Foster Woods recommends

The professor versus the chairman

By R.A. from "The Economist"

IN THE early 2000s, economist Ben Bernanke was a fierce critic of the Bank of Japan's response to prolonged weakness and deflation in the Japanese economy, a dynamic Mr Bernanke attributed to the central bank's self-induced paralysis. As his work made clear, a central bank had plenty of effective tools available to fight insufficient demand and deflation, even when nominal interest rates fell to near zero, depriving central bankers of their policy weapon of first resort. Among the options: aggressive currency depreciation, targets for long-term interest rates, money-financed tax cuts (the "helicopter drop"), and higher inflation. Fast forward a decade, however, and Mr Bernanke, having made his way to the helm of the Federal Reserve, has distanced himself from all of these possibilities. By the Fed's own diagnosis, the American economy is suffering from a prolonged period of growth below potential, and accompanying disinflationary pressures. But its chairman rejects the use of the tools he once energetically supported. Instead, the Fed has adopted milder and less effective interventions, which featured nowhere in Mr Bernanke's earlier admonitions of the Bank of Japan. 

This puzzling about face left observers of the economy scratching their heads. What changed? Some speculate that Mr Bernanke was unwilling to take bold steps without the support of a large majority of the Federal Open Market Committee, and he has been constrained by its greater conservatism. Some argue that political threats have tied the Fed's hands. And others hint that the Fed has been successful enough fighting off deflation that it hasn't needed to use other tools; the economy is weak but inflation is near the 2% target, and the Fed is content to keep things that way.

In a fascinating new analysis of the chairman, economist Larry Ball suggests that none of these explanations really explain Mr Bernanke's behaviour. Majority concerns don't add up, as the chairman abandoned his old positions before he rose to the top job. The timing aspect also rejects the argument by political constraints. As Mr Ball documents, Mr Bernanke's conversion occurred over a very short period of time very early on in his career as a Fed governor. Almost as soon as he had joined the government, Mr Bernanke gave up on depreciation as a tool, perhaps bowing to the political reality that leaders at home and abroad would strongly oppose Fed efforts to weaken the dollar. And, as Mr Bernanke noted, depreciation wasn't a necessary tool, since the other arrows he'd mentioned remained in the quiver.

Those fell by the wayside, it seems, between May and July of 2003, seemingly due to a presentation at the June FOMC meeting. At that meeting, economist Vincent Reinhart presented a view of policy options at the zero lower bound. He largely rejected or ignored Mr Bernanke's previous ideas, suggesting instead that the Fed might use rate communication, variation in the relative supplies of different-duration Treasuries (Operation Twist), and QE—exactly what the Fed did to fight the Great Recession and subsequent weak recovery. Mr Bernanke seems to have been won over entirely by one committee session. Within months, his discussion of ZLB policy reflected Mr Reinhart's views. In 2004, Mr Bernanke signed on as Mr Reinhart's coauthor on a paper that boiled down to the ideas presented at that June meeting.

This Damascene moment is striking, and odd. Transcripts of the meeting don't indicate a forceful exchange of views between participants. Mr Bernanke seemingly leapt to the new view of ZLB policy without much of a debate at all, despite the fact that he had taken the job as a prominent, respected monetary economist with strong, well-known views on that very issue.

How to explain this? Mr Ball posits two possibilities. One is that the Greenspan-era FOMC was characterised by a groupthink that strongly discouraged members from rocking the boat or challenging views deemed appropriate by the staff (or, more typically, by Alan Greenspan). Having found himself in a collegial, insular, consensus-oriented environment dominated by a single personality, Mr Bernanke may have succumbed to the desire to keep things running smoothly. It was far from obvious at the time, of course, that a change of heart on the subject would have an enormous impact on the American economy when a devasting shock hit just a few years later. Alternatively, Mr Ball writes, Mr Bernanke's submissive pose in the June meeting may simply be characteristic of the shy, unassuming personality he is so often described as having.

I can think of at least one other potential explanation: ambition. Agreement with and then endorsement of ideas he'd previously rejected might well have seemed like a reasonable price to pay in order to improve his odds at the chairmanship. After all, no one—not President Bush or the non-economists in Congress—wants a chairman who speaks recklessly about tanking the dollar and dropping money out of helicopters.

We can't know the answer of course, which might well be something else entirely. But Mr Ball does point out that a different institutional structure at the Fed might have reduced the odds of the groupthink that seemingly constrained Fed policy at the worst possible time. He compares the FOMC to the Bank of England's Monetary Policy Committee, which features external members who are often vocal and critical of Bank policy, which frequently splits narrowly on policy votes, and which long ago embraced the post-meeting press conferences that now expose Mr Bernanke to occasionally blunt criticism. Perhaps it's not entirely coincidental that the Fed has been moving toward a steadily more aggressive posture since introducing its own press conferences last year.

I recommend a read of the paper. It clearly illustrates that expertise isn't enough. Institutions matter—and so do personalities.


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