The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  Indeed, throughout late 2010 and early 2011, King faced the suspicion that he’d made an implicit deal with the Tories: He would stick with low-interest-rate policies in exchange for their quick shutoff of the fiscal spigot. When confronted, King was adamant that there was no such horse trading. “I have never discussed with [Osborne] propositions of the kind, ‘If we tighten fiscal policy, will you loosen monetary policy?’” King told a parliamentary committee in March 2011. “That kind of conversation has never taken place.”

  As King faced these political difficulties, the British economy was entering a nasty period of stagflation, a central banker’s worst nightmare—and the leaders of the Bank of England were all over the map about what to do about it.

  British GDP fell 0.4 percent in the fourth quarter of 2010, and while it rebounded at the start of 2011, growth was too slow to bring unemployment down. UK unemployment, 7.8 percent at the end of 2010, started rising above 8 percent again as 2011 progressed. Simultaneously, the weaker value of the pound, higher prices for imported fuel, and the value-added tax increase created another spike in consumer prices. And prices kept rising at a pace well above the Bank of England’s 2 percent target—at more than 3 percent in the final months of 2010, and at more than 4 percent at the start of 2011.

  It’s always a dilemma for central bankers when unemployment and inflation are both high at the same time, and this episode brought out particularly stark divisions on the Monetary Policy Committee. At one meeting, in February 2011, the nine-member committee split four different ways. The differences boiled down to what lessons each member drew from the Great Inflation of the 1970s.

  At one extreme, there was inflation hawk Andrew Sentance, who started advocating for raising interest rates in June 2010 and dissented from the rest of the MPC until the end of his term in May 2011. Sentance looked at those rising prices and saw an incipient threat that businesses and consumers would accept high inflation as the new state of affairs, much as Arthur Burns had in the United States four decades earlier. That could allow a vicious cycle of higher prices leading to higher wages leading to higher prices. “Notwithstanding my affection for the rock music of the seventies, the economic turmoil of that period is definitely not something we want to revisit,” Sentance said in a February 2011 speech titled “Ten Good Reasons to Tighten.” “But one of the lessons from the battles against inflation in the 1970s and the 1980s, was the importance of having credible policies. Statements about the need to reduce inflation need to be backed up by actions to achieve that objective.”

  At the other extreme was dovish Adam Posen, an accomplished macroeconomist who had been a leading analyst of Japan’s stagnation over the previous two decades. By the fall of 2010, he’d seen enough. On September 28, he gave a speech titled simply “The Case for Doing More.” Posen warned that the British economy—and, for that matter, the U.S. economy—appeared to be functioning well below its potential, meaning that inflation wasn’t nearly as big a threat as recent price increases suggested. If the Bank of England would “see through” the uptick in commodity prices and the hike in the value-added tax, it would discover that, due to the weak economy, the real pressure on prices was downward, not up. The lessons of the 1970s, he suggested, were the wrong lessons to draw in 2010, when the fundamental problem facing Britain and the other major Western powers was idle workers and idle factories:

  Central bankers’ fears on this score can be taken to intellectually unjustified extremes, and there is a risk of our doing so now when the damage could be great by so doing. When the overwhelming bulk of pressures in the economy are disinflationary, and when the level of output and employment is clearly likely to be below potential for an extended period, it is right for central bankers to take the additional negative effects of protracted recession on trend productivity growth and on capacity into account. That is a far cry from 1960s and 1970s monetary policy efforts to push the economy into growth without regard for the limits on, and in fact the decline then in, potential growth.

  In other words, let’s focus on the problem we’re actually facing, not on the problem of our parents’ generation. Posen started voting for an extra £50 billion of quantitative easing at the October 2010 MPC meeting, and he became as consistent an advocate for easier money as Sentance was for tighter throughout 2011. Posen actually violated Bank of England etiquette by giving strong suggestions of his policy view before changing his vote; by tradition he should have changed his vote and subsequently explained it. But while at times Posen seemed on the verge of becoming the next Danny Blanchflower–style black sheep on the MPC, he was better at playing by the rules than the Dartmouth professor.

