Street and face the short-term consequences. Unless Bernanke reverses himself again, he won’t be that chairman. No doubt he was in a difficult spot. It’s one thing to talk theoretically about letting big financial institutions fail but another, in the midst of an emergency, to face down the clamor for ameliorative action from Wall Street, Congress, and the media. The last Fed chairman to withstand that kind of pressure was Paul Volcker, who in 1981 raised interest rates sharply to bring down inflation, plunging the economy into the deepest recession since the 1930s. At the time, critics attacked Volcker from all sides; today, he is regarded as perhaps the greatest of all Fed chairmen.

Presented with the chance to play Volcker’s role, Bernanke flubbed it. Wall Street has taken the measure of its man and found him amenable to its wishes. Assuming credit starts flowing, it won’t be long before the cycle starts again.