Ben Bernanke versus Milton Friedman: the Federal Reserve's emergence as the U.S. economy's central planner.

• Author: Hummel, Jeffrey Rogers
• Position: Essay

Both Ben S. Bernanke and Milton Friedman are economists who studied the Great Depression closely. Indeed, Bernanke admits that his intense interest in that event was inspired by reading Milton Friedman and Anna Jacobson Schwartz's Monetary History of the United States, 1867-1960 (1963). Bernanke agrees with Friedman that what made the Great Depression truly great rather than just a garden-variety depression was the series of banking panics that began nearly a year after the stock-market crash of October 1929. And both agree that the Federal Reserve (the Fed) was the primary culprit by failing to offset, if not by initiating, that economic cataclysm within the United States (Ip 2005). As Bernanke, while still only a member of the Fed's board of governors, said in an address at a ninetieth-birthday celebration for Friedman: "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" (2002b).

This seeming similarity, however, disguises significant differences in Friedman's and Bernanke's approaches to financial crises, differences that have played an enormous yet rarely noticed role in the recent financial crisis. Not only have those differences resulted in another Fed failure--not quite as serious as the one during the Great Depression, to be sure, yet serious enough--but they have also resulted in a dramatic transformation of the Fed's role in the economy. Bernanke has so expanded the Fed's discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner. In short, despite Bernanke's promise, the Fed did do it again.

Conflicting Lessons of the Great Depression

The banking panics associated with the Great Depression were not only the worst in the history of the United States, but also the largest in the history of the world. The differences between Bernanke and Friedman center on why those panics generated economic catastrophe. For Friedman and Schwartz, the causal mechanism was the resulting changes in the money stock and therefore in the equilibrium price level. The panics brought about a collapse of the broader measures of the money stock over the four years from 1929 to 1933: a one-third fall in M2 and a one-fourth fall in M1. This collapse induced, in their view, a further fall in money's velocity (or in what is the same thing, an increase in the portfolio demand for money), requiring an enormous contraction in nominal income. Without full and immediate flexibility of all prices and wages, a one-third contraction in the economy's real output was the consequence. In other words, Friedman conceives of the bank panics as an enormous shock to aggregate demand.

This analysis leaves unanswered the prior questions of what triggered the banking panics in the first place and why the U.S. banking system was so uniquely vulnerable after so much government intervention to prevent such a crisis. Friedman and Schwartz attribute the panics to inept Fed policy, along with legal restrictions on the issue of money substitutes by private clearinghouses, but other economists have come up with myriad alternative explanations, ranging from the Smoot-Hawley tariff to misplaced adherence to the gold standard or a collapse of Keynesian animal spirits. Despite disagreement about what initiated the panics, however, there is a fair consensus that the collapse of the banking system, once under way, made the Depression far more severe than it otherwise would have been.

Yet, in contrast to Friedman's analysis, Bernanke's major article on the Great Depression, originally published in American Economic Review, is titled "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression" (1983, reprinted in Bernanke 2000a, emphasis mine). Banks were the economy's premier financial intermediaries, channeling savings from households to firms, which used the savings to maintain and accumulate capital, and to other households engaged in consumption. The failure of more than nine thousand banks caused a massive interruption of this credit flow, and in Bernankc's view that was the primary reason for the contraction in output and its long duration. Even in his tribute to Friedman, Bernanke reiterated his belief that during the Great Depression "banking panics contributed to the collapse of output and prices through nonmonetary mechanisms" by "creating impediments to the normal intermediation of credit" (2002b).

