Ben Bernanke Walks the Line

By Justin Fox

Much of what Ben Bernanke spends his days doing oscillates between the incomprehensibly arcane and the unspeakably dull. Lately, though, the Federal Reserve chairman has a stark, even exciting task at hand. He's been imitating Jimmy Stewart in It's a Wonderful Life and trying to halt a bank run.

While Stewart's George Bailey had to make do with his powers of persuasion and his honeymoon fund to save the Bailey Building and Loan, Bernanke has the full faith and credit of the U.S. government behind him. The Fed can effectively print U.S. dollars at will. It can even, as Bernanke famously suggested in 2002, drop them out of helicopters, if that's what it takes.

Unlike Bailey, though, Bernanke doesn't know all his customers or even his loan officers. He cannot reassure nervous depositors (a.k.a. lenders) by telling them exactly where their money is invested, because he has no clear idea himself. He probably suspects that many borrowers and lenders have been up to no good and richly deserve the bad things that are happening to them. And while he can manufacture cash, he knows that if he overdoes it, hyperinflation and a dollar crash could result.

So Bernanke walks a thin line. Too far in one direction, and he bails out all the irresponsible people and institutions that have gotten us into the subprime mess and subsequent debt-market crunch. Too far in the other, and the global financial system collapses on his watch. "In a run, fear that a bank may fail induces depositors to withdraw their money, which in turn forces liquidation of the bank's assets," Bernanke wrote in 1983 as a young economics professor. "The need to liquidate hastily, or to dump assets on the market when other banks are also liquidating, may generate losses that actually do cause the bank to fail."

It's a self-fulfilling panic, one that really needs to be nipped in the bud. At banks serving retail customers, it is automatically nipped these days by federal deposit insurance. Fretful depositors have still lined up at branches of the bank arm of troubled mortgage lender Countrywide, but there's really no rational reason to do so.

For other investments, though, the old rules apply. If you're worried about the soundness of the mortgage securities you've bought or the corporate loans you've made or the money-market funds you've invested in, it's entirely rational to pull out your money if you can. When everybody does that, though, the system freezes up. It gets called a liquidity crisis or a credit crunch, but the mechanics are the same as those of a bank run.

It is also, says Robert F. Bruner, dean of the University of Virginia's Darden School of Business, a classic "prisoner's dilemma." In game theory, the dilemma involves two arrestees deciding whether to squeal. Here it's about whether to pull your money from the market. For each worried individual, the rational answer is yes, but the financial system is far better off if everybody agrees not to. The invisible hand of the market can't deliver the best outcome; collective action, Bruner says, is the only good answer.

Bruner has been thinking about this a lot lately because he has co-written, with his Darden colleague Sean D. Carr, a fortuitously timed new book titled The Panic of 1907: Lessons Learned from the Market's Perfect Storm. That year saw a string of bank failures and a stock-market collapse that was halted only when J.P. Morgan browbeat his fellow moguls into ponying up cash to stop the panic. The 1907 crisis in turn led to the creation of the Federal Reserve, which was supposed to do what Morgan did, only more reliably.

The Fed failed its first big test--the bank runs of the early 1930s, which it allowed to snowball into the Great Depression. After that, tight domestic regulations and global exchange-rate controls kept financial-market panics at bay for decades, essentially by keeping markets themselves at bay. But when the exchange controls and bank regs proved too inflexible in the 1970s, markets made a comeback.

The first big global liquidity crisis came a few years later, on the morning after the 1987 stock-market crash. Fearful banks stopped lending until new Fed Chairman Alan Greenspan restored confidence with reassuring words and piles of cash. Greenspan did the same when credit markets froze after the Russian government defaulted on its debts in 1998. But he was criticized afterward for being perhaps too generous and reassuring and for launching an era of overly easy money.

Now it's Bernanke's turn. He and his Fed colleagues have sprinkled cash around and made loans to banks, but they've also made a point of moving so slowly and deliberately as to enrage some on Wall Street. Are they getting the balance right? We should know by the time the movie version comes out.