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On the morning of Nov. 4, two days after the midterm elections, Timothy Geithner was scheduled to fly to Kyoto for a dinner with Asian-Pacific finance ministers. At the last minute, Geithner postponed his trip; there was just too much going on in Washington. The dimensions of the electoral drubbing that President Barack Obama had taken were still sinking in when the Treasury Secretary arrived at the White House to plot strategy at the President's cabinet meeting.
Obama then extended an olive branch to newly empowered Republican leaders, inviting them to meet later in the month. Geithner had no illusion that peace was breaking out. In fact, as he returned to the Treasury Dept. for a private lunch with Federal Reserve Chairman Ben Bernanke, the next political battle was already taking shape.
Bernanke would be the new target.
Bernanke and Geithner, who sat for separate interviews for this story, won't say what they discussed at their Nov. 4 lunch; an official describes the meeting as routine. As the Administration's point man in its dealings with the Fed, Geithner lunches with Bernanke almost every week. The Treasury Secretary says there's one topic that's off-limits: "I don't give him advice on monetary policy for two reasons. One is out of respect for the basic independence of the Fed. The other is because I'm not living and breathing monetary policy every day."
The two had been scheduled to get together earlier that week but waited until immediately after a two-day Fed meeting that began on Election Day—the same session, as it turned out, that put Bernanke in play politically. At the meeting, Bernanke faced down opposition from Kansas City Fed President Thomas M. Hoenig and pushed through his plan for a second round of "quantitative easing"—pumping $600 billion into the economy over the next eight months by buying long-term Treasury debt. The strategy was designed to boost the flagging U.S. economy, bring the unemployment rate down from its painful 9.6 percent level, and prevent a Lost Decade of low growth and deflation similar to what Japan suffered after its real estate bubble burst in 1990.
With the impact of Obama's $814 billion stimulus program fading and Republicans unwilling to spend more, the President was depending on the Fed to prod the recovery. And Fed officials say they felt obliged to act—to try to reduce unemployment they think is dangerously high and increase inflation they fear is dangerously low. With short-term interest rates already near zero, they sought to bring down long-term rates by taking the unorthodox approach of buying Treasury bonds. The move had already elicited protests from German and Brazilian officials, who worried it would drive down the value of the dollar, making their exports costlier in the U.S. Bernanke and Geithner expected further complaints at the Group of 20 summit in South Korea the following week. They didn't anticipate the size of the battle that erupted at home.
The political attacks on the Fed—once the most sacrosanct of government institutions—started slowly, with Tea Party-backed candidates such as Republican Rand Paul, running for the U.S. Senate in Kentucky, campaigning against the central bank. When Bernanke announced round two of quantitative easing (or QE2, as it became known) on the day after the election, the response was swift. Indiana Representative Mike Pence, a conservative bellwether and possible 2012 Presidential candidate, released a statement accusing the Fed of "masking our fundamental problems by artificially creating inflation." A few days later, former Alaska Governor Sarah Palin, the unofficial leader of the GOP's Tea Party wing, posted on her Twitter account that the Fed was planning to "print $ out of thin air."
On Nov. 8, Palin dragged Bernanke more directly into the fray. In a speech in Phoenix, she demanded that he "cease and desist" before his "pump-priming addiction" brought "permanently higher inflation." On Nov. 15 a group of 23 mostly Republican economists, money managers, and former government officials sent an open letter to Bernanke arguing that the central bank's bond purchases "risk currency debasement." Two days after that the four Republican leaders in the House and Senate—John Boehner of Ohio, Eric Cantor of Virginia, Mitch McConnell of Kentucky, and Jon Kyl of Arizona—wrote to Bernanke to express their "deep concerns" over bond purchases that could lead to "hard-to-control, long-term inflation and potentially generate artificial asset bubbles."
Ever since, Bernanke and Geithner have found themselves pitted against the Republicans and the Tea Party in a battle that could help determine the fate of the economy, Obama's Presidency, and the Federal Reserve itself. Some of their Republican opponents, such as Pence and Tennessee Senator Bob Corker, want to strip the Fed of its mandate to pursue full employment and focus on price stability alone, which would make it harder to justify future rounds of quantitative easing. The most radical antagonists want to go further. Senator Rand Paul (R-Ky.) and his father, Rep. Ron Paul (R-Tex.), argue for doing away with the central bank altogether. Forty-one percent of Republicans and 55 percent of Tea Party supporters believe the Fed should be abolished or radically overhauled, according to a Bloomberg National Poll conducted Oct. 7-10.
