The Great Preventer

By NOURIEL ROUBINI
Published: July 25, 2009


LAST week Ben Bernanke appeared before Congress, setting off a discussion over whether the president should reappoint him as chairman of the Federal Reserve when his term ends next January. Mr. Bernanke deserves to be reappointed. Both the conventional and unconventional decisions made by this scholar of the Great Depression prevented the Great Recession of 2008-2009 from turning into the Great Depression 2.0.

Mr. Bernanke understands that in the Great Depression, the collapse of the money supply and the lack of monetary stimulus during contractions worsened the country’s economic free fall. This lesson has paid off. Mr. Bernanke’s decision to keep interest rates low and encourage lending has, for now, averted the L-shaped near depression that seemed highly likely after the financial collapse last fall.

To be sure, an endorsement of Mr. Bernanke’s reappointment comes with many caveats. Mr. Bernanke, a Fed governor in the early part of this decade, supported flawed policies when Alan Greenspan pushed the federal funds rate (the policy rate set by the Fed as its main tool of monetary policy) too low for too long and failed to monitor mortgage lending properly, thus creating the housing and credit and mortgage bubbles.

He and the Fed made three major mistakes when the subprime mortgage crisis began. First, he kept arguing that the housing recession would bottom out soon (it has not bottomed out even three years later). Second, he argued that the subprime problem was a contained problem when in reality it was a symptom of the biggest leverage and credit bubble in American history. Third, he argued that the collapse in the housing market would not lead to a recession, even though about one-third of jobs created in the latest economic recovery were directly or indirectly related to housing. Mr. Bernanke’s analysis was mistaken in several other important ways. He argued that monetary policy should not be used to control asset bubbles. He attributed the large United States current account deficits to a savings glut in China and emerging markets, understating the role that excessive fiscal deficits and debt accumulation by American households and the financial system played.

Still, when a liquidity and credit crunch emerged in the summer of 2007, Mr. Bernanke engineered a U-turn in Fed policy that prevented the crisis from turning into a near depression. He did this largely with actions and programs that were not in the traditional toolbox of monetary policy. The federal funds rate was effectively pushed down to zero to reduce borrowing costs and prevent the collapse of consumer demand and capital spending by business. New programs encouraged skittish institutions to resume lending. For the first time since the Great Depression, the Fed’s role as lender of last resort was extended to investment banks.

Mr. Bernanke also introduced a wide range of other programs, like those to maintain the functioning of the commercial paper market (which makes short-term loans to companies so they can cover operating expenses like payrolls). The Fed was involved directly in the rescue of financial institutions like Bear Stearns and American International Group. It lent money to foreign central banks to ease a global shortage of dollars. The Fed even committed to purchasing up to $1.7 trillion of Treasury bonds, mortgage-backed securities and agency debt to reduce market rates. These are all radical actions that had almost never been undertaken before.

Some of these moves have raised important questions: Did the Fed help bail out institutions that should have been allowed to fail? Did it cause moral hazard as reckless lenders and investors were effectively bailed out? How and when will the Fed mop up the excess liquidity that its actions have created? Will these actions eventually cause inflation and a sharp fall of the value of the dollar? Has the Fed lost its independence as it has accommodated the fiscal needs of the government by bailing out banks and printing money to cover large fiscal deficits?

Still, the basic point remains: The Fed’s creative and aggressive actions have significantly reduced the risks of a near depression. For this reason alone Mr. Bernanke deserves to be reappointed so that he can manage the Fed’s exit from its most radical economic intervention since its creation in 1913.

Nouriel Roubini is a professor of economics at the New York University Stern School of Business and the chairman of an economic consulting firm.