In FED We Trust (14 page)

Bernanke’s communication problems were hardly uncommon. No matter how often they are cautioned, new Fed chairmen (and Treasury secretaries) rarely appreciate how large and loud the megaphone they’ve been handed
is until an offhand comment or private whisper moves financial markets around the world. Bernanke’s mistake was humiliating — and in retrospect inconsequential — but it bred uneasiness about his command of the job. Grumbles of “Greenspan never would have done that” became commonplace. The markets didn’t want to know what he was thinking; they wanted to know what he was going to do next. Clarity and transparency, it turned out, were noble goals, but what the markets wanted was a clear guide to the Fed’s intentions, and Bernanke hadn’t mastered that art yet.

With few hints of the meltdown that was to come, Bernanke devoted himself to a pet project: setting a target for inflation and trying to meet it. Inflation targeting is an effort both to avoid a repeat of the inflationary 1970s and to employ the insights of scholars concerning the importance of public expectations about inflation. Some foreign central banks — including the European Central Bank, the Bank of England, and the Bank of Japan — are given one and only one explicit goal: price stability. The Fed, in contrast to most other central bankers, was instructed by Congress in 1977 to aim at both “maximum employment” and “stable prices.” Democrats in Congress warned Bernanke against any unilateral move to alter the Fed’s priorities, an admonition that Bernanke, like Greenspan before him, countered by maintaining that price stability
was
the road to maximizing employment and economic growth.

Bernanke was not the first Fed chairman to consider inflation targets. In 1996, the Greenspan Fed had come close to a consensus on setting 2 percent as an internal inflation target. But while Bernanke advocated an explicit public inflation target, Greenspan had admonished Fed officials to keep the consensus quiet. “I will tell you that if the 2 percent inflation figure gets out of this room,” Greenspan told his colleagues, “it is going to create more problems for us than I think any of you might anticipate.” Greenspan prized flexibility and resisted rules that limited his discretion; Kohn and, later, Geithner sided with him.

The Greenspan Fed’s semiannual reports to Congress avoided anything approaching specificity about the Fed’s goals. At one FOMC meeting, Fed governor Frederic Mishkin, a proponent of explicit inflation targeting, derided the reports as “sex made boring.”

Bernanke reopened the inflation targeting question soon after becoming chairman, but the process dragged on for so long that even fans of the approach and his usual allies grew impatient and began pressing for a resolution. The compromise called for the Fed to publish an economic forecast from each governor and regional bank president four times a year, instead of twice as had been the practice since 1979. More detailed than in the past, the forecast looked out three — and later more — years, instead of the two years that had been the custom. The reports amount to unofficial inflation targeting; most Fed officials in early 2009 predicted inflation would fall between 1.9 percent and 2.0 percent several years into the future. Everyone in the Fed and in the markets understood that was tantamount to a target.

Bernanke is proud of the expanded forecasts; he hopes that someday they may be seen as a significant innovation. However, his change initially was overshadowed by the beginning of the Great Panic, which, among other things, exposed the shortcomings of inflation targeting über alles. The targets provided no guidance for how the Fed should respond to the collapsing housing market or the financial calamity it triggered. As Blinder put it, the Fed essentially said: “Mr. Inflation, you’re going to have to wait, which is the opposite of inflation targeting.” But as the recession deepened and the inflation rate fell lower than the Fed thought desirable, the inflation target issue resurfaced — as a way for the Fed to assure everyone that it wouldn’t let inflation fall
too low
or let the economy lapse into a devastating deflation, where prices and wages fall and borrowers find it harder to repay their debts.

Ben Bernanke was just getting the hang of being Fed chairman when the housing market deteriorated and, contrary to expectations (including his
own), refused to bottom out. Both inside and outside the Fed, a sense spread that this might be the end of an era in which the economy and markets had been too good to be true. One of the most prominent warnings came from Lawrence Summers, who had been Clinton’s last Treasury secretary and later president of Harvard (until he crashed and burned). As the housing situation spun out of control, Summers was teaching, writing, and — successfully — positioning himself for a perch in a future Democratic administration and a run at succeeding Bernanke.