For Bernanke, who craves the freedom and flexibility of his predecessors to do what he thinks is right for the economy, this amounts to a political choke hold. "Republicans are using him as a proxy for Obama and are determined to make life miserable for both the Fed and its chair," says Arthur Levitt Jr., the former head of the Securities and Exchange Commission who is now a member of the board of Bloomberg, publisher of Bloomberg Businessweek, and a policy adviser to Goldman Sachs (GS). "The Republicans know this will embarrass Obama."
On Dec. 1, critics of the Fed got more to chew on when the central bank released details of the recipients of $3.3 trillion in emergency loans, asset purchases, and other Fed programs that helped shore up markets during the worst financial panic since the Great Depression. The documents were made public because of a sunshine provision that Vermont Senator Bernie Sanders, an independent, added to the Dodd-Frank financial reform bill. "After years of stonewalling by the Fed," Sanders said after the document release, "the American people are finally learning the … jaw-dropping details of the Fed's multitrillion-dollar bailout."
In truth, the details didn't drop all that many jaws. The world already knew that the Fed functioned during the crisis as a warehouse for bad debt. Perhaps the biggest revelation was that Goldman Sachs, whose president said the firm didn't need government help to survive, borrowed as much as $24 billion from the Fed in the weeks after the 2008 Lehman Brothers bankruptcy. Another surprise: European banks were among the biggest users of Fed programs. Zurich-based UBS (UBS) sold more commercial paper through a Fed emergency facility than any other bank, and Deutsche Bank (DB) led all bond dealers in trading mortgage securities with the Fed. All of which may have been more interesting to financial analysts than to the public—and none of which stopped the critics from hammering away at Bernanke. The Fed, charged Ron Paul, "prevented a bad recession for the people who deserved it, the big money people who made all the billions when they were blowing up the bubble. They prevented a deep, deep recession for the Goldman Sachs of the world."
There are substantive economic arguments to be made against the Fed's new round of quantitative easing. One senior banker, who does not want to be quoted disparaging Fed policy, says he thinks Bernanke misread the psychology of the markets and risks undermining the Fed's inflation-fighting credibility by buying bonds when deficits are so high. Yet some Republicans acknowledge that the latest attacks are about politics as well as policy. "There is a real perception among Republicans that for all intents and purposes, Bernanke is a member of the Administration," says Mark A. Calabria, a former aide to Alabama Senator Richard C. Shelby, the ranking Republican on the Senate Banking Committee. It doesn't seem to matter that Bernanke, a registered Republican, was nominated in 2005 by President George W. Bush, or that politics used to stop at the Fed's front door. "The Fed needs freedom to act and act quickly," says Martin Neil Baily, who served as chairman of the Council of Economic Advisers in the Clinton Administration and is now at the Brookings Institution in Washington. "Those are decisions that need to be made outside politics."
Bernanke and Geithner forged a relationship during the peak of the financial crisis of 2008-09, when Geithner was president of the New York Fed and then, from January 2009, Treasury Secretary. Together with former Treasury Secretary Henry Paulson, they used the Fed's balance sheet and taxpayer money to prop up the financial system and save the U.S. from another depression. "The main thing we share," says Geithner, "is that we went through the searing experience of the panic together, trying to design a strategy to contain it and clean up the mess afterward. We have the bond you get from that kind of combat."
"He's taken a lot of heat," Bernanke says of Geithner. "He did things I firmly believe needed to be done. We have a lot of mutual trust."
The two men took different paths to their foxhole. Bernanke spent 17 years teaching and writing about the Great Depression at Princeton University before becoming a Fed governor in 2002. Geithner spent most of his career as a government official and policymaker, honing his crisis-management skills in the 1990s as an aide to Treasury Secretary Robert Rubin during the fiscal meltdowns in Mexico, Asia, Russia, and Brazil. In those years, Geithner also helped author a hands-off policy toward the Fed, in which the Clinton Administration refrained from commenting on central bank moves. "If there's a big fight between the government and the central bank, then you have a problem," says Edwin Truman, who has served at both the Fed and the Treasury and is now a senior fellow at the Peterson Institute for International Economics in Washington. "It creates all sorts of uncertainty and financial market volatility about who's on top and who's on the bottom."
Geithner and Bernanke share temperament, too. Each is more pragmatic than political, and neither seems to relish the public aspects of his role. Geithner, says Obama strategist David Axelrod, "is kind of a unique character in this venue, in that he's just here to do a job. He's not looking for headlines or notoriety." The same could be said of Bernanke. Both have at times appeared uncomfortable when presenting or defending their policies. (Geithner's plan to repair the financial system in February 2009 was greeted with a 4.9 percent drop in the S&P 500 Index. Bernanke admitted in September that he should have been more straightforward in explaining why the Fed was unable to avert the bankruptcy of Lehman Brothers.) Colleagues describe them as nonideological, which is not always an asset in Washington. Geithner switched his political affiliation from Republican to Independent as he moved up the ladder at Treasury. Alan Blinder, a former Fed vice-chairman who is now a Princeton professor, says he doesn't understand how Bernanke is a Republican, given his lack of political orthodoxy.
