The law of diminishing returns

As Ben Bernanke, the outgoing chairman of the Federal Reserve, must recognise, he is the victim of the law of diminishing returns. In the initial days of the 2008-09 financial crisis, he mobilised the Fed as the lender of last resort. This helped quell an intensifying financial panic and, arguably, averted a second Great Depression. Mr. Bernanke’s role has been much praised and deserves the nation’s gratitude. It is doubtful anyone else would have done better.

But Mr. Bernanke’s ambition transcended calamity prevention. He sought to kick-start the economy by keeping short-term interest rates low (effectively zero since late 2008) and by massive bond-buying (called “quantitative easing”). The strategy was to reduce long-term interest rates, strengthen a housing revival, boost stock prices and stimulate corporate investment in plants and equipment. Here, his success is scant. Since mid-2009, the economy has grown at an anaemic annual rate of 2.4 per cent. Payroll jobs are still 1.2 million below their 2007 peak, and seven million Americans have left the labour force — some retired but perhaps half, by some estimates, quit out of discouragement of finding work.

What we ought to have learned is that the Fed lacks the sort of economic control that was, after Alan Greenspan’s run as chairman (1987-2006), taken for granted. The Fed was then cast as nearly omnipotent. By slight shifts in short-term interest rates, it could sustain economic expansions and cushion recessions. Or so it seemed. Some Bernanke critics say he should have done more. What exactly? Since 2008, the Fed has purchased roughly $3 trillion in Treasury and mortgage bonds. Would $5 trillion have saved the world?

As it was, interest rates fell below two per cent on 10-year Treasury bonds and below four per cent on 30-year mortgages. The stock market recovered, nearly tripling since its March 2009 low. But the connections between these financial events and the “real” economy of spending, production and jobs have proved frustratingly weak. Higher stock prices should cause consumer-investors to spend more, but memories of the Great Recession may limit this “wealth effect.” Mortgage lending has suffered from tougher lending standards, imposed in part by stricter government regulation. Meanwhile, in a 2012 survey of 517 chief financial officers, 68 per cent said that lower interest rates wouldn’t increase their plant and equipment spending. Some CFOs said they financed investment from internal funds, not borrowing; others said investment was tied more to demand than to interest rates.

Public psychology

So Mr. Bernanke’s weapons were less powerful than assumed or hoped. What subverted their effectiveness was shifting public psychology. The financial crisis and Great Recession changed the way that consumers, bankers, business managers and regulators thought and behaved. Before, a general belief in the economy’s resilience encouraged spending, borrowing and lending. People unconsciously assumed basic economic stability. After, there was a residue of fear and caution. Gone was the faith in automatic stability. The first mindset aided the Greenspan Fed. The second weakened the Bernanke Fed.

This explains why his massive exertions to improve the recovery have so far yielded paltry returns. Monetary policy (the influencing of interest rates, credit conditions and the money supply) is powerful, but it is not some potion that, taken in the right doses, can magically calm the business cycle and mechanically restore full employment. We are hostage to economic, psychological and geopolitical forces that cannot be completely or easily manipulated.

It is premature to judge Mr. Bernanke’s legacy. His policies will have ongoing consequences that, for good or ill, will shape his ultimate reputation. He was hindered in part by the high expectations set in the Greenspan years. As the economy weakened, so did public trust. In 2007, half of Americans expressed confidence in the Fed; by 2012, only 39 per cent did. Mr. Bernanke struggled to make the unpopular case — which is correct — that the Fed’s efforts to prop up the banking and financial systems (aka “Wall Street”) protected average Americans (aka “Main Street”) from greater harm.

The fate of Mr. Bernanke’s easy-money policies is also uncertain. Through the bond-buying and “forward guidance” — a loose commitment to keep short-term interest rates near zero until the job market strengthens convincingly — he has tried to instil confidence. Perhaps the lagged effects of these policies will soon boost growth. He has also argued that these policies can be withdrawn without disruption. As an academic exercise, this seems true. The real question is what happens if there are further surprises, from unanticipated inflation to an international financial crisis. The Fed and others have repeatedly erred in their economic forecasts.

Still, Mr. Bernanke’s record suggests a tentative verdict. Facing turmoil and danger, he helped stabilise the economy and reassure the public. His hallmarks have been competence, candour, decency and dignity. He was the right man at a fateful juncture. — © 2014. Washington Post.

Monetary policy is powerful, but it is not some potion that, taken in the right doses, can magically calm the business cycle