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Bank Shot

In the long narrative of central banking, there are few bursts of color. That’s why Federal Reserve Chairman William McChesney Martin’s journey to Lyndon Johnson’s ranch in 1965 leaps from the history books. Johnson extended an invite to Martin because he didn’t much like the tight monetary policy that the Fed had imposed—a war on inflation that placed severe constraints on Johnson’s wars (both on poverty and the Viet Cong). Down on the ranch, Martin received the full LBJ treatment. The president asked the Secret Service to leave the room and then actually began pummeling the banker, shoving him against the wall. “Martin, my boys are dying in Vietnam, and you won’t print the money I need,” he intoned. Johnson’s tactics worked. Martin lowered interest rates. An era of inflation began.

The image of Martin hanging by his lapels came to mind this past week. You could see the same look of panic and terror on the Fed’s face as it sliced rates, in a furious last-ditch effort to stave off recession. And, if there’s panic in the Fed about the current crisis, that might be because the Fed has played a significant role in its creation. Dare we say, some Alan Greenspan revisionism is in order.

By now, the story of how we got here is well known: Years of low interest rates fueled a housing bubble; banks issued millions of risky subprime loans to borrowers with low incomes and spotty credit histories. When these new homeowners began defaulting on their loans, a global credit crunch resulted. There’s no shortage of blame to go around, from the banks that pushed borrowers into subprime loans, to deadbeat ratings agencies that deemed the securitized loans investment grade (see Joshua Rosner, “Subprime Offender,” September 10, 2007), to (yes) borrowers who knowingly took out loans they couldn’t afford.

The Fed, though, is as culpable as anyone—if not more so. It’s responsible for regulating banks in order to prevent precisely this sort of meltdown. Despite his sterling academic credentials and technocratic reputation, Ben Bernanke, like his predecessor Alan Greenspan, has proven all too reluctant to embrace this role—at least, until it’s too late. In December, the Fed finally proposed a set of restrictions on deceptive lending practices, set to take effect in March. These new rules won’t make it harder for creditworthy applicants to get loans—they simply force lenders to disclose their fees up front and verify that borrowers can realistically expect to meet their repayment obligations. Incredibly, these basic regulations applied to less than 1 percent of all mortgages until the Fed took action.

Sadly, this looks like a classic case of closing the barn door after the horses have escaped. Why didn’t the Fed take action sooner? Partly because Greenspan displayed spectacularly bad judgment in insisting there was no housing bubble, even as real-estate prices soared to historically unprecedented levels. (Just a “little froth” is how Greenspan famously described it.) Partly because Greenspan hewed too tightly to a theory of central banking that recommends standing aside while a bubble inflates, then cutting interest rates like mad to cushion the damage when it finally pops. The problem with this is not only that it allows small blips to become massive balloons, but that cutting interest rates aggressively to offset one collapse can lead to another—which is exactly how the tech bust of 2000 became the real estate boom of 2002- 2005 and, then, the real estate bust of today.

Finally, and perhaps most importantly, Greenspan had a deep-seated ideological aversion to the notion that regulation might sometimes be necessary, an aversion that undermined his stewardship of the economy. In this instance, the Maestro didn’t even bother to lift his baton. (We’ll reserve judgment on Bernanke for now and hope that his vaunted pragmatic side asserts itself often.)

Would a swifter regulatory response have been enough to head off the looming recession? It’s unclear. The housing bubble was going to be a problem in any case. And last week’s rate jolt may caffeinate the economy just as it enters its slumber—at least the markets have responded well in the short term. But it’s nearly certain that the threat of recession would be, at least, smaller had the Fed been performing its proper role. (Or, for that matter, had the Bush administration not used its power of regulatory preemption to prohibit states from issuing their own rules.) And that’s to say nothing of all the homeowners and investors who wouldn’t be stuck with bad loans.

Hindsight, it’s true, is 20-20. But, in this case, foresight was 20-20, at least to all those commentators who for months pleaded with Greenspan and Bernanke to take action while there was still time. The central weakness in the economy couldn’t have been more glaring. We’re not suggesting they deserve an LBJ-style pummeling on account of their mistakes. But a stern reprimand is surely in order.

This article appeared in the February 13, 2008 issue of the magazine.