  King’s views in late 2010 and early 2011 were somewhere between Sentance’s and Posen’s. He often spoke more pointedly of the risks of inflation than Posen did, but he also argued that it was best for the bank to look past the short-term impacts of higher energy prices, increased taxes, and falling exchange rates. Yet as the British economy muddled along, unemployment and inflation rising together, the Bank of England sat on its hands and left policy unchanged.

  If the Tory–Lib Dem coalition thought there was an unspoken agreement with the governor of the Bank of England to offset austerity with more monetary easing, King disappointed terribly. Might there have been a different result under a central banker who didn’t have anything to prove about his political independence? Or one who had a less acidic tongue, a better gift for persuading his colleagues, and fewer enemies?

  The lesson from Threadneedle Street in the aftermath of the crisis is that even for a king, power isn’t limitless.

  FIFTEEN

  The Perilous Maiden Voyage of the QE2

  The reporters sat nervously in the basement of the Treasury building at 1500 Pennsylvania Avenue in Washington on November 3, 2010, tapping, glancing around, double- and triple-checking that their computers were working. Finally, a fax machine belonging to Dow Jones Newswires spit out a document, two pages containing information that seemingly every trader and money manager on the planet lusted for: the outcome of the latest meeting of the Federal Open Market Committee, the policy arm of the Federal Reserve.

  Sandra Salstrom, the young Treasury press staffer in the room, wouldn’t, by tradition, read or even touch the document. That, the logic goes, could compromise the vaunted independence of the central bank from the U.S. Treasury Department. Instead, Dow Jones reporter Jeff Bater took it from the fax machine, photocopied it, and with Reuters’ Mark Felsenthal placed the copies on a table so the thirty or so journalists who’d piled into a room that usually holds a dozen could make a mad dash for them. The reporters had a mere ten minutes to turn the 482-word statement into a story that would be blasted across the earth.

  Salstrom was there as official timekeeper. She used the timer on her BlackBerry, a technological advance over the cheap cartoon-character wristwatch that had served as the timepiece a few years earlier.

  “Five minutes,” she warned.

  “Two minutes.”

  “One minute—open your lines.” The reporters were now allowed to open communication with their editors, giving them sixty seconds to begin transmitting the information.

  When the big moment came, at 2:15 p.m., Salstrom rang a large bell. As she had been repeatedly advised when first taking up this duty, she gave the pull a good yank to ensure that everyone could hear.

  An instant after Salstrom rang the bell, word was transmitted to every trading floor on earth. The journalists, experienced at parsing Fedspeak, had seen quickly that the real news was buried in the third of seven paragraphs: Over the next eight months, using newly created dollars, the Fed would buy $600 billion of U.S. Treasury bonds.

  Within the Fed, the plan was known as “large-scale asset purchases,” a strategy to try to increase the supply of money in the economy when short-term interest rates were already near zero. Ben Bernanke could explain all day long how this was different from the �
��quantitative easing policy” the Bank of Japan had tried a decade earlier. (Both central banks expanded their balance sheets, but the BOJ did so only by buying short-term government debt, whereas the Fed was buying longer-term debt.) To anyone not involved in the rarefied debates that went on inside the Eccles Building, though, it was a distinction without a difference. This being the second round of quantitative easing by the Fed, the approach adopted that November afternoon would soon be known around the world as QE2, whether Bernanke liked it or not.

  The reaction was instantaneous—and surprisingly muted. Yes, a vast sum of dollars was about to be unleashed upon the global financial system. But the Fed had succeeded in telegraphing its plan in advance through a mix of public speeches and off-the-record statements to Fed watchers in the media and beyond. The Standard & Poor’s 500 stock index ended the day up less than four tenths of a percent, effectively flat. For Bernanke and the Fed, it was a moment of triumph: They’d guided markets to exactly where they wanted them to go. Even a major new policy could be announced without disruption.

