There were two. One was the Great Inflation of the ’70s. It was very worrisome, as inflation, and inflation expectations, kept rising and the economy wasn’t doing well. It was a bad period, and it took Paul Volcker to come in and say, “Enough. We’ve got to get control over inflation and do whatever it takes.
The first duty of a central bank is not to allow inflation to build up, and those were tough years. People look back on that inflation period and appropriately say the Federal Reserve, under Volcker’s leadership, took the tough steps.
A lot of people were unhappy. We had tractors surrounding the Federal Reserve building. We had consumer protests. Somebody introduced a petition to impeach Volcker. But we knew we were doing the right thing. In retrospect, that action set the stage for two decades of strong growth and increasing prosperity.
The other crisis was in the fall and early winter of 2008–09, after the collapse of Lehman Brothers. Two days later, we had to go in and stabilize AIG. A day or two after that, there was a run on money-market funds, a run on the commercial paper market. Corporations couldn’t raise money. Households were seeing their credit cut off. Major financial institutions were threatened with failure.
Looking back at that period, do you feel you made any serious mistakes?
No, I don’t. There were some very difficult decisions. AIG was perhaps the most difficult. We knew we crossed a line by providing emergency credit to AIG, which wasn’t a bank or SEC-regulated securities firm. Crossing the line was very, very hard.
How do you answer critics who say the crisis would have been less severe had the Fed found a way to prop up Lehman?
I don’t think we had a way to prop up Lehman. If there had been a private bidder for Lehman, perhaps the US government could have worked with that bidder to help it happen, the way we helped JPMorgan Chase acquire Bear Stearns.
I don’t know what we could have done to save Lehman. Lots of people say there must be some rabbit you could have pulled out of your hat. That would have been a dangerous thing to do in a democracy under the rule of law.
I think we used our authorities in a very flexible way to supply liquidity and help stabilize markets. But I do think there are lines that you shouldn’t cross over. I have not seen a concrete suggestion about what we could have done to save Lehman and stay within the lines the legislature had drawn for us.
Do you see a happy ending for the Great Recession like the one following the Great Inflation?
I think there’ll be a happy ending, but it’ll take at least a couple of years. The movie will get better over time. Growth will strengthen gradually. I don’t expect us to go back into another recession, but it’s going to be a tough slog out of a deep hole. There’s an overhang of debt in the financial sector and in households that’s going to have to be dealt with.
The Federal Reserve has already done a huge amount to help that process along by reducing short-term interest rates essentially to zero. There might be more things it could do. It would be a pleasant surprise if there’s a rapid snap-back in the economy. I just don’t think circumstances are going to allow that.
But I do think the US economy has an inherent resilience that will begin to come through as households feel more secure as they build wealth and pay down debt, as banks’ earnings compensate for the losses they’ve taken and their willingness to lend increases. We’ll come out of this.
Should we worry more about inflation or deflation in the next few years?
My expectation is that we’ll have price stability. As long as the economy is recovering relatively gradually, the Federal Reserve will be able to remove its accommodation in a timely way. There’s a lot of excess capacity both in the labor markets and industry right now, and that’s going to continue to dampen price pressures for quite some time.
So I’m not really worried about inflation. If inflation should begin to pick up, the Federal Reserve knows what to do: tighten up monetary policy. The lessons of the 1970s are very much in the bloodstream of central banks, not only in the United States but elsewhere.
On the deflationary side, I think there’s a risk that inflation could continue to be very low for some period of time. It’s good that inflation expectations have been anchored at a rate above the actual inflation rate. So people generally perceive accurately that the Federal Reserve hasn’t wanted inflation to stay as low as 1 percent, which is about what the most recent CPI for 12 months has been. They see us wanting to bring inflation back up [to 2 percent]. With that in mind, they act in a way that keeps inflation from dropping much further.
Inflation could drop a little bit further. But my expectation, against the background of a gradual strengthening in growth in the following years, would be that we would not get into a deflationary spiral.