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January 27, 2008
David Warsh, Proprietor


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Was There a Better Time for a Recession?

Certainly these are interesting times: “The Week that Shook the World” in the Financial Times’ skyline yesterday. Every day brings some new indictment of Federal Reserve Board Chairman Ben Bernanke’s conduct of monetary policy. The Economist reckoned that the Fed’s big cut last week “looked less like swift prudence than ill-judged panic.” Roger Lowenstein, in The New York Times Magazine, asserted recently that “despite having written extensively about how to prevent such episodes, Bernanke has thus far been unable to instill a sense of confidence.”

Anna Schwartz, Milton Friedman’s long-time collaborator (she is 92), told a British newspaperman that “the new group at the Fed is not equal to the problem that faces it.” George Soros, the currency trader, says that the current crisis, marking the end of a long period of when the US dollar as the world’s reserve currency was unchallenged, is the worst in sixty years. 

And Martin Feldstein, the Harvard professor who wanted the job that a couple of years ago Bernanke got, has twice publicly lobbied the chairman to slash rates, first in August, then in mid-November, each time without success. “Remember,” he told Business Week’s Maria Bartiromo in December, doing some jawboning of his own, “[Bernanke] is the chairman; he is not the entire central bank. And he has to bring along his colleagues, some of whom disagree with that [more deliberate] view.”

That’s strong language in a normally amicable club. 

For a slightly different vista, then, consider Ben Bernanke in historical perspective. How does the challenge facing him today stack up in comparison to those dealt with by his predecessors, Paul Volcker and Alan Greenspan?

Since Volcker was rushed into the job in 1979 to stem a panic in the bond market, Fed chairmen have enjoyed a certain freedom to do the right thing – that is, in terms of aiming for price stability. They don’t do this all by themselves, as Feldstein noted; they must persuade their fellow governors and the presidents of the twelve regional Federal Reserve banks in the course of a highly disciplined conversation. But they are the designated leaders, and as such have enormous power. 

In Volcker’s case, that meant running interest rates up to unprecedented heights, in order to stem an inflation that was threatening to get out of control. The 1980 presidential campaign was staged against the backdrop of a short, sharp recession as a result – and Jimmy Carter, the man who appointed him, lost the election. 

 

Another, longer and more brutal recession followed immediately on its heels – which Ronald Reagan chose to endure with relatively little complaint. The result was an eight-year expansion. Volcker retired in 1987 with an enduring reputation as a hero.

Greenspan began his tenure with a series of heroic judgments of his own, turning the dramatic stock market crash of October 1987 into another four years of smooth growth.  Then his decision to ease monetary policy only slightly in the autumn of 1990, as the US prepared to go to war with Iraq over its occupation of Kuwait probably caused a relatively short, shallow and fundamentally inevitable recession to take hold between July of 1990 and March of 1991. At that point, the ’80 expansion had gone on for ninety-two months. 

About the same time, New York Federal Reserve Bank president Gerald Corrigan threatened Citibank president John Reed with failure if he didn’t raise $5 billion in new capital forthwith. Reed promptly sold 14 percent of the bank to a Saudi prince (who agreed to be a passive investor) and eventually (with plenty of help from federal regulators) turned the bank around.

 

George H. W. Bush won the war in Iraq, and reappointed Greenspan to a second four-year term, but he vacillated in response to the eight-month 1990-91 recession. Squabbling among Bush’s aides – plus the third-party candidacy of H. Ross Perot — cost him the election.

Bill Clinton, who won, quickly accommodated himself to Greenspan’s conduct of monetary policy, beginning with a deficit-reduction package. Through many twists and turns, he followed Greenspan’s lead, and eventually was rewarded with a record-breaking ten-year expansion. 

George W. Bush, who began his term in 2001 with an eight-month recession, March through November, avoided his father’s earlier mistake. He responded to the recession and the 9/11 attacks with plenty of stimulus, winning large tax cuts from Congress, in 2001 and 2003.

