What Bernanke Knows That You Don't

Here’s why the Fed chairman is taking huge risks to fix the economy.


Love him or hate him, Federal Reserve Chairman Ben Bernanke is probably the most important economic official in the world right now.

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When the Fed flexes its muscles, financial markets from Santiago to Shanghai respond as if they're wired directly to Washington. And the Fed has been flexing like an overcaffeinated gym rat. With the Fed's official interest rates as low as they can go, the Fed has now begun its second round of "quantitative easing," a plan to buy $600 billion worth of U.S. government securities through the middle of 2011. This comes after an even bigger easing program that started in April 2009 and ran for about a year. The idea, in general, is to buy up a huge amount of the safe securities investors crave during anxious times like these, forcing investors to put their money into other types of securities like stocks and commodities. That, in theory, is supposed to drive up stock prices, make investors feel better off, and help restore consumer confidence. As a bonus, it also pushes interest rates down, which should help boost home sales, and devalues the dollar, which is good for exports.

The first time, it worked. The stock market surged by 83 percent while QE1, as it was known, was in effect. And mortgage rates fell. That helped repair some of the damage from the twin housing and stock-market busts of the Great Recession. But so far, QE2, which began in early November, has been far more controversial. A group of Republican economists argues that the Fed's latest move could trigger breakaway inflation in the future, fuel asset bubbles, drive the dollar too low, and jeopardize the Fed's own credibility. Foreign officials from China, Germany, South Korea, and other countries have blasted the Fed for manipulating currency markets and distorting the whole global economy. A few of the Fed's own top officials oppose more easing, and even Sarah Palin has brushed up on monetary policy—and become a Fed-basher.

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So why is Bernanke doing this?

I suppose it's possible that the Fed Chairman belongs to a secret star chamber whose mission is to convulse the world economy and agitate Sarah Palin. But of all the characters who have a finger on some pulse point of the global economy, Bernanke is one of the least unsavory. He's a Princeton Ph.D. who's an expert on the Great Depression and Japan's "lost decade" and has never worked for Goldman Sachs. After he leaves Washington, Bernanke will probably go back to academia, where he came from, instead of becoming a megamillionare dealmaker at some bank he once regulated. It's true that Bernanke once supported Fed policies that contributed to the 2008 financial meltdown, and failed to foresee the worst parts of the downturn. But there is virtually nobody in the financial or economic firmament who accurately predicted the course of the boom, bust, recession, and recovery.

So for the sake of argument let's say Bernanke is sincere about trying to fix the economy. If you read between the lines of his public statements and other Fed announcements, it's clear that Bernanke and most of his Fed colleagues are deeply troubled about America's prospects. Probably more troubled than the rest of us, in fact. Here's why:

An economic catastrophe is still possible. The Fed is responsible for two things: Low inflation and full employment. Inflation, for all the bluster, is actually too low right now; the most immediate threat is falling prices, not rising prices. Employment is obviously a much bigger problem. "On its current economic trajectory, the United States runs the risk of seeing millions of workers unemployed or underemployed for many years," Bernanke said in a recent speech. "As a society, we should find that outcome unacceptable."

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Bernankespeak isn't as dry or inscrutable as the mutterings of his predecessor, Alan Greenspan, but every central bank chief is a paragon of understatement. If you were to buy Bernanke a few beers and get him to tell you what he really thinks, he'd probably say that the economy is going to suck for a long time and America is circling the drain. There's nothing happening in the "real economy" that's likely to boost hiring by a meaningful amount any time soon. That's because the vaunted private sector is doing just fine without much need for additional workers—despite a 9.6 percent unemployment rate, corporate profits have been surging, and big companies are sitting on a record amount of cash. Unless growth picks up, hiring more workers would merely dilute profit margins.

That threatens most Americans, not just the unemployed. A large number of chronically unemployed people means less spending overall, and that in turn means economic growth will remain sluggish at best. Stagnation could easily degrade living standards for the majority of Americans, since incomes will plateau or fall, purchasing power will decline, retirement will drift further into the future and more people will fall through safety nets that are already fraying.

That's the hopeful scenario, assuming nothing terrible goes wrong. But it could. There are still a lot of major stressors bubbling around the world, and the economy is so fragile that it wouldn't take much of a shock to induce another recession. Ireland, for instance, is a tiny country, yet worries about its insolvency have unnerved global markets and stoked fears of a contagion that could spread to much bigger economies like Spain and Italy. Band-Aid solutions to sovereign debt crises may generate short-term relief, but there's a good chance that a large and painful reckoning is still in the future. Here in the United States, California and Illinois may soon face a similar debt crisis, and nobody knows if there will be panic or calm if a major municipality defaults on its debts. The foreclosure fiasco could be another time bomb that shakes banks already weak from four years of mounting writeoffs. China could be in the midst of an asset bubble that bursts any day. Or global investors could start to balk at buying U.S. debt. Or... Well, suffice to say that if you're Bernanke, the baseline scenario is pretty bleak, and most of the risks are to the downside. You try getting a good night's sleep with a list of worries like that.

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Washington could easily wreck the economy. Empowered Republicans and their Tea Party understudies are rushing to Washington with a manifesto to cut spending, lower taxes, and shake up government. Whoa. Washington clearly needs a makeover, but at the moment, the nation's economy is far more dependent on the government than anybody wants to admit. The loathed mortgage agencies, Fannie Mae and Freddie Mac, now back 95 percent of all new mortgages, which means the housing market would collapse without government support. Mainstream economists agree that the 2009 stimulus bill, also wildly unpopular, helped saved many jobs and end the recession sooner than it would have ended on its own. The wind-down of that spending is the biggest reason economic growth is slowing once again. Even a relatively small federal measure, like the extension of expired unemployment benefits, could weaken the economy if not renewed.

None of this means we should accept a bloated government that permanently plays an outsized role in the economy. What it means is that now is probably the wrong time to make dramatic changes in government that would directly affect the economy. The smart thing to do would be to outline an austerity plan that doesn't begin until the economy is healthy again and leaves plenty of time for companies and consumers to adjust. If Congressional cowboys promptly scale back the government's role in the economy before the private sector is ready to pick up the slack, it will simply leave a big hole in GDP—and make Bernanke's job even harder.

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The Fed is almost out of ammo. Bernanke would probably prefer not to mess with quantitative easing at all. But nobody else is doing much to help the economy, so he must figure that he's the last rational man in Washington. Big spending plans by Democrats have accomplished far less than promised, which has made them deeply unpopular. So the odds of more fiscal aid are slim. Republicans have railed against everything the Democrats have done, but that's hardly a plan to create jobs. And their big idea of cutting taxes to stimulate growth failed the last time they tried it, when George W. Bush was president. Plus, neither party has bothered to offset their spending hikes or tax increases with offsets in the future, to help keep the government solvent. That makes everybody's plan seem fanciful and silly compared to what the Fed can do.

Bernanke has been clear about the Fed's limitations and has called for Congress to do more. "There are limits to what can be achieved by the central bank alone," he said in his recent speech. "A fiscal program that combines near-term measures to enhance growth with strong confidence-inducing steps to reduce longer-term … deficits would be an important complement to the policies of the Federal Reserve." Translation: "You weenies on Capitol Hill need to help carry this load." As we all know, however, the era of gridlock has arrived, and it's time for government to get out of the way. When you see Ben Bernanke putting on body armor, you'll know why.