Governor Olli Rehn
Bank of Finland
Book review: Kansantaloudellinen aikakauskirjassa 118. vsk. – 4/2022
Ben S. Bernanke, 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19. W.W. Norton 2022, 512 pages.
19.12.2022
Nobelist Ben Bernanke reviews the evolution of monetary policy – and the legacy of his own work
It has been said of Sir Winston Churchill that he fought the Second World War twice over: first as British Prime Minister and war leader, later as the leading historian on the war. By doing so, i.e. “both fighting and writing the Second World War”,[1] Churchill tried to ensure that his own interpretation would prevail in the judgments of posterity. For his efforts, Churchill was awarded the Nobel Prize in 1953, not the Peace Prize he was evidently seeking, but the Nobel Prize in Literature – an obvious second-best for Churchill, even though many non-fiction writer would certainly have been happy to receive it.
The work of Ben Bernanke, the recent winner of the Nobel Prize in Economics, in the book he has now published, 21st Century Monetary Policy, has much of the same spirit as Churchill, consciously or unconsciously. Making monetary policy in the crisis years – and writing the history of it with his own hand.
Bernanke received his Nobel primarily for his research on banking crises and financial stability, which has had enormous practical significance for the development of crisis management and prevention. In his new book, he writes a recent history of monetary policy for the period that he himself shaped as Chair of the Federal Reserve, the single most important decision-maker of monetary policy. This is not a drawback, rather an advantage: Bernanke provides in an essential way, for example, analytical background to the decisions of the 2007–2009 financial crisis, which makes the book compulsory reading for every monetary policy maker and researcher.
Of course, the book represents the mainstream, although at many points Bernanke is also self-critical of the Fed’s decisions and, to some extent, of his own communication. For example, during the taper tantrum of 2013, he writes that he misjudged investors’ reaction to the Fed’s decision to put the brakes on quantitative easing, which created considerable turbulence in Treasury bond and other financial markets. At the same time, it also caused a significant outflow of capital from emerging economies, which even shook the recovery of the world economy. Governor of the Reserve Bank of India Raghuram Rajan, a former Chief Economist of the IMF, became, according to Bernanke, “a regular and elegant critic of (especially US) monetary policy, who criticised the insufficient attention given to the financial side-effects experienced by emerging economies”. I vividly remember how, at the meetings of the G7 group of finance ministers and central bank governors in Washington DC and Brussels in 2013–14, Bernanke justified to his colleagues the Fed’s decisions to shrink its balance sheet to ensure price stability under its own domestic mandate, which he did with his cool, analytical style.
Evolutionary roots in the Great Inflation of the 1970s
The most valuable contribution of the book is a description of the evolution of monetary policy over the last half century, both drawn with a broad brush and, on the other hand, examined in its main points with a clinical magnifying glass.
The name of the book is misleading insofar as it also deals extensively with the monetary policy of the 20th century, from the roots of the Great Inflation in the 1960s. The current millennium is not reached until page 83. This, in my view, is correct, because although there is much that is familiar in the text, it is difficult to understand the monetary policy of this millennium without the events of the 1970s and 1980s – first, the triggering of inflation during the terms of President Richard Nixon and Fed Chair Arthur Burns, then the determined, even brutal, taming of inflation by President Jimmy Carter's appointee Fed Chair Paul Volcker in the early 1980s, at the cost of a severe recession. Burns and Nixon do not receive much sympathy, Volcker more so. Volcker was not so much a theoretician taken by the finer points of monetary policy, but a pragmatist focused on one thing, i.e. taming inflation, for whom monetary policy was at least as much art as science.
Bernanke’s verdict on the high inflation period of the 1970s is severe:
“Where was the Federal Reserve? Why did the Fed let inflation get out of control, and, once that happened, why didn’t it do more to stop the inflationary cycle? The short answer is that a brew of raw politics and flawed views of the inflation process prompted Fed leaders to hold back at crucial moments, avoiding the painful steps that would have brought inflation under control.”
As we now know, through the experiences of inflation in the 1970s as well as the taming of inflation in the 1980s and the subsequent rapid economic growth, the independence of central banks became the cornerstone of modern monetary policy. In Europe, it is anchored in the Treaty on European Union.
Declining natural interest rate – and changing inflation landscape
When Bernanke reaches this millennium, he highlights several key trends that have shaped the monetary policy environment. Many of these are familiar to researchers or decision-makers that follow macroeconomics and monetary policy. Firstly, a long-term downward trend has taken place in the interest rate level, which is the result of the decline in the so-called natural interest rate, i.e. the equilibrium interest rate, from the 1980s until recently, at least until the COVID-19 and energy crises. Secondly, the Phillips curve no longer operates in the same way, i.e. inflation has reacted more slowly to changes in unemployment than before. Thirdly, the risk of financial system instability has increased in the global financial market conditions.
Based on these long-term structural trends, Bernanke ended up driving the renewal of the Fed’s monetary policy strategy in a direction that would better take into account the decline in the natural interest rate and the weakened link between inflation and unemployment. The Fed renewed its strategy in summer 2020, announcing that, after a period of inflation that was too slow, it would accept lower unemployment than before without pressure to raise interest rates and to tame inflation – a world that has already passed. The reform was objectively well justified. The ECB, too, renewed its own strategy in summer 2021 with similar reasoning.
Bernanke does not, however, support raising the inflation target in the current situation to four per cent, for example. In his view, moving the goalposts like this in the middle of the cost-of-living crisis would erode the credibility of central banks.
