President Obama did the right thing Tuesday when he reappointed Ben S. Bernanke as chairman of the Federal Reserve Board of Governors. The Fed made its share of mistakes during his first term, but its resourcefulness last fall helped to limit the damage caused by the credit market's collapse. Looking ahead, Bernanke's experience and scholarship seem well-suited to the challenges the central bank will face as the economy rebounds. Yet the Fed's track record also demonstrates why lawmakers should enact new rules for the financial industry to reduce the risk of another round of meltdowns and bailouts.
Bernanke's innovative use of the Fed's emergency powers helped ease the credit crunch, but it also left the Fed -- and taxpayers -- holding onto billions of dollars worth of troubled investments, either directly or as collateral for loans to banks. One test for the Fed will be extricating itself (and us) from those risks. At the same time, it must figure out how to raise short-term interest rates to normal levels without stunting the economy. The Fed took too long to raise the rates it cut after the 2001 recession (when Alan Greenspan was chairman and Bernanke was a board member), leading to the surfeit of dollars that pumped up the housing bubble. Bernanke is an expert on the Fed's missteps during the Depression, including the premature tightening of lending standards that reversed the initial recovery. That makes him acutely sensitive to the risk of a "double-dip" recession. We hope his years under Greenspan will make him equally aware of the risks of moving too slowly.
There's another important lesson to be taken from the Fed's recent history. The back-to-back bubbles in dot-com companies and the housing market show that the Fed isn't good at preventing the kind of "irrational exuberance" that causes spectacular booms and busts. The core problem is that financial companies can grow so large and interconnected with other firms that they pose a risk to the entire economy. Ironically, some of the biggest "too big to fail" banks have grown during the downturn by swallowing up other troubled firms.
Lawmakers should work with the administration to develop a more effective regulatory system for the financial industry. That should include new ways to let big companies fail without taking down the companies they're financially intertwined with; to deter growing companies from becoming big enough to pose systemic risks; and to require larger cash reserves at financial companies that are already too big to fail. The Senate should confirm Bernanke for a second term. But no matter how well he performs, the country shouldn't have to depend on the central bank to avert the next crisis.