(Photo via the White House flickr feed.)
At a 2002 event honoring the Nobel Prize-winning free-market economist Milton Friedman, Federal Reserve Governor Ben Bernanke jokingly admitted to Friedman that the Fed had caused the Great Depression: “I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”
Friedman and Schwartz, famously, had argued in their Monetary History of the United States that the Fed had exacerbated the Great Depression by allowing a steep drop in the money supply. Bernanke’s speech marked the extent to which Friedman and Schwartz had influenced the thinking of the members of the Fed.
After becoming Chairman of the Federal Board, Bernanke did in fact face a crisis that threatened to become another Depression, but he failed to live up to his own promise to Friedman, and once again allowed an excess demand for money to damage the economy. At least that’s the counterintuitive thesis presented by Jeffrey Rogers Hummel, an economist and historian at San Jose State University, in his article Ben Bernanke Versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner, which appears in the new book Boom and Bust Banking, edited by David Beckworth.
Even though the Federal Reserve’s balance sheet has expanded drastically over the past few years, Hummel argues, it has not served to loosen monetary conditions in the way Friedman would have recommended. Bernanke engineered the Fed’s stimulus programs – including the now-famous QE programs -- not to boost system-wide liquidity and aggregate demand, but to preserve the banking system and ensure the functioning of credit markets. According to Hummel, the difference between Bernanke’s approach and the one that would have been favored by Friedman is a profound one, with significant repercussions for the U.S. economy.
To learn more about his thesis, I asked Prof. Hummel via email about Bernanke’s record.
RealClearPolicy: Bernanke considered himself a student of Milton Friedman, but did he miss something about Friedman and Schwartz’s argument that the Great Depression was the result of a contracting money supply, as you seem to suggest?
Jeffrey Rogers Hummel: (Bernanke was not technically a student of Friedman, having gotten his PhD under Keynesian economists at MIT; it might be more accurate to say he invokes, praises, or cites Friedman.)
Bernanke didn't exactly miss anything. Friedman and Schwartz convinced nearly all economists that what made the Great Depression great was the series of banking panics that began a year after the stock market crash of October 1929 and continued into 1933. But disagreements about the details remain, and one is why the collapse of the banking system had a disastrous impact. For Friedman and Schwartz, it was the resulting enormous drop in the broader measures of the money stock. They believed that if the Fed had aggressively pumped in enough money to prevent this fall, the U.S. could have gotten by with a garden-variety depression at worst. For Bernanke, by contrast, the problem was the interruption of financial intermediation through the banks, and therefore what was needed was not a general injection of liquidity but targeted bailouts to keep specific institutions, even if insolvent, afloat. Bernanke's alternative view is clear in his 1983 American Economic Review article on the Great Depression. In it he argued explicitly that the "banking panics contributed to the collapse of output and prices through nonmonetary mechanisms [emphasis mine]" and went on to praise the "extensive government intervention and assistance" that Presidents Hoover and Roosevelt directly provided to certain sectors of the credit market.
You write that Bernanke’s nickname shouldn’t be “Helicopter Ben” but “Bailout Ben.” Why, and what’s the difference?
JRH: Part of the reason is reflected in my previous answer. It was Friedman who advocated responding to negative monetary or velocity shocks with monetary expansion. Bernanke's policies during the financial crisis emphasized targeted bailouts rather than monetary expansion. The crisis first became apparent in the late summer of 2007. Bernanke responded during this first phase with the creation of new Fed lending facilities and the bailout of Bear Stearns. But he was so afraid of inflation at a time of rising commodity prices (particularly the price of oil) that he sterilized all those bailouts; for every dollar the Fed loaned to a specific institution it pulled a dollar out of the economy through the sale of government securities. Then when all hell broke loose in September of 2008, Bernanke moved into the second phase of his response, somewhat misleading referred to as QE1. True, he presided over an unprecedented explosion of the Fed-controlled monetary base, which other things equal would have been inflationary. But at the same time, the Fed began paying interest on banks reserves, a deflationary step. The two almost perfectly offset each other, with M1 ending up with more than 100-percent reserves behind it, and very little significant impact on the broader monetary measures.
In essence, this allowed the Fed to conduct more targeted bailouts, particularly purchasing mortgage-backed securities, with little monetary impact. The so-called QE2 and QE3 worked out similarly, and only with QE4 does Bernanke seem to be making some genuine effort to increase the growth of the total money stock. Whether it will work out that way is another question.
You also suggest that Bernanke has transformed the Fed into something like Fannie and Freddie.
JRH: Fannie and Freddie have no effect on the money stock but merely borrow and redirect savings from other uses to government-preferred borrowers. The Bernanke Fed has become like Fannie and Freddie in two respects. (1) The traditional role of the Fed, or at least the role Friedman envisaged, was simply to control the quantity of money but let the market determine where money was allocated. With targeted bailouts, the purchase of mortgage-backed securities, and most recently the new "Operation Twist" designed to manipulate the yield curve, Bernanke is now using the Fed to determine exactly where credit is allocated. (2) Under Bernanke, the Fed is not only lending out money it creates, but in addition explicitly and implicitly borrowing money that is already in circulation. The most obvious example of this was the liquidity swaps with foreign central banks conducted during the height of the crisis. Most of those funds came not from Fed-created money, but from Treasury borrowing that did not cover government expenditures but was loaned to the Fed through deposits so the Fed could re-loan the funds. Indeed, you can think of paying interest on bank reserves as implicit Fed borrowing from the banks, and Bernanke has waiting in the wings other mechanisms for the Fed to borrow, including reverse RPs and what is called the Term Deposit Facility (which are essentially CDs the Fed will offer to banks).
In the final analysis, central banking is becoming the new central planning. Under the old central planning, the government attempted to manage production and the supply of goods and services. Under the new central planning, the Fed attempts to manage the financial system and the supply and allocation of credit.
Why might QE4 be different from Bernanke’s past efforts?
JRH: The reasons QE4 might be different is that the Fed – rather than just raising the monetary base to a new height with a one-shot level effect – now promises to increase the base growth rate by pumping in $85 billion every month until unemployment comes down. So without any offsetting changes, this just may accelerate growth of the broader monetary measures. I should hastily add that unlike some of the advocates of what is called Market Monetarism. I believe it is much too late for an expansionary monetary policy to be desirable.
Is it possible that QE4-style policies are what Bernanke would have preferred all along if he hadn’t been concerned about maintaining a unified Fed? I’m thinking of his months-long efforts to win over Narayana Kocherlakota to a more “dovish” viewpoint. What if Kocherlakota and others had been more open to such efforts from the beginning?
JRH: I doubt we yet know enough about the internal workings of the Fed to answer your question definitely about Bernanke's motives. But my best guess is Bernanke's response to the crisis was constrained by his long-time advocacy of inflation targeting. The problem with inflation targeting is that it doesn't handle supply shocks well. You can think of the rising commodity prices at the outset of the crisis as a kind of supply shock to the U.S. economy induced by China and India coming on line. If prices rise due to a supply shock, the best policy is simply to let that happen. If the Fed tries to offset the price rise by tightening, it will only aggravate the negative shock to output.