Bernanke v. Friedman

Milton Friedman argued that the Great Depression was caused by a banking collapse that reduced the money stock and decreased velocity leading to a massive failure of aggregate demand that was not countered by the Federal Reserve. The title of his book with Anna Schwartz is apt, A Monetary History of the United States. Ben Bernanke also put the banking crisis at the center of his story of the Great Depression but the propagation mechanism was quite different. Bernanke argued that the banking crisis led to a collapse of credit. His contribution to Great Depression literature is also aptly titled, Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.

In an excellent paper from Boom and Bust Banking, Jeff Hummel shows that these two stories have different implications for policy. (FYI, B&BB was edited by David Beckworth and also contains excellent papers by Scott Sumner, Nicholas Rowe, Larry White and others. Full disclosure, I was the general editor.) In Friedman’s story what is required is monetary policy, an increase in the money stock to keep nominal GDP from falling. In Bernanke’s story what is required is actually fiscal policy (albeit fiscal policy performed by the Fed), namely emergency lending to banks to keep credit flowing. These two approaches are not mutually exclusive and in ordinary times the differences are subtle. Under the immense pressure of the great recession, however, the differences became large and important. Instead of primarily pursuing a Friedman policy of injecting liquidity into the system, Bernanke followed his nonmonetary prescription and injected credit. Bernanke’s approach has turned the Fed into what Hummel calls a central planner of credit (e.g here), an unprecedented change with potentially very large consequences for the future.

??????????????????What brought Hummel’s paper to mind today was strong support from a surprising source, a broadside against Bernanke’s handling of the great recession from the President of the Federal Reserve Bank of Richmond, Jeffrey Lacker (writing with Renee Haltom). Lacker and Haltom don’t cite Hummel but they support his analysis and although they write in careful, measured tones you don’t have to be a Straussian to recognize that it’s a direct attack on Bernanke:

When the central bank utilizes “lender of last resort” powers to allocate credit to targeted firms and markets, it encourages excessive risk-taking and contributes to financial instability. It also embroils the central bank in distributional politics and jeopardizes the independence that is critical to the central bank’s ability to ensure price stability. The lesson to be learned from the expansive use of the Fed’s emergency-lending powers in recent decades is that it threatens both financial stability and the Fed’s primary mission of ensuring monetary stability.

One thing Lacker and Haltom don’t do, however, is say how the Fed can unwind its positions. During the crisis the Fed pulled a genie out of the bottle and the genie delivered trillions to grateful borrowers. But how can the genie be put back in the bottle? The problem, in my view, is not primarily one of inflation or economics but now of politics.


Sorry Tyler, but it was always a political problem. That's the central defect of modern economics. You guys are convinced that moral and political problems can be addressed with mathematics. When that fails, you punt and claim it is no longer a math problem.

As to the question about putting the genie back in the bottle, why is that never included in the grading of the Fed's performance? If the cure to your case of the flu is stomach cancer two years later, no one would accept that as an acceptable trade-off. If the cure to the Great Recession is a bill we can never repay, that's not a great trade-off either.

The problem however is not too much credit it's the lack of good entrepenuers to use this credit to its greatest potential. That's why the political AND moral solution here is open borders to allow the best of the best to come the US and really kick start the economy. This isn't mathematics - this is smart policy based on logic AND morals.

And a bunch of school-age kids who have had the enterprise to thrust their way over the border will make fine entrepreneurs, obviously.

Yes, there's certainly a lot of talent out there. We need more credit but also more smart entrepenuers whether they're starting App companies or Taco food trucks.

That's why I'm against any immigration restrictions. If you have a system that allows some people in and not others this is exactly like an industrail policy of "picking winners" we should let everyone come here and have a chance.

One, politics are essentailly coercion and deceit.

Two, You can have a welfare state or open borders; but not both. (M. Friedman).

Three, for each entrepreneur absconding in there are 50 to 100 MS-13 gang bangers and other assorted low-life nitwits with no skills and a no regard for education and our laws.

