Today’s crisis isn’t a replay of the problem in the 1930s, but last night’s 60 minutes interview with Ben Bernanke made it clear that our central bankers don’t understand the distinction.
Bernanke’s academic career was spent studying the policy responses to the Great Depression. His analysis suggests that the Fed made two errors:
- Central banks allowed the money supply contract sharply. “Price fell. Deflation. So monetary policy was, in fact, very contractionary. Very tight– during that period,” he said last night.
- They permitted bank failures. “And then the second mistake they made was they let the banks fail. They didn’t make any strong effort to prevent the failure of thousands of banks.”
The first point, about money supply, is a rather orthodox position that was popularised by the University of Chicago’s Milton Friedman and Anna Schwartz in their book “A Monetary History of the United States.” They argued that in the 1930s, the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors panicked and bank runs began. This led to a cycle of bank failures.
“If the borrowers hadn’t withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress,” Schwartz explained in an interview with the Wall Street Journal several months ago.
Notice that there is a subtle–but extremely important–difference between Schwartz’s analysis and Bernanke’s. In Schwartz’s view, healthy banks were failing due to a liquidity crisis. This could have been prevented by adding more liquidity. For Bernanke, even the failure of unhealthy banks should have been prevented. This is a serious departure from the historical precedent.
Bernanke’s approach is premised on the idea that there will be a crisis if you don’t rescue a failing firm. But there’s no evidence for that. In fact, Bernanke’s approach probably makes the problem worse. If bank runs were caused by an inability of depositors to distinguish between healthy and unhealthy firms, Bernanke’s approach is actually creating this same confusion.
“The market knows when a firm isn’t sound,” Schwarts told William Cohan in a separate interview. “And if the Fed didn’t behave as if every failing firm is too big to fail, then it would permit the exit of firms that weren’t really viable and the market would recognise this as a just decision. It’s not the job of the Fed to be intervening to help such firms. People are knowledgeable. They knew that there were troubles with Lehman.”
“If they’re going to go into the business of rescuing every failing firm,” Schwartz said, “we won’t have a capitalist system . . . People are responsible for the decisions they make. If they’ve made wrong decisions, lost money and don’t have the funds to operate, well, it’s time to leave the market. And that’s what the Fed’s responsibility is, not to shore up firms that have no reason to continue.”
Way back in October we described this approach as fighting the last depression while ushering in the next one. Unfortunately and depressingly, it seems that Bernanke is immune to evidence or argument on this subject.
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