For decades, you could always count on the Federal Reserve to pull the plug on prosperity too soon, seeing ghosts of inflation everywhere. The Fed, responsive as it was to creditors, preferred a dose of recession to any sort of price pressures, especially wage increases. That changed with the regimes of Fed chairmen Alan Greenspan and Ben Bernanke. Greenspan was willing to keep interest rates low because the banks kept getting into difficulty after bouts of speculative excess in the 1980s and '90s and needed the cheap money to rebuild their balance sheets. The ultimate such collapse occurred just five years ago this week, when the crash of Lehman Brothers revealed the rot in the entire system, and one over-leveraged domino after another fell. The Fed, after a somewhat anomalous run as the engine of recovery, seems to be reverting to type. Trouble is, the economy won't cooperate with this scenario. Inflation is nowhere to be seen, and the recovery continues to be weak.
Larry Summers is running hard to succeed Ben Bernanke as chairman of the Federal Reserve. This is a terrible idea. Once appointed chief of economic policy, Summers with Tim Geithner was a prime architect of propping up and bailing out the biggest banks, rather than cleaning them out and altering the conflicts of interest at the core of Wall Street's business model. Today, the banks are more highly concentrated, more profitable, and less in the business of financing the real economy than ever. This is Larry Summers' legacy. The prime alternative to Summers is Fed Vice Chair Janet Yellen, who is very much like Bernanke, only better. She has gone even further in expressing concern for the economy's persistent unemployment and in criticizing the bipartisan obsession with deficit reduction. Yellen deserves to be Fed chair purely on the merits. It pains me to write that if she gets the job, one other major contrast with Summers will weigh in her favor. She is female.
A consequential challenge facing the Fed and the U.S. economy is the risk of a gradual decline in this powerful institution's policy responsiveness, adaptability and flexibility. It is likely that, at some stage within the next few years, the Fed will need to exit from its highly-experimental monetary policies. The hope is that it is able to do so in an orderly fashion because its key objective is attained -- namely, that of promoting high and sustained economic growth with low and stable inflation. The risk is that the collateral damage of policy experimentation overwhelms the benefits. Having succeeded in temporarily restoring calm to the markets after the May/June upheavals, Mr. Bernanke still faces the more difficult challenge of regaining policy flexibility for an institution that is central to the well-being of the U.S. and that of the global economy.
Ben Bernanke has been saying that the economy's getting a bit better, so interest rates are going up. And at some point, sooner than later, he and his buds at the Federal Reserve are going to start adding a bit less juice to the punch bowl. I don't really know what to make of the markets and I suspect they're just going to be volatile for a while. But it's the real economy I'm worried about, and I used to have a friend in Bernanke when it came to that. Now, I'm not so sure. Fed policy always has costs and benefits and deep monetary stimulus is no free lunch. But as long as the broader economy remains in the residual gravitational pull of the great recession, the benefits of the Fed's aggressive actions outweigh the costs. I get that they're planning their pivot, which isn't the same as pivoting. But they're doing so too soon.