Bernanke Won the Nobel, but Is His Bubble About to Burst?

Ben Bernanke will go down as one of the most influential U.S. Federal Reserve chairs ever, and many economists believe he deserved the Nobel prize in economics he was co-awarded Monday. Rarely, if ever, has an academic scholar’s work—in Bernanke’s case, he showed how failing banks caused the Great Depression—been put to the test in the real-world laboratory of the entire global economy. A test administered by its own author, no less! Thus, in 2008 and afterward, we had the startling spectacle of Bernanke, a Republican-appointed Fed chief—and erstwhile admirer of libertarian former Fed chief Alan Greenspan—pushing a massive bank bailout and exploding the Fed’s balance sheet by trillions of dollars to keep the Great Recession from getting far worse.

Bernanke himself explained his 180-degree ideological turn by saying there was no way he was “going to be the Federal Reserve chairman who presided over the second Great Depression.” As he later recalled, he had to “hold my nose and stop those firms from failing.” In this, Bernanke showed remarkable flexibility of intellect and character, and most economists believe he played a truly heroic role.

Yet in some ways, Bernanke may have been too influential. His Fed successors, Janet Yellen and now Jerome Powell, might have kept his policies going for far too long. What worked to stabilize markets back then may be fuel on the fire now. Following Bernanke’s lead, Yellen and Powell transformed the Fed from a central bank into a fiscal policymaker, with a massive quantitative easing (QE) program and the perpetuation of rock bottom interest rates. This led to the easy money bubble—call it the “Bernanke bubble”—that has helped feed today’s inflation, with consumer prices rising this month to a 40-year high. There are also fears of a new recession, though the inflationary cycle has been also fed by U.S. President Joe Biden’s big spending plans and COVID-19-related supply shocks. The QE policy was begun by Bernanke in 2008 and involved the Fed buying hundreds of billions of dollars in U.S. Treasury Department and government-backed mortgage securities. Today, it has ballooned the Fed’s balance sheet from around $900 billion to nearly $9 trillion. To help fight inflation, Powell has scaled that back but fairly modestly—only by several hundred billion dollars in recent months. Biden has since reappointed Powell for another four-year term.

The massive policy shift initiated by Bernanke—what began as an emergency “break the glass” response 14 years ago—has, in turn, triggered new questions about financial stability. This emerging problem is part of Bernanke’s legacy as well. There are questions, too, about the huge too-big-to-fail banking problem that Bernanke and his collaborators at the time, mainly then-U.S. Treasury Secretary Timothy Geithner, did not address after the immediate storm of the financial crisis had passed—despite promises to do so.

Almost no one expects a crisis like 2008, when nearly the entire banking system was sunk by a tide of complex junk mortgage-backed securities and swaps. But then, no crisis is ever like the previous ones. Now, with recession projected for next year and other central banks following Powell in raising interest rates, the new joints in the international financial system could be seriously tested for the first time. This test could come in the credit markets, but as investment guru Warren Buffett famously said, “Only when the tide goes out do you discover who’s been swimming naked.”

The current run-on U.K. gilts may be an early indicator of where still-mysterious trade in swaps and other derivatives could hurt badly. A massive sell-off by hedge funds of government securities designed to evade interest rate rises had whiffs of the 2008 panic about it; on Tuesday, the Bank of England warned that “dysfunction in this market, and the prospect of self-reinforcing ‘fire sale’ dynamics pose a material risk to U.K. financial stability.”

According to Princeton University scholar Harold James, whose work on the 1930s banking crises Bernanke cited after winning his Nobel, British regulators have encouraged pension funds to hold a large part of their assets in fixed income government securities. But these securities are very vulnerable to interest rate rises, and derivative traders exploited that.

“This is the kind of weakness that is obvious after the fact, but it wasn’t at all what worried regulators up to now,” James told FP this week. “There are so many other potential sources of fragility.” The U.K. bond market is fairly localized, but the panic is already “reverberating globally,” Seeking Alpha analytic firm reported Wednesday, adding, “Many countries could soon be facing a similar battle between fiscal and monetary policy and traders said the Bank of England’s credibility could be on the line.”