  The policy itself was hardly revolutionary—the Fed’s internal analysis viewed it as the equivalent of cutting short-term interest rates by half to three quarters of a percentage point. But Bernanke could rest easy knowing he’d moved boldly enough to prevent the U.S. economy from the long slog of falling prices and stagnant growth that Japan had experienced for the better part of two decades. And he’d done it with a fair degree of consensus: Only one of eleven policymakers with a vote in that meeting had dissented, and that was Tom Hoenig of the Kansas City Fed, who had been voting against the rest of the committee all year long.

  The sense of triumph wouldn’t last long. The financial markets may have been well prepared for the decision to launch QE2, but the rest of the world, it soon became clear, was not.

  Backlash against the Fed’s $600 billion intervention in the economy began that very evening, with Glenn Beck, then near the peak of his influence as an evening conspiracy theorist on Fox News. “I’ve been telling you that it would be the Weimar Republic moment,” Beck, never one to pass up a reference to Nazi-era Germany, told his audience of nearly two million. “It is largely untested and unconventional. I mean, I’m sure Zimbabwe tried it. It’s a huge gamble. It is probably the biggest bet in history and the biggest bet in the history of our planet.” Failed vice presidential candidate cum media sensation Sarah Palin was comparatively restrained: “We shouldn’t be playing around with inflation,” she said a few days later, showing her first public sign of interest in monetary policy. “Maybe it’s time for Chairman Bernanke to cease and desist.”

  The criticism from American conservatives extended to a newly energized Republican Party. Just a day before the Open Market Committee’s decision, the GOP had prevailed in midterm elections and gained a majority in the House of Representatives. In the Republicans’ telling, the easy-money policies of the Fed were aiding and abetting excessive government spending. Opposition to QE2 became a rallying cry.

  “Look, we have Congress doing tax and spend, borrow and spend. Now we have the Federal Reserve doing print and spend,” said Wisconsin representative Paul Ryan, tapped to chair the House Budget Committee in the new Congress, on Fox News a few days after the announcement. “What the Fed is basically doing is they’re trying to bail out the fact that our fiscal policy is so bad. The Fed should focus on keeping our money sound and honest, not on doing this, which I think is going to give us a big inflation problem down the road.”

  American conservatives had a surprising set of allies overseas. “I don’t recognize the economic argument behind this measure,” acid-tongued German finance minister Wolfgang Schäuble told Der Spiegel. “The Fed’s decisions bring more uncertainty to the global economy” and “artificially depress the dollar exchange rate by printing money.” As President Barack Obama prepared for a meeting of the Group of 20 in Seoul, South Korea, officials from governments around the globe joined in the fusillade of criticism. The United States “does not recognize . . . its obligation to stabilize capital markets,” said Zhu Guangyao, China’s vice finance minister. “Nor does it take into consideration the impact of this excessive fluidity on the financial markets of emerging countries.” The Chinese government’s media campaign against the Fed was so vigorous that the shampoo girl in a Beijing hair salon asked an American customer about it with a tone of accusation.

  The Germans and Chinese and South Koreans and Brazilians were arguing that by flooding the market with dollars, the Fed was essentially engaging in a currency war, trying to benefit American exporters by depressing the value of the dollar. It may seem nonsensical that the central bank was simultaneously being accused by U.S. conservatives of undermining the American economy and by foreign governments of giving American businesses an unfair advantage. But those were the strange bedfellows of the great QE2 debate.

  In Seoul, Obama found himself in the uncomfortable position of being attacked by foreign leaders for a decision over which he had no power. In Basel—by coincidence, one of the six-times-a-year gatherings of the world’s central bankers was scheduled for the weekend immediately following the QE2 decision—Fed vice chairman Janet Yellen and New York Fed president Bill Dudley faced more polite and economically literate criticism from the other central bankers. But in the formal sessions and the intimate dinner high above Basel alike, the accusations of fecklessness flew.

