In FED We Trust (19 page)

Rick Mishkin, the Fed governor, applauded the Bernanke innovation as an attempt to put more liquidity into the markets without increasing the total amount of credit, targeting the remedy at what appeared to be the most serious symptom at the moment. A student of the history of financial crises, Mishkin was convinced that this was the opening act of what could be a much more serious crisis and argued that the Fed needed to be very aggressive very quickly. In a fifteen-minute conversation before the FOMC meeting, he had told Bernanke that he wanted an even bigger cut in the discount rate and said so at the meeting itself. On the other side, Jeff Lacker of the Richmond Fed didn’t want to cut the discount rate at all, and told Bernanke as much.

The second prong of Bernanke’s action plan was more conventional: crafting words to undo the impression left at the end of the FOMC meeting ten days prior that the Fed was fixated on inflation. Don Kohn, as a veteran of Greenspan’s artful market communication, considered this more important and worked on the wording of the sentences with Brian Madigan, a tall, red-bearded career Fed economist who now was in the pivotal monetary-affairs staff job that Kohn had once held.

To those fluent in Fedspeak, the Friday-morning message of August 17 was clear: a cut in interest rates was now on the table for the first time in Bernanke’s tenure. “Downside risks to growth have increased appreciably” (Translation: It’s going to be worse than we anticipated), and the Fed “is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.” (Translation: We will cut rates unless markets turn around soon.)

Theater and substance wound around each other. At moments of panic, the financial system acts less like the automobile engine of the favorite metaphor and more like a collection of worried people, with emotions and trust that wax and wane. When people are concerned about money, they make choices — such as delaying purchases, hoarding cash, distrusting each other — that are completely rational acts of self-preservation but that worsen an already bad situation.

A successful central bank attacks on both fronts, and that’s what Bernanke had hoped to do. The substance: the Fed belatedly acknowledged that a weakening economy meant that it would cut the interest rate that mattered most, the federal funds rate. The theater: the Fed was shouting that it was eager to lend to cash-short banks through the discount window. But banks were reluctant to borrow from the discount window because doing so, if word leaked, could be seen as a sign of their own financial weakness. If a bank suddenly stopped bidding for short-term funds in the open market, others would guess that it had gone to the Fed. The Fed hoped to dispel that stigma.

Geithner and Kohn convened an unusual conference call with bankers and urged the strong and weak alike to borrow from the discount window. The first to do so — the American arm of Germany’s biggest bank, Deutsche Bank — quietly let the press know, figuring other banks would be doing the same. But none of the others did initially, embarrassing Deutsche. So the Fed cajoled four big banks into borrowing $500 million each and saying so loudly.

The effort was a flop. “The thing about ‘lending freely and at a penalty rate’ only works when people want to borrow,” Kohn said, referring to Bagehot’s
prescription. Banks, it turned out, didn’t want to borrow sufficiently at the discount window to lubricate the system.

Bernanke, though, didn’t have time to ponder what Greenspan might have done, or even to mull over if there was something he and his lieutenants might have done differently. Events were moving too fast for that. He canceled plans to join his family on vacation in Charlotte, North Carolina, and Myrtle Beach, South Carolina. He no longer even had time to shoot baskets with the staff in the Fed gym, although he did occasionally don T-shirt and shorts to shoot baskets alone.

Until August 2007, the Fed was something like a firehouse in a town of brick houses: long stretches of boredom punctuated by the occasional one-alarm blaze. The pace was slow, the routine almost unvarying. That changed in August. Now the houses were frame, the weather bone dry, and the alarms were ringing incessantly. In response, the Four Musketeers began a series of daily early-morning and late-afternoon conference calls with key staffers to monitor markets and reassess strategy.

As they did every year, the biggest names in global central banking — Fed officials, their overseas counterparts, Wall Street’s Fed watchers, and a handful of journalists — gathered from August 25 to 27 at Grand Teton National Park in Jackson Hole, Wyoming, for golf, hiking, socializing, and sometimes ponderous, sometimes provocative, academic presentations sponsored by the Federal Reserve Bank of Kansas City, in whose turf the spectacular park is located.

Jim Wolfensohn, the former president of the World Bank, hosts a dinner Friday night at his house nearby. Friedman, the former Goldman CEO, hosts one Saturday night. Invitations to Jackson Hole are coveted by academics and Wall Street analysts, who prize the schmoozing with the Fed’s elite.

Bernanke and four other Fed governors were at Jackson Hole that late August 2007, as were all but one of the twelve Fed bank presidents. Greenspan hadn’t been since 2005, a session that had turned into an almost unrestrained celebration of his tenure. Now, two years later, the hangover from the
Greenspan years was giving his successors a massive and growing headache. The formal topic was timely and reinforced the pain: housing and housing finance.

This year, a revisionist account of the Greenspan years began to take hold inside the fraternity. John Taylor, the noted Stanford monetary expert, indicted Greenspan for having created the current housing crisis by keeping interest rates too low too long earlier in the decade. Taylor believed that government economic policy worked best when the people who made policies publicly described the rules that governed their decision making. He was famous among central bankers around the world for “the Taylor rule,” a simple formula for setting interest rates that depended on where inflation was versus the Fed’s goal for it, how far from full employment the economy was, and what the short-term interest rate should be when the economy was perking along. Taylor had been among George H. W. Bush’s economic advisers, and nearly made it to the Fed board then until internal political squabbles thwarted him. In 2005, he had been among the unsuccessful contenders to succeed Greenspan, for whom he had once worked when Greenspan was a private consultant. Taylor’s critique particularly stung Greenspan because of Taylor’s stature and because it gave legitimacy to other critics with lesser pedigrees.

