From the May 2008 issue of Wealth Manager Web • Subscribe!

Legacy Issues

Ben Bernanke just can't get a break. From day one he was saddled with the burden of filling his predecessor's shoes. No mean feat when you take the helm from someone widely hailed as "the maestro." But that was yesterday. Managing expectations tied to Alan Greenspan's legacy is the least of Bernanke's worries in 2008. Slow growth and rising inflation threaten, and so the Federal Reserve chairman is now grappling with what may be the central bank's biggest challenge in a generation.

To understand the extent of the challenge let's start by considering the range of the criticism. On one side are those who say the Federal Reserve has been too slow in cutting interest rates to fend off a slowdown in the U.S. economy. Others complain that easy money policies of the past have let the inflationary cat out of the bag.

The debate about what to do has risen to the highest levels. In testimony to Congress in late February, Bernanke counseled that "inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities."

Doubts were raised just a week later by Dallas Federal Reserve President Richard Fisher, who's also a voting member of the Federal Open Market Committee. "One would like to think that as the economy slows, inflationary pressures will do likewise. But we cannot always be sure they will, given the globalized nature of the U.S. economy," Fisher advised.

The definitive truth will out, of course. Eventually. A year or two from now it will be clear whether Bernanke and company's choices on monetary policy were prudent, reckless or just plain naive.

So it goes for crafting monetary policy in a world of fiat currencies. Faith and guesswork are inextricably entwined with picking interest rates and adjusting money supply. Ideally, the results claim some basis in economic reality, although history suggests that something less than the ideal is always possible and at times, even likely.

That's no surprise if you consider that running a central bank is a thankless task, even under the best of conditions. Problems range from making decisions in real time using yesterday's data for making decisions today that won't fully affect the economy for months and perhaps years.

Arguably the biggest challenge is that mere mortals can't possibly fathom the depth and complexity of a $14 trillion economy. The job only gets tougher in a globalized economy, where policy decisions on the other side of the world can unexpectedly cast a long shadow locally. None of this stops monetary authorities from doing their jobs, of course, but no one should be surprised to learn that the results can and do vary.

Fortunately for the United States, the Fed compares well in the grand scheme of central banking history (the Swedish parliament founded the first government-sponsored bank in 1668). A key reason? The Federal Reserve is one of the more independent institutions of its kind. Government meddling, in other words, is kept to a minimum.

Politics is a major risk for any central bank. The potential for government mischief has been recognized by dismal scientists since at least the early 19th century, when the great classical economist David Ricardo warned: "neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power: in all States, therefore, the issue of paper money ought to be under some check and control...."

That led Ricardo to favor the gold standard, a prescription that the United States has embraced in various forms in the past. But the fashion of linking the money supply to the 79th element died in 1971, when the Nixon administration suspended the Bretton Woods system of dollar-gold convertibility that had prevailed since the late 1940s.

Today, arguably more than ever, the American experience with central banking is one of trust in the intellect of humans--trust that the Fed can choose the correct interest rate for the prevailing economic winds, trust that the choice will neither spark inflation nor torpedo the economy.

The trouble is not just that the Fed's so-called dual mandate of maintaining full employment and price stability may be unworkable at moments when success in both is needed most. There's also the issue of human fallibility. The Fed is many things, but foolproof isn't one of them.

It was a series of extraordinary blunders that helped turn a recession into the Great Depression, Milton Friedman and Anna Schwartz explained in Monetary History of the United States, 1867-1960. The Fed's excessively tight monetary policy in the early 1930s was exactly the wrong policy at exactly the wrong time. The central bank didn't fare much better in the 1970s, when it aided and abetted inflation with another series of ill-advised decisions based on the fallacy that economic growth can be manufactured by printing money.

To be fair, the central bank isn't usually so clueless about monetary policy. In fact, one could argue that the Fed's track record is pretty good on balance--even stellar at times.

But the potential for miscalculation is omnipresent. Meanwhile, the stakes are especially high in 2008. Hanging in the balance is Bernanke's legacy, which is still being written.

James Picerno ( is senior writer at Wealth Manager.

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