  When it wasn’t international central bankers pummeling the Fed, it was animated bunnies. In a seven-minute YouTube video created by Omid Malekan, then a thirty-year-old real estate manager, two animated animals with computer-generated voices—whether they were in fact rabbits or bears or pigs or dogs was hard to say—engaged in a Socratic dialogue about “the quantitative easing” that had been launched by “the Ben Bernank” to benefit “the Goldman Sachs.” The video went viral; by mid-December, it had been viewed 3.5 million times. That November, after two of Bernanke’s closest advisers at the Fed, Governor Kevin Warsh and communications chief Michelle Smith, had each been sent links to the video multiple times, they concluded that they needed to show it to the chairman. Bernanke found the video funny despite deep flaws in its economic analysis.

  There was even criticism from within the Federal Reserve System itself. On the Monday after the decision, Warsh published an opinion piece in the Wall Street Journal. “The Federal Reserve,” he wrote, “is not a repair shop for broken fiscal, trade or regulatory policies.” The Fed’s easing should be reversed, he said, if “purported benefits disappoint, or potential risks threaten to materialize,” and the increased role of the Fed in the bond market “poses nontrivial risks that bear watching.” The wording was all very polite, but anyone who knows the language of central banking could read between the lines: Warsh was deeply apprehensive about the action he had voted in favor of five days earlier. It was Warsh’s way to balance his deep respect for Bernanke with his distaste for the new policy: The chairman would get Warsh’s reluctant vote for QE2; Warsh would publicly explain his reservations a few days later. Bernanke had even read the piece before it was published.

  But Warsh’s apprehension was only part of a broader discontent within the Fed. Tom Hoenig’s lone official dissent reflected a quirk of the calendar: Voting rights rotate among the twelve Fed bank presidents each year, and in 2010 only one of the four officials who were dead set against QE2 had a vote. Warsh and two or three more policymakers had serious reservations.

  The weekend after the decision, the Atlanta Fed held a “Return to Jekyll Island” conference to mark the hundredth anniversary of the gathering off the Georgia coast where the First Name Club had plotted out what would become the Federal Reserve System. In the chilly late fall air that Friday night, as Fed officials, economists, and reporters made their way from a conference space that was once J.P. Morgan’s indoor tennis court to dinner in the old main hotel building, then on to the small underground bar where they would order after-dinner drinks and
jockey with a wedding party for elbow room, Charles Plosser, the president of the Philadelphia Fed and perhaps the most voluble of Fed officials, spoke in increasingly animated fashion with Sandra Pianalto of the Cleveland Fed, perhaps the least.

  “How can you say we’ve got a consensus?!” he bellowed, within earshot of reporters. “We don’t have anything close to a consensus!”

  • • •

  How had it come to this?

  In the spring of 2010, a U.S. economic recovery had seemed under way. After shedding jobs for twenty-four straight months, the private sector finally began adding jobs that March. The Obama administration launched a publicity tour it called “Recovery Summer,” pointing to projects funded by its fiscal stimulus program that were presumably contributing to a surging economy. At the Federal Reserve, the words on seemingly everyone’s lips were “exit strategy.” On the markets desk at the New York Fed, small-scale experiments began to test some of the methods of draining liquidity—that is, extra cash—out of the banking system.

  Bernanke and other officials wanted to be sure that when the time came to tighten the money supply, the Fed had the ability to do so without letting prices spiral out of control. If they succeeded at persuading the world that that was the case, it could actually benefit the economy in the near term: If people expected high inflation in the future, they would demand higher interest rates on longer-term bonds, which would in turn lead to higher interest rates for mortgages and corporate borrowing, discouraging growth. The Fed’s exit strategy talk could, in theory at least, help keep inflation expectations down, long-term interest rates low, and the American economy humming.

  But such plans began to seem premature as the summer of 2010 progressed. The near implosion of Europe drove the S&P 500 index down 16 percent from April 23 to July 2. And the economic data that was coming out pointed not to a recovery but to a possible dip back into recession. When the May 2010 jobs report initially came out at the start of June, it showed a mere forty-one thousand private jobs created that month, far too few to represent meaningful growth in the United States, with its 150 million workers. Later revisions put the number at more like eighty-four thousand, though even that suggested job growth too weak to drive down the unemployment rate.