Bernanke May Owe Milton and Anna Another Apology

Oct. 4 (Bloomberg) -- “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

-- Ben Bernanke, Nov. 8, 2002

That was how Federal Reserve Chairman Ben S. Bernanke concluded his remarks at a University of Chicago conference honoring Milton Friedman on his 90th birthday. Anna is Anna Schwartz, Friedman’s less famous yet no less significant collaborator who died in June.

In his speech, Bernanke refers to Friedman and Schwartz’s “A Monetary History of the United States: 1867-1960,” published in 1963, as “the leading and most persuasive explanation of the worst economic disaster in American history, the onset of the Great Depression.” Their research, which countered decades of Keynesian orthodoxy on the 1930s, placed the blame for what they dubbed the Great Contraction of 1929-1933 squarely at the feet of the Fed.

Bernanke read “Monetary History” as a graduate student and became a self-described Great Depression buff. Not convinced the 1929-1933 contraction of the money supply was sufficient to account for the fall in output, he offered an additional explanation in a 1983 paper, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” Bernanke posited that the failure of financial institutions and increased cost of credit intermediation were partly to blame for the protracted decline in output and prices.

Theory Tested

Little did he know that, 25 years later, he would get an opportunity to test his academic theory.

How did he fare? Bernanke may have inadvertently repeated some of the same mistakes of the 1930s, in the view of some monetarists.

The parallels between the two periods are striking, according to Robert Hetzel, author of “The Great Recession: Market Failure or Policy Failure?” In both instances, the Fed attributed the recession to the bursting of an asset bubble and resulting insolvencies of financial institutions. In both instances, policy was focused on facilitating the flow of credit.

“In neither instance did policy makers make any association between a central bank and money creation,” writes Hetzel, a senior economist and research adviser at the Richmond Fed.

The similarities don’t end there. During both the Great Depression and the 2007-2009 recession, policy makers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves, the deposits banks hold at the central bank over and above what is required. The Fed unwittingly aborted the mid-1930s economic recovery when it raised reserve requirements in 1936-1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.

What did the banks do in response? They cut lending so they could rebuild their excess reserves to desired levels.

Lesson learned? Apparently not. Fast forward seven decades, and the Fed started paying interest on excess reserves, “increasing the incentive for banks to hold more excess reserves, just as it did in 1936-1937,” says David Beckworth, an assistant professor at Western Kentucky University in Bowling Green, Kentucky.

He said that in a blog post in October 2008. Beckworth is part of a group of market monetarists who advocate a nominal gross domestic product target for the Fed. Nominal GDP plummeted in 2008-2009. And in the last four years it has grown at the slowest pace since the Great Depression.

New Assessment

It has taken your humble correspondent a few more years than Beckworth to come around to the view that the Fed isn’t running a recklessly easy policy. As I said in an Aug. 1 column, I have started to rethink monetary policy, partly in response to the results it has produced (lousy) and partly in response to recent research (provocative). Because the economy is stuck at sub-2 percent growth, and because the only bang from fiscal policy comes from monetary policy -- unless the Fed monetizes the spending, it’s just a transfer of resources -- the Fed must bear primary responsibility.

The Fed was slow to start easing before the recession even though there were warning signs that policy was tight. The Fed had been raising its benchmark rate in small steps from June 2004 to June 2006, when it reached 5.25 percent. Long-term rates peaked at about that time and headed lower, inverting the yield curve, a reliable harbinger of recession.

Yet the Fed waited until September 2007 to start cutting rates. Shortly thereafter, in December, the Fed announced the creation of the first of many credit facilities to funnel loans to specific sectors and borrowers.

Bernanke was putting his nonmonetary solutions into practice. He was also ignoring Friedman and Schwartz, at least initially, by neutralizing the increase in the monetary base with offsetting sales of Treasuries. The Fed didn’t begin to expand its balance sheet aggressively until after the collapse of Lehman Brothers Holdings Inc. on Sept. 15, 2008. And much of the increase in the money supply merely satisfied the elevated money demand on the part of the public and the banks, which Hetzel documents in his book.

Last month the Fed made an open-ended commitment to buy $40 billion of mortgage-backed securities a month until the labor market improves. Listening to Bernanke explain how this third round of quantitative easing works, it seems he’s still focused on credit policy.

Yes, buying mortgage securities -- actually buying anything -- expands the money stock. But Bernanke sees that as a byproduct, not the focus, of monetary policy.

The Fed needs to get out of the business of ministering to existing or potential homeowners; that’s fiscal policy. Nor should the Fed be selling its entire portfolio of short-term Treasuries in exchange for long-term notes and bonds under the guise of stimulus.

It’s time for the Fed to put the “money” back in monetary policy. Maybe a re-reading of Friedman and Schwartz is in order.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)

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To contact the writer of this article: Caroline Baum in New York at

To contact the editor responsible for this article: James Greiff at

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