Congress will soon consider whether Ben Bernanke merits another term as Chairman of the Federal Reserve. It is fair to say that no single individual played a larger role in responding to the recent financial crisis. The Fed has directly lent more than $2 trillion to financial and non-financial institutions in the last two years. It has guaranteed trillions more. It is also fair to say that few individuals and institutions played as large a role in the economy leading up to the crisis than Ben Bernanke and the Federal Reserve.
However, at the moment Congress lacks the independent and objective analysis needed to fully assess Bernanke’s performance and therefore to make an informed judgment as to whether he deserves re-appointment. For this reason, Congress should put off a vote on Bernanke’s nomination until there has been a full audit of the Fed’s actions preceding and during the crisis.
Before considering Bernanke’s role in containing the financial crisis, Congress should, via the Government Accountability Office (GAO), investigate the role of Fed policy in allowing the housing bubble to grow. This is not just an effort at playing the blame game; an objective assessment of this policy will also be helpful in avoiding future bubbles.
It is often noted that Mr. Bernanke’s research on the Great Depression makes him well prepared to run the Fed in this period of crisis. Unfortunately, Mr. Bernanke’s research apparently did not tell him the obvious: that allowing an $8 trillion housing bubble to grow unchecked would lead to an economic disaster like what we are now experiencing. He and his colleagues at the Federal Reserve Board either could not see, or did not care about, this huge bubble. As a result, Ben Bernanke has been running around for much of the last year and a half telling us about his knowledge of the Great Depression.
It is worth quickly explaining why a collapsed housing bubble leads to a recession, since the policy people responsible for this disaster have done so much to try to obscure the obvious. In the years prior to its collapse, the bubble was driving the economy. Bubble-inflated house prices created an unprecedented housing boom. Residential construction peaked at more than 6.0 percentage points of GDP in 2005.
The $8 trillion in bubble housing wealth led to a consumption boom also. This is the well known housing wealth effect that holds that one dollar of additional bubble wealth will cause annual consumption to increase by 5–7 cents. The implication was that an $8 trillion bubble would push annual consumption up by between $400 billion and $560 billion.
When the bubble collapsed, residential construction fell through the floor as builders suddenly realized that we had an enormous housing glut. The drop in annual construction was more than 3 percentage points of GDP, or more than $500 billion. At the same time, when the bubble driven housing wealth disappeared, we lost close to $500 billion in annual consumption.
Further losses in demand associated with the bursting of a bubble in non-residential real estate, added to the problem pushing the total drop in annual demand to more than $1 trillion. This was an entirely predictable outcome of the collapse of a housing bubble.
The simple reality is that there is nothing in the Fed’s bag of tricks that allows it to easily replace over $1 trillion in annual demand. In short, the bubble guaranteed the economic disaster that we are now experiencing: end of story.
Those who are opposed to a full audit of the Fed’s conduct often contend that this sort of audit counters an international consensus towards central banks that are independent of legislatures. While the extent of this consensus is questionable, it worth noting that Iceland was often held up as a model by those who shared in this consensus because of its independent central bank and its strong record on inflation targeting.
Examining the Fed’s decision-making during the crisis can also inform Congress, and the public, not only on the appropriateness of Bernanke’s actions, but also on the Fed’s framework for distinguishing between liquidity and solvency problems. The public has been given the impression that such institutions as Citibank and Bank of America are worth more as on-going concerns than if they were liquidated as insolvent banks. To better understand the nature of financial crises, GAO should analyze the Fed’s framework for evaluating market liquidity and bank insolvency.
Bernanke has argued that an audit of Federal Reserve activities would undermine the independence of the Fed and unhinge inflation expectations. Nothing could be further from the truth. Subjecting the Fed’s decision-making on monetary policy to objective and independent analysis could improve inflationary expectations by increasing the public’s understanding of the conduct of monetary policy.
Congress and the White House already have ample opportunity, both in regular hearings and in private meetings, to influence the Federal Reserve as to monetary policy. It would not be unfair to characterize Bernanke as an active member of both the Obama and the Bush Administrations. A GAO audit will, if anything, reduce political pressures by exposing such pressures to the light of day, as well as the influence of the financial industry on Fed policy.
As Bernanke can continue to serve indefinitely as Chairman after his term expires in January 2010, there is no urgency in his nomination. Congress has ample time to consider an audit of the Fed before weighing the merits of his confirmation.