Bernanke trains his guns on Elizabeth Warren by Chris Matthews @FortuneMagazine May 15, 2015, 1:52 PM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons Ben Bernanke spent eight years as chairman of the Federal Reserve, and during that time he faced withering criticism from both the right and the left. Now, it’s his turn. From his Brookings Institution blog, he has taken aim at Larry Summers, German policy makers, economist John Taylor, and The Wall Street Journal editorial page. On Thursday, it was progressive hero Elizabeth Warren’s day to get the Bernanke treatment. The topic of the former Fed chair’s latest post was a piece of legislation introduced this week by Senators Elizabeth Warren and David Vitter that would place more strict rules on the Fed’s emergency lending powers, requiring the central bank to do an analysis of a financial institution’s solvency, based on four months of data, and also charge that institution an interest rate 5% higher than the rate at which the federal government borrows. As Bernanke explains it, “The Fed could suspend these two conditions, but Congress would have to approve the suspensions within thirty days or the lending programs would have to be shut down.” Bernanke believes that these rules would “superficially” be consistent with the Fed’s so-called lender of last resort function, in which it offers loans to solvent institutions during times of stress so that financial firms don’t unnecessarily fail and exacerbate a financial crisis. The legislation, Bernanke argues, is misguided. He writes: The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay. However, if the financial institution believes that its borrowing from the central bank will become publicly known . . . It may worry . . . that its providers of funding will conclude that the firm is in danger of failing, and, consequently, that they will pull their funding even more quickly. Then borrowing from the central bank will be self-defeating, and firms facing runs will do all they can to avoid it . . . Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector. Bernanke cites the example of British lender Northern Rock, which, after it became public that it had accepted emergency funding from the Bank of England, failed as the result of a bank run. The British government ending up having to nationalize Northern Rock. Bernanke argues that while it might be a good idea to enact policies that prevent financial institutions from relying on government help during a financial crisis, tying the Fed’s hands and forcing emergency lending provisions to face public scrutiny is simply the wrong way to go about it. Writes Bernanke, “their approach is roughly equivalent to shutting down the fire department to encourage fire safety…. Rather than eliminating the fire department, it’s better to toughen the fire code.” That would mean, first and foremost, forcing banks to hold more capital. New international agreements like Basel III, along with Dodd-Frank, have moved us in that direction, but there is more Congress could do to make the financial system safer using this strategy. (Check out financial economists Anat Admati and Martin Hellwig book The Bankers New Clothes for more on this argument). The Federal Reserve is one of the few agencies in Washington that has been free to act decisively to both fight financial crises and stimulate the economy. It’s strange that Warren and Vitter would want to take power away from that institution in favor of Congress, which has proven it’s incapable of making even the simplest decisions. A wide range of economists on the left and right believe that the Fed’s actions in the wake of the crisis saved the world from another Great Depression. If a few financial institutions reaped undue benefits in the process, is this not a small price to pay?