Sunday, February 14, 2010

What Bernanke believes

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.

Whatever attention is being paid to Chairman Bernanke’s allusions to an exit strategy from under the massive reserves the Fed has dumped on the banking system – which is not much because observers realize that they merely repeat the musings of a year ago -- are misplaced because the chairman is not really interested in monetary policy. This may seem strange, but it is not the first time the Fed that has been uninterested in what one might have thought was its principal mission.

For example, the Fed allowed the money stock to collapse (falling 38% between 1929 and 1933) while the Hoover administration focused on bank reforms (deposit insurance and changes in banking structure and regulation, including the Glass-Steagall Act that separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation, which was expanded by the New Deal. Among other interventions, RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management. In their monumental Monetary History of the United States, Friedman and Schwartz contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the recovery of the money supply (as Christina Romer also pointed out in a 1992 paper in the Journal of Economic History).

We might have thought, in light of these experiences and the opening quotation, that Chairman Bernanke would eschew direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. 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 numerous 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 controls and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and to lower rates in recession – just as in mid-2008, when it 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,” as Robert Hetzel pointed out in a recent paper in the Richmond Fed’s Economic Quarterly.

Perhaps the key to these similarities is found in Bernanke’s view of the financial markets. His fame as an academic economist rests on his 1983 paper that stressed the banking structure and the nature of capital flows as causes of the Great Depression. He argued that bank failures and falling bank loans – the interruption of credit arrangements – were significant contributors to the severity of the Great Depression that had been overlooked by Friedman and Schwartz. Although the latter’s message that recovery came with the turn-around in money (while bank loans remained weak) has been reinforced, Bernanke has not, despite the protestation quoted above, come around to the Friedman-Schwartz view of the importance of money or, just as significantly, free markets.

As fundamental as money to their monetarist philosophy is the freedom of markets, which necessarily includes their component institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. The Federal Reserve under Bernanke has done neither.

There is much talk of the Fed’s independence (of what or whom is not made clear). We should be more concerned about our independence of the Fed.