Why did Ben Bernanke support such a crappy plan?

A subject that has mystified me as it’s mystified pretty much everyone. I’ve always guessed he felt it was the best he could get out of Paulson with whom he had to come up with a joint plan. That’s what Steve Randy Waldman thinks too – though he suggests a bit more detail – over the fold. Anyway, Paulson has been forced back towards a bit of sense by the unworkability of his own proposed plan.

Why did Ben Bernanke, widely respected among economists as both a scholar and gentleman, support a rescue plan that very few of his colleagues considered “first-best” or even “second-best”? While there was no firm consensus among economists about precisely what ought to have been done, a plan based on no-strings-attached purchases of difficult-to-value assets by taxpayers was particularly surprising. Here’s Greg Mankiw being politely puzzled. Paul Davidson quotes correspondence with Chris Carroll, in which the Hopkins economist admits he wants to

spur Bernanke to try to provide his own views… My suspicion …is that he [Bernanke] thinks buying the toxic assets is a bad idea …. I think Bernanke believed all along that a recapitalization was the only effective thing that could be done, but he could not persuade Paulson of that.

Cynics can easily find reasons for Secretary Paulson to have favored the original TARP proposal. But why did Dr. Bernanke play along?

Here’s a possibility: Sometime in the middle of September, the Fed hit its balance sheet constraint. Dr. Bernanke could not have provided liquidity on the scale he thought necessary to support the financial system without injecting unsterilized new cash into the banking system and potentially sparking inflation or a run on the dollar. At that moment, the U.S. Federal Reserve lost its independence entirely. In order to pursue the policy its technocrats thought best, it required large-scale funding from the US Treasury. Dr. Bernanke had to negotiate with Secretary Paulson, whose nickname “The Hammer” is not a tribute to his love of carpentry. A deal was struck, and the Supplementary Financing Program was born.

Undoubtedly, inside both the Fed and the Treasury, a variety of options were considered on how to intervene as credit conditions continued to deteriorate. Perhaps the Treasury settled upon the TARP approach, while the Fed might have preferred something different. Perhaps the Fed had to give a little to get a little. Perhaps that’s why the Paulson Plan emerged as what Greg Mankiw terms the “new Washington consensus”.

The Fed has now regained some of its independence. The “stabilization act” included a clause that gives the Fed authority to pay interest on bank deposits, which permits the central bank to partially sterilize cash injections without having to sell securities from its much depleted portfolio.

But in mid-September, events were spiraling, and the Fed was cornered. Even a gentleman and a scholar might have decided that acceding to a proposal that could do little immediate harm and might do some good was better than having his hands tied and watching the banking collapse he was born to prevent unfold before tired eyes.

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5 Responses to Why did Ben Bernanke support such a crappy plan?

  1. Ingolf says:

    Interesting, Nicholas. Like you, it seemed very odd to me that the bailout plan was the best Bernanke could come up with after a lifetime of preparation. Perhaps this is at least part of the answer.

    Mind you, even if this conjecture is correct, Bernanke was in at least as strong a negotiating position as Paulson. All he had to say was: “Mate, you can do that, but you’ll have to do it without me.” Not really an ideal time for switching Fed Chairman, I wouldn’t have thought.

  2. Tel_ says:

    People are probably gonna write me off as a loon (if they haven’t already) but I agree with George Washington on this one:

    http://georgewashington2.blogspot.com/2008/10/theres-no-difference-between-martial.html

    There’s been a few jokes going around that the Mexicans are setting up border patrols to chase down illegal jobseekers and throw them back North over the border. I don’t think it’s funny, people aren’t treating this with the seriousness that it deserves.

    By the way, I doubt Ben Bernanke ever was particularly independent.

  3. I agree with you Ingolf. Perhaps Ben is strong of intellect and weak of character? (I have no idea I hasten to add – just a hypothesis.)

  4. Patrick says:

    Maybe not particulary weak, but I would bet a lot that Paulson is probably exceptionally strong of character and a very experienced and skilled negotiator.

    His resume might be subtitled something like” ‘about being strong of character and developing very strong negotiation skills’, after all!

  5. Pingback: Club Troppo » The end of the party or the start of a new one? Observations on the financial crisis.

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