Bernanke's Dilemma

Alan Greenspan popped the late-1990s stock market bubble and threw the economy into recession. Will the new Fed chief do the same with the housing bubble?


This article is from the November/December 2005 issue of Dollars and Sense: The Magazine of Economic Justice available at

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This article is from the November/December 2005 issue of Dollars & Sense magazine.

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If Ben Bernanke is unlucky, he may inherit the whirlwind when he succeeds Alan Greenspan as Federal Reserve chairman early next year. The Greenspan Fed is once again pursuing a high-risk strategy while concealing its real intentions from the public: raising short-term interest rates in the name of fighting inflation, but actually aiming to defuse the price bubble in housing. The last time the Fed tried this maneuver, it was hoping to subdue the stock market bubble. That gambit ended badly: shareholders lost $6 trillion, and instead of subsiding gently, the bubble collapsed and the economy went into recession.

This time, as sophisticated financial-market analysts understand, the Fed's true objective is asset deflation--though neither Greenspan nor Bernanke will acknowledge even that a housing bubble exists. Raising short-term rates, the Fed assumes, will induce financial markets to raise rates on long-term loans like mortgages, and higher interest on mortgages would definitely dampen housing prices.

Trouble is, the Fed strategy has so far failed utterly. Long-term rates are not rising. If Bernanke persists with Greenspan's strategy, short-term rates may rise higher than long-term rates. That unnatural condition means the imminent threat of recession, which is what has occurred repeatedly when the Fed has induced this state of inverted short-term and long-term rates.

A recession, as always, imposes the worst pain and loss on the weakest parties--the newly unemployed, families already struggling with debt, and small businesses already squeezed by energy costs and other negatives. Thorstein Veblen called it "the slaughter of the innocents." It's simply wrong for the Fed to put the real, Main Street economy at risk in order to solve a financial problem, the housing bubble, that Greenspan, Bernanke and their colleagues at the Fed won't even acknowledge exists, let alone admit their culpability in creating.

If Bernanke, like Greenspan, is convinced that long-term rates need to rise, there's a better way to do it--an ingenious strategy proposed by Paul McCulley, Fed watcher at PIMCO, the giant bond investment house. Contrary to conventional thinking, McCulley suggests the Fed can effectively force long-term rates to rise if it now starts to reduce short-term rates. Inflation vigilantes in the bond market would be alarmed, McCulley explains, believing that the central bank has given in to the return of price inflation that depresses the value of long-term financial assets. In that event, bond-market players would bid up bond rates to protect themselves. Pushing long-term rates up would address the housing bubble; doing so without raising short-term rates would be easier on the Main Street economy.

The logic is persuasive, but don't count on Bernanke to grasp it. Like Greenspan, he belongs to the orthodox school: Markets are logical and efficient, so there should be no need for central bankers to game or surprise market players to induce them to react one way or another. Holding firm to their economic principles--in this case, protecting the interests of the wealth holders and financial markets--is often more important to central bankers than protecting the economic well-being of the overall society.

But perhaps Bernanke will turn out to be a more supple thinker than the excessively admired Greenspan. We will soon find out.

William Greider is a journalist and the author of many books, including Secrets of the Temple, Who Will Tell The People?, and The Soul of Capitalism: Opening Paths to A Moral Economy.