21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19
Ben S. Bernanke
W. W. Norton, $35.00 (cloth)
Few figures are better situated to write a book about the theoretical and practical challenges of monetary policy than Ben Bernanke. The former two-term chair of the Federal Reserve, who arguably almost single-handedly prevented the global financial crisis of 2007–09 from devolving into a second Great Depression, was a leading academic specialist on money and monetary history before providing nearly two decades of exemplary public service.
In addition to its considerable analytical and narrative strengths, 21st Century Monetary Policy contains a fascinating subtext—what might be called “the education of Ben Bernanke.” After spending a quarter century as a distinguished scholar, in 2002 Bernanke jumped from Princeton’s ivory tower to join the Board of Governors of the Federal Reserve—moving to Washington and never looking back. And within a few short years, Bernanke learned that the practice of monetary policy was far removed from its pristine classroom depiction.
Successful economists are not known for changing their minds, so the shift in Bernanke’s thinking on several key questions—about financial markets and about the relationship of politics and policy in particular—is unusual and important. In the real world, it turns out that the financial system is not a marvel of economic efficiency; rather, left to its own devices, finance is downright dangerous, and requires vigilant supervision. Even more profoundly, academic economists tend to imagine that their theories operate on a lofty plane of technocratic reason, rising above the narrow-minded politics that disfigures their impeccably tailored recommendations. But the ideal of apolitical and singularly correct economic stewardship is a myth. Monetary policy is impossibly slippery in practice, and inevitably involves much guesswork and judgment. Moreover, and crucially, every choice—even efforts to reduce the inflation rate—inevitably benefit some at the expense of others. Bernanke’s evolution on these issues is rare and commendable.
Still, other lessons from experience are stubbornly unlearned in 21st Century Monetary Policy. Bernanke is loyal to a fault to former friends and colleagues—most notably the disgraced Alan Greenspan. More strikingly, Bernanke seems unable to grasp fully the staggering injustices produced by the global financial crisis and its aftermath, or to appreciate the political consequences of those injustices. This inability may well come with the job, which is designed not for a politician but for a master of the complexities of monetary policy, despite the extraordinary political consequences of the work.
In a long introduction, 21st Century Monetary Policy offers a smart, concise historical and thematic overview of the history of U.S. central banking. Bernanke then explores the tumultuous (and now, again, freshly relevant) saga of the rise and fall of U.S. inflation in the last third of the twentieth century and follows with an overview of his eight years as Fed chair. The second half of the volume remains highly readable but leans more technocratic—Bernanke assesses the Fed regimes that followed in his footsteps, under the leadership of Janet Yellen and Jerome Powell (Bernanke gives each high marks), and concludes with some musings about the prospects, possibilities, and limitations of monetary policy.
The initial overture does an excellent and efficient job of reviewing the history of the Federal Reserve, raising the key analytical questions that monetary policymakers perennially face. These are among the book’s best and most vital passages—anyone with an interest in public affairs should read them with care. Bernanke’s tour of the history of the Fed begins with its founding during the Wilson administration in the wake of the financial panic of 1907. (Both the late establishment of an American Central Bank and its complex and relatively decentralized structure reflect an enduring heartland suspicion of the “eastern establishment” that can be traced to the earliest days of the Republic.)
In the twenties the Fed was essentially run out of the hip pocket of Benjamin Strong, president of the powerful Federal Reserve Bank of New York. His untimely death in 1928 likely contributed to the Fed’s dismal performance during the Great Depression, which managed to make a very bad situation much worse. Subsequently a vassal of the War effort in the 1940s, the modern Fed emerged with the Treasury-Fed accord of 1951, the result of a conflict with the Truman administration that was resolved by ceding greater independent authority to the Fed. For the following twenty years, William McChesney Martin, Jr., served as the Chairman of the Federal Reserve Board. Martin’s stewardship would be characterized by sobriety, caution, and (a culturally-common characteristic among bankers) a tendency to err on the side of suppressing inflation at the expense of economic growth—it was he who famously defined the role of the Fed “to take away the punch bowl just as the party gets going.” More importantly, Martin was a vigilant guardian of the Fed’s independence and a non-partisan steward devoted to what he perceived to be the general public good; he is easily recognizable as Bernanke’s role model, and (with Paul Volcker who served as Fed chair from 1979 to 1987) one of the heroes of this narrative.
The invaluable introduction to 21st Century Monetary Policy also articulates the book’s central (if at times implicit) thesis, which is that several “broad economic developments” have fundamentally changed the setting in which contemporary central bankers must practice their craft. Two of these developments are especially notable: a discontinuity in the behavior of inflation and its relationship with employment, and “the increased risk of financial instability.” Each of these acknowledgments reflects major changes to Bernanke’s own perspective (in a well-known 2002 toast honoring Milton Friedman, Bernanke defined the task of the central banker as keeping inflation low and otherwise staying out of the way).
