Volcker Shuns the Blame Game


Without fingering Bernanke, the former Fed chairman talks tough in reiterating the Fed's responsibility to "resist pressures toward inflation"

So which is it, Paul Volcker? Is Ben Bernanke doing the right thing as Federal Reserve chairman or not?

Volcker, who himself ran the Fed from 1979 to 1987, broke his silence on Bernanke's performance in a major address on Apr. 8, saying the Fed's recent dramatic actions (BusinessWeek, 3/26/08) to arrest the credit crunch "extend to the very edge of its lawful and implied powers." That seemed like a pretty clear criticism of Bernanke. But a day later, Volcker told reporters he felt his remarks had been misinterpreted. Referring to a New York Times headline that said "Ex-Fed Chairman Chides Current One," Volcker said "I thought that was ridiculous." He added: "It's the opposite of what I think."

Until now, Volcker has been far quieter about the institution he used to run than has Bernanke's immediate predecessor, Alan Greenspan. On the lecture circuit, Greenspan has repeatedly offered his views on the state of the U.S. and global economies, though he has generally avoided specific comments about Bernanke. Volcker preferred to keep his views to himself.

Rhetorical Red Flags

That changed in a big way on Apr. 8 in a keynote speech to the Economic Club of New York in which Volcker waved some rhetorical red flags about the Fed's recent actions, such as opening the discount window for the first time for emergency borrowings by investment banks and helping finance JPMorgan Chase's (JPM) takeover of crippled Bear Stearns (BSC).

Volcker's abrupt emergence into the public forum got economists' and analysts' attention. "He almost seems to say, 'I don't know what else Bernanke could do, but I'm still worried,'" says Milton Ezrati, senior economist and strategist of Jersey City (N.J.)-based Lord, Abbett & Co. "On the one hand, he has a notion that Greenspan clearly does not share, that he should be quiet. On the other hand he's worried about his legacy" of suppressing inflation, Ezrati says.

"Not Natural" for a Central Bank

In his prepared remarks to the Economic Club, Volcker used strong language: "Out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank."

The ex-Fed chief is a stern inflation hawk who engineered a severe recession in the early 1980s by sharply raising interest rates to knock down an inflation rate that reached nearly 15% by 1980. "As custodian of the nation's money, the Federal Reserve has the basic responsibility to protect its value and resist chronic pressures toward inflation," he said (BusinessWeek.com, 3/13/08).

In another comment that is bound to be quoted and re-quoted (including here), Volcker said: "To meet the challenge, the Federal Reserve judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices."

Volcker said that recent actions to extend a hand to investment banks, which have not until now been under the Fed's aegis, "will surely be interpreted as an implied promise of similar action in times of future turmoil." Without mentioning Bear Stearns by name, he said the deal to rescue it by taking $30 billion worth of questionable collateral stretches "to the point of no return," the banking mantra of lending freely against good collateral.

Bernanke's Burden

On Apr. 9, however, Volcker appeared chagrined that his remarks were taken as a criticism of Bernanke, whom he never mentioned by name. In a public address at the Harvard Club of New York City and in remarks to reporters beforehand, he said the Federal Reserve had to do something to avoid a financial crisis that was exacerbated by the use of exotic derivatives and extreme financial leverage. He said "it is a sign of the nature of a new financial system that these seldom-used powers had to be taken out of the knapsack."

In another nod in Bernanke's direction, Volcker said the Fed was forced to step in because of the ineffectual response of other players, including Fannie Mae (FNM) and Freddie Mac (FRE), the giant, government-chartered mortgage insurers and buyers. He said too much of the burden for solving the crisis was being placed on the Fed. "If the market needs more support, which it well may, the government ought to do it" (BusinessWeek.com, 3/30/08) through measures other than purely monetary policy, Volcker told reporters. "Don't shoot the central bank" for problems it didn't cause, he said.

No "Inflating Your Way Out"

Volcker himself was hardly a free-market purist during his tenure at the Fed. Irvine Sprague, a former FDIC director, recalled in a 1986 book that Volcker was a leading force in the bailouts of Philadelphia's First Pennsylvania Bank in 1980 and Continental Illinois in 1983. Testifying in 1984 on the Fed's loans to prop up Continental Illinois, Volcker said: "The operation is the most basic function of the Federal Reserve. It was why it was founded." One difference between then and now: Those two were commercial banks, for which the Fed has traditionally taken responsibility.

Volcker didn't completely change his tune on Apr. 9. He kept returning to the idea that the Fed needs to focus on preserving the value of money by keeping inflation low. "Don't think you can find an easy escape [from trouble] by inflating your way out," he said during a question-and-answer session. "Whatever you do, you'd better take care to think about the implications of that for future inflation."

Coy is BusinessWeek's Economics editor.

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