Four, We need more people because 92,000,000 working-age Americans out of the labor force are not enough.

Five, Brevity is the soul of wit. You could have said it in eight monosyllabic (so that even a liberal could understand) words, “I have a lump of shit for brains.”

1 With the coming of BitCoin the era of Big Government will soon be over
2 Well we want open borders, why would we want a welfare state?
3 That is made up nonsense
4 these Aericans are unskilled themselves, if they were skilled they would be employed
5 Many smart people agree with me, including prominent Economists

Why would anyone take the risk of being an entrepreneur when the implicit-Fed/govt-backstop on financial asset values has made financial careers so incredibly valuable with so little risk?

@ Z - it was not Tyler but AlexT, in one of his better posts IMO. Nice synopsis. All of this would be moot IMO if we were under a Gold Standard, and/or had no central bank, but don't let me Jacksonian and gold bug nut leanings hijack this post.

All of this IS moot anyway with the coming of BitCoin.

It's not moot - bitcoin will come a helluva lot sooner if the dollar fails.

White people all look the same to me.

"All of this would be moot IMO if we were under a Gold Standard."

The basis for the post was the differing views of Friedman and Bernanke with regard to Great Depression, a time when we were on the gold standard. They both also argue that the Fed should have done things differently, not that it shouldn't have existed at all.

Furthermore, the gold standard only applies to the monetary base, not the money supply in a fractional reserve banking system. I think both would argue that this becomes a detrimental constraint when the underlining relationship between the monetary base and money supply changes (due to thinks like hoarding, bank runs, and bank failures).

I also think people should spend a lot more time reading about the details of the Wildcat Banking era before romanticizing it too much.

@Nylund: Roosevelt debased the dollar at the start of the Great Depression so it was really not a Gold Standard. Fractional reserve banking is another gripe of mine: savers should not have FDIC insurance, and banks should offer both fractional reserves and interest rates for depositors, as well as "inventory storage" (non-fractional) services for saver's gold. The Wildcat Banking era was a success...see the growth rates in the 19th century in the USA and Canada, they were equal to today's rates. As for no FDIC insurance, that too was a success: less than 5% (I believe it's actually less than 2%) of depositors during the Great Depression, before FDIC insurance, actually lost money. And the ones that did were in the Deep South, and from what I've read they actually took over real estate from bank borrowers, meaning they stepped into the shoes of the failed banks and assumed many loans. Very few people lost everything in the days before FDIC, except for fraudulent bank schemes of course, akin to today's Ponzi / Madoff schemes.

Bring back the Panic of 1837 (i.e., no Keynesianist fiscal or monetary stabilizers), free banking and the Gold Standard! If it was good enough for grandpa, it's good enough for me.

> "You guys are convinced that moral and political problems can be addressed with mathematics."<

Yup -- mathematics... or at least wise "experts" directing/guiding everything via collectivized government power. That's modern economics and its core fantasy

All government actions are ultimately based on politics and political power. The Federal Reserve is a textbook example of socialism, established and controlled by narrow political forces -- its consistent, huge failures over the past century are routinely excused as mere missteps in an otherwise noble and irreplaceable institution.

Post is by Alex, not Tyler.

So nice to see the esteemed Virginia Postrel comment here. Just ordered your latest book. !

When the central bank utilizes “lender of last resort” powers to allocate credit to targeted firms and markets, it encourages excessive risk-taking and contributes to financial instability.

Is this a current issue? The banks have repaid the Federal Reserve and repurchased the preferred stock bought by the Treasury. The oddities faced at this time would be that the Federal Reserve Banks have abnormally high holdings of Treasury securities and mortgage-backed securities and that commercial banks have abnormally high reserves. The residential mortgage portfolios held by commercial banks still have elevated (though declining) delinquency rates. How acute are these problems?

There's still the excess reserves.

