In Box

Trial by Fire

What crises lie in wait for Janet Yellen?

Each of the last three chairs of the U.S. Federal Reserve faced daunting challenges soon after assuming leadership of the world's most powerful central bank. It will be no different for Janet Yellen, the highly talented and respected incoming chair. How she reacts to the set of known challenges, let alone the unanticipated ones, will impact the well-being of every American and huge swaths of the global economy.

Back in 1979, Paul Volcker came to the Fed with a mandate to snap the United States out of a debilitating period of low growth and high inflation (or "stagflation"). Shortly after taking office, he did more than raise interest rates; he embarked on a multiyear policy effort that ended up underpinning a three-decade period that took inflation from public enemy No. 1 to essentially a nonissue.

Success was far from obvious in Volcker's early days, however, and it would not have materialized without his now-legendary steadfastness and conviction. With sky-high interest rates throwing the economy into recession, he faced enormous political pressures to abandon course, including from Jimmy Carter, the president who appointed him but then seemed surprised by the consequences of the monetary policies he pursued. Volcker made multiple brave calls along a difficult path. With the Fed-induced recession contributing to Carter's bruising loss to Ronald Reagan in the 1980 election, you can still find Democrats today who blame Volcker for giving the election to Republicans-and for laying the groundwork for what came next.

Alan Greenspan, Volcker's successor, faced his own moment of truth. Just months into his tenure, he had to deal with a sudden and dramatic financial market collapse. On Oct. 19, 1987 (what came to be known as Black Monday), the Dow Jones industrial average plummeted some 22 percent for no apparent reason-an unprecedented drop that threw global markets into disarray. Greenspan's boldness in aggressively injecting emergency liquidity contained the damage and, in the process, safeguarded the integrity of the global financial system.

Fast-forward to September 2008. Just 31 months after Ben Bernanke took the reins from Greenspan, he found himself facing a fearful situation: the disorderly bankruptcy of an influential broker-dealer (Lehman Brothers), the near collapse of a massive insurance company (AIG), a potential depositor run on a large money market fund (the Reserve Fund), and a host of nightmarish cascading financial dislocations. Thrown into urgent crisis management, the new chair stepped up to battle a financial crisis that was on the verge of tipping the global economy into another Great Depression.

Bernanke was forced to do more than just come up with innovative Fed instruments to slow the metastasizing market failures that were sucking liquidity out of virtually every major economic interaction worldwide. Together with Treasury Secretary Hank Paulson, he marched up to Capitol Hill to convince skeptical lawmakers to approve a massive bailout package-with a calm, decisive persuasion of which only a scholar of his stature would have been capable.

How Janet Yellen would deal with these types of challenges no one yet knows for sure. But she had better be ready. It would not surprise me one bit if she finds herself the fourth consecutive head of the Federal Reserve to face a serious crisis soon into her tenure.

Yellen takes over a Fed that is playing an unusually broad role in supporting markets and the global economy. The institution finds itself deep in experimental mode, using largely untested tools-be it purchasing tens of billions worth of bonds a month, keeping interest rates artificially floored, or seeking to influence private-sector behavior by venturing ever deeper into "forward policy guidance" (basically, orchestrated communication to markets about the Fed's intentions).

There are few historical parallels, analytical models, and policy playbooks to guide her. Indeed, there isn't even a common and detailed understanding among academics of how the Fed has really influenced economic prospects and the functioning of markets since the global financial crisis. Meanwhile, financial investors are delighted to have the continuous support of the Fed's wide-open wallet, which has driven asset prices to rise to historical records, despite unusually sluggish fundamentals.

It's not quite a poisoned chalice, but Yellen is taking over a Federal Reserve that has ended up, mostly inadvertently, underwriting a series of consequential and unusual disconnects. Under her guidance, the Fed will need to find a way to better reconcile booming financial asset prices with the unfortunate realities of what is now being labeled "secular stagnation"-an unusually prolonged period of low growth and high unemployment. The central bank will also have to find a way to reconcile its steadfast commitment to supporting the domestic economy with the disruption that causes for other countries. After all, with the United States both supplying the global reserve currency and hosting the world's deepest financial markets, what the Fed does has enormous consequences for the flow of international capital in and out of other countries. Those countries have felt the Fed's largesse, and many will find their capacity to cope challenged when the taps begin to close.