 

But this time it was Greenspan who was forced to accommodate himself to the president’s policies, sanctioning tax cuts and keeping interest rate low for a very long time, being reappointed to a fourth term 2003 before retiring in June 2006.

Today’s subprime lending crisis is one result of monetary policy and bank regulation in those years. Lasting damage to Greenspan’s reputation as a central banker is another.  

Today, it is too early to judge whether the economy is already shrinking, much less how long and deep will be the recession – if there is one underway – and its attendant bear market. The fiscal stimulus package quickly negotiated in the House of Representatives last week seems unlikely to change the circumstances very much. The recession of ’90-91, which followed the savings and loan crisis of the late ’80s, didn’t end until market participants were relatively certain that the necessary write-downs had been taken. Neither will the subprime crisis until institutional investors are confident that there won’t be more bad news.

(It seems to be the case the French bank Société Générale, whose distress liquidation of a rogue trader’s positions precipitated the market panic in global markets Monday that preceded Fed’s emergency measures Tuesday, didn’t tell even the French government about its problems until Wednesday – never mind the European and American central banks. Even if the Fed’s dramatic easing was had more to do with the downward revision of its growth forecasts than the market decline, the display of suave qui peut only added to the thorniness of the problems that Bernanke must solve.) 

But already the lesson of the last quarter century is clear enough.  It is that the independence and dedication of the Fed chairman to maintaining price stability is important.  And that successful Fed chairmen should serve for a long time – long enough to outlast a single president. Nobody knows this better than Ben Bernanke, whose distinction is to have taken the job in the years just after economists consider they have made key breakthroughs in understanding how to conduct monetary policy. He is determined to showcase the new knowledge – to demonstrate that he can defuse the present crisis without kindling a new bout of inflation.

So put yourself in Bernanke’s shoes. Assume that recession was inevitable. When was the right time to take it? At seventy-two months, the current expansion is already longer than any of the thirty years before Volcker, except for the inflationary nine-year Vietnam boom. 

Meanwhile, the problems awaiting the next president are simply enormous, whoever it is who takes office in January 2009 – budget deficits, the war in Iraq, health care reform, climate change. Would it be doing the new administration a favor to push a recession ahead into its first couple of years as well?

So fast-forward to the spring of 2010, when the issue of Bernanke’s reappointment as chairman comes up.  Imagine that the worst storms of the new president’s first legislative session are over; that another expansion has begun; that inflation is low, the bond markets are happy and stocks are climbing again.  What are the chances he won’t be reappointed?

None of this is to minimize the drama of the past few months, or the uncertainty about what will happen next. There were breathtaking days in November when it seemed that credit flows among large lending institutions might suddenly freeze up, for fear of the unknown; and again last week, when the news was of troubled bond insurers and unexpected losses at Société Générale.

So far, though, the Fed has shown itself at least to be “nimble,” in Brandeis professor Stephen Cecchetti’s phrase, and perhaps far-sighted, depending on the course of further interest rates to come. It wouldn’t be the first time that the critics were wrong. As serious as the situation is today, the chorus of complaints about the Fed calls to mind an old maxim: the dogs bark, the caravan moves on. 

                                           xxxx

Speaking of Martin Feldstein, who intends to step down in June after thirty-one years at the helm of the National Bureau of Economic Research, the search committee that has been seeking his successor is said to have nearly completed its work. 

As expected (second item), the front-runners are thought to be N. Gregory Mankiw, 49, of Harvard University, and James M. Poterba, 49, of the Massachusetts Institute of Technology. Both are long-time affiliates of the NBER, which under Feldstein became the nation’s premier venue of applied economic research, with more than 1,000 professors of economics and business publishing under its aegis.

The more likely choice is textbook author Mankiw. Poterba remains devoted to research.

Correction:  Greg Mankiw reports that he has withdrawn his name from consideration.

EP regrets the error.

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