Firefighter arson is a serious problem.  The U.S. Fire Administration, part of Homeland Security, concluded in 2003, “A very small percentage of otherwise trustworthy firefighters cause the very flames they are dispatched to put out” (p.1). Illustrative and shocking anecdotes are on pp. 9-15 of that report, as well as here and here.

Macroeconomic policy making now has a similar issue to confront.

As the economy begins to stabilize and the financial system shows signs of recovery, accolades start to shower down on various officials, including most recently Ben Bernanke, who was rewarded this week with renomination – and almost certain confirmation – to a second term as chairman of the Federal Reserve Board of Governors.

Bernanke is widely seen as our financial firefighter in chief (BusinessWeek; USA Today)  Similar terms are used to describe Treasury Secretary Tim Geithner and the entire gigantic financial rescue effort.  Larry Summers, head of the White House National Economic Council and administration economic guru-at-large, is applauded as an “experienced crisis manager”, which amounts to the same thing in this context.

If any of this sounds familiar, you’re probably remembering the famous cover of Time magazine from November 1999, which depicted Alan Greenspan, Robert Rubin, and Summers as “The Committee To Save The World.”  The idea then was that crises in Asia, Latin America, and Russia had spilled over to US financial markets, most notably in the near failure of Long Term Capital Management, but disaster had been averted by – essentially – the financial firefighting abilities of this troika.

But what if the financial crises in recent decades – you can add the dotcom bubble, the S&Ls fiasco, and various emerging market debt crises to our recent housing and banking disaster – is not a sequence of random unfortunate events, but rather the product of a dangerous financial system?  Given that today’s firefighters also previously held responsibility for overseeing this system, both recently and as long ago as the early 1990s, this question is relevant – particularly as the very same team, in various combinations, repeatedly pronounced on the system’s fundamental soundness. 

Some of today’s firefighters pushed hard for deregulation of derivatives markets in the 1990s, and this now proves to have been an important cause of the crisis (Summers and others).  Others had responsibility for the solvency of Wall Street over the past half decade, yet disguised all potential warnings in layers of impenetrable opaqueness (e.g., Geithner; see p.91 in David Wessel’s bestselling In Fed We Trust, Crown Business, 2009).  Still others pronounced that there was no housing bubble exactly as things spiraled out of control and the potential costs to taxpayers rose (Bernanke and his colleagues at the Fed; again, pick up Wessel’s book, p.93 is among the most damaging).

No one is suggesting that our illustrious financial firefighters deliberately triggered a crisis.  But, for over two decades, they and their close mentors oversaw the operation and development of a banking and securities system with profound instability hard wired into its DNA.  Don’t take my word for it; review this speech by Summers in April 2009, or – in the light of what we know now – look at his talk on crises to the American Economic Association in 2000.

Perhaps that was all a legitimate mistake on their parts and they have now learned the right lessons.  But how then do you explain their amazing reluctance to reform the financial system today?

President Obama said on Tuesday that Ben Bernanke helped avert a second Great Depression.  That is a considerable achievement, but why then are this administration and the Federal Reserve proposing only minor adjustments in oversight and governance for the financial system that ran amok – producing “financial innovation” that harms consumers and destabilizes everything?

It makes no sense at all.  Unless, of course, they are not afraid of future financial fires – despite the enormous fiscal cost (likely 40% of GDP from this round alone), the unemployment (heading to and lingering at 10%, by the administration’s own revised estimates), and the millions of people hammered hard by lender abuse, house price collapse, and job losses.

You may not like the implications, but keep in mind this advice: “To ignore the problem or suggest that it does not exist will only increase the damage caused by the arson firefighters involved, as well as destroy the morale of the other firefighters in their departments” (Minnesota Fire Chief, March/April 1995 issue, quoted on p.1 of above cited report).

By Simon Johnson

A slightly edited version of this post originally appeared on NYT.com’s Economix, and from that version you can link directly to the referenced pages in David Wessel’s book. 

This post is reproduced here with permission.  If you would like to use the entire post, please contact the New York Times.  The usual fair use rules apply to short quotations.

