What I've Learned: Dollars and Sense

After four decades at the Federal Reserve, Don Kohn talks about the crises he’s seen, personalities and politics, and a most important trait

Dohn Kohn says the hard lessons the Fed learned in previous economic crises helped us cope with this one. Photograph by Stephen Voss.

From the Great Inflation of the 1970s to the Great Recession now hobbling the economy, Donald Kohn has been at the center of the nation’s policymaking. Until his retirement this fall after almost four decades with the Federal Reserve, he played an outsize role largely out of public view.

Kohn began his career in 1970 as an economist at the Federal Reserve Bank of Kansas City and five years later moved to the Fed’s DC headquarters. There he rose to become a key adviser to five Fed chairmen, from Arthur Burns to Ben Bernanke. In his last four years there, he was vice chairman of the board of governors and Bernanke’s close confidant.

Kohn gained a reputation for sharp economic analysis and a soft-spoken demeanor. During the financial system’s meltdown in the fall of 2008, he was part of a core crisis-management group—along with Bernanke and now–Treasury Secretary Timothy Geithner—that worked around the clock to keep the wheels from coming off the economy.

A Philadelphia native, Kohn discovered his love for economics at the College of Wooster in Ohio. His career path was set when he earned his doctorate at the University of Michigan, which had served as a farm team for economic thinkers in the Johnson administration.

Kohn, 68, raised his family in Arlington, a good location from which to ride his bicycle to work occasionally. The parents of two children, Kohn and his wife, Gail, now split their time between an apartment in their son’s Takoma Park home and a house in Annapolis.

In his office at the Brookings Institution, where Kohn is now a senior fellow, he talked about what he’s learned.

What was your most frightening moment dealing with the economy?
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.

On a topic Washingtonians care more about than politics, what is your outlook for house prices?
I thought you were going to ask about the Redskins. I have no view on house prices in the region. Nationally, house prices have been relatively flat for a while. My expectation is they will not move very much for a while. There could be some downward pressure because of all the foreclosures coming on the market. So nationally the housing market is extremely weak. Construction and production are very, very low—much lower than the increase in the population, which you might think would dictate the long-run trend of production. The country overbuilt houses. There is an overhang, and it’s being worked off gradually.


What advice would you give investors as they try to preserve capital in this environment?
I’m not in the business of offering investment advice. My general advice would be to diversify—don’t put all your eggs in one basket. That’s certainly a truism.

The other piece of advice I would have is there’s never something for nothing. If it looks like something’s offering a bit of a higher yield, a bit more interest return, an expected extra profit on a particular investment, that probably implies there’s some extra risk involved and you need to look under the hood.

Leading up to the crisis in 2007, people didn’t look under the hood. They were looking for a little bit more return. They forgot that the extra return comes with extra risk. In the end, the extra yield and extra return they were getting wasn’t enough to compensate for the extra risk.

There was a widespread complacency about the amount of risk in the financial markets and the economy. That complacency grew out of 2½ decades of economic growth, interrupted only twice by relatively mild recessions, by the upward march of housing prices since the 1930s without a significant national decline. Everybody got a little relaxed about the kinds of risks they could take, chasing that extra half a percentage point or percentage point, the promise of extra profits and buying a house and rolling it over and refinancing it on a periodic basis. There’s just no free lunch there.


What careers should young people pursue in the wake of this recession?
I would tell those graduating from high school to go to college. If we’ve learned anything about the distribution of income and winners and losers over the last decade or two, it’s that the winners have been concentrated among people who have a college education, particularly those in the knowledge industries. The information-technology area has been rewarding.

High-school graduates have fallen behind. Even people with run-of-the-mill college degrees who haven’t thought carefully about the demand for their profession can fall behind. You need to consider carefully where the needs of a rapidly aging population are, where the knowledge can be applied. The more sophisticated the profession, the more likely you’re going to reap the rewards from education.

Let me add that the community colleges of this country are playing a really valuable role in training people to meet the needs of the 21st century. So when I say get a college education, it doesn’t have to be a four-year college.


Of the five Fed chairmen you served under, who stands out?
I was closest to the last three—Paul Volcker, Alan Greenspan, and Ben Bernanke. Each has served the Federal Reserve in an outstanding way. Their personalities are somewhat different, but there are some similarities people don’t always recognize: three really smart people who had a knowledge and an awareness of how they and the Federal Reserve fit into history and what their responsibilities were as Federal Reserve chairman to further the welfare of their fellow citizens.

That sense of history is important because it helps you avoid repeating mistakes of the past. The country was fortunate that in Bernanke they had somebody at the helm who had done deep studies of the Great Depression and the policy errors and successes of that era.


