The Financial Crisis March 20, 2008, 5:00PM EST

The Fed's Revolution

To head off a catastrophe, Bernanke has reinvented the central bank while injecting a huge dose of money into the system

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Scenes of the New York City Financial District, 3/18/08 Christopher Anderson / Magnum

by Michael Mandel and Peter Coy

The current financial crisis—perhaps the biggest since the Great Depression—has turned Federal Reserve Chairman Ben Bernanke into a reluctant revolutionary. The quiet academic who wanted to make the post of Fed chairman less heroic is leading a dramatic expansion of the central bank's role. In the process, he is setting the stage for the next big boom—or bubble.

In the short run, Bernanke is waging a war to keep the financial markets from collapsing. The biggest move so far: On Sunday, Mar. 16, the Fed brokered the fire sale of troubled investment bank Bear Stearns (BSC) to JPMorgan Chase (JPM) and announced that it would be willing to lend directly to major Wall Street brokers, which have never before had access to loans from the central bank.

The two moves represented a new level of direct Fed involvement in the financial markets and made it clear that Bernanke would take any step needed to prevent a financial catastrophe. These maneuvers should work, says Julian Jessop, chief international economist of London-based research firm Capital Economics. "At the end of the day, the Fed can provide a lot of support," he says. "It certainly won't prevent a sharp downturn, but it should prevent a debt deflation spiral."

At the same time, by stepping in so aggressively, Bernanke is pouring an enormous slug of money into the financial system. To be sure, its full impact won't be felt right away, because banks are reluctant to lend and consumers are afraid to borrow. Indeed, consumer spending is likely to lag, leading to job cuts in coming months and a deepening of the recession.

Eventually, though, the Fed's stimulus will show up as some combination of stronger economic growth and higher asset prices. It also could boost inflation, further eroding the value of the dollar and raising the risk of a run on the world's most important currency. The possibility that a primarily domestic crisis could quickly become global highlights the need for international cooperation. Former Fed Chairman Paul A. Volcker, who broke the back of high inflation in the early 1980s, told BusinessWeek on Mar. 19: "If you have a closely integrated world economy with free trade and free movements of capital, the logical complement of that is a global currency."

The engine that eventually pulls the U.S. out of recession will most likely not be consumption but corporate investment. That will be good for big global corporations with clean balance sheets and access to markets around the world. The very fact that they already have plenty of cash will likely make investors all the more eager to fuel their expansion.

Still, the jury is out on whether the Fed's actions will result mainly in a useful boom or a wasteful bubble. The Fed-fueled boom of the 1990s was a big plus for the economy, because it stimulated investments in cutting-edge technology, which paid off as higher productivity and growth. That of the 2000s, though, mainly spurred homebuilding and higher house prices, with little or no long-term boost to growth. Except for the best-educated workers, many saw real wages fall.

GREENSPAN'S LEAD

Not everyone is pleased with Bernanke's approach. "They have basically polluted the world with dollars," says Dan North, U.S. chief economist for Euler Hermes, a unit of Allianz Group (AZ) that insures accounts receivables. "It lays the foundation for inflation and another asset bubble later on."

In some ways, Bernanke is following the lead of former Fed Chairman Alan Greenspan, who argued that the central bank should not try to pop bubbles beforehand. Instead, the appropriate role of the Fed is to cushion the impact when the boom comes to an end. In a Mar. 17 article in the Financial Times, Greenspan said: "Periods of euphoria are very difficult to suppress as they build [and] they will not collapse until the speculative fever breaks on its own."

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