Anyone who does graduate study in economics will spend at least some time reading the work of Ben Bernanke, one of the winners of this year’s Nobel prize in economics. I read more Bernanke than most given that my PhD thesis was on monetary policy in Japan’s Great Recession. I found his work with Brian Sack and Vince Reinhart on monetary alternatives at the zero bound to be particularly useful. Scott Sumner puts that contribution in context in his paper The Princeton School and the Zero Lower Bound.
For students of the Great Depression, Bernanke’s work is essential, although Scott Sumner’s Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression is still the most coherent and economically compelling narrative of that episode. See Scott’s reflection on one of Bernanke’s contributions.
Another major influence on me was Bernanke’s paper showing how the interaction of investment and uncertainty can generate business cycles (“Irreversibility, Uncertainty, and Cyclical Investment,” Quarterly Journal of Economics 98, no. 1 (1983)). Bernanke argued that ‘events whose long-run implications are uncertain can create an investment cycle by temporarily increasing the returns to waiting for information.’ Investment opportunities are analogous to options contracts, where the firm has the option, but not the obligation to invest. The option is valuable until such time as it is exercised. The firm’s investment decision is the optimal time to exercise the option.
The option theory of investment gives a major role to uncertainty as a determinant of investment spending. When economic, political and policy uncertainty are high, the value of the option to invest in the future increases, delaying the decision to invest. The Baker, Bloom and Davis measure of economic policy uncertainty has since allowed us to better operationalise Bernanke’s model and has a lot of explanatory power for investment spending and business cycle dynamics.
Bernanke moved from academia to the policy world with his role as CEA Chair in the Bush Administration, then as a Federal Reserve Board Governor and ultimately as Federal Reserve Chair. Bernanke had huge shoes to fill following Alan Greenspan. He adopted a more consultative approach as Fed Chair, in contrast to Greenspan’s dominance of the Committee. But the policy outcomes looked like capture of the Chair by the Federal Reserve system. The best evidence for that policy capture was the disconnect between Bernanke’s policy recommendations as an academic and his subsequent choices as a key policymaker on the FOMC. Marcus Nunes does a stocktake of some the differences.
The Bernanke Fed dragged the chain in lowering the Fed funds rate in response to the financial crisis of 2008. As Scott Sumner has shown, it was this slow monetary policy response that turned 2008 into a serious and persistent downturn. As editor of the now defunct journal Policy, I published Scott’s first long form treatment of this issue outside of his blog, the thesis of which ultimately became his book, The Money Illusion.
The Bernanke Fed not surprisingly turned to QE, but by paying interest on reserves, ensured that the increased liquidity only accommodated the increased demand for reserves. QE1 was fully offset by other asset sales. That did not preclude QE working through a portfolio balance channel, but QE was not as potent as it could have been and this was very much by design. The stop-start nature of QE and the continued signalling of future tightening also undermined its effectiveness.
Policymakers assumed post-crisis monetary policy to be easy, failing to internalise Friedman’s insight that lower for longer meant that policy was too tight. These errors were further perpetuated by the Yellen Fed. The best indication we have that this was both an intellectual and policy error was that Yellen had impeccable dovish credentials going into the role, yet still manage to preside over monetary policy that was too tight.
Fortunately, the Powell Fed seems to have internalised these lessons. The monetary response to the pandemic shock was rapid and massive. Without that massive response, it is unlikely that the RBA would have resorted to QE given Governor Lowe’s aversion to balance sheet expansion.
While I think Bernanke’s tenure as Fed Chair was ultimately disappointing, that does not diminish his intellectual contributions. Indeed, his contributions form part of the basis for benchmarking Fed policy during his tenure. In the event, he failed his own benchmarks, but it is all too easy to envisage a counterfactual Fed Chair who would have performed much worse in the face of the 2008 shock.
I can’t recall which laureate assured us that the Riksbank prize money ‘spends just as well’ when asked whether it was a real Nobel prize or not, but it surely was a prize-worthy response.
ICYMI
What I learned from Ben Bernanke
How to do evil things by pretending to be stupid.