How close did we come to another depression?
If the Federal Reserve and the Treasury hadn’t acted very aggressively in the fall of 2008, the Great Recession would have been even greater. When the private sector was unwilling to extend loans to one another, the Federal Reserve stepped into that in a classic central-bank function. Going back to the late 19th century, [economics writer] Walter Bagehot said that in a panic you should lend widely and lend often to solvent borrowers against good collateral. And that’s what we did.

We had to do a lot of innovating. I also think that if Congress hadn’t passed TARP [the Troubled Asset Relief Program]—as much as they say they regret it now—and the Treasury hadn’t used that to stabilize the banking system, the situation would have been far worse. We might have had a bunch of nationalized institutions, as many people were calling for in the spring of ’09, and a real problem on our hands that would have been very, very difficult to unwind.

You worked under eight Presidents—which ones made your work easier and which more difficult?
I’ve established good relationships with Democrats and Republicans alike, and we’ve shared common goals.

In terms of Presidents, the relationship improved when President Clinton and his advisers decided they weren’t going to publicly comment on monetary policy. That decision was carried forward by President George W. Bush and now President Obama.

That doesn’t mean they don’t express their views about where the economy is going. But it has helped not to have the public back-and-forth that sometimes existed in the Reagan administration, when you had supply-siders and monetarists, both of whom seemed unhappy with the Federal Reserve’s performance from time to time from completely different angles.

The first President Bush’s relationship with Alan Greenspan was not great. President Bush himself said in a television interview, “I reappointed him. He disappointed me.” I think there’s no secret that Treasury Secretary Nicholas Brady and Greenspan didn’t hit it off as well as they could have. There were still good relationships with parts of that administration. Michael Boskin, the chairman of the Council of Economic Advisers, and Greenspan talked frequently. So it wasn’t as if the Fed was cut off from the administration, but it was a more difficult relationship. They waited a long time to reappoint Greenspan.


How should the government tackle the huge federal deficit?
I don’t have an easy solution for what to do about the long-run trajectory of the deficit and the amount of debt.

I worry that the very bad political dynamic that you see now would make something like the Greenspan Commission in the early ’80s—which came up with a bipartisan fix for Social Security—very hard to do. We need both parties to give up on some of their sacred cows and come together and figure out some way that we’re not going to bequeath to our children and grandchildren a much worse problem than we have today. I don’t see any evidence that it’s going to happen.

The demographics driving this—the aging population, people signing up for Medicare and Social Security, as I’ve done recently—mean society has a lot of obligations. We’ve got to figure out how to do some combination of controlling those obligations and raising the funds to meet the obligations that we do have. We can’t keep pushing it off. The longer we push it off, the tougher the problem is.

I would combine a shorter-term fiscal stimulus and longer-term fiscal restraint. You can’t do the stimulus without the restraint because by doing the stimulus now, you risk making the longer-term restraint more difficult.

I don’t think we can rule out the possibility that if the political process seems unable to come to grips with this, the financial markets will wake up one day and say this is a real problem. The government’s going to be issuing huge amounts of debt. That’s not a problem right now because the private sector isn’t issuing any debt because the private sector isn’t spending. It’s going to be a problem in five or ten years and start putting upward pressure on those long-term interest rates.


Since coming to Washington, have you seen a change in the political climate that makes it harder to forge bipartisan compromises?
I think so. I’m hesitant because I’m old enough to remember the late ’60s and early ’70s, when people were literally beating each other up and blowing up things and the far left and the far right were resorting to violence. That was a terrible time in this country.

If I look back since the ’70s, I do think things have deteriorated—I see a dynamic in which each party feels it’s being most successful when it energizes its base. It pushes centrists away from the center toward either end. I don’t blame one or the other party—I think they’re both guilty. They feel like their electoral success is appealing to either extreme.

President Obama was elected with huge support from the center of the political spectrum. Somehow that’s eroded. The Democrats wanted to push through health care and things that contributed to losing the center. Certainly the economic woes of the country have eroded the center.

I consider myself a pragmatic centrist, and I find myself increasingly isolated within the political spectrum. I’m not registered with either party.


What have you learned about life?
To expect the unexpected. One of the difficult things is to recognize what you don’t know. One of the traits I would advocate for policymakers is flexibility. I’m sure this is true in foreign policy and elsewhere, but it’s certainly true in economic policy. Our understanding of the systems that we’re interacting with, people’s behavior, is very partial. We should expect to be surprised quite often.

One of the very hard things to know is, when incoming data on the economy isn’t going the way you expect it to go, does that suggest something really has changed or that it’s just a blip in the data? Sorting out the signal from the noise is very hard. You’ve got to be open to the possibility that what you expected to happen isn’t happening. You’ve got to be ready to ask tough questions of yourself, of your colleagues, of the data.

You’ve got to be creative in thinking about current situations and how to respond to them. That all starts with, in my mind, humility about what you know.

This article first appeared in the November 2010 issue of The Washingtonian. 

Subscribe to Washingtonian
Follow Washingtonian on Twitter