Another convert

Here’s Caroline Baum of

“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, Nov. 8, 2002

That was how Federal Reserve Chairman Ben S. Bernankeconcluded his remarks at a University of Chicago conference honoring Milton Friedman on his 90th birthday. Anna is Anna Schwartz, Friedman’s less famous yet no less significant collaborator who died in June.

In his speech, 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- 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 1929-1933 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.

Theory Tested

Little did he know that, 25 years later, he would get an opportunity to test his academic theory.

How did he fare? Bernanke may have inadvertently repeated some of the same mistakes of the 1930s, in the view of some monetarists.

The parallels between the two periods 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. In both instances, policy was focused on facilitating the flow of credit.

“In neither instance did policy makers make any association between a central bank and money creation,” writes Hetzel, a senior economist and research adviser at the Richmond Fed.

The similarities don’t end there. During both the Great Depression and the 2007-2009 recession, policy makers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves, the deposits banks hold at the central bank over and above what is required. The Fed unwittingly aborted the mid-1930s economic recovery when it raisedreserve requirements in 1936-1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.

What did the banks do in response? They cut lending so they could rebuild their excess reserves to desired levels.

Lesson learned? Apparently not. Fast forward seven decades, 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 WesternKentucky University in Bowling Green, Kentucky.

He said that in a blog post in October 2008. Beckworth is part of a group of market monetarists who advocate a nominal gross domestic product target for the Fed. Nominal GDP plummeted in 2008-2009. And in the last four years it has grown at the slowest pace since the Great Depression.

New Assessment

It has taken your humble correspondent a few more years than Beckworth to come around to the view that the Fed isn’t running a recklessly easy policy. As I said in an Aug. 1 column, I have started to rethink monetary policy, partly in response to the results it has produced (lousy) and partly in response to recent research (provocative). Because the economy is stuck at sub-2 percent growth, and because the only bang from fiscal policy comes from monetary policy — unless the Fed monetizes the spending, it’s just a transfer of resources — the Fed must bear primary responsibility.



18 Responses to “Another convert”

  1. Gravatar of AKB1 AKB1
    5. October 2012 at 10:37

    Wow. I know nothing about monetary, obviously, but I was amazed at the (little remarked upon) about-face of James Pethokoukis (does anyone remember his fairly recent Commentary article, “Let There Be Growth, and / or Inflation”??), and today I am amazed as I also recall Caroline Baum complaining a few months ago that the Fed was keeping interest rates too low and thereby harming savers.
    This kind of flexibility precedent makes more comfortable with the idea of voting for Mr. Romney, who is nothing if not flexible!

  2. Gravatar of ssumner ssumner
    5. October 2012 at 11:27

    It’s great to know that people in the press are open-minded, and rethink their position when presented with persuasive arguments.

  3. Gravatar of AKB1 AKB1
    5. October 2012 at 11:57

    Mr. Sumner is right. My post above was stated in an “inelegant” manner so I apologize to Mr. Pethokoukis and especially to Ms. Baum.

  4. Gravatar of Tommy Dorsett Tommy Dorsett
    5. October 2012 at 12:10

    As Emerson once said, ‘a dogmatic inflexibility is the hobgoblin of little minds.’ Kudos to Caroline and James.

  5. Gravatar of Doug M Doug M
    5. October 2012 at 13:10

    You edited out some of the best stuff that Ms. Baum had to say.

    It appear to me that she has in any way endorsed NGDP targeting.

    Nor do I see this as any kind of about face. She has been critical of the Fed policy for years. She said in 2006 that the Fed was too tight.

    Caroline Baum’s main beef with the Fed should stick with outright purchases of short-dated treasuries. Operation twist and forward guidance do nothing to increase the money supply.

    She would say that the shape of the yield curve is the best measure of the fed’s current policy stance — a steep curve is stimulative and a flat curve is restictive.

  6. Gravatar of johnleemk johnleemk
    5. October 2012 at 15:21

    Still not enough converts:

    A majority of economists polled by the Economist rate monetary policy being too tight as least important on a scale of 1 to 5 in how important various factors have been in explaining the slow economic recovery.

