Educating Ben

Yesterday's fine piece of writing by Roger Lowenstein that appeared in the NewYork Times Magazine, "The Education of Ben Bernanke", does a great job of retelling the recent history of the Federal Reserve and of Fed chief Ben Bernanke's rise to the top post, but does little to instill confidence that he is up to the job at hand.

Not that there is a soul on the planet who would be up to the job at hand, given the "current mess" (Mr. Lowenstein's words) that was left behind by his predecessor.

During the first years of the new century, Greenspan lowered the fed funds rate to 1 percent, which was exceptionally low. Low rates were partly an attempt to revive the economy after the dot-com fiasco. In an illustration of how one bubble seems to beget another, however, the Greenspan rate cut greatly stimulated the housing industry. In particular, since adjustable-rate mortgages are determined by short-term interest rates, low rates paved the way for the explosion in ARMs, the very mortgages that lately have been defaulting at an epidemic pace.

As demand for mortgages swelled, banks began to engage in highly dubious lending practices, including issuing mortgages without verifying the income of borrowers. The Fed, which apart from its monetary role is also one of the federal agencies that regulates banks, was warned that standards were slipping. Greenspan, however, ignored the warnings, and the speculative lending continued, reaching a peak during Bernanke’s first year. Thus, in both of its main areas of responsibility — monetary and regulatory policy — Fed laxity has seemingly contributed to the current mess. Bernanke deflects such criticisms, partly because he maintains that the mortgage fiasco had many fathers and partly because he has a scholar’s disdain for perfect-hindsight-type judgments.

Uh...

There were plenty of people back in 2004 who had, what turns out to be, near perfect foresight - you didn't have to wait for hindsight for everyone to see clearly.

It's one thing to cut short-term interest rates to one percent, but it's entirely another to, not only look the other way as the credit market excesses and soaring home prices began to reinforce each other, but to encourage the various bubbles all the way up.

All you had to do was spend a few hours in a mortgage lender's office or a realtor's office back in 2004 and anyone with any sense of what's right and wrong in the real world would have clearly seen that something was very wrong.

But, economists don't seem to do that sort of thing.

The new Fed chairman, just like the old Fed chairman, seems to share the same naiveté that plagues almost all economists (including, apparently, 220 economists at the Fed).

The housing meltdown has defied the forecasting abilities of the Fed’s 220 crack economists, computers and all. As late as May, Bernanke gave a speech in which he opined that “the effect of the troubles in the subprime sector on the broader housing market will likely be limited.”

It has proved to be anything but. The country’s banks have admitted to mortgage-related losses of almost $100 billion, and the full extent of the damage, as homeowners continue to default, is not known. As the crisis unfolded last summer and fall, Bernanke repeatedly faced a devil’s choice. He could cut interest rates and risk inflation and a run on the dollar and, at the same time, be seen as bailing out people and institutions who made bad bets on subprime mortgages. Or he could do nothing and run the risk that the troubles in housing would leach into the general economy, causing people to lose jobs and possibly a recession.
...
The Fed faces not only the twin demons of recession and inflation but also the specter that further rate cuts would cause foreign investors — who own more than $2 trillion of U.S. debt — to bail out, sending U.S. interest rates soaring. That, combined with the steadily worsening housing slump, could make for a long and nasty recession. And it would mark the end to the Great Moderation.

Perhaps the Great Moderation has been the result of good luck. Or perhaps it has been because of improved management skills —business learning not to overstock inventories, for example. Bernanke has written that it is something else. He sees it as a result, in large part, of better monetary policies. He says that central bankers have finally learned how to guide economies — not with mystique but with economic science. If that is so, we will not need a wizard behind the curtain anymore, only intelligent engineers who can steer markets to a promised land of rational expectations. To prove that he is right, Bernanke will need to minimize or, if possible, avoid the looming recession that looks ever more likely. It will not be easy. Bernanke’s education has just begun.

Central bankers have learned how to guide economies - with economic "science".

We are in deep, deep trouble.