The Washington Post is hosting an on-line chat about Ben Bernanke and his likely reappointment as chairman of the Federal Reserve Board of Governors (today, 1pm eastern: use this link to chat).  News story on President Obama’s announcement of Bernanke’s renomination this morning, with video of press conference, is here.

You can submit questions in advance or live during the chat, which will probably run until about 2pm.

By Simon Johnson

Update: here’s the transcript of the chat; a lot of very good questions.

Ben Bernanke will be nominated for a second term as chairman of the Federal Reserve.  But which Bernanke are we getting?  There are at least three.

1. The Bernanke who led the charge to rescue the US (and world’s) financial system after the Lehman-AIG collapse.  If you accept that the choice from late September was “Collapse or Rescue,” this Bernanke did a great job.
2. The Bernanke who argued for keeping interest rates low as the housing bubble developed.  This Bernanke was part of the Greenspan Illusion – the Fed should ignore bubbles and “just clean up afterwards.”  Is that still Bernanke’s view?  Surely, he has learned from that experience.
3. Then there is Bernanke-the-reformer.  Given #1 and #2 above, shouldn’t he be pushing hard for tough re-regulation of the financial system – particularly those dodgy parts where markets meet banking?  But is there any sign of such an agenda, even with regard to recently trampled consumers – let alone “too big to fail” financial institutions?

Most likely, we’re in for another bubble.

The Fed will keep interest rates low for the foreseeable future.  This will make sense given continued high rates of unemployment in the US economy.  But unemployment indicates average economic outcomes – high unemployment is completely consistent with some parts of the financial sector expanding at record rates: this is part of the two-track story.

The big banks have access to large amounts of Fed-provided funding at very low rates.  We’ll see this reflected in speculative market activities (think oil).

We’ll also see this in global capital flows (i.e., gross flows, perhaps also net flows – but the new global imbalances may not be so obvious in the pattern of current account surpluses/deficits around the world).  The US is increasingly a cheap funding environment, if you are a big player (definition: anyone regarded as an important client by Goldman).  Rates now begin to rise in emerging markets, as their economies turn around.  The Asia story will be compelling fundamentals and a great carry trade (borrow cheaply in dollars, lend at higher rates in Asian currencies) - and the exchange rate risk is for appreciation against the dollar.

Everyone involved knows this is unsustainable, but also that it can last for a while – and they can get out before everyone else.  Or, alternatively, that – as major financial players – they can’t afford to sit on the sidelines (talk to Chuck Prince: what has changed, in ideology, policies, and people at the top since his day?).

Presumably, commodity prices also get dragged up – or perhaps they jump up in anticipation of the Coming Asian Boom?  Now this might lead Asian central banks to tighten, but probably not if these economies can continue to keep wage costs under control.  And it might lead the Fed to tighten, but probably not as the mantra of focusing on “core inflation” (without food and energy prices) remains intact – however anachronistic it may seem to the rest of us.  It’s hard to see Bernanke #2 doing anything different, except perhaps at inconsequential margins. 

So then we really bubble – and perhaps we even mistake it for a boom.

When the Big Crash comes, there’ll be another moment of decision: “Collapse or Rescue.”  And we know what Bernanke #1 will do.  Which is, of course, why this administration is reappointing him – and not seriously reregulating big finance.

By Simon Johnson

In November 2002, Ben Bernanke apologized – for the Fed’s role in causing the Great Depression of the 1930s.  “I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again” (conclusion of this speech).

Bernanke’s point, of course, is that the Fed tightened monetary policy inappropriately – and allowed banks to fail – in 1929-33.  And much has been made of his strong focus, over the past year, on avoiding a repeat of those or closely related mistakes (including here).

But today we need a different kind of apology, or at least a statement of responsibility, from Ben Bernanke and the Fed.

From the Federal Open Market Committee meeting transcript of August 2003, we know that Bernanke said, “Despite the good news, I think it’s premature to conclude that we should not consider further rate cuts, if not at this meeting then at some time in the near future depending on how the data play out” (p.63).

