Is the Criticism of Bernanke Warranted?

A Bloomberg story, in what may be becoming conventional wisdom, charges Federal Reserve Chairman Ben Bernanke with making a novice’s error:

By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about- face, coming after months of assurances that the subprime- mortgage rout was contained, as Chairman Ben S. Bernanke’s first serious error since taking office last year.

“It was a rookie mistake,” said Kenneth Thomas, a finance professor at the University of Pennsylvania’s Wharton School in Philadelphia. The Fed “underestimated liquidity needs” of investors and the fallout from the housing recession, he said, adding, “This demonstrates the difference between book-smart and street-smart.”

Note that the dig at Bernanke’s academic credentials may not simply be to contrast him with Greenspan. Arthur Burns, the last Fed chairman with a similarly illustrious scholarly pedigree, was considered to have been particularly ineffective.

But is this criticism fair? Now that Greenspan is out of power, commentators have become increasingly willing to blame him for overly cheap credit which is now being repriced with a vengeance. Indeed, veteran investor Jeremy Grantham went as far to declare the existence of the first worldwide bubble covering all asset classes.

So if you believe Grantham (and he has plenty of company, from uber-bears like Nouriel Roubini and Marc Faber to conservative types like Bill Gross at Pimco to opportunists like Jim Rogers), Bernanke inherited a huge mess.

The Fed wasn’t wrong to be worried about inflation. In fact, some economists and investment pros have taken issue with the Fed’s reliance on core inflation, rather than broader inflation measures which include more volatile and more rapidly rising food and energy costs. And others have argued that the methodology used for including housing in CPI measures understates housing cost increases.

But the Fed has very few tools at its disposal. Monetary policy is a blunt instrument, and it is very easy for the Fed to undershoot, or as Greenspan did, overshoot.

The Fed will be almost certainly be criticized heavily no matter what course of action it takes. It’s hard to see how the Fed can find clear sailing through these stormy seas. And while the Wall Street Journal, in true form, marshals whatever upbeat evidence it can find (a story today offers reassuring comparisons to 1987 and 1998), its page one blow-by-blow recounting of the events leading up to the Fed’s discount rate cut makes it clear that the Fed was seeing acute distress in multiple markets.

Bernanke’s biggest error to date is not his decisions but his stage management. Greenspan’s impenetrable statements and his widely touted obsession with statistics shrouded him in a Wizard-of-Oz-like mantle. Bernanke, with his desire for greater transparency, opened the curtain at the worst possible moment.