The following short essay was written for the Wall Street Journal as part of a symposium in which five economists were asked this same question.
During the Fed’s first 100 years, it has shifted gradually from being a banker-run to an economist-run central bank, culminating in Ben Bernanke’s assumption of the chairmanship in 2006. His appointment promised to bring the academic rigor of modern monetary economics to the chairmanship. Bernanke’s research, advocating greater transparency and better communication to enhance the central bank’s credibility, augured well for continuing low and stable rates of inflation.
Before he could address this agenda, his watch was consumed by the financial crisis of 2007-2008 and the Great Recession. Bernanke’s approach to these challenges was influenced by his research on the Great Contraction of 1929-33. He identified the Fed’s failure to counter the banking panics as the key factor that reduced the money supply and disrupted credit disintermediation, leading to massive deflation and high unemployment.
The prelude to 2007-2008 was the tech-stock bust of 2001 when Bernanke was a governor on the Fed board. Concerned about the possibility of deflation, as happened in Japan in the 1990s, he advocated a low fed funds rate from 2002 to 2006. In retrospect, this fear of deflation was overblown and low interest rates contributed to the housing boom.
Apparently conditioned by his interpretation of the 1930s, Bernanke initially viewed 2007-2008 as a liquidity crisis. Flooding the market with liquidity, the Fed was slow to recognize the underlying problems of counterparty risk and insolvency. To protect credit markets, new lending facilities were created, expanding the Fed’s balance sheet and taking on risk. Competing concerns about the prospects of “too big “ or “too interconnected” firms failing and of moral hazard led to inconsistent policy, with the government bailing out Bear Stearns, letting Lehman Brothers fail, then bailing out AIG.
By the time the crisis subsided, the fed funds rate was near zero– a lower bound that left conventional monetary policy unable to treat the still contracting economy. Purchasing long-term securities—quantitative easing—lowered longer rates but because the Fed paid interest on excess reserves, the banks were discouraged from lending, hindering recovery. These policies formulated by discretion rather than rules threaten the Fed’s credibility and independence, and Bernanke’s legacy.