From ivory tower to ground zero

Financial Express, 27 August 2009

Seldom has an intellectual been as lucky as Ben Bernanke. He spent 23 years in an ivory tower, learning one obscure subject. And then he got thrust into the limelight, chairing the US Fed, when the challenge of the day was to put his 23 years of knowledge to work, to save the world economy. And by and large, he did it.

The Great Recession was hard to prevent. But once it got going, OECD governments have done well in coming up with responses. By and large, people like Ben Bernanke, Mervyn King, Henry Paulson, Timothy Geithner, and Larry Summers, has been rather effective in making a difference. This is partly about the intellectual capabilities of these individuals. It is also about the body of knowledge, of modern macroeconomics and finance, that they were able to tap into, which was not available to the key decision makers at the time of the Great Depression.

Bernanke's story is a particularly remarkable one. For decades, Bernanke doggedly worked (in university) on understanding the Great Depression and on the interplay between monetary economics and finance in a financial crisis. Milton Friedman had told a story of the Great Depression emphasising the mistakes of monetary policy. Bernanke brought finance integrally into that story. The `financial accelerator' of Bernanke and Gertler is now a part of the intellectual toolkit of every macroeconomist. This involved the amplification of business cycle fluctuations by the credit market. When times become bad, things are exacerbated by the reduced extent to which lending takes place; this worsens the downturn.

In 2002, after 23 years in academics, Bernanke shifted into public life as member of the Board of Governors of the Federal Reserve System. The Board of Governors of the Federal Reserve System plays an important role in the governance and the operations of the US Fed. In 2006, at the age of 53, he became Chairman when Greenspan stepped down.

And so it was that the Fed Chairman in the Great Recession turned out to be the one person in the world who had worked the hardest on the Great Depression, and on the way monetary policy functions in a financial crisis. It was a lucky break for the world economy. In a speech on Milton Friedman's ninetieth birthday, Bernanke said:

I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

As it turned out, he was tested on a scale that he could have never anticipated.

Throughout Bernanke's academic career, he emphasised the importance of inflation targeting as the right way to hold an independent central bank accountable, and the right way to think about optimal monetary policy. While the US Fed is not a de jure inflation targeter, it is effectively an inflation targeting central bank in practice.

When the crisis broke, the monetary policy transmission broke down. There was a risk of a big monetary contraction, much like that seen in the Great Depression. If that was allowed to take place, it would have given deflation, which would mean that the inflation target would be violated. Bernanke was able to draw on these two themes in his mind: the first being that financial crises lead to sharp monetary contractions because the monetary policy transmission breaks down, and the second being the importance of inflation targeting.

Bernanke's Fed plunged into a diverse array of unorthodox interventions designed to stave off these problems. The balance sheet of the Fed expanded on an unprecedented scale, one that frightened many practical people. It required an intellectual bent of mind to have a depth of clarity about core principles, and follow them through to the logical conclusion. A practical man might have increased the size of the Fed balance sheet by 30 or 40%, and announced that he had done a lot. It took an intellectual to grow the Fed balance sheet by more than three times. And that made all the difference.

Some people think that because the US Fed and other central banks came up with unorthodox operating procedures of monetary policy when the policy rate hit the zero lower bound, this proves that the traditional wisdom of inflation targeting is suspect. This is mixing up means and ends. Monetary policy strategy remains inflation targeting; it is the tools that had to be changed in a hurry. In peacetime, we will go back to the old tools.

From an Indian perspective, the cast of actors in economic policy in the crisis tells us something about the kind of intellectual firepower that is required to man fiscal, financial and monetary policy of a mature market economy.

Bernanke, Summers, and Mervyn King came out of academics, imbued with the wisdom of modern monetary and financial economics. Paulson came out of a top financial firm. At present in India, people like Bernanke or Summers are not found in academics; people like Paulson are not found in the financial industry, and people from academics and industry do not man key policy functions. Each of these three deficiencies needs to be addressed.

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