He was concerned not just to keep interest rates low for a prolonged period but also to signal this to financial markets, “To the extent that we can sharpen our message that economic growth no longer implies an immediate and automatic policy tightening, we should make every effort to do so” (p.65; see also his role in the broader discussion around p.93).

This was, of course, at a time that the speculative fever and outright malpractice in the housing market was really taking off.  The build-up of financial market risk was starting to head towards system-threatening dimensions.  And many consumers were being set up for a trampling of epic proportions.  It is striking there is barely a mention of these issues in the FOMC transcripts.

And that’s the issue.  We can argue for a long time about whether the Fed should have tightened earlier.  Defenders of the Fed will say the data were ambiguous – and will point to the serious discussion of these issues in the FOMC transcript.

We can also dispute whether or not the Fed should have said anything in public about the impending housing-financial-consumer-taxpayer doom, or tried to tighten regulation.  “It’s not our job” or “we don’t have the powers,” or “the politicians wouldn’t have supported us” is what senior Fed people now whisper around Washington.

But this and other FOMC transcripts make it clear that the senior Fed decision makers were not even thinking about the first order financial sector issues.  They weren’t aware of what the big investment banks were really doing – show me the intelligence reports before the FOMC or the analytical discussion that indicated any degree of worry.  No doubt someone somewhere in the Federal Reserve system was thinking critically about finance – feel free to send me any relevant details - but from the point of view of evaluating the institution, it only counts if the top decision-making body at least has the issues on the table.

We have transcripts so far through the end of 2003.  Others should be forthcoming soon; there is supposed to be only a 5 year lag in their publication.  But, given their likely content, it would not be a surprise if the appearance of these transcripts slows down. 

At this moment of potential regulatory reform, who within the Fed really wants us to know that their leadership in the Greenspan era completely framed the problem wrong, didn’t understand what was happening, and repeatedly, brazenly, and callously ignored the damage being done to consumers?

I fully understand that financial market considerations are not the established focus of central bank interest rate deliberations.  But the scope and nature of such deliberations has changed a great deal since the founding of the Fed almost 100 years ago.  As the economy changes, central banks have to adapt their conceptual frameworks and our broader regulatory frameworks need to change also.  We’ve done this many times before, and we need to do it again.

Huge problems were missed by people using anachronistic conceptual frameworks.  Those frameworks should change.  This was the assessment of Ben Bernanke, building on Friedman and Schwartz, for 1929-33, and this should be our assessment today.

Our top monetary policy makers completely missed the true nature of the Great Bubble and its consequences, until it was far too late.  They should apologize for that and we can start work on redesigning the institution, its decision-making, and how financial markets operate, to make sure it won’t happen again.  And it would also be nice if the Fed could avoid adding insult to injury – and stop opposing the administration’s consumer protection proposals.

Hopefully, this time the Fed’s apology won’t take 70 years.

By Simon Johnson

Ben Bernanke is opposed to the creation of a new Consumer Financial Protection Agency.  Disregarding his organization’s disappointing track record in this regard, he claims that the Fed can handle this issue perfectly well going forward.

He thus adds his voice to the cacophony of financial sector lobbyists favoring the status quo.

At the same time, Bernanke and the lobbyists talk about the importance of consumer confidence for the recovery.  But how can you expect anyone to have confidence enough to spend and borrow when so many people have been so badly treated by the financial sector in recent years?

What happens when there is a scare regarding food contamination in the US or globally?  People buy less of that kind of food until the government assures them that (1) we know understand the cause of the problem, and (2) it will not happen again.

Word has got around that many financial products are not safe – as well as the idea that the debt levels encouraged by the finance industry are not always healthy.  Consumers are going to be more careful and, if there is no way to reassure them fully, they may be excessively careful.

In addition, we have learned that allowing financial firms to abuse consumers is very bad for our overall financial system health – leading directly to the current crisis, loss of jobs, and still rising unemployment; all of this further undermines confidence of all kinds.  If the financial system can turn nasty or even nastier, we should all carry more “precautionary” savings.

