The Good, The Bad, and the Fed, Part I: Bernanke Gets a Nobel. For What?

Ben Bernanke got a Nobel Prize for economics last month. Considering his tenure of government service, particularly his performance as Chairman of the Federal Reserve from 2006 to 2014, one wonders why. 

During Bernanke’s tenure as Fed Chairman, the subprime mortgage crisis nearly caused the collapse of international financial markets, the oil price whipsawed from around $60 per barrel to $146, down to $35, up to $110, and started another drop to $35. Bernanke denied the subprime mortgage problem until it became a destructive worldwide crisis, cut interest rates to nearly zero and kept them there for years, created and distributed hundreds of billions of dollars of new money into the U.S. economy, and increased the Fed balance sheet over 5-fold.

Economists will debate for decades how the near zero interest rates severely disrupted the U.S. economy, slowed recovery from the financial crisis, distorted investment, and contributed to increasing economic inequality in the U.S. population. Similarly, with respect to the effects of hundreds of billions of dollars of new money in the economy over a short time.  During all the economic and financial turmoil, Bernanke remained very calm according to President Obama.  Calm is easy if you do not know you are causing problems. The deer in the headlights is calm until the moment of impact.

Past Fed actions and their consequences are of interest for understanding our current situation and what we can expect from Fed actions now. The Federal Reserve has over 700 economists, over 400 with PhDs – and a recent survey concluded their forecasts are wrong with respect to core inflation 71% of the time, unemployment rate 76%, and Real GDP growth 83%. One wonders why we have the Fed?  It has huge uncontrolled power and influence over our economy. What good does it do? It’s wrong most of the time. Only cynicism can find a purpose for it.  

The Bernanke Fed demonstrated clearly the close interrelationships between Fed actions and oil markets and pricing. Also it showed such a lack of understanding of these interrelationships that they were not acknowledged or considered.   

When Bernanke became the Fed Chairman on February 1, 2006, several long-term trends were converging:

• For the first time in history world oil demand reached world productive capacity.  The developing shortage put upward pressure on oil prices which surged upward from 2004 through 2007 to the $70 range. 
• Improved horizontal drilling and hydraulic fracturing techniques combined proved effective for developing gas resources in “tight” shale formations. Some operators started trying the same techniques in “tight” oil reservoirs. 
• Early signs of the subprime mortgage problem were developing. Bernanke denied it would become a major problem.

In 2008 oil prices spiked to $148 with heavy Chinese buying just before the Summer Olympics in Beijing. The subprime mortgage problem became a major crisis and the international financial system nearly failed. Interest rates were cut to near zero in November. When the Chinese quit their oil buying the price fell precipitously into the financial crisis situation to around $45 in early 2009.  

In 2009 as the U.S. economy stabilized, oil prices returned to the $75 range, a level which the Saudis indicated they considered a reasonable level for a stable world market.  

In 2010 two government actions significantly affected the oil markets; (1) The Dodd-Frank Act passed by Congress July 21 constrained bank lending practices. (2) In November, Ben’s Fed initiated a program creating, by computer, new money that was injected into the economy to stimulate a sluggish recovery.  

This program, known as Quantitative Easing (QE), injected hundreds of billions of dollars into the U.S. economy over the next four years, through the end of his term as Fed Chairman.  

When the Saudis learned of this program to create massive amounts of new dollars, they announced in Vienna they would therefore prefer a price range about $25 higher; around $100.  (Pre-Covid, when the Saudis announced something in Vienna one paid attention; anywhere else, not so much). The price did rise to that range and stayed there for the four years of QE and came down when QE ended.  

This oil price increase points out two great misunderstandings in the U.S. Government regarding oil markets and prices: 

1. Oil companies do not set oil prices. Foreign governments do. Foreign governments or government-dominated companies produce over 80% of the world’s oil and they establish price levels by increasing or cutting production within a narrow range above and below demand.

2. The Saudis effectively agreed to sell their oil only for U.S. dollars after the Embargo in the 1970s. When they realize the value of those dollars is being diluted, they want more of them for their oil. QE was a big dilution.  

No one in the U.S. Government seems to understand these two features of oil markets and pricing and the intimate relationship between U.S. Government actions and the reactions of foreign oil-producing governments. When the Fed acts, the Saudis react, followed by other producer governments. For six years now, that includes the Russians. High oil prices and high gasoline prices were a reaction to Fed policy but the Fed did not seem to realize this would be a result.  Policy making while stumbling in the dark.            

So by the end of 2010, QE was pumping billions of dollars into the banks to stimulate the economy, the banks were restricted by Dodd-Frank in what they could do with the money, but publicly-traded oil companies were okay, the technology was available to develop “tight” oil reservoirs of which there were many, financing was available at very low interest rates, and the oil price was up in the $100 to $110 range. Guess what? The U.S. got an oil boom. The “Shale Revolution” and U.S. production nearly doubled in five years. Ben’s Fed financed the first Shale Boom with new QE money.

And Ben Bernanke got a Nobel. But not for blundering around as Fed Chairman; he got it for his professorial studies many years ago on causes of the Great Depression in the 1930s. Lessons he evidently did not learn.  

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