Another big worry: If a crisis comes, how will the world react? During the 2008 crisis, the U.S.-China relationship was a focal point of stability and cooperation, with Beijing agreeing to hold onto its faltering Fannie Mae and Freddie Mac bonds as well as the U.S. Treasury’s. Yet China is now in a trade war and likely a new cold war with Washington. That’s even though it remains the No. 2 holder of U.S. government debt (after Japan), in what former Treasury Secretary Lawrence Summers once called “a kind of balance of financial terror.” In the event of a crisis, would there be any international cooperation at all? Would a badly divided U.S. House of Representatives and Senate even be capable of reacting as Bernanke once did, with critical help from then-Treasury Secretary Henry Paulson—and later Geithner and then-European Central Bank President Mario Draghi, who, like Bernanke, is a Massachusetts Institute of Technology-trained economist?

“The main thought I have is that the Fed would not have the capacity and Congress would not have the political will to implement another rescue package,” said Frank Partnoy, a University of California, Berkeley law and finance professor and former Wall Street trader who has become a prominent advocate for financial reform. “So if the borrowers of leveraged loans start to default, there will be no one to bail out the lenders.”

Economist Robert Johnson is among those who believe that what is mainly raising market fears now is widespread political uncertainty around the world. This includes U.S.-China tensions and the economic decoupling that might come from it, pandemic-related supply chain stoppages and the unwinding of international supply chains, and Russian President Vladimir Putin’s invasion of Ukraine. The Biden administration’s inability to resolve any of these issues—for example, by cutting any kind of deal with Beijing on climate or other threats—is a major problem, Johnson said. “You’ve got a double shock: a supply shock and a Putin shock. That, together with Powell’s aggression, is what is frightening financial markets. What’s driving the stock market is momentum fears.”

The stress test may come sooner rather than later. This week, the International Monetary Fund (IMF) downgraded its forecast for the global economy, saying, “the worst is yet to come, and for many people 2023 will feel like a recession.” With inflation persisting longer than expected, “[m]ore than a third of the global economy will contract this year or next, while the three largest economies—the United States, the European Union, and China—will continue to stall.” Famed “Dr. Doom” economist Nouriel Roubini wrote that “a hard-landing scenario is becoming the consensus among market analysts, economists and investors,” adding that he sees the “risk of a severe and protracted stagflationary debt crisis.”

Other financial analysts remain sanguine, saying the financial system is much safer in the wake of the 2010 Dodd-Frank regulations on banking and finance. “As far as I can see, despite an almost 400-basis-point rise in rates, there is almost no sign of stress in the banking system proper nor of any sort of run on the shadow banking system,” said Liaquat Ahamed, a market expert and author of the Pulitzer Prize-winning Lords of Finance: The Bankers Who Broke the World. “The only real run that we witnessed was in some of the crypto shadow banks earlier this year, but that seems to have been localized and well contained.” New York University economist Mark Gertler, Bernanke’s sometime collaborator on economic research, echoes that view, saying although Powell has been too slow to move off the Bernanke program of quantitative easing and low rates, it’s not too late for him to change.

“It is true that with the benefit of hindsight, the Fed was too slow to increase rates. To be fair, few anticipated the combination of rapid recovery and supply shocks,” Gertler told FP. “The Fed does though seem to have regained its footing.” As for maintaining financial stability, Gertler said, “The interventions in government and corporate bond markets in the spring of 2020 were both effective and appropriate. Because they involved protecting the market as opposed to individual borrowers, I believe the moral hazard effects were minimal.”

Other experts disagree sharply. Bernanke, along with Geithner and others of that era, left in place what Johnson calls “the mother of all moral hazards.” The giant banks left intact after the 2008 crash are only bigger and more powerful. They’ve managed to persuade the markets that they are now far too big to be allowed to fail, and that has given them an enormous competitive advantage. “It allows them to get more market share and take more risk,” Johnson said.

