Alan Greenspan may be giving Ben Bernanke the keys to the Federal Reserve, but he won't be giving him the key to central banking. That's because he can't.
Observers say the most important weapon for a top central banker is credibility, and that has to be earned the old fashioned way, says former Treasury Secretary Robert Rubin.
Former Fed chief Paul “Volker had enormous credibility and Alan had to establish it on his own. And so Alan now has enormous credibility and Bernanke will have to establish it on his own,” says Rubin.
Fed governor Donald Kohn says the key to credibility can sometimes mean going against markets, as Greenspan did in 1994 when he hiked interest rates to blunt inflation.
Greenspan gained credibility by “delivering results. I think he got it by doing things like 1994, and taking actions that were seen and at the time didn't look obvious, but in retrospect, were clearly the right thing to do to stabilize the economy,” says Kohn.
Even Glen Hubbard, the former chairman of the President's Council of Economic Advisers who recommended Bernanke to President Bush in 2002 to become a Fed governor, says his old friend has work to do. “He will have to show the market over time he's tough on inflation.”
Few doubt that Bernanke, who got his Ph.D at just 26 and was a prolific academic at MIT and Princeton, is a quick study. But no amount of research will transfer Greenspan's hard-won Wall Street credibility on inflation. In fact, the new chief may have some repair work to do.
His colorful comments in 2002 that the Fed could, theoretically, fight deflation with “a helicopter drop of money” has raised questions in some quarters about how tough he will be on inflation and protecting the dollar.
Fed historian Martin Mayer worries that higher oil prices could challenge Bernanke with an inflation surge sooner rather than later.
“There is an overhang, an inflationary potential around, which if Bernanke is not careful, could in fact come and sweep a lot of things away,” says Mayer.
And former Fed Vice Chairman Alan Blinder, a colleague of Bernanke's at Princeton, says other shocks could crop up in the medium term. “The dollar is overvalued, I don't think it can last another 4 years. So I think Chairman Bernanke is very likely to have to preside over a sizable decline in the dollar.”
Rubin worries most about the long-term challenges facing Bernanke. “You have the very large increase in the rate of entitlement spending, which begins roughly in the middle of the next decade. You have roughly a zero personal savings rate, you have high levels of personal debt. You put all that together and while it's possible that we'll just muddle through and nothing untoward will ever happen, it's also possible that the next chairman, who will now be Ben Bernanke … is going to have to face the effects that could have on markets,” Rubin says.
As his predecessors will attest when it comes to calming markets in a crisis, having a reserve of credibility can go along way to getting the job done.