Submitted by Rich Marino
Lately, there has been never ending discussions about today’s government bailouts and stimulus packages within the context of currency devaluations, deflation, yesterday’s gold standard, and how all of this relates to the history of the Great Depression. All of this banter begs the question: what did we actually learn from this history?
Moreover, we have been hearing the term “too big to fail” over and over again. What actually is too big to fail? In my opinion, the banks should be the only entity considered too big to fail because the banks are basically the “system”. Their decisions affect all of us; so, they should be heavily regulated to prevent this nonsense from ever happening again. Ironically, day before yesterday, I read an article in the FT where Alan Greenspan, the former Chairman of the Federal Reserve Board of Governors, made the case for nationalizing the banks; now, there’s a guy who has come full circle from his old Reaganomics days when he was the chief minstrel for de-regulation!
Given the severity of today’s economic calamity and given the fact that all of us are entitled to our own opinion which can probably be supported by citing some historical account found in the history of the Great Depression, I thought that it would be timely to post part of an interview with Ben Bernanke that took place in 2005. A transcript of the complete interview was sent to me by one of my former colleagues who took it off of a university website (University of North Carolina) and I understand that the interviewer might be Bernanke’s editor, but unfortunately I don’t know the person’s name. I can say this. My former colleague is a very reliable, very professional analyst with Morgan Stanley in New York.
Please remember that Bernanke has a very analytical mind and he speaks and writes with intense academic vigor. I have never read anything that he’s written that I didn’t have to read at least twice:
A Portion of the Bernanke Interview
Ben Bernanke was raised in Dillon, SC, entered Harvard College in 1971, and graduated in 1975 summa cum laude. After Harvard, Dr. Bernanke went on to graduate school at MIT, and completed his Ph.D. in 1979. His first job was at the Stanford Graduate School of Business. In 1985 he accepted a tenured professorship in the Woodrow Wilson School at Princeton University. He was Howard Harrison and Gabrielle Snyder Beck Professor of Economics and the Chairman of the department of economics at Princeton University when he was appointed by President Bush to the Federal Reserve Board of Governors in 2002. Thereafter, he was appointed Chairman of the Council of Economic Advisers from June 21, 2005 until January 31, 2006. He assumed the duties of Chairman of the Federal Reserve Board of Governors on February 1, 2006. “I spoke with then Governor Bernanke in his office at the Federal Reserve Board of Governors building in Washington, D.C. on May 9, 2005. Given the enormous workload that Dr. Bernanke has always maintained, I was given one hour of his time and I had no intentions of abusing his kindness. One hour, to the minute, with Chairman Bernanke begins now…”
Do you think we can go as far as to say that we have our hands around “the holy grail of macroeconomics”? Eichengreen and Temin (1997) have said “the modern literature can be regarded as having substantially solved the riddle of the Great Depression” and it is the gold standard explanation. Is that so?
I think Barry Eichengreen, Peter Temin, Jeffrey Sachs and others who introduced the gold standard into the analysis made a very important contribution. I think we will never have the full story. There are many issues associated with why wages, for example, didn’t adjust more quickly in the face of large pressures from the monetary system. There are issues about the role of financial crises, banking crises, exchange rate crises and the like, independent of changes in the money stock. But I do think that the only theory that explains the timing and the widespread nature of the Great Depression has to involve, broadly speaking, monetary and financial issues which in turn are intimately connected to the gold standard.
If I may, I’ll break the Depression down into several different questions. What started it? Why was it so deep? Why did it last so long? Why did it spread so completely? Why did recovery come when it did? Is there any one of those segregating questions that you think remains a mystery today?
I don’t think of any of them as a complete mystery. I think we have ideas about all of them. I think we still may be missing some complete explanations in terms of the quantitative magnitudes. For example, there’s a good monetary story that explains why the initial downturn occurred and secondly why the decline in the early 1930s was severe.
We are only beginning to get a sense of what we would need to understand and see why these effects were as large as they were quantitatively in an economy that was presumably more flexible than the one we have today. With respect to the recovery, the gold standard had a lot to say about that. We know from Eichengreen and Sachs (1985) that leaving the gold standard was very strongly correlated with the recovery process.
But once again, there is quite a bit of variation across countries in the speed of recovery. We need to better understand why, once the monetary contractionary forces were removed, the recovery was not more powerful than it was. In the case of the United States some scholars like Cole and Ohanian (2004a) and others have argued that the National Industrial Recovery Act, which reduced the flexibility of wages and prices, was a significant contributor.
That may be true, but the question remains as to whether or not that theory can explain the sluggishness of the recovery, the extent of unemployment during that period and more seriously, can it explain the similar performance in other countries that did not have the same type of program but may have had other interventions in wage–price movements.
Romer (in Snowdon, 2002) has called the US decision to stay on the gold standard “perhaps the biggest policy error of the Depression” and labels the Depression a result of failed policy. On the other hand, Peter Temin told me after 1931 the Fed had “picked their side” and thus their actions should not be construed as policy failures. Their behavior was not a “shock” or “inept” but was a continuation of the path they had chosen to defend the exchange value of the dollar. What do you have to say about this? Was it a failure of policy or not?