"One thing Lacker and Haltom don’t do, however, is say how the Fed can unwind it’s positions. During the crisis the Fed pulled a genie out of the bottle and the genie delivered trillions to grateful borrowers. But how can the genie be put back in the bottle?"

I don't understand this hand wringing. During the crisis, liquidity dried up, and people feared for the ability of banks to meet their day to day obligations. The Fed had to fill the gaps of credit to keep the economy functioning. With the crisis past, the private sector can go back to creating credit, and the Fed can withdraw its support as the private sector stands up.
Alex, Lacker, et al just seem uncomfortable with the fact that "lender of last resort" can work. There must be a downside!

To deploy a familiar analogy: alcohol works on hangovers, too. When will they let us off this clunky ride?

Credit is the lifeblood of modern economies. It's not some artificial stimulant.

Also, while the initial response to the crisis involved emergency lending to banks to stop the panic (aided by TARP, which came from the traditional fiscal power), the Fed transitioned from that kind of un-Friedmanlike response that Tabarrok disdains to a very-Friedmanlike policy of increasing the Fed balance sheet by buying safe government assets and increasing the money supply.
The distinction that Tabarrok is trying to make no longer applies. QE is what St. Milton would have prescribed.

Alcohol is good for you in moderation, too. :)

I already know the party line, louis. It just happens not to make any sense. And nobody said anything about being against "credit."

louis makes perfect sense. +1 to him.

When you said "alcohol works on hangovers" I assumed your analogy was credit provision by the Fed soothing the effects of credit provision by the private sector the "night before". Did you mean something else?

I would have been happier with a few bank implosions and perp walks/public lynchings of bank execs.

Lucky we have semi-responsible people in charge who know they need to protect the hyper-productive wealth creators of society and not appeal to raving lunatics such as yourself.

Only $12.39 on Kindle. Nice!

Lacker has been in the Wrong-About-Everything Club for years now. We really ought to stop paying attention to him.

Yep. Not a great forecasting record at the Fed:[]=Janet+Yellen&c[]=Charles+Plosser&d=0

And from wiki this is sort of impressive: "Lacker's vote was the solitary dissent in the August, September, October, and December 2007 FOMC meetings... Mr. Lacker voted for additional tightening."

That's just embarassing.

Don't forget when Lacker said in June 2008 "'at some point we're going to have to choose to let something disruptive happen.'That is, let a too-big-to-fail bank fail"

How did that work out for him?

Can someone explain to this non-economist what the different policies follow from the Bernake vs. Friedman way of looking at things. If I understand what happened in the crisis correctly, then the Fed acted by buying government bonds using dollars that it had magicked into existence. Banks could increase their reserves by lending to government and selling the bond to the bank.

Is there any other mechanism available to a central bank?

Also, doesn't the new money turn up in the form of government spending? Or at least added confidence that the government can borrow freely. Since the central bank can't control what the government does with this credit, how is it picking winners?

There is a mechanism for the prevention of these artificial crises, yes, but it would leave the bankers out of work.

No good deed goes unpunished. The hawks supported raising interest rates (raising interest rates!) as the financial crisis unfolded in 2007-08, certain as they were that runaway inflation was imminent, Lacker foremost among the hawks and strongest critics of Bernanke, Paulson, and Geithner as they tried to manage the crisis and avoid another depression. Lacker was clueless then and no less clueless now.

Excellent post, Alex. Turning the Fed into a central planner of credit is dangerous not just for the reputation of the Fed, but also the reputation of government as not really caring about its own citizens and their representation in the economy. They don't want to unwind their positions because those positions are so lucrative for the arrangements of government and finance.

One thing Lacker and Haltom don’t do, however, is say how the Fed can unwind its positions. During the crisis the Fed pulled a genie out of the bottle and the genie delivered trillions to grateful borrowers. But how can the genie be put back in the bottle? The problem, in my view, is not primarily one of inflation or economics but now of politics.

