How the fed got huge: the financial crisis fundamentally changed the nature of central banking.

• Author: Hummel, Jeffrey Rogers

Before he became chair of the Federal Reserve, Ben Bernanke agreed with the free market economist Milton Friedman that central bank policy played a key role in making the Great Depression the most severe in U.S. history. But the two parted ways on the reason why. And that disagreement goes a long way toward explaining why the financial crisis of 2007-2009 has brought not just a dramatic increase in the powers and activities of the Federal Reserve but a fundamental transformation of its role within the economy.

Friedman viewed banking panics as monetary shocks, in which the checking accounts and other deposits at failing banks wink out of existence, causing a sudden fall in the total money supply. In contrast, Bernanke treats panics as shocks to the flow of savings, causing the failure of firms whose continued existence is crucial for the allocation of credit. Such disparate diagnoses dictate significantly different cures.

If the danger from bank panics is primarily a collapse of the money supply, then the proper response is a general injection of money by the central bank. The survival of particular financial institutions is of secondary significance. On the other hand, if the danger comes from key financial institutions failing and choking off credit, then the proper response is bailing them out.

This isn't just an obscure academic debating point of economic history. The difference has played an enormous role in the response to the financial crisis under both Presidents Bush and Obama. Instead of a sharp increase in Fed-created money that would have calmed the panic and then been quickly reversed, we got targeted bailouts with almost no impact on the effective money supply, despite all the chatter about "quantitative easing." Even more ominously, Bernanke's response resulted in an unprecedented and potentially dangerous expansion of the financial assets on the Fed's balance sheet to nearly $4.5 trillion, a value five times greater than before the crisis.

Alan Greenspan's Crises

The United States has experienced at least two episodes of extensive bank failures unaccompanied by maj or economic downturns. Throughout the 1920s, inordinate numbers of rural banks failed due to distress in the agricultural sector, even though the '20s were boom times for the U.S. economy overall. During the savings and loan crisis of the otherwise prosperous 1980s, more than 2,000 financial institutions failed, and taxpayers were hit with a $130 billion cleanup bill. (Unlike our more recent bailouts, the S&L money mainly went to cover depositor losses, not to keep insolvent institutions in business.)

A close comparison of the records of Bernanke and his predecessor at the Fed, Alan Greenspan, indicate that Friedman's theory of the Great Depression has much more to recommend it. Many have now forgotten that Greenspan faced three potential financial crises: the October 1987 stock market crash, the fear surrounding Y2K, and the terrorist attack of September 11,2001. His primary response to all three was not bailing out banks but temporarily flooding the economy with money.

The crash of Black Monday, October 19, occurred almost exactly two months after Greenspan took over the Fed. Before trading began the next morning, he issued a short statement affirming the Fed's "readiness to serve as a source of liquidity to support the economic and financial system." The Fed poured money into the economy by purchasing $12 billion of Treasury securities and obligations of federal agencies. It also increased lending to banks to a little over $2 billion through what is called the "discount window," a facility where banks can borrow Fed-created money when they face a temporary shortage of liquidity.

The most serious threat was centered in the investment banks. Back in 1987, investment banks were not yet engaging in the massive proprietary trading that caused such difficulty in the 2007-08 crisis. But they still depended heavily on money borrowed from major commercial banks. If the lending banks had refused to roll over these loans, which were contractually repayable on demand, the collapse of credit could have cascaded outward. But Greenspan's prompt liquidity response ensured that such lending actually increased during the crisis.

Greenspan at the time did consider taking the additional step of lending directly to investment banks, something Bernanke would start doing in 2008. But this experiment proved unnecessary when the crisis dissipated almost as quickly as it had emerged. In short, while the Fed increased the money supply temporarily in 1987, none of its actions during the crisis involved a Bernankeite bailout of insolvent institutions.

The Y2K threat, arising from fear that computer programs worldwide were unequipped to handle the transition to the year 2000, made the biggest blip in the Fed's monetary base (the sum of currency in circulation plus bank reserves), despite being the least remembered of the potential crises Greenspan faced. But all of the new money he injected was quickly pulled back out when Y2K fizzled into a non-event.

An equally dramatic though somewhat smaller spike in base money took place following the 9/11 terrorist attacks on the World Trade Center and Pentagon. The money was quickly withdrawn after the stock market reopened with orderly trading on Monday, September...