There’s no question that some financial firms would like to return to abusive practices, figuring they can once again make money and then move on.  Yet serious financial sector firms would prefer to clean up their acts and work with properly informed customers.  These firms are making a bad mistake in opposing the CFPA.

If the CFPA does not make it through Congress – and right now it seems a toss-up – this will just feed the backlash against finance more generally, e.g., in the 2010 midterm elections and beyond.  There is no way that is good for overall confidence.  It just doesn’t make sense for well-run financial firms to go down this road.

Industry thought leaders,  the American Bankers’ Association, the Financial Services Roundtable, and other interest groups should switch their positions and support the CFPA – if they really want consumer confidence in financial products and more generally to return.

The Fed, it seems, just wants to defend its turf.  This is unfortunate, particularly given its ambition to become even more responsible for the safety and soundness of the entire financial system.  How can our financial system ever be sound when so many elements prey on so many consumers’ confidence?

By Simon Johnson

(The material after the break is an excerpt from my Economix column on NYT.com this morning. )

There has been a lot of talk recently about Ben Bernanke, he of the Wall Street Journal op-ed and the multiple Congressional appearances. (Hey, can anyone put me in touch with his agent?*) At the risk of seeming ignorant (or revealing myself to be ignorant), I must say I don’t really understand what the fuss is about.

The question seems to be whether the Fed will be able to tighten monetary policy fast enough when necessary to dampen the potential inflationary effect of its current expansive monetary policy (Fed funds rate at zero, buying long-term securities, etc.). My read on the situation is as follows:

1. Almost everyone agrees that expansive monetary policy has been appropriate during the crisis and recession to date.
2. Everyone agrees that at some point monetary policy will have to be tightened.
3. No one knows when that will happen.
4. Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.
5. Everyone agrees more or less on what tools will be available to the Fed.
6. No one is certain the Fed will or will not be successful, because there are no relevant datapoints to compare it to.
7. No matter what Bernanke actually thought, he would still have to say exactly what he is saying this week.

I don’t see much in there worth arguing about.

As Catherine Rampell says, a more interesting question is when the Fed will start tightening policy. This is the kind of thing that can set the Fed against the administration, as stereotypically one focuses on inflation and the other on unemployment. But since most people think it is too early to start now, that debate would be purely speculative at the moment.

* He does need a grammar checker, though. His first sentence – “The depth and breadth of the global recession has required a highly accommodative monetary policy” – contains an error in subject-verb agreement.

By James Kwak

Ben Bernanke gave a good speech yesterday, warning about the dangers associated with not putting the federal budget immediately on a path to credible fiscal consolidation.  But he didn’t push his points hard enough – see my column, joint with Peter Boone, on the NYT’s Economix this morning.

U.S fiscal policies helped break the recent panic by showing that the government will support aggregate spending, irrespective of what the private sector fears.  But once households and firms calm down, you need to demonstrate that the national debt is not on an explosive path.

Mr. Geithner’s speech in China this week, trying to make this claim, was not convincing.  Mr. Bernanke, politely but firmly, pointed this out yesterday.

We should also worry about the Fed, of course, because there is no indication that they are ready, willing or able to curtail their quantitative easing if the real economy definitely turns more positive.  David Wessel’s column in the WSJ today (page A2) has a sensible discussion.

By Simon Johnson

It may strike you as extraordinary that the G20 summit barely touched on what is, arguably, the key policy issue going forward – what will central banks do, including the detailed when and how of avoiding falling wages and prices (deflation).  Fiscal stimulus is already almost fully in play around the world, regulatory reform will at best be slow and not relevant to the recovery, and “we promise to avoid an irresponsible protectionist trade war” is nice but more about not making things worse rather than getting our economies going again.  Funding and leadership model change for the IMF can help prevent emerging markets from cratering, but in terms of impact on global growth or unemployment, it’s second order relative to the macro policies of the world’s largest countries.

