Bernanke succumbs to Potomac Fever

William F. Shughart II Research Director, Independent Institute
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Federal Reserve Chairman Ben Bernanke claims to be a student of the policy failures that deepened and prolonged the Great Depression. Yet, as he pushes forward with one failed stimulus after another, he seems to ignore the lessons of history — hoping, perhaps, that this time the story will end differently.

Like Joseph Stiglitz, who criticized the minimum wage in a 1993 economics textbook but changed his tune after being appointed to President Clinton’s Council of Economic Advisers that year, Bernanke seems to be the victim of “Potomac Fever,” a malady that causes politicians and policymakers to bend their views when they assume power.

By failing to acknowledge the lessons of history, Bernanke seems to be as clueless about the consequences of the Fed’s monetary policies as President Obama is about the effects of the administration’s fiscal policies. So, despite the evidence, they unthinkingly plow ahead.

Bernanke’s latest initiative to jump-start the struggling economy was announced in late September. The “new” strategy, however, is not new: It’s a replay of something tried in the early 1960s called Operation Twist, which was designed to reduce long-term interest rates in the hope that it would encourage private businesses to invest in new plant and equipment, thereby creating jobs, and encourage prospective home buyers to start buying again, reinvigorating the real estate market.

What was Bernanke thinking? As an economic historian, he must know that the first Operation Twist failed to achieve its objectives. There is no reason to believe the new version will fare any better.

Then, as now, the purpose of Operation Twist is to rotate the so-called yield curve downward. That curve, which tracks the relationship between interest rates and the terms to maturity of government securities and other debt instruments, normally slopes upward. That’s because lending or borrowing for longer periods of time exposes both sides of the transaction to greater risk. So a 10-year Treasury note will pay a higher interest rate than a one-year note.

As a result of the Fed’s “quantitative easing” measures, however, short-term interest rates are now close to zero and cannot be lowered further. The Fed has shot its bolt at that end of the yield curve.

If the yield curve can be “twisted” so long-term rates also are reduced, then long-term investment projects become relatively more attractive. If, that is, the Fed’s strategy of selling $400 billion worth of short-term securities and using the proceeds to buy longer-term securities works.

The reason Operation Twist failed in the 1960s was that, given advance notice of the Fed’s plan, investors were able to employ profitable counter-strategies to neutralize the effects. If the Fed is selling short (that is, selling its holdings of short-term bonds) and buying long (buying those with longer-term maturity dates), a knowledgeable investor can make a tidy profit by buying short and selling long. That’s because the Fed’s purchase of long-term securities will raise their prices and reduce their yields, while the selling of short-term bonds will reduce their prices and increase their yields.

As investors rearrange their portfolios to counter the Fed’s move, the term structure of interest rates will hardly budge. Long-term rates fell by only 0.1 to 0.2 percentage points in the wake of the 1960s version of Operation Twist.

The yield on 10-year Treasuries was 2.5 percent a year ago, 1.9 percent a month ago and 2.2 percent at the beginning of November. Chubby Checker had a larger impact on the charts.

As should be abundantly clear by now, Ben Bernanke is floundering and wants to be seen as “doing something” to avert a still-possible double-dip recession. If “Operation Twist” fails, as it likely already has, Bernanke will want to try something else, as Depression-era policymakers repeatedly did.

It should be clear by now that the Keynesian policies guiding Washington are not working. If Bernanke and company don’t acknowledge this soon, America will be doomed to repeat the mistakes of the past.

This will be no better for the United States than it has been for Europe.

William F. Shughart II, a senior fellow with The Independent Institute, Oakland, CA, is J. Fish Smith Professor in Public Choice at Utah State University’s Huntsman School of Business.