In reality, Bernanke is following a monetarist depression-prevention model laid out by Nobel laureate and libertarian patron saint Milton Friedman. The Fed chairman has invoked the late economist in support of lowering interest rates to zero and bailing out banks. The Fed hiked interest rates in to curb what it saw as rampant speculation on Wall Street-a conflagration of leverage, margin buying, and outright Ponzi scheming fueled in the first instance by cheap credit from the Federal Reserve.
Friedman and Schwartz rejected the widely held theory that speculation had been a major problem, or that there had even been a credit bubble in the s. In this narrative, a Federal Reserve paranoid about speculation had needlessly constricted the money supply, imploding an otherwise sound economy. After the Great Crash of , the Federal Reserve drastically cut interest rates from a brief high of 6 percent to 1.
But during the first few years of the crisis, the Fed occasionally felt forced to abruptly raise rates again in complicated maneuvers to stem outflows of gold into Europe. Friedman and Schwartz blamed these sporadic interest rate hikes for smothering incipient recoveries, opening a vortex of deflation, and transforming a recession into the Great Depression.
When it comes to his academic specialty, Bernanke is a disciple of Friedman and Schwartz. Schwartz was present at the birthday party. And Bernanke stayed true to his word. In he replaced Alan Greenspan as chairman of the Federal Reserve. This approach was not new. But deflation continued. There were massive and multiple ironies in that stance.
Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed. Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers e.
Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression
Friedman also said democracy would thrive better under a regime of free markets, and he was entirely correct. Fiscal policy action was at last subject to the deliberations of the legislature and, in come vague sense, electoral review by the citizenry. By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance.
As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it. Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy.
Obviously, such a discount window—based system could have no pretensions at all as to managing the macroeconomic aggregates such as produc- tion, spending, and employment. In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates.
The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington. Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1?
There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed during — had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash. Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves.
Conse- quently, commercial banks were not constrained at all in their ability to make loans or generate demand deposits M1. But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits.
By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.
Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate.
In short, the tenfold expansion of excess i. As it happened, the money supply M1 did drop by about 23 percent during the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits the bulk of M1 did not represent a squeeze on money.see
Lessons from the s Great Depression | Oxford Review of Economic Policy | Oxford Academic
It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period. As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. As in most credit- fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production.
In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank. In fact, there has never been any wide-scale evidence that bank loans outstanding declined during — on account of banks calling performing loans or denying credit to solvent potential borrowers.
Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression. Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Yet this is academic pettifoggery. Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth. In actual fact, by the bottom of the depression in , interest rates proved the opposite.
Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from credit-worthy borrowers. The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. Bernanke, his most famous disciple, in a real-world experiment after September As is by now transparently evident, the result was a monumental wheel-spinning exercise.
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By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in — By contrast, the real cause of the Great Depression was the massive and unsustainable expansion of credit and bank lending during the Great War of , and the financial boom of Indeed, even the famous banking crisis of was not what it is cracked-up to be.
As explained below, both the recession and the banking crisis were over by the summer of ; a Hoover Recovery had actually begun. Indeed, the banking holiday declared by FDR upon his inauguration was the result of a day run on the banks that had been caused by his actions during February Once Roosevelt went for domestic autarky, the New Deal was destined to be a one-armed bandit. It capriciously pushed, pulled, and reshuffled the supply side of the domestic economy, but it could not regenerate the external markets upon which the post American prosperity had vitally depended. Herbert Hoover had been correct: the US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated.
Indeed, the American economy had been thoroughly internationalized after August and had grown by leaps and bounds as a great export machine and prodigious banker to the world. While it lasted, the export boom of — generated strong gains in growth had averaged nearly 4 percent annually, a rate that has never again been matched over a comparable length of time.
The Education of Ben Bernanke
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