The real issue is monetary policy, including interest rate cuts where there is still room for these - to me the biggest news of the week was actually that the European Central Bank cut rates by less than expected (its main interest rate stands at 1.25 percent).  This confirms the ECB still does not see deflation as a clear and present danger.  Look at all the downward pressures in the European economy, from East European collapses (and associated West European banking problems) to property market declines in the UK, Ireland and Spain (and what that means for banking) and export industry stress (and they have bankers too).  The ECB is taking an extraordinary and – to my mind – incorrect position.  If they truly wait until deflation is “fully in the data” (central bank jargon), it will be too late.

The dramatic trans-Atlantic, or at least eurozone-dollar, contrast is in terms of monetary policy, not fiscal stimulus or attitudes towards future regulation.  In our piece in the Washinton Post Outlook section on Sunday (already online), we provide an updated back story on how exactly the Fed and its chair got to the point of taking bold and unprecedented moves towards expansionary monetary and credit policy. 

In our view, the Fed’s current ”print the money” strategy (and, yes, I know the Fed doesn’t like this term or even “quantitative easing”) is make-or-break for turning the economic corner any time soon.  It’s incredibly risky in terms of potential inflation – more than the Fed would ever concede – but preferable to all the available alternatives.

The power of our big banks presents a profound economic and political problem.  Whatever happens – miraculous recovery or prolonged depression – this needs to be fixed.  But we also can’t wait around for attempts to break up the banks; the prospects for unemployment and poverty are too dire to tolerate delay.  First and foremost, we need to prevent global deflation and begin the difficult process of sustaining a recovery. 

Remember this.  If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus.  But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

There is only one person who can talk the ECB out of its current, ruinous policy: Ben Bernanke.

By Simon Johnson

Update (by James): This article has gotten a fair amount of commentary already.

• Mark Thoma says it depends on whether inflation expectations remain anchored (at 2%, where the Fed wants to peg them).
• Tim Duy says that we are making the mistake of confusing “credit easing” with “quantitative easing.” Duy points out (correctly) that Bernanke has repeatedly insisted that the Fed will mop up the excess money when necessary in order to dampen inflation; this means that the Fed is trying to keep inflation expectations where they are, despite the influx of money now. This could be Bernanke’s intention, but I think there’s still a question of whether the Fed will be able to follow through when necessary, and the resulting uncertainty could itself feed inflation expectations.

One thing I want to clarify, which Simon says above but is perhaps not clear in the article, is that we do not think that Bernanke is making a mistake. We think that despite the inflation risk, this is still the right strategy, because of the risk that the other tools used to restart the economy may not have sufficient oomph.

Here is Ben Bernanke’s problem.

1. The financial sector is busy setting up arrangements in which employees are guaranteed high levels of compensation if they stay on through the difficult days ahead.  These retention-type payments allow firms to survive in their existing form, pursue business-as-usual, and gamble for resurrection, i.e., make further risky investments.

2. But these same payment schemes, e.g., Goldman Sachs’ loans-for-employees deal, are a form of poison pill with regard to further bailouts – the Administration may want to help these firms down the road, but this kind of tunneling means Congress will put its foot down.  Do you think that President Obama’s $750bn for bailouts (scored as $250bn) will survive the budget process?  No New Bailout Money is a slogan reaching from here to the midterm congressional elections. 

3. And the financial system is in big trouble.  Unless the economy turns around, somewhat miraculously, we are in for a big slump.  Or even for a Great Depression – watch closely the words and body language in Bernanke’s interview on 60 Minutes. 

The big banks are essentially making themselves Too Politically Toxic To Rescue, and this has potentially bad macroeconomic consequences.  So what will Bernanke do?

As he sees the world, there is only one course of action remaining: print money and hope for a moderate degree of inflation.  The money part was, of course, the announcement yesterday from the Fed.

The inflation part is a leap of faith.  If inflation is driven by the so-called “output gap,” i.e., how far the US economy is below potential output, then prices will not increase much, the yield curve steepens moderately, and banks make out like bandits (it’s just an expression). 

But if the whole world is moving more into an emerging market-type situation then (a) inflation expectations become deanchored (central bank jargon for “really scary”), (b) potential output falls as we massively deleverage, and (b) people move increasingly into alternative assets – storable commodities spring to mind – and we get some serious inflation. 

