‘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, November 8, 2002.
That was how Federal Reserve chairman Ben Bernanke concluded his remarks at a conference honouring Milton Friedman on his 90th birthday. Anna Schwartz was Friedman’s less famous yet no less significant collaborator; she died in June.
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 to 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 to 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. Little did he know that, 25 years later, he would get an opportunity to test his academic theory.
Bernanke may have repeated some of the same mistakes. The parallels 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, and policy was focused on facilitating the flow of credit.
“In neither instance did policymakers make any association between a central bank and money creation,” writes Hetzel, a senior economist and research adviser.
During both the Great Depression and the 2007 to 2009 recession, policymakers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves. The Fed aborted the mid-1930s economic recovery when it raised reserve requirements in 1936 and 1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.
The banks cut lending so they could rebuild their excess reserves.
Lesson learned? Apparently not. Fast forward 70 years 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.
Last month the Fed made an open-ended commitment to buy $40 billion (R346bn) of mortgage-backed securities a month until the labour market improves. Listening to Bernanke explain how this third round of quantitative easing works, it seems he’s still focused on credit policy. Buying mortgage securities expands the money stock. But Bernanke sees that as a by-product, 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 to put the “money” back in monetary policy. Maybe a re-reading of Friedman and Schwartz is in order.
Caroline Baum is a Bloomberg columnist.