In FED We Trust (22 page)

Although modest in light of what was waiting down the road, the TAF was still controversial inside the Fed. The notion had been cooked up in August when Fed officials brainstormed at Jackson Hole, and it was raised
with FOMC in September, where it came under hostile fire from Bill Poole of St. Louis and Jeff Lacker of Richmond. Before Bernanke convened the FOMC conference call to consider the TAF on December 6, Lacker circulated a memo to the entire committee arguing against it. He didn’t buy the underlying diagnosis. The market
was
working: banks were paying more to borrow because they were, for good reason, seeing greater risk of losing money in deals with other banks, he argued. Fed lending was unlikely to change that in the short term; in the long run, the TAF would lead markets to expect the Fed to jump in every time some new crisis loomed.

The concerns were noted and duly disregarded. Geithner — in the
only
public speech he made between August 2007 and March 2008 — described the TAF on December 13 to a conference of academics as a way to provide banks with “a more effective form of access to liquidity” that he hoped would reduce their appetite for hoarding cash or lending it to each other “in ways that might lead to a further deterioration on market conditions.” The Fed auctioned off the first $40 billion in December. A year later, it would be lending $450 billion through the auctions versus $90 billion through the traditional discount window. The TAF was widely seen as a success — despite a skeptical reading of the markets by Stanford economist John Taylor. Most Fed officials saw it as implementing Walter Bagehot’s nineteenth-century basics of central banking in a panic.

Geithner, in the same speech, hinted that providing liquidity might not be enough because that didn’t “directly address the balance sheet or capital constraints facing financial institutions” — in other words, the possibility that they might have much deeper problems than a temporary inability to borrow. But other than lauding those financial firms that had raised capital privately, he offered little guide to the Fed’s thinking about how to cope with the looming possibility that some banks might be insolvent, or have losses so great that their capital cushions had vanished.

Bernanke quickly discovered that the Fed couldn’t think only about lubricating American banks. European banks had a problem, too, and one that
their central banks couldn’t solve. In what Bernanke delicately described as “a novel aspect of the current situation,” European banks craved U.S. dollars — and couldn’t easily find them in malfunctioning markets.

For years, there had been hand-wringing and naysaying about the U.S. dollar losing its status in the global economy to other currencies. But the value of securities issued outside the United States denominated in U.S. dollars — as opposed to home currencies of the countries in which the borrowers were located — rose from $322.5 billion in 2005 to $753.3 billion in 2006. That 134 percent increase far surpassed the 25 percent increase in euro-denominated issues. During the credit boom that preceded the Great Panic, the U.S. dollar was gaining market share in global finance, not losing it. With one hand, British and continental European banks were lending dollars to corporate customers and buying U.S. mortgage-linked securities. With the other, they were borrowing dollars in money markets to balance their positions. U.S. banks do the same thing but have one huge advantage: they have billions in ordinary deposits in dollars, so they don’t have to borrow as much. European banks, especially those not large enough to have branches in New York or Chicago or Los Angeles, didn’t have that option. So they had to rely almost exclusively on borrowing in the very wholesale markets for dollars that were suddenly seizing up.

The European banks’ desperate scramble for dollars all over the world was obvious to men and women who constantly watch markets on the trading floor of the New York Fed, the one place where the Fed actually lays its hands on the market. It has the Bloomberg screens that are now ubiquitous and digital clocks that give the time in Tokyo, Frankfurt, London, and New York, but little of the unrelenting frenzy and buzz of moneymaking trading rooms. Its primary job is straightforward: to drip just enough money into the markets or drain just enough to keep the federal funds rate — the one that banks charge one another for overnight loans — close to the target set by the FOMC.

The European banks’ lust for dollars was making that job difficult. Global finance is nearly a round-the-clock operation these days, but time zones still matter. The traders of the New York Fed could see rising demand for dollars in the bank-to-bank market during daylight in Europe, pushing up the federal funds rate in the market. The demand then would abate when the sun
set in Europe — early afternoon in New York — and the federal funds rate would come down.

All this amounted to a classic liquidity shortage in Europe, the kind that “the lender of last resort” can usually solve, but this time the problem had a twist. The ECB could print euros, the Swiss National Bank could print Swiss francs, but their banks didn’t need those. They needed U.S. dollars. In ordinary times, the ECB would hand out euros and let the banks exchange them for dollars on global markets, but those markets weren’t working normally. It was an early manifestation of the global nature of the Great Panic: many of the loans and securities that proved to be poisonous were grown in the United States, but they were consumed by banks and investors all over the world whose appetites appeared to be insatiable.

The solution was for the Fed to give dollars to the ECB and take euros in exchange. Then the ECB could lend dollars to its own banks. That was easily done mechanically, but egos and national pride interfered. Key players at the Fed and at the ECB, for different reasons, were reluctant to make what seemed the obvious move.

Some at the Fed had objections in principle, others thought there were ways for the ECB to get dollars other than borrowing from the Fed. At the ECB, the plan ran up against a strong effort to pin the Great Panic on the United States. The Fed, as early as August, offered dollars in exchange for euros. But in an Alphonse-Gaston routine, the ECB replied, “It’s a dollar problem. It’s
your
problem.” The Fed’s position was that you have to ask for dollars if you need them.

By December, the dollar shortage was so acute that reluctance melted away. The swaps began, with the FOMC approving up to $20 billion for the ECB — with only half that immediately available — and $4 billion to the Swiss National Bank in December. The Fed got euros (and Swiss francs) in return, about as solid collateral as any available. The ECB and the SNB took the risk that banks might not be able to pay back the dollar loans. Over the next year, the Fed expanded both the list of countries to which it was offering to swap dollars and the size of the swaps. In October 2008, it decided to lift altogether the cap on swaps with the European, British, Swiss, and Japanese central banks and provide as many dollars as their banks wanted.