He wasn’t Greenspan’s only critic at Jackson Hole. At lunch one day, in a speech that had to be read by a designated hitter because severe illness kept him from attending, former Fed governor Ned Gramlich underscored warnings he had made to Greenspan about the risks of refraining from regulation of the subprime mortgage market. Coming from a revered figure — and a dying one — and after the subprime debacle had been exposed, Gramlich’s implicit criticism of Greenspan also stung.

Fed officials had little time to reevaluate the past. They were preoccupied by the present and near future. From the podium at Jackson Hole, Rick Mishkin, the Fed governor, choosing his words with great care to avoid triggering
an unwelcome market reaction, explained what the Fed officials were worried about: “I generally do not place the housing and mortgage markets close to the epicenter of previous cases of financial stability,” he said. But “periods of rapid financial change … often lead to lending booms … [and] lending booms can sometimes outstrip the available information resources in the financial system, raising the odds of costly, unstable conditions in financial markets in the short run.” (Translation: Housing and mortgage booms don’t usually burst in ways that disrupt an entire economy, but they can.) It would prove a prescient warning.

In a small conference room on the second floor of Jackson Lake Lodge, the Four Musketeers met to figure out what to do next. Their initial response: the discount rate maneuver and the hint of lower interest rates to come hadn’t been sufficient. Banks were reluctant to lend to one another, but they were reluctant to borrow from the Fed, too. The new solution: auction Fed loans to banks, a more anonymous way of getting funds than applying at the discount window. They asked the staff to work on the technicalities. Although most of the officials didn’t realize it at the time, the notion was similar to one the Fed had considered during a deflation scare in 2002.

From the sidelines, Larry Summers sounded an even louder alarm. Writing in his regular column for the
Financial Times
, Summers suggested that the real threat to the economy might lie in financial institutions either beyond the Fed’s purview or resistant to its carrot-and-stick remedies. “The problem this time,” Summers wrote, “is not that banks lack capital or cannot fund themselves. It is that the solvency of a range of
non-banks
is in question, both because of concerns about their economic fundamentals and because of cascading liquidations as investors who lose confidence in them seek to redeem their money and move into safer, more liquid investments.” (Emphasis added.)

The commercial banks, it would turn out, weren’t nearly as well capitalized as Summers asserted. But the “non-banks” — Freddie Mac and Fannie Mae, big investment banks and brokerage firms, insurance companies — would prove major threats to financial stability in the months ahead and highly resistant to the Fed’s traditional cure of cutting interest rates.

T
he Federal Open Market Committee had a passing resemblance to high school. There were the cool guys, the jocks, and the geeks. Bernanke, Don Kohn, Tim Geithner, and Kevin Warsh fell into the first category, the cool ones. The jocks were regional Fed bank presidents determined to show their manhood by talking tough about inflation and economic rectitude: economists Jeffrey Lacker in Richmond and Charles Plosser in Philadelphia, investor-turned-policy-maker Richard Fisher in Dallas. The geeks included monetary policy scholars who shared Bernanke’s view of the world: Rick Mishkin in Washington, Janet Yellen in San Francisco, Eric Rosengren in Boston. And then there were the wannabes: among them Randy Kroszner, the book-smart University of Chicago professor who managed to rub much of the Fed staff the wrong way, and newcomers James Bullard of St. Louis and Dennis Lockhart of Atlanta.

The FOMC can be a fractious group, as even Alan Greenspan discovered. In 1988, the cacophony of competing views was so pronounced that the
Wall Street Journal
labeled the FOMC the “Open Mouth Committee.” As Greenspan accumulated clout, he fixed that. With occasional exceptions, renegade governors in Washington and district bank presidents were replaced by appointees with views closer to the mainstream and personalities more
inclined toward following the leader. By the late 1990s, Greenspan’s papal-size reputation for infallibility made insiders wary of challenging him. And then there was his masterful ability to silence internal critics when he grew weary of them. “You challenge Greenspan, and he tolerates it — at first,” one Fed bank president said. “If you keep going, it’s like a cartoon: a sixteen-ton weight drops on you from the ceiling, and it’s clear the conversation is over.”

BERNANKE’S DASHBOARD
September 18, 2007

Bernanke had neither Greenspan’s skill at cowing critics nor his desire to dominate the committee. He was “influenced by his own experience on the Board as a governor, by academic research that tended to show groups perform better than individuals, and by the foreign precedent of argumentative yet still successful monetary policy committees,” according to Vincent Reinhart, who was the top Fed monetary staffer until the summer of 2007. Bernanke admired the Bank of England, which consists of five insiders and four outsiders, some of whom sharply disagree in public with Bernanke’s counterpart and former MIT office mate Mervyn King, to no apparent harm.

All that won Bernanke high points for collegiality, but as the Great Panic unfolded through 2007, several things became clear: in a fast-breaking crisis that demands a prompt, decisive response, waiting for a committee to reach consensus can be a mistake. In such a crisis, the markets and the public prize clarity, and clarity will always be elusive when a Fed chairman allows everyone else to outshout him. Just as bad, waiting for a consensus to form didn’t
guarantee a positive outcome. No matter how much smarts they command or how expansive their powers, central bankers can and do badly misread their economies. Finding central bankers who can avoid making such mistakes is preferable, but finding central bankers who recognize their mistakes and then change course may be the best any country can expect.