Thursday, November 12, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

8. Monetary Policy as Credit Control

Let me end my talk [in honor of Milton Friedman’s 90th birthday] by abusing slightly my status as an official representative of the Federal Reserve. 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.

Ben Bernanke, University of Chicago, Nov. 8, 1992.

In fact the Federal Reserve has learned nothing, and is doing it again, it being the substitution of controls for monetary policy.

Friedman and Schwartz argued that the Federal Reserve caused the Great Depression by allowing the money stock to fall 38% between 1929 and 1933, while the Hoover administration focused on bank reform (deposit insurance and banking structure in the Glass-Steagall Act, which separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation. RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management (Butkiewicz 2002). Friedman and Schwartz (1963, pp. 325-30) contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the growth of the money supply (Romer 1992).

The following contemporary account of the RFC, which was expanded by the New Deal, is interesting:

The best banking walls of Wall Street did not fall down last week before the long trumpet-blasts of Jesse Jones [head of the RFC]. But most of them opened their postern gates and let Mr. Jones come in with the money he was determined to inject into them.

The National City was the only big bank last week to surrender completely. It the stockholders approve, it will let the RFC buy $50,000,000 of its preferred stock. Mr. Jones radiated assurance that the government would not make itself a nuisance at stockholders’ meetings. But the fact remained that the U.S. will become National City’s biggest stockholder – and if ever two preferred stock dividends should be omitted, the Government will have complete control.

Eight other New York banks were able to resist the RFC’s passion to become a stockholder because they were state institutions. They compromised by selling the RFC “capital notes.” Thus supersolvent Guaranty Trust, already vexed by having more money than it can profitably use, planned to let the Government lend it $20,000,000.

Having removed the curse of taking government aid, Mr. Jones could now proceed to make the Government a large, if not the largest stockholder … in perhaps one-quartet of all the country’s banks ….

National City planned to use its huge piece of government money to write down its common stock [and] surplus. “With the adoption of the plan,” Chairman Perkins informed his stockholders, “the assets of the bank will be carried at conservative values ….”

“Without disgrace,” Time, Dec. 18, 1933.

We might think that, given the opening quotation, Bernanke would have eschewed direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. But we would be wrong. He and his colleagues have done the opposite. The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.

What about monetary policy? The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression. In 1928-29, the Fed focused on credit control and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and lower rates in recession – just as in mid-2008, when the Fed suddenly became hawkish about inflation. The intensification of the recession began before the financial turmoil of September 2008. “In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets (Hetzel 2009).

A key to this similarity may be found in Bernanke’s view of the financial markets (in which he, like the Fed of 1929-33, has found plenty of support in official circles). His fame as an economist rests on his 1983 paper that stressed capital flows and the banking structure as contributors to the severity of the Great Depression. In particular, bank failures and the fall in bank loans joined the money stock as significant causes of the downturn. The recovery came with the turn-around in money (while bank loans remained weak), but Bernanke has never, despite his protestations, been shared the Friedman- Schwartz view of money’s importance, or of the economy in general. A key element of Friedman’s monetarist philosophy, as important as money, is its reliance on free market institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. Bernanke and the present Fed have done neither.


Ben Bernanke. “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” American Economic Rev., June 1983.

James Butkiewicz. “Reconstruction Finance Corporation,” EH.Net Encyclopedia, ed. Robert Whaples, July 19, 2002

Milton Friedman and Anna Schwartz. A Monetary History of the U.S., 1867-1960. Princeton Univ. Press, 1963.

Robert Hetzel. “Monetary policy in the 2008-2009 recession,” Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009.

Christina Romer. “What ended the Great Depression?” J. Economic History, Dec. 1992.