Bernanke laudably explains how his thinking has evolved on various issues (“since then, the evidence has led me to shift my view,” “given what we know today . . . I was too timid”). Most notably, the erstwhile defender of monetary orthodoxy now finds it self-evident and of great practical significance that “inflation can be too low as well as too high.” Similarly, although the United States had previously enjoyed a long, unprecedented period of financial stability (left unstated is that this extended era coincided with the practice of strict regulation and oversight of the financial sector, one that was abandoned at the turn of this century), it is now clear that “severe financial instability is not an historical curiosity or something that can only happen in emerging markets. It can happen in, and do terrible damage to, the most advanced economies and the most sophisticated financial systems.” Thus, contra the minimalist mantra of 2002, ensuring financial stability must necessarily return to its originally intended position as a core mission of the Federal Reserve. Or, as Bernanke now holds (with my emphasis), “monetary policy, bank supervision, and responding to threats to financial stability are a pretty good description of the Fed’s main responsibilities.”
The saga of the rise and fall of U.S. inflation is an important and formative experience well retold here. That story begins in 1966, with President Johnson simultaneously fighting the war in Vietnam and the War on Poverty. Johnson was reluctant to raise taxes to pay for either in fear of losing political support for one or the other, and his largesse caused the economy to overheat. Faced with persistent inflationary pressures, the Nixon administration then dumped fuel on Johnson’s fire. Convinced that sluggish economic growth (and Martin’s cautious monetary policy at that time) had cost him the presidency in 1960, Nixon was determined to have an economy roaring full speed ahead as the 1972 election approached, regardless of any inflationary consequences.
Where was the Fed at these key junctures? Bernanke reviews how Martin crossed swords with LBJ, tightening in 1966 (briefly and abruptly slowing economic activity), and again in 1967, but he was outfoxed by Johnson’s promises and cajoling, and, despite misgivings, was ultimately not as aggressive as he might have been. Martin’s successor, Arthur Burns, was another story—essentially in the bag for Nixon (though Bernanke at first puts it more kindly, noting he “made only limited efforts to maintain policy independence and . . . enabled a decade of high and volatile inflation”). Bernanke proffers the gently revisionist, and not fully convincing, theory that although Burns was surely Nixon’s lackey, he might have made the same monetary mistakes in any event. But a summary dismissal from late in the volume acknowledges the plain truth: “The damaging effects of Burns Fed’s lack of independence from the Nixon administration were evident.”
As inflation (and, worse, inflationary expectations) galloped ahead, Jimmy Carter made the fateful and gutsy call to appoint Volcker as Fed chair. At enormous cost—and requiring a spine of steel necessary to withstand an avalanche of public criticism during the waning Carter years and overt political pressure from the Reagan administration’s power brokers—Volcker crushed U.S. inflation by slamming the brakes on the economy, contributing to the then-worst economic downturn since the Great Depression. Inflation was indeed racing disastrously ahead in 1979—and with the wind at its back. But that year, unemployment was at 6 percent and the economy grew at a 3 percent clip; by 1982 inflation was successfully contained, but unemployment touched a postwar high of 10.8 percent, and the economy contracted by almost 2 percent. In a chapter with the fitting title “Volcker’s Costly Triumph” (though economists still debate whether the full weight of those costs were necessary, and it is crucial to remember, as the data above illustrate, that those costs were not distributed evenly across society), Bernanke reviews this “landmark accomplishment.” He writes that, despite its “destructive side effects,” it “helped underpin several decades of strong and stable growth.”
21st Century Monetary Policy stumbles badly in its treatment of the 1990s, especially in its misguided (and almost invariably misleading) attempt to rehabilitate the justly shattered reputation of Alan Greenspan. Mistelling the story at almost every crucial turn, Bernanke assesses Greenspan’s legacy with a generosity that is hard to fathom. Greenspan was wrong on financial deregulation, obtuse on the Asian financial crisis of 1997, and a rank political opportunist who was catastrophically supercilious in his disregard for the toxic systemic risk that metastasized throughout the U.S. economy on his watch.
