Bernanke Changed Course

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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?

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