The end of the Greenspan Put?

Bernanke Breaks Greenspan Mold

From the Wall Street Journal
By GREG IP

WASHINGTON -- When Ben Bernanke was nominated to head the Federal Reserve in 2005, he promised to "maintain continuity with the policies and policy strategies established during the Greenspan years." But in handling his first financial crisis, Mr. Bernanke shows signs of a break with Alan Greenspan, the Fed's chairman from 1987 to 2006.

That shift is important in understanding why Mr. Bernanke hasn't cut the Fed's main interest rate yet, and it could alter investors' expectations of how the Bernanke Fed will function.

The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.

To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998 to prevent investor reluctance to take risks from undermining the nation's economic growth.

By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed cut the interest rate and lengthened the term on loans to banks from its little-used discount window in hopes banks would use the window -- or at least the knowledge it was available -- to lend to solid borrowers having trouble getting credit amidst the market turmoil. The action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth.

The Fed, meanwhile, hasn't cut the far more economically important federal-funds rate, charged on loans between banks, which is the benchmark for all short-term U.S. borrowing costs.

To be sure, all central bankers see a link between financial and economic stability. Falling prices for assets like stocks, bonds and homes and tighter credit conditions can damp spending and investment.

But, "There's no doubt they were trying to draw a distinction between using the main tool of monetary policy, which is the federal-funds rate, and aiming the discount rate at restoring the plumbing," says Alan Blinder, a former Fed vice chairman.

To be sure, if Mr. Bernanke eventually cuts the federal-funds rate, as markets anticipate, the contrast with Mr. Greenspan will be less sharp. Mr. Bernanke will elaborate on the outlook tomorrow at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyo.

Yesterday, Sen. Charles Schumer, a New York Democrat, released a letter from Mr. Bernanke dated Monday that repeated the Fed's Aug. 17 pledge to "act as needed" to help the economy. Though there was nothing new in the pledge, traders said it contributed to the Dow Jones Industrial Average rising 1.9% to 13289.29. (See article.)

Mr. Bernanke's approach to the credit crunch is, in part, an effort to undo perceptions fostered by Mr. Greenspan's rate-cutting interventions. Though successful, they drew allegations of "moral hazard" -- that is, of encouraging investors to act more recklessly because they think the Fed will protect them.

Neither Mr. Bernanke nor his closest colleagues, some of whom served under Mr. Greenspan, believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss.

Yet officials acknowledge the perception that the Fed has bailed out investors in the past. When the stock market crashed in 1987, Mr. Greenspan, then on the job for just two months, used aggressive open-market operations -- buying and selling government securities -- to pump banks full of cash, which caused the federal-funds rate to fall to about 6.75% from 7.25%. His priority was to keep banks well supplied with cash so that strapped securities dealers wouldn't fail for lack of financing.

"We shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos," transcripts record him telling colleagues the day after the crash. The Fed kept the funds rate low in ensuing months, and the economy didn't skip a beat.

In 1998, Russia's default on its debt, followed by the near-collapse of Long-Term Capital Management, caused credit markets to freeze up, much as they have recently. Mr. Greenspan's reaction illustrated how much he considered investors' attitudes toward risk as intrinsic to the economy's health.

"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world." The Fed cut interest rates three times by a total of three-quarters of a percentage point that fall. The economy accelerated, and the stock market, erasing its losses, went on to more spectacular gains.

Al Broaddus, research director and later president of the Federal Reserve Bank of Richmond during Mr. Greenspan's tenure, says Mr. Greenspan's response in 1987 was right. "A 20% drop in the stock market was a clear threat to economic conditions." But he says that in 1998, he and some others were skeptical of the need for such drastic action to deal with market instability. "If we could have argued for something like Bernanke is doing this time as opposed to three funds-rate reductions, we might have done that."

Mr. Bernanke may yet have to cut rates. But the longer he waits, the more likely he can break investors of the assumption that market convulsions lead to interest-rate cuts. There is evidence he is succeeding. On Aug. 16, with stocks plunging and debt markets in disarray, money manager Bridgewater Associates wrote in its widely read daily commentary: "Credit in the economy is shutting down, and the Fed needs to ease now."

By this past Tuesday, with markets having settled down, the same firm wrote: "If we were in the Fed's shoes, we certainly wouldn't be in a hurry to 'save the system' until there was more evidence that the system needed saving."