Because of their personal bond and common interest in protecting their economic prescriptions from political interference, Bernanke and Geithner tend to look out for each other. "They've wisely not allowed themselves to become Siamese twins," says Senator Christopher Dodd (D-Conn.), outgoing chairman of the Senate Banking Committee. "They're complementing each other and utilizing the tools of their offices to enhance common goals—without appearing to be sitting in the same boat, but rather rowing two boats in the same direction."
In February 2009, Bernanke took Geithner's side when the Treasury Secretary was fighting calls for the government to take over large, ailing banks—a step that Bernanke's predecessor, Alan Greenspan, had suggested might be necessary. Geithner's alternative, dreamed up on a beach in Mexico while he was between his New York Fed and Treasury jobs, was to put the biggest banks through Fed stress tests before forcing them to take on more capital. He ultimately prevailed, but only after a nine-hour White House meeting on Mar. 15, during which Geithner and his consigliere Lee Sachs faced down skepticism from the rest of Obama's brain trust, including White House National Economic Council director Lawrence H. Summers.
The favor was returned later that year when Obama, advised by Geithner, nominated Bernanke to a further four-year term as Fed chairman, choosing him over Summers. In backing Bernanke, Geithner was favoring a new ally over the man most responsible for his own rise through the ranks at Treasury. With the economy still fragile and Bernanke's credibility with investors high, Geithner felt it wasn't the right time to make a change, officials say. Geithner took to the phones when Bernanke's renomination looked in jeopardy in the Senate last January. "Tim played an important role in persuading some reluctant senators to support Bernanke's confirmation," says Alan Krueger, a former Treasury chief economist under Geithner who returned to Princeton last month. The Geithner-Bernanke alliance was further cemented during the year-long debate over financial reforms, which Obama signed into law last July. Led by Geithner, the Administration fought off congressional efforts to rein in the Fed's independence. Bernanke emerged stronger than ever.
As their relationship deepened, Geithner and Bernanke learned to understand each other through gestures. A knowing chuckle by Geithner suggests skepticism. The financial crisis generated a number of Geithnerisms, such as "spray foam on the runway," meaning taking steps to limit the fallout when a financial firm crashes. "Two of Tim's favorite aphorisms bear repeating," says Bernanke. "â'Life's about alternatives' and 'A plan beats no plan.' To me, these two aphorisms pretty well sum up what we know about respectively, economics and political science."
There may be new adages to come. Bernanke and Geithner "were very successful in avoiding a depression," says Mohamed A. El-Erian, chief executive officer of Pimco in Newport Beach, Calif. "Now they have to be equally successful in avoiding a lost decade."
The risk is that the attacks could undermine the policy before it's had a chance to accomplish anything. After falling in anticipation of the Fed's move, long-term interest rates rose as criticism mounted. Partly driving the trend: investor fears that Bernanke's Fed colleagues may rally against him, suspending bond buys or at least not extending them when they expire in the middle of next year. "This is going to strengthen his internal opposition," says Vincent R. Reinhart, who directed the Fed's Monetary Affairs Div. from 2001 to 2007. "He's going to have a harder time."
There are limits to what Bernanke and Geithner can do in response to the attacks. As an advocate of Fed independence, Bernanke doesn't want to be seen as doing Obama's bidding. Obama advisers say the White House isn't going to speak out now for the same reason—the threat isn't grave enough, they argue, and to draw the President into the fray would only heighten the danger. Bernanke, for his part, must be careful about speaking out against Republican arguments for immediate budget austerity, even though he believes such a strategy could hurt the recovery. If he answers their attacks, he risks looking like another Obama partisan.
As a former central banker, Geithner is sympathetic to Bernanke's concerns and loath to comment publicly on the Fed's monetary policy actions. Geithner bent that rule after Greenspan suggested the Fed was pursuing a policy of "currency weakening." While professing "enormous respect" for Greenspan, Geithner said the former Fed chairman's comment was "not an accurate description of either the Fed's policies or our policies." In a Nov. 19 interview on Bloomberg Television's Political Capital with Al Hunt, Geithner warned Republicans against politicizing the Federal Reserve and said the Obama Administration would oppose any effort to strip the Fed of its mandate to pursue full employment. "It is very important to keep politics out of monetary policy," Geithner said. "You want to be very careful not to take steps that hurt our credibility."
