Bernanke’s Bear Baiting

“Bear baiting is a blood sport involving the
worrying or tormenting (baiting) of bears.” – Wikipedia

Bear baiting was a favorite of both Henry VIII and Elizabeth I. They even built a specialized pit, the Bear Garden, at Bankside in London that could seat up to 1,000 bettors. The bear was attached to a post in the pit and several English bulldogs were tossed in to carry out the “worrying” cited above.

We doubt that Ben Bernanke came to the job of Chairman of the Federal Reserve with much experience in this peculiar form of Elizabethan entertainment. He had an introduction to “worrying the bear” during his June 19th press conference when he noted that with the emerging strength in the job market it might be “appropriate to moderate the monthly pace of purchases later this year”.

The mere mention of a potential reduction in the monthly $85 billion Quantitative Easing program caught the bear by surprise. The reaction was instant and formidable with bonds and equities selling off quickly and globally against a 100bps rise in long rates.

Then the July 10th release of the mid-June FOMC minutes revealed that half (our interpretation of “several”) of the committee members supported a tapering of (QE) soon inspiring anther sell-off. In a speech that afternoon, Bernanke abandoned the pit entirely at which point the bear went back to sleep and the market has continued to rally.

Not a very impressive performance. Elizabeth I would have been appalled.

We now know that the Chairman’s ability to take a tough stand in the face of negative market reaction does not matter. We know this because President Obama assured the nation and a no doubt surprised Fed Chairman that he had “already stayed on a lot longer than he wanted or was supposed to.” It is not clear why the President choose to humiliate Bernanke in this way on a public TV broadcast. Bernanke has clearly been one of the most accommodative and politically pliable Fed Chairmen in history (with the possible exception of Jimmy Carter’s choice of G. William Miller).

So the bear baiting will be left to someone else. Who?

This is a key appointment because the new Chairman will be confronted by a bloated $3.6 trillion balance sheet and more than $2 trillion in excess reserves sloshing around the banking system – a 200-fold increase from 2008. Although almost no one talks about it this way, this situation is a huge problem. According to some estimates, the Fed had $192 billion in paper losses on its portfolio since June. Climbing down from this cliff will not be easy.

The technical execution is trivial. Stop buying bonds and eventually start selling them. This will drain the excess money out of the system and market interest rates will rise substantially. But the fragility of equity and bond markets in June shows how rapid the asset value compression might be once the change in policy becomes clear. The Fed has been pumping up the markets for so long it is like a narcotic to an addict. Take away the drug permanently and…well, just picture Lindsay Lohan reacting to the judge sending her, yet again, to rehab.

So who has the intestinal fortitude to take this down? Think of someone who is tenacious, brilliant, with an impressively thick skin and rapier-like wit. We need someone easily able to sit amidst a firestorm of controversy without flinching.

The candidates profiled in the press are current Fed Vice-Chair, Janet Yellen, Larry Summers and Don Kohn. In an odd Forrest Gump-like experience, I have actually met all three over the years.

Out of this limited choice only Larry Summers meets our notion of what is needed. He is a brilliant economist with sufficient experience in the markets to know how Fed policies will be absorbed at gut-level. He has run large complex politically difficult organizations (were thinking of Harvard here). As Clinton’s Treasury Secretary, he saw up close how a balanced budget combined with a limited government and a reasonable tax regime can produce broad and consistent growth.

The only negative associated with Summers in our view was the failed stimulus of 2009. Recent accounts of that chaotic period appear to show him as a moderating voice of reason arguing that a stimulus focused on building physical infrastructure would have the better multiplier. We now know, of course, that the vast majority of the $800 billion went into service sector jobs with almost no knock-on effect.

What are Summers’ chances of getting the job? We guess less than 50 percent. Selecting Larry Summers is a real challenge for the Obama administration where ideology has so frequently trumped common sense and produced generally unsuccessful economic policies. People will point to his controversial speech in 2005, in which he speculated about the scarcity of women at advanced levels in the hard sciences. The resultant uproar pushed him out of his position at Harvard.

He is also up against Janet Yellen who has a rich academic biography, a history of behind the scenes influence at critical moments and a successful track record managing the San Francisco Fed. According to the Wall Street Journal, Yellen has the best forecasting record among all Fed staffers. Last, Vice-Chair Yellen has one clear and obvious advantage that Larry Summers could never equal.

End Notes

“The Puritan hated bear baiting, not because it gave pain to the bear, but because it gave pleasure to the spectators.” Thomas Babington Macaulay (~1830)

Despite the fact that bear baiting was outlawed in 1835, you will still find the terms `post’, `pit’ and `bear’ in common usage at certain venues in lower Manhattan.