Ben Bernanke and the Winner’s Curse

The Torment of the Fed’s Chairman-designate

In economics there is a phenomenon known as the “winner’s curse” whereby the winner of an auction over-pays. The most that she should have paid is the second-highest bid, which is the highest value attached by all other bidders. This curse provides a useful analogy for thinking about the recent selection of Federal Reserve Chairman Alan Greenspan’s replacement. There is a good chance that the winner, Ben Bernanke, may end up with a bout of the winner’s curse.

Within Washington there is a new trend to appoint academic research economists to leading economic policy positions. Several recent Federal Reserve governors and district bank chairpersons are former academics or researchers, as is Chairman-designate Bernanke. This trend is disturbing. Academic economists believe in economic models. Though the economy is subject to shocks that make outcomes unpredictable, the economy’s structure is supposedly known through their models. This view contrasts sharply with that of Chairman Greenspan who held strong ideological convictions about markets and government, but believed the economy’s structure was unknowable. This belief kept Greenspan open despite the strength of his convictions, and it made him an uncanny central banker. The new danger is that academic policymakers will be less open and more inclined to ignore new facts in favour of their theories.

That said, Chairman-designate Bernanke is probably one of the most open-minded academics. He began his career studying the devastating effects of the Great Depression’s deflation on the U.S. banking system, which explains his concern about deflation in the last recession and why he advocated such deep interest rate cuts. Unfortunately, financial markets have less sympathy with this view. Consequently, they may initially punish him as being potentially “soft” on inflation. One curiosum about his pedigree is that in many regards his intellectual profile better fits a new Democrat. That raises a puzzle regarding the basis of the romance between Bernanke and the Bush administration.

As Federal Reserve Chairman, Bernanke faces several major challenges. The first is that he is taking office at an extremely difficult economic moment. On one hand, the economy exhibits significant financial fragility that calls for interest rate caution: on the other, it is suffering a bout of oil price inflation. Though higher interest rates are not appropriate for dealing with such inflation, financial markets deem that they are and are pushing for higher rates. This comes just as the “Greenspan premium,” earned through a decade of costly anti-inflation policy, is being replaced by the “Bernanke discount.” The net result is that Chairman Bernanke will have less room for manoeuvre and will be under greater pressure to raise rates to prove his anti-inflation credentials. That could spell trouble for the U.S. economy.

A second challenge is that there is a very good chance of a very hard landing within the next two years. Economic policy is like a game of hot potato, and the person who gets blamed is the person holding the potato when the music stops. Chairman Greenspan baked this potato, but it is likely Chairman Bernanke who will end up holding it. If the housing bubble bursts and recession ensues, lower interest rates will likely have a similar effect to “pushing on a string.” This is because lower rates will not benefit households that re-financed previously when rates were down, while others will find it difficult to refinance because home values will have fallen.

A final challenge facing the new Chairman is how to deal with asset price bubbles without recourse to the blunderbuss of higher interest rates, which harms innocent economic sectors. Here, Bernanke will have to reverse his earlier views. This has already started regarding his views on inflation-targeting, which now looks ill-advised in light of today’s complex inflation and Europe’s poor economic performance under inflation-targeting. Bernanke has written that asset prices should not be considered independently of their impact on overall inflation. If it transpires that there has been a housing bubble that wreaks widespread havoc when it bursts, he will have to change his views. In principle, that is quite easy. The difficult part is choosing to do so.