It is a glaring omission that the book fails to note that Volcker stood in direct contrast to Greenspan on all of these scores. As Fed chair Volcker fought hard to preserve the Glass-Steagall Act, the Depression-era law that built firewalls between different parts of the U.S. financial system. Greenspan championed its dismantling, encouraging the emergence of what would become known as institutions that were “Too Big To Fail.” This goes unmentioned in 21st Century Monetary Policy, save for one footnote that mentions the law that obliterated Glass-Steagall. Bernanke also glorifies Greenspan’s role in the Asian crisis. In fact, Greenspan was unable even to acknowledge the possibility of an international financial crisis. Instead, incorrectly and implausibly, he blamed the entire affair on domestic economic practices in the affected economies. His swing-and-miss takeaway: “One consequence of this Asian crisis is an increasing awareness in the region that market capitalism, as practiced in the West, especially in the United States, is the superior model.” Astonishingly, Greenspan’s suggested remedy for an international financial crisis was to urge even more financial deregulation. Not surprisingly, and working closely with the Clinton Treasury Department, Greenspan soon helped secure the passage of the Commodity Futures Modernization Act. Another watershed moment that passes unmentioned in 21st Century Monetary Policy, it guaranteed that exotic financial derivatives—including those that would crucially abet and accelerate the global financial crisis—would be shielded from government regulation.
Bernanke also looks the other way when Greenspan, “a Republican and a deficit hawk,” who was a “strong supporter of deficit reduction,” provided visible and vital public support for the enormous tax cuts proposed by George W. Bush. Most economists (including, initially, Greenspan himself) wisely favored using the sustained Clinton surpluses to pay down the national debt. Yet, as Bernanke reports, “despite his fiscal conservatism,” Greenspan changed his tune, testified in favor of the $1.6 trillion boondoggle, and was rewarded with an early announcement of his reappointment.
Greenspan’s greatest blunder, and one which at times Bernanke gently gestures at but routinely qualifies and ultimately elides, is his disdain for the notion that the financial sector needs any regulation or oversight, and his cavalier and ultimately catastrophic rejection of the concept of systemic risk. Unlike Volcker, the last thing Greenspan wanted to do was keep an eye on how the bankers were behaving (“why do we wish to inhibit the pollinating bees of Wall Street?” he asked). Fortunately for him (but not for us), as Fed chair he found that “being a regulator was not the burden I had feared.” The system was safe and sound, and best left to oversee itself. As Greenspan said in 2005, “increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago.”
Who knows better than this? Ben Bernanke. As he notes, “the preservation of financial stability is, of course, a core responsibility of central banks,” and “the traditional tools for limiting systemic risk are regulation” and the “supervision of financial institutions.” Thus, although Greenspan is generally and repeatedly given a free pass, Bernanke does bemoan the regulatory failures in the lead up to the financial crisis, and the flawed and passive disposition that was inattentive to the buildup of systemic risk. The U.S. financial system was riddled with behavior that was reckless, duplicitous, and of shallow integrity. But even short of that, unfettered finance is inherently vulnerable because even risk taking that makes sense individually can be collectively disastrous. As Bernanke explains plainly, “risk taking overshoots” because “borrowers, lenders, and investors lack incentives to take account of the possible effects on the overall stability of the system.” That’s what central banks are (supposed to be) on the lookout for.
Any discussion of Bernanke’s terms as Fed chair is necessarily dominated by the management of the financial crisis and its aftermath. This narrative has been covered by many leading authorities—including by Bernanke himself in his outstanding The Courage to Act: A Memoir of a Crisis and Its Aftermath (2015), and more breathlessly in Firefighting: The Financial Crisis and Its Lessons (2019), written with Timothy Geithner and Henry Paulson. The new book covers this ground concisely and effectively, and is improved further by the detached assessments and lucid self-criticisms afforded by the passage of time. If anything (and in contrast with Firefighting), Bernanke here understates the centrality of his crucial role in navigating the financial crisis. His expertise, creativity, and innovations executed under almost unimaginable weight-of-the-world pressure were so successful that as the economy limped forward for a decade (underperforming due to the politically motivated failure of Congress to act more decisively), it is too easy to forget the likely counterfactual: a much more severe global economic disruption, on the scale of the Great Depression. (Moreover, many of the innovations introduced then were road tested and ready to be deployed when a very different emergency surfaced: the severe economic contraction caused by the COVID-19 pandemic.)
Nevertheless, the expert treatment of the crisis reveals a second weak spot in 21st Century Monetary Policy—Bernanke’s continued tone-deafness to the fact that the necessary, often brilliant, emergency measures he introduced nevertheless embittered many in the country who understood that when the dust finally settled, the plutocratic plunderers whose greed and recklessness precipitated the catastrophe suffered few, if any, of its enormous economic costs. Bemoaning the government’s “perceived favoritism to Wall Street,” and lamenting that the bailouts “were seen as benefiting people who had helped create the crisis in the first place, at the same time that many ordinary people were left unshielded”—as if it were all about untutored, lay misperceptions—reveals a vast blind spot that has contributed considerably to our current public despair. (As Adam Tooze observed, “the presidential race of 2016 turned out to be more about the financial crisis of 2008 than 2012 had been.”) One can hold the view (as I do) that those bailouts were essential and nevertheless understand that favoritism toward Wall Street is deeply baked into America’s contemporary crony capitalism. It is impossible to improve on Martin Wolf’s characterization that in the wake of the crisis “well-connected insiders” were “shielded from loss” but imposed “massive costs on everybody else”—and it remains utterly baffling that Bernanke fails to understand this.