In a December 27, 2006, op-ed piece in the
Financial Times
, Summers wrote: “Changes in the structure of financial markets have enhanced their ability to handle risks in normal times.” Translation: Lenders were more willing to lend because they share with the investors the risk that borrowers wouldn’t repay. Derivatives allowed investors to hedge their bets, making them comfortable with positions they might once have shunned. Hedge funds and other huge pools of capital reduced volatility by pouncing when markets push an asset price even slightly out of line.

That was all to the good, but recalling the 1987 stock market crash and the 1998 Asian financial crisis, Summers observed presciently: “Some of the same innovations that contribute to risk spreading in normal times can become sources of instability following shocks to the system as large-scale liquidations take place.” (Translation: Everyone was counting on always being able to quickly sell any newfangled financial instrument.) Normally, that made sense. But if something bad happened, and everyone tried to sell at once — look out! Looking back over the preceding twenty years, Summers suggested that financial crises seem to occur in about one out of every three years. The beginning of the Great Panic was less than one year off.

Soon, cracks in the subprime market began to surface. In January and February 2007, several subprime mortgage originators filed for bankruptcy court protection. In March, New Century Financial — one of the largest subprime lenders — stopped making loans and said it needed emergency financing; a month later, it, too, was in bankruptcy.

Nonetheless, the concern about potential problems found no official voice in Washington. After Bernanke and Paulson met their counterparts from the Group of Seven major economies in February 2007 in Essen,
Germany — where the Germans were obsessed with the risks posed not by house prices but by hedge funds — Paulson confidently predicted that “housing activity appears to have stabilized” and observed that the strength of consumer spending and exports was offsetting the “cooling” housing market.

The Fed was similarly optimistic. At the March meeting of the Federal Open Market Committe, officials agreed that “the economy was likely to expand at a moderate pace” and cited data that suggested “demand for homes was leveling out.” They did acknowledge that the “downside risks” were growing — Fedspeak for a sense that any surprises are more likely to be bad ones than good ones. As for the subprime market, it was in trouble but wasn’t big enough to overturn the entire U.S. economy. Bernanke told the Joint Economic Committee of Congress at the end of March, “At this juncture … the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” he said.

Soon, the word
contained
would become a mantra for both Bernanke and Paulson, an attempt to reassure everyone that housing might be bad but the rest of the financial system and the overall economy would muddle through. It was neither accurate as a description nor successful at reassurance.

Bernanke, Geithner, and Paulson all had a gut sense that the U.S. economy was overdue for a financial crisis of some sort and thought they were doing what was necessary to prepare for one. Geithner organized teams at the New York Fed to attempt to get a more comprehensive view of the financial system than was provided by looking at individual banks or markets. In Washington, Bernanke also asked existing Fed task forces to prepare “financial stability reports” twice a year. The Fed created an online crisis manual so officials could instantly check Wall Street prices and find contact information on their foreign counterparts. But, in fact, the Fed spent more time preparing for physical disruption to the banking system, such as a terrorist attack, and for the avian flu than it did for anything resembling the scope and magnitude of the Great Panic.

Bernanke and Geithner simply never imagined that things could get so bad, that the crises they would confront would be so much larger than the worst of those that Greenspan had managed. It was, as much as anything, a failure of the imagination, similar to the failure to anticipate terrorists hijacking big airlines and steering them into the World Trade Center. Yes, there was a sense that something bad might happen someday. And, yes, someone somewhere probably did predict exactly what happened. But to the officials overseeing the economy and many others, a crisis as big and broad as the Great Panic simply wasn’t considered a plausible scenario — and they weren’t preparing for anything this large.