Obama is in an especially tricky spot. He, too, wants to protect the independence of the central bank and avoid playing into arguments that Bernanke is an extension of his economic agenda. As a result, the President was hamstrung in responding to attacks on the Fed's policies from G-20 officials in the run-up to the South Korea summit. Obama's defense was not as robust as some, including Levitt, thought it should be. "The Federal Reserve is an independent body," Obama said at a Nov. 8 press conference in India on his way to the summit. "It doesn't take orders from the White House, and it's important as a policy matter, as an institutional matter, that we don't comment on particular Fed actions." He added, "I will say that the Fed's mandate, my mandate, is to grow our economy."
Having spent months laying the groundwork for QE2—starting with a Bernanke speech on Aug. 27 in Jackson Hole, Wyo.—Fed officials say they were surprised by the fierce criticism that greeted the move. In the scramble to respond, central bank officials urged sympathetic economists to write newspaper pieces, and laid out their arguments in print interviews and TV appearances. Bernanke went to Capitol Hill to brief members of the Senate Banking Committee. He has defended the bond purchases as a natural extension of monetary policy—a way to bring down long-term interest rates, boost growth, and fend off deflation. In an opinion piece in The Wall Street Journal, Blinder, the former Fed vice-chair, supported his old friend's view, calling the bond purchases "garden-variety monetary policy" and labeling the Fed's critics "the economic equivalent of the Flat Earth Society."
Bernanke is not backing down from his decision. While the economy has shown some signs of picking up, it has yet to achieve escape velocity. Growth is likely to average 2 percent over the last three quarters of 2010, too slow to make a dent in the unemployment rate. If joblessness were to climb back to 10 percent, that could sap what little confidence consumers and companies have, sending the economy back down. It's that dangerous cycle Bernanke is seeking to break. That's why the Fed opted to act despite the criticism.
In the back of Bernanke's mind is Japan. Both he and Geithner share an interest in that country's travails—and a desire to avoid seeing them visit the U.S. "The big risk on the table is a lost decade like Japan," says Mark Gertler, a friend of Bernanke's and professor of economics at New York University. "Both Geithner and Ben are acutely aware of that." Geithner, who speaks Japanese, worked as a Treasury rep in the U.S. embassy in Tokyo in 1990-91. Bernanke wrote a scathing paper about Japan's policies while at Princeton in 1999, then followed up with critical speeches after he became Fed governor in 2002. He focused his criticism on Japan's monetary policy, accusing its central bankers of being too timid in tackling deflation. He suggested they finance a tax cut by buying government bonds. Bank of Japan officials chose not to take his advice, partly out of fear such a move would undermine the central bank's independence.
Geithner insists the U.S. won't go the way of Japan. "We were much more aggressive at an earlier stage in the crisis than has been true for any major country, including Japan," he says. The biggest U.S. banks have been recapitalized. Companies have moved rapidly to lay off workers and shut down excess capacity. And policymakers have been quicker on the draw, with the Fed cutting short-term rates to zero in December 2008 and Obama pushing through a stimulus program just after taking office. "If you look forward from now," Geithner adds, "we have a much healthier balance sheet in the non-financial corporate sector than Japan had and a much healthier balance sheet in the financial sector."
Yet with all of that, the U.S. economy has not achieved a self-sustaining recovery. Growth downshifted in the second and third quarters, to the surprise of both Bernanke and Geithner. Just as in Japan, borrowers in the U.S. remain saddled with too much debt while banks remain cautious about lending. Geithner has warned repeatedly that one lesson of Japan's Lost Decade is that policymakers must not prematurely withdraw stimulus. That's what Japan did in 1998, increasing value-added taxes in an effort to tackle its ballooning deficit. The move pushed the economy back into recession. Geithner is determined to avoid the same thing in the U.S. and is ready to oppose victorious Republicans if they insist on big, immediate budget cuts. "We're fighting against that," he says, adding: "I think we can muster a policy consensus to avoid a large, premature contraction" of fiscal policy.
Now the Fed's independence—and its willingness to do whatever it takes—is being tested. "I don't think the Fed wants to get into a major confrontation with one of the two parties in Congress," says Vin Weber, managing partner of the lobbying firm Clark & Weinstock and a former Republican congressman from Minnesota. The outcry, he says, "is not going to kill Quantitative Easing 2, but it will curtail further easing."
Don't be so sure. Former Fed Governor Laurence Meyer predicts the central bank will end up buying $1 trillion worth of Treasury securities—$400 billion more than planned. And if things get worse and the economy flirts with deflation, expect Bernanke to be even more creative. Fed officials have already talked about the possibility of setting a specific, low target for long-term interest rates, although for now they've decided not to do that because it might entail buying bucket-loads of Treasury bonds. That calculus might change if the economy were to relapse. Then Bernanke would be unwilling to let political pressures curtail his monetary moves. That would put the Fed's independence to its biggest test yet. If it happens, Bernanke will once again count on Geithner for crucial support. That's what foxhole friends are for.
—With Mike Dorning