Yet the Fed under Yellen will need to find a way to transition the economy from artificial growth to genuine private-sector-led growth. It must gradually reduce its direct involvement in the markets and do so without causing disorder that undermines economic growth. Bernanke has already signaled the route ahead: namely, a gradual retreat from monthly bond purchases in favor of great reliance on forward policy guidance.

There may be no imminent crises like the ones Volcker, Greenspan, and Bernanke faced. Yet the situation Yellen inherits is arguably more complicated and fluid. Indeed, it may well constitute one of the most complex challenges ever faced by a central bank. If that weren't enough, the Fed's tool kit is ill-equipped for the task at hand, and the institution is hampered by political polarization and congressional dysfunction.

No one knows for sure how much time the Fed has before it must deal with the unintended consequences of its experimental policies. It could be months; it could be years. Much depends on whether Bernanke has actually bought enough time for U.S. household balance sheets to heal and for the economy to pick back up robustly.

But Yellen can't wait to find out. She needs to deliver on four interrelated fronts early on in her tenure. First, as the benefits of the Fed's unconventional stimulus decline, as they inevitably will, she must avoid exposing the fragility of a recovery still hampered by inadequate infrastructure and demand, unresolved pockets of excessive indebtedness, and long-term unemployment.

Second, with many equities and corporate bonds flirting with bubble-ish levels, she must work with other agencies to ensure that recent progress in banking regulation and supervision has materially reduced the threat of destabilizing market incidents.

Third, she must find a way of breaking the unhealthy co-dependency that has developed between markets and the Fed. Markets cannot function well in the long term on the assumption that they will always have the Fed to support them, and the Fed cannot always rely on artificially boosting financial assets to promote growth and jobs.

And fourth, she must clearly communicate Fed policy in a world that has become extremely sensitive to every word, signal, and whisper emanating from the world's most powerful financial institution.

What is undeniable, even at this early stage, is that the to-do list awaiting Janet Yellen when she enters the Fed is as daunting as those that ended up facing her three predecessors. And we have no idea what challenges and crises the world could soon throw her way. She brings enormous talent and experience to the Fed chair, but she'll need some good luck too.

Alex Wong/Getty Images

In Box

The Darknet: A Short History

A look at the Internet's lurid underbelly -- your one-stop shop for weapons, drugs, and illegal pornography. 

Beyond the prying eyes of Google and Bing exists a vast cyberfrontier -- by some estimates hundreds of times larger than the World Wide Web. This so-called "deepweb" is often more humdrum than sinister, littered with banal data and derelict URLs, but it is also home to an anything-goes commercial underworld, called the "darknet," that will make your stomach turn. It's a place where drugs and weapons are openly traded, where terrorists link up, and where assassins bid on contract killings. In recent years, the darknet has found itself in government cross-hairs, with the FBI and National Security Agency (NSA) cracking down on drug merchants and pornographers. Despite a series of high-profile busts, however, this lawless realm continues to hum along, deep beneath the everyday web.

October 29, 1969
Charley Kline, a student at the University of California, Los Angeles, types out the first message between computers connected by ARPANET, the Internet progenitor developed by the Pentagon's Defense Advanced Research Projects Agency. (Only the first two letters of the electronic dispatch, "LOGIN," make it all the way to computers at Stanford University.) Within just a few years, a number of isolated, secretive networks begin to appear alongside ARPANET. Some eventually become known as "darknets."

With the birth of the modern web, arguably marked by the 1982 standardization of the Internet protocol suite, the problem of storing sensitive or illegal data looms large. Early solutions involve physical "data havens" -- the informational analogues of tax havens -- in the Caribbean that promise to host everything from gambling operations to illegal pornography. 

Late 1990s
As the Internet goes mainstream, falling storage costs coupled with advances in file compression set off an explosion of darknet activity, as users begin to share copyrighted materials. Soon, the Internet's peer-to-peer data transmission gives birth to decentralized data hubs, some of which, like so-called topsites -- where most illegal music and movie files originate -- are password-protected and known only to insiders. Others, like Napster, operate in the open and facilitate millions of file transfers per day.