Geithner did muse, occasionally, that the evolution of financial markets might produce fewer crises, but bigger ones. (The “bigger” so far has proven dead-on. “Fewer” remains an open question.) And he did help clean up one mess: an alarming backlog of paperwork in a rapidly growing corner of the markets, the securities called credit default swaps, which allow banks and other lenders to buy insurance against borrowers going bust. The buyers and sellers used sophisticated twenty-first-century finance; but the back office was more circa the late nineteenth century. One firm confessed in June 2006 that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than ninety days. The risk was that in a crisis, no one would be sure who owed what to whom — and everyone would stop doing business. With the help of his predecessor, Gerald Corrigan, then at Goldman Sachs, Geithner summoned representatives of fourteen big Wall Street firms — “the Fourteen Families,” they called themselves — and prodded them to automate the process before a crisis hit. It worked. On September 30, 2006, the firms counted 97,000 unconfirmed trades outstanding for more than thirty days. By October 2008, the backlog had been reduced by 75 percent. And in all the turmoil of the Great Panic, the failure to process credit default swaps was one problem that
didn’t
occur. Big players on Wall Street knew who their counterparties were — even if they didn’t completely trust them.

No one at the Fed, however, rang the gong and warned investors, lenders, business executives, and consumers that years of easy credit even for risky borrowers, placid markets, and shared optimism were unsustainable. There
was no analog to Alan Greenspan’s famous — and unheeded — admonition about “irrational exuberance” in the stock market in 1996. Nor would any Fed official be able to point to a warning as dramatic as ECB president Jean-Claude Trichet’s headline-making caution in January 2007 that “elements in global financial markets … are not necessarily stable” and prediction of a “repricing” — also known as a crash — in asset prices.

Occasional bursts of public prescience by Fed officials were so circumspect they were hardly noticed, let alone heeded. Geithner’s expressions of concern were enveloped in so much jargon that only sophisticated listeners sensed any anxiety on his part. For instance, there was this 2005 passage in one of his speeches: “We are in the midst of an unusual dynamic in financial markets, in which low realized volatility in macroeconomic outcomes [Translation: everyone thinks we’ve licked the boom-bust cycle], low realized credit losses [Translation: even deadbeats are paying their loans], greater confidence in the near term path of monetary policy [Translation: everyone assumes the Fed will never surprise them], low uncertainty about future inflation and interest rate [Translation: everyone
really
believes the Fed will never surprise them], rapid changes in the nature of financial intermediation [Translation: the rise of finance outside the core banking system in the securities markets], and a large increase in the share of global savings that is willing to move across borders [Translation: the huge sums of money sloshing around the world economy], have worked together to bring risk premia down across many asset prices [Translation: all of which have led prices of stocks and other assets to rise awfully high].”

His bottom line, but only if you could understand him: don’t invest as if these unusually good times will last forever.

Outside the Fed, warnings were starting to pile up. Larry Summers was increasingly pessimistic. Housing, he warned in March 2007, was becoming a brake on the U.S. economy and would eventually make lenders reluctant to make home equity, auto, and credit card loans. It was “premature” to predict
recession, he said, but “the U.S. economy will slow down very significantly in 2007.”

Summers suggested that, with hindsight, policy makers should have better restrained imprudent subprime lending, and the Greenspan Fed should have raised interest rates sooner. These, however, were solutions to yesterday’s problems. “Economic policy makers who seek to correct past errors by doing today what they wished they had done yesterday actually compound their errors. They are in their way as dangerous as generals fighting the last war,” Summers wrote, adding that “if recent developments mark a genuine change, let us hope that policy makers look forward rather than backwards.”

How bad were things really? In an early warning of what was to come, a couple of Bear Stearns — sponsored investment funds that had borrowed heavily to invest in subprime mortgages ran into trouble and were initially bailed out by the parent company. One of them, the deliciously named HighGrade Structured Credit Strategies Enhanced Leverage Fund, had taken $600 million from investors and borrowed $6 billion to make huge, and ultimately losing, bets. The global consequences of a collapsing U.S. housing market became equally evident when big Swiss bank UBS fired its chief executive after discovering how exposed the company was to the U.S. sub-prime market. Yet the Fed could take comfort from the impressive resilience of the overall U.S. economy despite the spreading subprime stain. On July 20, 2007, the Dow Jones Industrial Average crossed 14,000 for the first time; the stock market kept rising until October — as did the price of oil, widely seen as a sign of the strength of economies around the world.