Bernanke Changed Course

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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.

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