Bernanke is cautious in his reflections on the current situation of far-too-fast inflation. The book was completed last spring, when inflation figures in the United States and other developed economies had already risen close to double digits. The rapidly changing inflation landscape in 2021–22 is reflected in the fact that part of the analysis of the Fed’s relatively new (from 2020) monetary policy strategy seems better suited to the previous low-inflation phase than to the current situation. Bernanke does not criticise the current leadership of the Fed directly, although some conclusions can be drawn, or at least guessed at, from the harsh criticism of the 1970s and the corresponding appreciation directed at Paul Volcker's tough policy.
Bernanke also evaluates extensively the term of his predecessor Alan Greenspan (1987–2006). The general assessment, especially of the period of strong growth and productivity development in the 1990s, is positive. Even so, Bernanke considers that Greenspan underestimated the financial market risks, not so much to maintain the rise in the stock market, but because he trusted too much in the correct pricing of market forces. On the other hand, he describes Greenspan a few pages later like this: “Despite his libertarian roots and his strong belief in the market, Greenspan was not a fundamentalist who always believed in efficient markets.” I am, perhaps, not the only reader to be puzzled by this.
In the achievements of his own term, Bernanke includes three changes in the development of the Fed’s operations. Firstly, transparency was increased and communication improved. It is actually quite a surprise to remind oneself that the Fed Chair has held press conferences on Monetary Policy Committee decisions only since 2006, following the ECB’s example. Second, more focused attention began to be systematically applied to financial stability. Bernanke appears, however, to woken up to the importance of financial stability only after the financial crisis struck, even though one might have thought, given his research background, that the realisation could have occurred earlier. Regulation and supervision of banks was completely reformed. Thirdly, out of sheer necessity, during Bernanke’s term the Fed had to develop a new toolkit, i.e. expand the available monetary policy instruments, such as the Fed’s first securities purchase programmes (so-called quantitative easing) and clearer forward guidance. These have, indeed, also been used on this side of the Atlantic in Frankfurt’s decision-making.
Euro area crisis management consultant
Bernanke also comments extensively on the handling of the euro area debt crisis. He describes how the escalation of the euro crisis also began to infect the US economy, which is why solving it became one of the central priorities of President Barack Obama’s administration. I have described this in more detail in my work Walking the Highwire: Rebalancing the European Economy in Crisis (2020). Bernanke and Secretary of the Treasury Tim Geithner were active and useful crisis management consultants also from the European Commission’s perspective.
During the years of the euro area debt crisis, Bernanke warned in his measured interventions, e.g. in the G7 group, about financial instability and the threat of bank collapse, as the damage caused by the banking crisis to the real economy would be so extensive and difficult to repair. This reminds one of the financial accelerator, which Ben Bernanke developed as a leading researcher of the Great Depression of the 1930s, long before he was appointed as Fed Chair. The basic idea of the theory is that “a recession generally impedes access to credit, which in turn worsens the recession”. During recessions, banks burdened with losses lend more cautiously and, at the same time, the creditworthiness of loan applicants deteriorates as their financial situation weakens. Limiting access to credit, in turn, impacts household purchases and corporate investments, which deepens the recession. All this forces economic activity into reverse gear (Bernanke 2015, 35–36; see also Bernanke 2000, 5–38, 70–160).
Based on my experiences of the financial and euro crises, there is every reason to emphasise, like Bernanke, the centrality of financial institutions in the transmission of monetary policy. Banks, in particular, but also other financial institutions, act as intermediaries between central banks and financial actors, and many actors engage with the financial sector primarily through these intermediaries. At the time, economic and econometric models did not take this into account. If the monetary policy transmission mechanism, which operates in the euro area largely through banks and other financial institutions, is seriously impaired, changes in key interest rates are also weakly transmitted. Since then, the models have developed, of course, and their further development is indeed essential.
The book is fluently written and well edited. I encountered one error regarding the history of the euro crisis: when, in spring 2010, the first economic adjustment programme for Greece was planned and decided on, the managing director of the International Monetary Fund (IMF) was still Dominique Strauss-Kahn, not yet Christine Lagarde, who did not start until the end of summer 2011. Strauss-Kahn’s personal reputation since then may be in low oxygen, but his merits in reforming the IMF during the financial crisis and in avoiding the Greek default and potential exit from the euro are indisputable. After all, there is no need to do to DSK as happened to Leon Trotsky, the founder of the Red Army, who was later excised from photographs taken during the Russian Revolution!
Overall, with his book analysing the evolution of monetary policy, Ben Bernanke has done a great service to all those interested in monetary policy, and particularly to the central bank and economics community. The work will serve well as a university textbook for a course on the history and practice of monetary policy, based on its solid theoretical foundation. It is also suitable for home bookshelves, fluently written and free of unnecessary jargon, and thus a useful manual on the history of monetary policy over the last half century in the world’s largest economy and most important central bank.
References
Bernanke, B. (2000), Essays on the Great Depression, Princeton University Press, Princeton, NJ.
Bernanke, B. (2015), The Courage to Act. A Memoir of a Crisis and its Aftermath, W. W. Norton, New York, NY.
Rehn, O. (2020), Walking the Highwire – Rebalancing the European Economy in Crisis, Palgrave-Macmillan.
Reynolds, D (2007), In Command of History: Churchill Fighting and Writing the Second World War, Basic Books, New York, NY.
[1] Reynolds (2007).
The Finnish Economic Association: Kansantaloudellinen aikakauskirja 4/2022 (in Finnish)