At first glance, Bernanke appears to be arguing that the bank panics constituted an enormous shock to aggregate supply. Despite finding "this possibility.., intriguing," he actually develops (especially in subsequent articles: Bernanke 1988; Bernanke and Gertler 1995) a convoluted explanation of why a banking collapse would instead depress aggregate demand even without any impact on the money stock (1983, 267). He speculates that such a disruption of what he calls "the credit channel" in effect will induce household and firms to hold more money rather than spend it on consumption and investment. True to his New Keynesian inclinations, what Bernanke is thus saying is that the failure of banks brings about a prolonged, negative velocity shock, although he never expresses this idea in such straightforward terms. Although the supply-side effects of bank failures would seem to make Bernanke's emphasis on the credit channel more compelling, either avenue clearly posits a mechanism for severe economic dislocations distinct from Friedman and Schwartz's explanation. (1)

These two explanations for the Great Depression's severity are admittedly not mutually exclusive, as Bernanke himself has pointed out. Financial panics clearly constitute a hit both to the money stock and to financial intermediation. But very different policies are implied, depending on which effect is primary. If the danger from bank panics is a collapse of the money supply, then the proper response is a general injection of liquidity into the financial system in order to prevent a drastic fall in aggregate demand and the price level. The survival of particular financial institutions is at most of secondary significance, and indeed those that are already insolvent because of taking on excessive risk, corrupt management, or other reasons can safely be permitted to go under if money and prices remain stabilized. So long as very few banks fail because of a pure liquidity squeeze that forces the selling off of assets at fire-sale prices, the damage should be contained. (2)

However, if the danger from bank panics is a choking off of credit that reduces either aggregate supply or aggregate demand, then targeted bailouts may be the proper response. A general stabilization of the money stock in order to hold up prices will be utterly inadequate if major financial institutions are insolvent. The economy will still suffer from a throttling of financial intermediation, making these institutions too big to fail. Even should contagion effects have no significant impact on money, they might in and of themselves bring about a serious economic contraction. Notice that this view bestows on the financial sector a privileged status that no other economic sector enjoys. Threats to the financial sector's solvency are uniquely dangerous to the economy. (3)

Bernanke did not make these policy implications explicit in his scholarly writings, nor do they necessarily follow from his focus on the credit channel. As George Selgin points out, "So long as some banks are pre-run solvent, a sufficient dose of base money should suffice to keep those banks afloat, and in the presence of an efficient interbank market would do so even if the dose were administered via the open market"--that is, through the Fed's purchase of Treasury securities or federal-agency issues on the market. "Friedman and Schwartz took for granted that the same base creation that would have sufficed to maintain M2 would also suffice to maintain the flow of credit, though not without allowing some perhaps substantial change in banks' credit-market shares. The mere change in credit-market shares itself needn't entail any credit-channel effects" and therefore no "fall in aggregate intermediation" (email message to the author, September 9, 2010).

It was left for the British monetary theorist Charles Goodhart (1987; 1995a; 1995b; 1998, 188-93, 202--4) to extend Bernanke's analysis into a rationale for targeted bailouts. He concludes it is necessary to keep specific banks afloat, mainly because rebuilding relationships between borrowers and lenders takes time, so that financial intermediation can be impaired even if the central bank preserves aggregate liquidity. Nonetheless, we can see more than a glimmer of Goodhart's argument in Bernanke's 1983 article. Both believe that what distinguishes banks from other financial intermediaries is not merely that deposits are used as money, but also that banks, in Bernanke's words, "specialize in making loans to small, idiosyncratic borrowers whose liabilities are too few in number to be publicly traded." Because bank loans are especially unmarketable, a bank collapse interrupts the flow of funds more than the insolvency of other financial institutions does. Bernanke concedes that "some of the slack" might be "taken up by the growing importance of alternative channels of credit," but "in a world of transaction costs and the need to discriminate among borrowers, these shifts in the loci of credit intermediation must have at least temporarily reduced the efficiency of the credit allocation process" (1983, 263-64). It is no giant leap from Bernanke's claim that commercial banks in general are uniquely vital to financial intermediation to Goodhart's suggestion that some banks in particular are vital, especially if they are very big.

Moreover, Bernanke clearly reveals in his original American Economic Review article that he...