March 2000
Software developer Ian Clarke releases Freenet, revolutionary software that offers anonymous passage into the darkest reaches of the web, where one can access everything from child pornography to instructions on how to build explosives. "Freenet is a near-perfect anarchy," Clarke tells the New York Times. "I have two words for … companies [trying to halt free file-sharing]: Give up."

June 2000
Libertarian cyberpunks Ryan Lackey and Sean Hastings go into business on Sealand, a bizarre, nominally independent state located on a World War II-era sea fort off the British coast. The start-up, called HavenCo, envisions hosting restricted data (except spam, child porn, and money-laundering activities) on high-tech nitrogen-encased servers hidden in the fort's legs. Despite generating considerable attention, HavenCo begins to bleed money almost immediately, and by 2002, Lackey and Hastings have jumped ship.

September 20, 2002
Researchers at the U.S. Naval Research Laboratory release an early version of Tor ("The Onion Router"), which conceals the location and IP address of users who download the software. Originally designed to protect the identity of American operatives and dissidents in repressive countries like China, Tor also has another natural constituency: denizens of the darknet.

January 2005
magazine estimates that the "media darknet distributes more than half a million movies every day." Propelled by booming bandwidth, the underground network explodes into wholesale copyright infringement, from Hollywood blockbusters to Microsoft Office. A study by IT research firm IDC estimates software piracy alone costs businesses $34 billion worldwide in 2005.

January 3, 2009
A man calling himself Satoshi Nakamoto "mines" the first Bitcoin, a form of untraceable cryptocurrency. Unlike previous digital currencies that failed because there was nothing to prevent users from literally copying their money, Bitcoin makes use of an innovative public accounting ledger that prevents double spending. Unsurprisingly, the cryptocurrency is an instant hit in the darknet, its anonymity making it a perfect tool for money laundering and criminal activity.

The cybersecurity and intelligence firm Procysive estimates that the darknet is home to "more than 50,000 extremist websites and more than 300 terrorist forums." The illicit sale of pirated digital content, it reports, "serves as a source of financing for [terrorist] operations."

June 1, 2011
A Gawker-affiliated blog publishes an exposé on Silk Road, a hidden marketplace that "makes buying and selling illegal drugs as easy as buying used electronics." It's like for crystal meth and LSD, except only available to Tor users with Bitcoin accounts. Traffic to Silk Road surges, and the value of a Bitcoin jumps from around $10 to more than $30 within days.

August 1, 2013
Irish authorities raid the Dublin apartment of Eric Eoin Marques, described by the FBI as "the largest facilitator of child porn on the planet." His arrest coincides with a mysterious shutdown of vast swaths of the darknet, allegedly as part of an FBI sting operation that exploited a breach in the web browser Firefox to identify Tor users. Users' identities are reportedly routed back to a server in Northern Virginia.

August 4, 2013
The U.S. government intercepts secret communications between al Qaeda chief Ayman al-Zawahiri and Nasir al-Wuhayshi, the head of the Yemeni-based al Qaeda in the Arabian Peninsula. The online confab leads to the shuttering of U.S. embassies in 21 countries across the Muslim world. According to researchers at the Institute for National Security Studies in Israel, the high-level al Qaeda talks "apparently took place in a part of the internet sometimes called deepnet, blacknet, or darknet."

October 1, 2013
The FBI shuts down Silk Road and arrests Ross William Ulbricht, known by his online moniker Dread Pirate Roberts, for allegedly masterminding the operation. The site did more than $1.2 billion in sales between 2011 and 2013, according to an indictment filed in U.S. federal court.

October 4, 2013
The Guardian reports that the NSA has repeatedly targeted people using Tor by exploiting vulnerabilities in other software on their computers. According to a 2007 top-secret internal presentation leaked by former NSA contractor Edward Snowden, the agency "will never be able to de-anonymize all Tor users all the time," but with manual analysis, it can "de-anonymize a very small fraction of Tor users."

October 2013
Tech-news site, the Verge, reports that online markets like Black Market Reloaded and Deepbay, both of which openly advertise narcotics, are seeing a surge in traffic. "No doubt we will all regroup elsewhere," one Silk Road moderator wrote after the marketplace was shuttered. "I look forward to seeing all of you again … still engaging in free trade without government interference into your personal affairs." In November, a new anonymous darknet marketplace called Silk Road 2.0 was back online, just over a month after the original was shut down.

Illustration: R. Kikuo Johnson