Bernanke Broke Rules, Paulson Fumbled, Fed Managed Great Panic

Review by Caroline Baum

-- On Nov. 21, 2002, Ben Bernanke gave a speech to the National Economists Club of Washington titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In it, the newly appointed Federal Reserve governor explained how a central bank can fight falling prices even when its target interest rate is zero.

He never imagined that five years later, in the role of Fed chairman, he would be digging deep into that emergency tool kit and crafting out-of-the-box solutions to prevent the U.S. financial system from falling into the abyss.

How Bernanke and a handful of senior policy makers worked around the clock, making ad hoc decisions on little sleep and with limited information just to keep up with unfolding events, is the story told in David Wessel’s well-written, thorough book, “In Fed We Trust.”

It’s the story of a self-described “academic lifer” unschooled in the ways of Washington and Wall Street, who came to the Fed determined to be what Wessel calls the “un- Greenspan” and elevate the stature of the institution over that of its chairman. Before long, the former Princeton professor, whose approach to policy was based on rules, was breaking all of them.

It’s the story of the worst financial crisis since the Great Depression and the imperfect individuals who consistently underestimated just how bad things really were.

“Even when officials thought they were planning for the worst-case scenario, they weren’t,” Wessel writes.

‘Fourth Branch of Government’

It’s the story of a central bank that effectively becomes the Treasury’s “piggy bank” because crisis managers had neither the time nor the stomach to secure Congress’s authorization to spend trillions of taxpayer dollars to rescue the banks that got the economy into the mess.

Finally, it’s a story whose ending has yet to be written. Should an unelected group of officials be in the business of picking winners (Bear Stearns Cos.) and losers (Lehman Brothers Holdings Inc.), or of saving an insurance company (American International Group Inc.) because it posed a systemic risk? Is what Wessel refers to as a “fourth branch of government” consistent with our democracy? These are questions he leaves unanswered.

Wessel is the consummate Washington financial journalist. Readers of his weekly Capital column in the Wall Street Journal, where he is economics editor, will recognize the assured voice and insider’s access that give the book its heft.

Four Musketeers

Much of the material in the book won’t be new to those who have followed the Great Panic, as Wessel calls it, day by day. For those who haven’t, “In Fed We Trust” is a comprehensive account of all things financial the last two years.

Wessel walks us through every twist and turn in the crisis, telling us about the decisions made, opportunities missed and people who made or missed them. Then-Treasury Secretary Henry Paulson may have been the public face of the government’s rescues along with Bernanke, but it was the Fed’s “Four Musketeers” who called every key play, according to Wessel.

The group included Bernanke, the Great Depression scholar, who promised to do “whatever it takes” to prevent a repeat of the 1930s; Timothy Geithner, president of the New York Fed (and now Treasury secretary), a technocrat who was “more disciplined, calmer and politically savvy” than Paulson; Fed vice chairman Donald Kohn, a long-time Fed economist and trusted insider; and Fed governor Kevin Warsh, a former investment banker with ties to Wall Street.

‘Theater and Substance’

Unlike Geithner, who understood the importance of getting both the “theater” (communication) and “substance” (policy) right, Paulson continually “botched the theater,” Wessel writes. His failure to deliver a consistent message -- he refused to use government money to save Lehman, only to reverse himself days later and advocate an AIG rescue -- did little to instill public confidence.

The U.S. economy, currently in the 19th month of recession, has yet to deliver its verdict on the Fed’s “extraordinary responses ... to extreme circumstances.” Did the Fed’s aggressive actions make a difference?

Wessel, for his part, says they did. After failing to anticipate the risks, diagnose the problem and understand the dimensions of the crisis, the Fed took “creative and bold” action, he says. Without it, “the economy would have been even worse than it is now.”

And, as he says, he would have written a much more critical book.

“In Fed We Trust: Ben Bernanke’s War on the Great Panic,” is from Crown Business (323 pages, $26.99).