With this, the Fed became the lender of last resort — of dollars — to the entire world, and the world responded the way parched desert travelers do to an oasis. In the first week after the cap disappeared, the total sum of dollars the Fed had offered the foreign central banks doubled to $135 billion and grew by another $100 billion the week after that. By the end of December 2008, the Fed’s swaps amounted to $545 billion, about a quarter of all the credit it had put into the economy. One in every four dollars that the Fed was lending was going not to Bear Stearns or Bank of America but, through the ECB, to France’s BNP Paribas or Germany’s Commerzbank.

This didn’t get as much attention as the Fed’s aggressive lending in the United States. But it was a major — and innovative — way to fight the Great Panic. “Central banks have been in constant communication, which of course they also were in the 1930s,” observed Barry Eichengreen, a Berkeley economic historian. “But in contrast to the ‘30s, this time there has been a readiness to back words with deeds.”

By the end of December 2007 and the beginning of January 2008, Bernanke realized he had misread the economy. It was worse than he anticipated, and he began thinking he should deliver a speech that said so as a way to signal that the Fed would be cutting interest rates soon. He didn’t yet know that the U.S. economy had slid into recession in December. (That verdict would not be delivered until much later by the official arbiters of such things, a committee of academics at the nonprofit National Bureau of Economic Research on which Bernanke had served before going to the Fed.) But whatever was happening to the economy looked and smelled alarmingly like a recession.

Thinking about the speech and other matters, Bernanke talked to Greenspan and Paulson. Then on Thursday evening, January 3, he got the customary heads-up from the White House Council of Economic Advisers that the next morning’s Bureau of Labor Statistics monthly employment report would be bad: the unemployment rate had leaped from 4.7 percent to 5 percent, the
BLS said. The stock market responded to Friday’s announcement by giving up six months of gains in three days. Inside the Bush White House, discussions intensified among the president’s economic advisers about proposing a tax cut to provide emergency first aid to the economy before it got worse — and Bernanke encouraged them.

Around 5
P.M.
on Wednesday, January 9, Bernanke and the other Fed governors gathered in the Fed’s “special library.” They sat around three sides of a small table that had been used by the original Fed board back in 1914 and faced the camera so the Fed’s regional bank presidents could see them and they, in turn, could see the presidents’ faces. The next stage of Rick Mishkin’s “adverse feedback loop” had arrived: the weakening of the job market in an economy starved for credit. A further constriction of credit and a decline in house prices were all but certain to follow, which would make financial markets even worse.

BERNANKE’S DASHBOARD March 14, 2008

Clearly, the Fed was going to cut interest rates — a lot. The issue was when. Although some presidents anticipated Bernanke would press for an immediate rate cut, he didn’t. In part, he hoped to avoid any hint of panic by waiting until the FOMC meeting scheduled for the end of the month. Waiting two or three weeks to cut usually didn’t make much difference — at least in normal times. So Bernanke told his colleagues he was planning a speech the next day — evidence of the new, more alpha-male chairman. He planned to send
a clear signal, and indeed he did. Speaking before a lunchtime gathering in Washington, Bernanke came about as close to announcing an imminent rate cut as any Fed chairman ever has. The Fed, he said, already had cut rates from 5.25 percent to 4.25 percent because credit was scarce and housing was weak. But its forecast for the economy was growing grimmer, so “additional policy easing may well be necessary,” he said.

Bernanke wouldn’t need long to regret not pushing the FOMC to cut rates on January 9. His speech wasn’t the boost to confidence he had hoped it would be. Very soon afterward, the economy — and, particularly, the markets — got very much worse.

U.S. markets were closed on Monday, January 21, for Martin Luther King Jr. Day and so were Fed offices. But Bernanke was in his office — as he was nearly every day, weekends included — watching Asian and European stock markets plummet. Futures markets Monday were predicting a 4 percent plunge Tuesday in U.S. stocks. Facing what seemed to be yet another meltdown of the economy, Bernanke convened a videoconference call of the FOMC with little advance notice. He and Kohn could no longer deny that the Fed was seriously “behind the curve,” as they put it at the time, and they were determined to remedy that.

Basically, they told the videoconferees, the target for the federal funds rate was more than a percentage point too high for the Fed’s then-current forecast. Cutting interest rates that much in one move would have been seen as panic and desperation, but Bernanke and Kohn thought that a demonstration of the Fed’s “commitment to act decisively” to support the economy might make markets more sanguine and avoid another twist in the “adverse feedback loop.” Flexing his muscles as he had rarely done before, Bernanke won the FOMC’s backing for what — for the Fed — was a king-size rate cut: three-quarters of a percentage point, with a strong hint of more to come at the FOMC meeting scheduled for the following week. It was the first time
the Fed had cut rates in between regularly scheduled meetings since the aftermath of September 11, 2001.
Whatever it takes
.

One president dissented — St. Louis’s Bill Poole. It was his last hurrah as an official naysayer. Poole surrendered his vote at the next scheduled FOMC meeting and retired before St. Louis’s turn to vote came around again. Poole said he wanted to wait till the scheduled meeting to make the move, but he wasn’t the only reluctant member of the committee. A few warned that the Fed’s newfound aggressiveness at cutting rates would need to be matched by similar aggressiveness once the economy rebounded. The concern was reasonable, especially given the widespread regret that the Fed had held rates too low too long earlier in the decade, but it was also evidence that, if they worried about anything, Fed officials thought they might be doing too much.