Fed Chairman Ben Bernanke literally wrote a new playbook for financial crisis management
Somchai Kongkamsrifrom Pexels; Canva
Who Is Ben Bernanke?
Ben Bernanke, 14th Chairman of the Federal Reserve, was hailed for his leadership through the 2007–2008 Financial Crisis. Although the crisis would result in the 18-month-long Great Recession, Bernanke steered the economy to safer waters relatively quickly—that is, compared with other crises of similar magnitudes, such as the Great Depression, which lasted for over a decade.
Bernanke achieved many accomplishments during his 14-year tenure helming the Fed, including increasing transparency at an agency known for issuing riddle-like pronouncements that often left Wall Street scratching its head. Bernanke implemented quarterly press conferences that shed light on the Federal Open Market Committee (FOMC)’s policy decisions as well as its projections for the future.
In these Summaries of Economic Projections, Bernanke did away with previously “flexible” inflation targeting and instead instituted a formal threshold of 2%. He also defined “normal” levels of long-term unemployment at between 5.2% and 6% as clear standards the Fed should fulfill in order to achieve a healthy U.S. economy through low prices and maximum employment—after all, that’s its mandate.
In addition, Bernanke used unconventional monetary policy tools that helped the economy quickly recover from the subprime mortgage crisis, including large-scale asset purchases known as quantitative easing.
What Is the Bernanke Doctrine?
In a speech to the National Economists Club in Washington, DC, on November 21, 2002, Bernanke famously outlined his views on using both monetary and fiscal policy measures to resolve recessions. The core of his speech centered around Japan’s Lost Decade, a particularly steep crisis that ensnared Japan’s economy between 1991 and 2001 (and some argue, even longer than that). Several years into the recession, Japan faced a liquidity trap because its central bank had slashed interest rates as low as they could go, 0%, which is also known as the “zero lower bound.”
Liquidity traps can lead to deflation, which may be the most precarious situation for a central bank to resolve, because prices are declining, and consumers aren’t spending. What tools can a central bank use to combat deflation if interest rates are already at zero? It’s a slippery slope.
But Bernanke believed that, under a fiat currency system, which is not backed by gold, deflation is “always reversible.” He used the parable of an alchemist who discovered a way to produce unlimited amounts of gold with no production cost. The market should respond to this discovery by immediately devaluing gold prices, he reasoned, even before the alchemist actually produced said ingots.
Why? Because things, like commodities, or even currencies, have value because they have limited supply. Bernanke extended the metaphor to the U.S. dollar, saying that if the Federal Reserve used its printing presses and created many more dollars in circulation (or even issued a promise to do so), the U.S. government could thus reduce the value of the dollar in terms of goods and services, and thus raise the prices of said goods and services, thereby escaping the liquidity trap.
“Under a paper money system, a determined government can thus always generate higher spending and hence positive inflation.” —Ben Bernanke
Bernanke reasoned that, even though it had reached the zero lower bound, Japan’s central bank did not “run out of ammo.” Had it opened its printing presses and added more yen into circulation, it could have increased demand as well as economic activity, although he also noted that political reforms, and not just policy measures, were needed to heal Japan’s economy, since it had experienced the crushing burst of a years-long asset bubble in its real estate and stock markets, which had caused a country-wide network of businesses to become insolvent.
What Are the Three Principles of the Bernanke Doctrine?
The situation in Japan was riveting storytelling, but it alone did not make central banks flock to the Bernanke Doctrine. Rather, it was three principles that Bernanke outlined that have become a de-facto playbook for central banks to follow to avoid deflation, rescue economies from recessions, and deal with other large-scale economic challenges.
Principle 1
The first principle outlined in Bernanke’s doctrine is that central banks should aim to create a “buffer zone” for inflation rates to avoid the liquidity trap that comes when interest rates hit the zero lower bound—and often fosters deflation. After all, inflation isn’t always a bad thing: A country with zero inflation also has zero growth! Therefore, most countries should set inflation targets between 1% and 3%. “Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero,” Bernanke said.
Principle 2
Central banks should do everything in their power to prevent financial crises, even if that means resorting to unconventional policy measures. Bernanke pointed to former Fed Chairman Alan Greenspan’s promise to “do whatever necessary” to calm markets in the aftermath of the 1987 stock market crash. Greenspan had encouraged banks to continue to make loans on their usual terms, which went a long way in maintaining financial liquidity.
Other examples of the “unconventional measures” Bernanke was referring to included fiscal policy measures that increased the monetary supply, like quantitative easing. Through this measure, a central bank attempts to restore confidence by buying back trillions of dollars of long-term Treasury securities, which also spurs banks into lending (because it drives down long-term interest rates).
A still more fantastical form of support is the practice of injecting “helicopter money” into circulation. A government can invoke this tactic by sending its citizens a short-term monetary stimulus through a tax cut, increased government spending, or even a paper check. “Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers,” Bernanke said. The idea was met with such surprise that it earned Bernanke the moniker “Helicopter Ben.”
Principle 3
If inflation is low and the economy suddenly sputters, the central bank should act “more preemptively and more aggressively than usual” in cutting interest rates. This should keep the economy from deteriorating into deflationary territory, Bernanke concluded.
Why Is the Bernanke Doctrine Important?
Bernanke spoke to the National Economists Club in 2002, while he was serving as a Fed Governor, but it wouldn’t be until several years later, under the mantle of Fed Chair, when Bernanke would have the opportunities to put his theories into practice.
And, in short, they worked.
After Lehman Brothers imploded due to rampant speculation in toxic subprime debt, the stock market crashed in October, 2008. Bernanke quickly positioned the Fed as the “lender of the last resort” and worked diligently alongside Treasury Secretary Hank Paulson and New York Fed President Timothy Geithner to provide emergency capital to other investment banks and thus prevent further contagion.
In addition, the Fed slashed interest rates, and would keep them at ultra-low levels until 2015.The Fed also began a series of quantitative easing measures that helped the economy stage a rebound.
When extending Bernanke’s tenure at the Fed, then-president Barack Obama praised Bernanke for preventing the U.S. economy from falling into a second Great Depression. Ever since, central banks around the world, including in Japan and Europe—especially as European central banks struggled to recover from their sovereign debt crises—have looked to Bernanke’s doctrine as the modern economic playbook on how to respond and recover from economic crises.