One unknown is the vast currency swaps market overseas, in which big banks have managed to evade Dodd-Frank regulations using loopholes, said Michael Greenberger, a former senior regulator at the Commodity Futures Trading Commission. “As we sit here today, there are only four big banks that are swaps dealers—Citibank, Goldman Sachs, Bank of America, and J.P. Morgan Chase, and they can choose for themselves whether they want to be regulated or not.”

The IMF also raised concerns this week about the effects stemming from a “widening of the cross-currency basis swap spreads,” with the U.S. dollar rising in value. But because the market remains out of sight of regulators, “We don’t know how big the problem is,” Greenberger said. “We don’t have the data.”

Developing nations this week warned of imminent problems. “It’s clear there will be no calm after the COVID storm,” said Alvaro González Ricci, head of the Bank of Guatemala and chair of the G-24 countries that gathered this week in Washington, in a statement. “Financial conditions are worsening. Policymakers, especially in advanced economies, have rapidly moved to curb higher-than-expected inflation by tightening monetary policy with sharp and repeated increases in interest rates, which bring currency depreciations and large capital outflows in emerging markets and developing economies.”

In a new paper, economist Maurice Obstfeld of the Peterson Institute for International Economics writes that “many foreign economies may buckle before the Federal Reserve’s hiking cycle is complete. … Still laboring under pandemic legacies, many of these economies could soon face crises that the international financial system remains ill equipped to handle in an orderly fashion.”

Bernanke himself is now suggesting that policymakers could be blindsided by a cascade of firm failures and economies in crisis, just as he and his colleagues were before the 2008 crash. “Even if financial problems don’t begin an episode, over time, if the episode makes financial conditions worse, they can add to the problem and can intensify it, so that’s something I think that we really have to pay close attention to,” Bernanke said on Monday during a briefing at the Brookings Institution, where he’s a distinguished senior fellow.

Bernanke has remained reticent on the topic. Yet whatever inflationary trends he may have left behind, Bernanke also added a great deal to the economics profession, both in empirical research and practice. As the Royal Swedish Academy of Sciences said in awarding the prize to Bernanke along with Douglas Diamond at the University of Chicago and Philip Dybvig at Washington University in St. Louis, their work has “been of great practical importance in regulating financial markets and dealing with financial crises.”

In many ways, it was ironic that Bernanke went from being an advocate of a restrained Fed to Wall Street’s “loan arranger,” as former Rep. Barney Frank quipped. Indeed, Bernanke originally got the Fed chairmanship by playing the eager acolyte to his predecessor’s view of the markets and the Fed’s minimalist role. He even supplied scholarly ammunition to Greenspan’s doctrine of noninterference when the then-Fed chairman struggled with whether he should declare the markets guilty of “irrational exuberance.” In 1999, as a Princeton University economist, Bernanke and his longtime collaborator, Gertler, presented a paper during the dot-com bubble, arguing against a strategy of using interest rates to deflate asset prices.

Yet even in late 2007, Bernanke expressed confidence in the mortgage market and the financial derivatives built on it. In a testimony to Congress, Bernanke pooh-poohed the idea of a systemic collapse, saying he saw only a “limited” impact of subprime mortgages on “the broader housing market.”

Bernanke did finally see the dimensions of the disaster as it engulfed him, and at one point, he declared, “Too big to fail has got to go.” But that problem was never addressed, helping to contribute to populist anger because, as progressive economist Joseph Stiglitz, another Nobel winner, once said, “The polluters get paid.” In other words, the financiers who crash the economy always get bailed out. Even now, some economists are criticizing Bernanke and his Nobel. “Today, Ben Bernanke won the Nobel Prize for Economics, despite being the instigator of the worst boom-bust cycle since WW2,” Australian economist Steve Keen tweeted.

Bernanke, the freshly minted Nobel winner, is in many ways the author of this era—for better and possibly worse.

Correction, Oct. 31, 2022: A previous version due to an editing error misstated which organization awards the Nobel Memorial Prize in Economic Sciences.