February 7, 2014

Bernanke Policies at Fed Broke His Own Rules Of Central Banking

Thomas L. Hogan

Fellow in Public Finance, Baker Institute Center for Public Finance, Rice University

Linh Le

Summary

As Ben Bernanke's tenure at the Federal Reserve drew to a close, many wondered how history will remember this controversial chairman. Although he is widely respected as an academic, economists are divided regarding Bernanke's actions during the 2008 financial crisis.

As Ben Bernanke's tenure at the Federal Reserve drew to a close, many wondered how history will remember this controversial chairman. Although he is widely respected as an academic, economists are divided regarding Bernanke's actions during the 2008 financial crisis.

Some think the Fed did everything by the book, while others contend its bank bailouts were unprecedented, possibly bordering on illegal. Former Fed Chairman Paul Volcker, for example, said the Fed's actions "extend to the very edge of its lawful and implied powers, transcending certain long-embedded principles and practices."

Did Bernanke save us from another Great Depression, or did he sell out to Wall Street by bailing out the big banks?

One way to evaluate his performance is to ask what course of action most economists recommend in a crisis and see if Bernanke followed their advice. In fact, Bernanke himself has proposed exactly that. He claims to have followed the standard playbook for financial crises: the rules for a classical lender of last resort set forth by 19th-century economist Walter Bagehot.

Bagehot's rules are considered the most effective guidelines for central bankers in times of panic. In his famous book "Lombard Street," Bagehot proposed a course of action for the Bank of England in response to banking crises.

Bagehot was not an advocate of central banking, but given the role taken on by the Bank of England as a central banker, he believed that the bank should act as the lender of last resort in times of panic. Bagehot had four rules for a lender of last resort:

1. The central bank should lend freely to solvent banks. As long as they are backed by sound collateral, there should be no limit on the loan amounts.

2.The central bank should only provide last-resort loans at a high rate of interest. This penalty rate serves as a self-selection mechanism so only the banks that are truly in need of funds seek them.

3. The central bank should only lend to illiquid but fundamentally solvent institutions. During a crisis, the central banker is under pressure because many banks are short on liquidity. However, the central bank should only make loans that it expects to be repaid in the future.

4.The central bank should announce its policies before any crisis takes place. This creates an expectation that the central bank will help to stabilize the banking system in future financial crises.

It is clear that the Fed's bailouts deviated significantly from Bagehot's recommendations. The Fed did not charge a high penalty rate of interest on its loans to at-risk banks. To the contrary, the Fed lowered its lending rates during the crisis.

Nor did the Fed deal only in good securities. Rather, it freely accepted risky assets such as mortgage-backed securities in order to get these toxic assets off banks' balance sheets and replace them with safe, liquid assets.

Did the Fed announce its policy in advance? Hardly. It bailed out Bear Stearns, then let Lehman Brothers fail, and then bailed out everyone else.

Perhaps the most important deviation from Bagehot's rules is the Fed's bailout of insolvent financial institutions.

The Fed made three rounds of "emergency" loans to American International Group before taking over almost 80% of the firm's equity. Citigroup received its third bailout just before the firm went bankrupt, after its stock price fell from 57 before the crisis to less than 1 in 2009. After coercing Bank of America to buy a failing Merrill Lynch, the Fed had to write guarantees on Merrill's assets in order to keep BofA afloat.

If you believe Bernanke, this was all just part of the master plan.

Were the Fed's methods successful? It depends on the exact definition of success. Judging by the yardstick of averting another Great Depression, the Fed's actions were clearly successful. However, by Bernanke's own metric of comparing the Fed's actions to Bagehot's rules, they surely were not. Bernanke failed by the standard he himself selected.

Perhaps Bernanke will be remembered as neither a sellout nor a savior — but merely as a politician, saying one thing and doing another. And as any politician would say, he had only our best interests at heart.