If oil prices jump, then we have an even bigger inflation problem.  Oil is not storable, supposedly.  But if you can explain to me exactly why oil prices rose as they did during the first part of 2008, despite the slowing global economy, I might be greatly reassured that we are not heading immediately into a runaway inflation spiral.

By Simon Johnson

Stabilization programs in emerging markets often come down to this: the government needs to do something unpopular, e.g., reduce some subsidies, privatize an industry, or eliminate the crazy credit that goes to oligarchs – no one likes oligarchs, but their factories employ a lot of people.  There is naturally resistance - pushback from legislators, riots in the streets, or oligarchs calling their friends in the US foreign policy establishment.  The question becomes: does the government have the ”political will” to get the job done?

In fall 1997, a key issue for Indonesia’s IMF program was whether the government could close the banking operations belonging to one of President Suharto’s sons.  There was an epic and fascinating struggle and, in the end, the government did not have sufficient political will or power.  The subsequent loss of US support, and further currency and economic collapse is (messy and painful for many) history.

It is striking that Ben Bernanke now asks whether the United States today has sufficient political will.

How did we get to the point where the U.S., with a strong balance sheet relative to the size of problem banks, is regarded – by the markets and more broadly – as less likely to resolve the problems in its financial system than say the British (with big banks relative to a weak fiscal position) or the Germans (who talk all the time about how they are not going to bail anyone out)?

You can point the finger at Congress.  The parliamentary system in Britain and Germany means that the government can implement and innovate a bailout policy without worrying about being able to legislate enough financial support.  The Obama Administration has much to worry about in this regard.

The problem surely goes deeper – at least back to the bailouts of the fall.  Poor communication, particularly by Hank Paulson, undermined popular and congressional support.  And the lack of a consistent strategy exacerbated initially negative perceptions.

But the underlying issues are deeper still and laid bare by this week’s latest round with AIG.  We have moved far beyond financial policy and into the kind of scandal that really gets taxpayers’ backs up.  The greed of bankers slaps you in the face while the hubris of their leadership remains unchecked. 

There is no sense of responsibility, no feeling of shame, no acknowledgment of any kind of mistake: read Lloyd Blankfein’s FT article again – or print it out and tape it to your wall.  Because we now know, from the newly disclosed AIG counterparties list, that the wealth of Goldman Sachs insiders remains high solely because we saved their sorry bank, their failed risk management strategy, and their pretence of wisdom with our cash in mid-September.

This resentment against bankers pervades Congress, and even the Administration begins to get the message – being called “asinine” yesterday by Richard Kovacevich, the Chairman of Wells Fargo, may have helped underline to Treasury how deeply the bankers appreciate the help they have received.  There can be no resolution and no moving on until there has been a proper congressional investigation, with full subpoena powers, into exactly what did and did not happen around AIG.  This will take months and may well slow down the economy (Jamie Dimon’s clever point: if you vilify us, you will lose), but it is now inescapable.  And, if channeled productively, this kind of hearing may lead to a better regulatory system (and smaller big banks) than the current anemic proposals on the table - as last weekend indicated, the G20 process is currently worse than useless on this issue.

Ben Bernanke knows all this, at the same time as he sees our economy worsening and global storm clouds still gathering.  So where will he take us, starting with the Federal Open Market Committee meeting this week?  The British experiment with quantitative easing is pushing down the yield on long government debt.  It’s risky - inflation, once started, is not so easy to control.  And it may not work so well in the US (where the dollar tends to appreciate as the world becomes more scary) as in the UK (where they can successfully push for depreciation, particularly vis-a-vis the hidebound eurozone). 

Inflation breaks the political and social logjam around banking.  With some luck, it helps growth – at least in the short-term.  And of course the surviving bankers win big.

Ben Bernanke spoke at length today on Capitol Hill.  But did he say anything?

Over in The Guardian’s on-line comment page, James and I suggest an answer.  There was nothing new on the big macroeconomic issues of the age.  And on banking, we remain disappointed…