Lessons from the Depression

Bernanke, a student of the era, is likely to avoid the errors made then and keep rates lowdespite inflation

Testifying on Capitol Hill on Feb. 27, Federal Reserve Chairman Ben Ber-nanke explained the central bank's policy dilemma. On one hand, he said, "financial markets continue to be under considerable stress," and the risks to the economic outlook "remain to the downside." The right treatment for those problems is lower interest rates. On the other hand, he said, inflation has risen. The orthodox remedy for that is higher rates. One day before his semiannual testimony, the government said producer prices soared in January, bringing the annualized increase over the past three months to nearly 11%.

So far Bernanke and his colleagues have chosen the side of cutting rates, betting, he said on Feb. 27, that inflation will "moderate significantly." But if higher inflation sticks, the Fed's policy dilemma will sharpen.

What would Bernanke do then? One clue comes from his academic work on the Great Depression, which oddly enough posed a similar dilemma then for the newly formed Fed. Bernanke has written that the Federal Reserve itself worsened what would have been an ordinary recession beginning in August, 1929. The Fed, he said in a 2002 speech, ignored severe troubles in the banking system and kept rates high to keep gold from escaping abroad.

The parallels between the Great Depression and now are instructive, if inexact. In the 1920s there was a stock market surge, a tech craze (in radio), and a real estate bubble (in Florida). The Fed should have cut rates when the economy toppled and banks failed, but instead it kept them high in the mistaken belief that they were essential to keep the dollar's link to gold. (High rates persuaded foreigners to hold dollars instead of exchanging them for gold.) Bernanke cited research showing that the longer countries remained on the gold standard during the 1930s, the deeper their economic depressions.

Today, the roughly equivalent policy mistake would be keeping rates too high out of fear of inflation. The Fed chief may well lean against making that error because his intuitions have been shaped by his Depression research. "Bernanke is highly aware of the central bank's role as a lender of last resort to prevent serious disruptions to the financial system," says Barry Eichengreen, a University of California at Berkeley economist.

That's not to say Bernanke's choice is easy. If higher inflation becomes entrenched, the Fed eventually will be forced to tame it by raising rates. It took two punishing recessions from 1980 to 1982 to extinguish the 1970s' inflation. Meanwhile, complex financial innovations such as securitization make it harder for the Fed to get a read on financial conditions, let alone influence them. So anything's possible. Says Eichengreen: "Central bankers are kind of making things up as they go."

FED DISSENSION

Under Bernanke, the Fed has already cut the federal funds rate by 2.25 percentage points, to 3%. The lower that rate gets, the more resistance to cuts he will face. Richard W. Fisher, president of the Federal Reserve of Dallas, the lone dissenter from the bank's Jan. 30 cut, said in a Feb. 7 speech in Mexico City that easy money is like "truly great tequila"—tasty but dangerous. The question is whether Bernanke will defer to those who oppose cuts. He once said the Depression occurred in part because "the central bank of the world's economically most important nation in 1929 was essentially leaderless and lacking in expertise." If that's his attitude, he may decide that leadership lies in cutting rates as long as needed to steer the economy clear of danger.

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