Seems pretty easy to me, just do nothing. Hold onto to the various loans and let the borrowers make their payments. As the bonds are paid off the Fed simply has to keep the cash that comes in and not buy new bonds. Private sector type securities like MBS simply unwind themselves just as 3 month Treasury notes 'self-unwind' by simply waiting...uhhh...3 months.

Granted unwinding a security with a 5 or 10 or 30 year maturity in 3 months isn't as easy as unwindinga T-bill, still if you had a booming economy that you were afraid was veering towards inflation I suspect many of those private securities would become self-unwinding. For example, booming house prices would lead to people selling their homes for a profit, paying back their original mortgages early thereby turning cash over to holders of MBS's.

If the Fed had randomly bought a boatload of risky assets in 2008/2009 (more than it did, and nothing targeted about it), then not only would the economy be in better shape, but the treasury would have realized a gigantic profit. (If Warren Buffett does it, it's brilliant. If the Fed does it then OH MY GOD COMMUNISM END OF THE WORLD!)

As it is, the Fed has been reporting large profits, but it's the wrong source of's mostly coming from interest rate risk, not credit risk. So the Fed is profiting from its failure (unexpectedly low interest rates being a byproduct), instead of profiting from its success.

"Instead of primarily pursuing a Friedman policy of *injecting liquidity* into the system, Bernanke followed his nonmonetary prescription and *injected credit*."

Embarrassingly, I don't really understand the distinction between these two.


The Friedman policy of "injecting liquidity" primarily involved having the Federal Reserve purchase government securities on the open market as you and I might, with its payment effectively increasing the money supply but without the Fed choosing a recipient of their funds. The Bernanke policy of "injecting credit" meant lending money to specific financial institutions chosen by the Federal Reserve, which also increases the money supply, but does so by picking the particular target of the funds.

One is simply an increase in the money stock, adding to the available supply and trusting the market to allocate those funds. The other involves directly allocating credit to the target institution the Fed is trying to help. Indeed, the Fed under Bernanke often "sterilized" their injections of funds by SELLING government securities at the same time, so that it increased the money supply with one hand and decreased it with the other. They were, in effect, picking winners (and losers, as Lehman discovered).

When the Fed buys a Treasury bond and pays for it by increasing the monetary base (i.e. the liability side of the Fed's balance sheet), it increases the amount of liquidity available to the private sector, because cash is more liquid than bonds.
When the Fed lends money to a private sector bank on an unsecured basis, or buys a risky bond, it is bearing some risk on its balance sheet, which I guess you can call "extending credit". Some see a fiscal flavor to this type of action, though historically acting as a lender of last resort is very much part of the central bank's responsibilities, and a major reason central banks were created.

Hmm, the distinction between Friedman's monetary and Bernanke's non seems largely a matter of intent rather than result. That is, Friedman would have issued a lot of base money to increase money supply, whereas Bernanke issued a lot of base money to enable and motivate banks to lend.

The characterization of Friedman seems right - he believed in a simplistic direct relation between money stocks and spending flows. But I think the characterization of Bernanke is only a little right. His crisis response was to be a very active lender of last resort, even to hedge funds. It wasn't really quasi-fiscal credit policy as you see in China or with the recent BoE and ECB policies that tie loans to banks to their lending to the real sector. His recovery policy was mainly to chase private investors into risk ie to boost asset prices, through base money expansion. The only aspect I would call quasi-fiscal is the purchase of mortgages, essentially subsidizing mortgage lending.

There is though a big, I think dangerous trend internationally towards quasi-fiscal central banking and I wouldn't be surprised to see much more in the US in the next recession. This is partly due to political dysfunction - the Fed is a run round Congress, the ECB is a run round the EU voting rules (ECB board is mostly one country one vote, which happens to favor the left/periphery).

Miron and Rigol showed that the famous Bernanke (1983) paper lacked all robustness anyway:

Ironic that Lacker broadsides Bernanke, since he rejects the implication of the alternative: stabilizing nominal GDP.

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