  7. Gravatar of Evan Soltas Evan Soltas
    5. October 2012 at 15:53

    Baum has been moving towards this position “out loud” in her columns for a few months now: Still, every voice helps.

  8. Gravatar of Scott Sumner Scott Sumner
    5. October 2012 at 17:43

    Doug, Did someone say she endorsed NGDP targeting? I don’t see that. Indeed I made no comment at all, I merely quoted her. She’s the one that said she’s a convert.

  9. Gravatar of Jim Glass Jim Glass
    5. October 2012 at 20:06

    Stiglitz says that you and Woodford and Hetzel and Baum and Pethokoukis and Evans plus the others coming around at the Fed and all the monetarists are all wrong, having “mystified” yourselves money-wise.

    He concludes: “the stimulus that is needed – on both sides of the Atlantic – is a fiscal stimulus”. Of course.

    It’s great to know that people in the press are open-minded, and rethink their position when presented with persuasive arguments”.

    People in the press, maybe more than others.

    OTOH, I do remember a few years ago when Stiglitz was a consultant for the Greek government and was making the world PR tour with his personal friend Papandreou and other top Greek politicians to assure the markets, saying on its behalf: “Greece default?? Not a chance! It’s implausible even to talk about it…”

    I guess he did rethink his position about that. 🙂

  10. Gravatar of Peter N Peter N
    5. October 2012 at 20:22

    It should be noted that both here and in Europe (and in China) part of the success of monetary policy has come from expanding its traditional scope.

    I don’t know what the exact boundaries should be, but it’s hard to determine how much success to attribute to vigor and how much to nontraditional interventions, that some have criticized as fiscal policy in disguise.

    Of course the IMF has meddled with fiscal policy for years, but it isn’t really a central bank.

  11. Gravatar of James in London James in London
    5. October 2012 at 22:40

    Johnleemk. At least they asked the question. Four years ago today “money too tight” would not have been on the poll.

  12. Gravatar of Saturos Saturos
    6. October 2012 at 00:49

    Stiglitz is the one who thought that the declining farming sector caused the Great Depression. I think we know who’s mystified.

  13. Gravatar of To To
    6. October 2012 at 03:36

    “the only bang from fiscal policy comes from monetary policy “” unless the Fed monetizes the spending, it’s just a transfer of resources “” the Fed must bear primary responsibility.”

    In the current situation, extra government bonds would be paid for with excess reserves, thereby injecting these into the economy. Otherwise, if the CB uses an interest rate as its policy instrument, the bonds would be bought with extra base money borrowed from the CB. Ricardian equivalence only holds if the CB explicitly controls the quantity of money.

    Fiscal policy works precisely because it acts as a vehicle for monetary expansion (depending on the monetary regime) while everybody else is comparing rates and/or wondering what to expect.

    It looks like local governments in the US started hiring again. I wonder who will get credit for the recovery.

  14. Gravatar of Saturos Saturos
    6. October 2012 at 05:57

    Scott, I’ve just been listening to Bob Hetzel’s speech at CEPOS, what did you think of it?

  15. Gravatar of Saturos Saturos
    6. October 2012 at 06:01

    I think there are a number of flaws with Hetzel’s framework (in contrast to yours) as he tries too hard to fit everything into the narrative that market behavior is pure and all instability is exogenous to it (he comes close to endorsing a purely Lucasian view of why nominal shocks have real effects); but on the other hand he made some points which were interesting even to me, for instance he identified one interest group that did benefit from the Great Recession…

  16. Gravatar of Saturos Saturos
    6. October 2012 at 06:10

    I’d go so far as to say that Hetzel is the Stigler to your Friedman.

  17. Gravatar of Saturos Saturos
    6. October 2012 at 06:22

    I feel like he might be just the guy to convert John Taylor though, going on about real interest rates, and rules versus discretion.

  18. Gravatar of ssumner ssumner
    7. October 2012 at 11:55

    Saturos, You said;

    “I’d go so far as to say that Hetzel is the Stigler to your Friedman.”

    You have it backwards, and even that would be far too generous to me.

    I haven’t heard the talk, but I’d reserve judgement on Hetzel until you’ve read his book. He’s not New Classical.

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