Still, there is much of value to be gleaned from the second half of the book, which considers the lessons Bernanke learned from his experiences, and their relevance for the future of Central Banking. Regarding the former, two evolutions of thought are notable. The first, not surprisingly, is his full conversion regarding financial stability from the reckless, gee-whiz libertarian Greenspan to Volcker’s sober, old-school emphasis on regulation and stability. “One reason that risk-taking, once ignited, can become excessive is that, in the real world, people are not the fully informed rational actors of economics textbooks,” Bernanke now emphasizes. Systemic risk is a concern that demands continuous attention—the Fed must be vigilant in guarding against it. Regulation and oversight are essential parts of that process, but “troubling gaps” and “significant shortcomings” remain in the U.S. regulatory system, as “reforms were incomplete” and “serious risks remain.” We are, Bernanke warns plainly, “far from where we need to be.”
A second lesson might seem counterintuitive, given the current disruptive domestic and global spike in inflation. However, a major revelation of this book is Bernanke’s conversion to the position that inflation can be too low. The surging price levels of the past year have been painful and consequential, but this does not alter the fact that for an economy, some modest, positive level of inflation is optimal; indeed, inflation which is very low (and policy measures that err on the side of keeping it too low) are harmful to the real economy—which is not the case for moderate levels of inflation. Although it impinges on tight family budgets and, politically, is wildly unpopular, as a technical matter the costs of moderate levels of inflation to real aggregate economic growth have never been shown, despite devoted efforts to find such costs. Inflation that is too low both defangs the most important tool of monetary policy (most recessions are mitigated by steep reductions in interest rates, which is not possible if they are already very low), and also risks deflation (falling prices), which we know for sure is bad and even dangerous for an economy. As Bernanke notes, not only can the inflation rate be “too low,” but since Volcker’s conquest of inflation, the Fed can be fairly criticized for placing “too much emphasis on inflation at the expense of employment.” (It should be acknowledged that in clinging to an arbitrary 2 percent inflation target, Bernanke—again with Volcker—ultimately remains committed to hard money.)
The current struggle with inflation is uneasily timed for the publication of 21st Century Monetary Policy, as Bernanke (with many others, including myself) did not anticipate the level and endurance of the recent surge in prices. But with time, crucial messages from this book will endure. One is that in this era of political polarization and paralysis (“partisan gridlock and delay,” is a recurring lament throughout the book) the Fed is routinely left as “the only game in town.” As a result, it is often asked to do too much, and to take on challenges that monetary policy is not ideally equipped to handle. There are some things that only fiscal policy (taxes and transfers) or microeconomic interventions (laws and regulations to facilitate disrupted economic activity) can achieve, but grinding political gridlock has hamstrung these vital tools.
Another key reminder here is that, although monetary policy is well served by insulation from the day-to-day vagaries of political opportunism, there is no escape from the politics of money, and every policy option involves difficult, even agonizing, choices. This is notably so with the contemporary inflation challenge, particularly as it is more the manifestation of supply-side problems—pandemic- and war-related disruptions and tightness in the labor market—than it is a monetary phenomenon. Crucially, this means that as the Fed raises interest rates, it will mute rising prices not by reining in monetary excesses, but by purposefully suppressing economic activity—reducing aggregate demand and cooling off the labor market (that is, encouraging unemployment).
This will come at a high cost to many. As Bernanke notes, “much evidence suggests that ‘hot’ labor markets disproportionately benefit minority and lower income groups, whereas extended recessions increase economic inequality by reducing employment opportunities for people in those communities, as well as for workers with fewer skills or less experience.” The fact that all monetary policy choices, even arguably wise ones, will inevitably benefit some at the expense of others was recently—if inadvertently—well expressed by Larry Summers. “We need five years of unemployment above 5 percent to contain inflation,” he insisted, “in other words, we need two years of 7.5 percent unemployment or five years of 6 percent unemployment or one year of 10 percent unemployment.” It is well within the capacity of the Federal Reserve to make that happen, but this is a sentiment most easily expressed by one who does not expect to be among those thrown out of work.