I think the distinction is not a fundamental one from the point of view of explaining the Depression. Romer may be thinking of a policy failure as a point-in-time decision, perhaps within a general framework for policy, whereas Temin in a lot of his work has emphasized the idea of regime choice. The idea that, for example, the devaluation of the dollar in 1933 was a regime change that generated new expectations and a new policy regime in general. I don’t see a fundamental contradiction.
It’s clear that the theories and policy frameworks of the time suggested that sticking to gold and maintaining the gold value of the currency was the only way for long-run stability. The problem was they had reached a new environment where the political calculations were different, for example the power of domestic constituencies vis-a-vis the orthodoxy of currency stabilization had grown more powerful. The institutional structures supporting the gold standard, for example the use of key currencies in place of gold as a reserve, reduced the stability of financial markets compared to the classic period. And as Eichengreen (1992) pointed out, the degree of cooperation among central banks had been reduced by World War I and the “peace” that followed.
So, what had been a successful policy regime in the nineteenth century turned into a very dangerous policy regime in the twentieth century. Policy makers didn’t understand or know how to respond to that. They went with what they had, which is understandable. I agree with Temin, it was something bigger than a policy choice. It was really an attempt to stay within an existing framework and an existing regime. But nevertheless, some policy makers like Takahashi in Japan, for example, understood that the gold standard was causing trouble and he abandoned the gold standard very quickly.
So, I think a better organized, intellectually more cogent approach might have led the US to abandon gold earlier on and therefore would have avoided some of the severities of the Depression.
Do you see the evils of deflation, whether it was anticipated or unanticipated, as the greatest villain in the story of the Depression? And given the ruinous inflation of the 1970s, is not then price instability, either up or down, one of the greatest sources of economic instability in the last century?
That’s true and I think that’s why both conservative and liberal economists are generally agreed that price stability, certainly in the medium and long term, is the most important objective for modern central banks. In some cases, central banks have codified that objective in terms of an inflation target. In others, like the Federal Reserve, it remains more implicit. But nevertheless, there is a strong commitment to maintaining price stability in both directions.
I think it is interesting that the Federal Reserve in its May 2003 statement indicated for the first time the concern that inflation may be too low as well as too high, thereby essentially making clear that the Fed has a range for inflation that’s considered consistent with a dual mandate. Deflation and inflation are destructive perhaps in different ways. For example, deflation has particularly insidious effects on debtors whereas inflation perhaps robs more from creditors. The adjustment of wages may be different in the two circumstances. The inflation of the 1970s was primarily monetary but it had other factors as well such as the oil price shocks and so on. There are some differences but I think the broad conclusion that the policy for a central bank is to maintain medium-term price stability is widely accepted. In many ways this is a return to the gold standard in the sense that they too valued long-run price stability and put the highest value on long-run price stability and thought the gold standard was the way to get there. What they didn’t fully appreciate was the potential for collapse of money supplies in the context of the gold standard that could generate major price instability.
Likewise, Milton Friedman in evaluating the Depression came to the conclusion that monetary stability was the key. So he suggested stable money of money though turn out to have somewhat loose relationships to the ultimate price level. And so where we are today is central banks are stepping away from intermediate targets like the money supply or the price of gold and looking directly at inflation as an objective of monetary policy. Ultimately that’s achieving what these other systems were trying to achieve, but more directly.
Looking at Figure 2 in Cecchetti’s 1998 paper “Understanding the Great Depression” which shows Fed discounting behavior from 1919 to 1934, does this not show the failure of the Fed to be the lender of last resort? Eichengreen has argued that, since we were on the gold standard, if the Fed had provided liquidity it would have called into question our commitment to gold. But even though they were on the gold standard, the graph shows little was done before Britain left gold, when all agree the Fed had some room to do something, and the first and second banking panics pass with discounting barely even registering a pulse. I saw that graph and was somewhat taken aback by it and I’d like to know what your impression is.
Well, I was aware that the Fed was not very aggressive in rediscounting loans in order to support the banking system. There are two alternative explanations for that and I think both have some validity. One is that at various times they were concerned that increasing the money supply would accentuate the external drain.
This goes back to Walter Bagehot who talked about the dilemma of trying to deal simultaneously with an internal and an external drain. Essentially that easy money and lower interest rates could help support the liquidity of the banking system but increase the pressure on the gold standard. I think it was Wigmore (1987) who talked about the final crisis in the 1933 banking crisis, which eventually led to the bank holiday and the abandonment of the gold standard, having been driven very directly by a run on the dollar which not only affected gold stocks but precipitated withdrawals from banks. A lot of other countries like Germany simultaneously experienced exchange rate crises and banking crises as hot money flowed out of the banking system as foreigners tried to escape from the domestic currency.
So, at least in principle the Federal Reserve policy makers would have seen the potential contradiction between internal and external drains and it may have been on their mind at certain junctures. But Friedman and Schwartz (1963) suggest that there was more to it than that. To some extent the Fed may have agreed with Andrew Mellon that liquidation was the prelude to a healthy recovery, that you had to get rid of the dead wood and the excesses of the 1920s.
Purge the rottenness from the system, especially since small banks were particularly vulnerable to runs. Indeed there was some correlation between financial weakness prior to the Depression and the tendency to fail, as current scholars have found. There clearly was some view that it was good for the system in the long run to allow the weaker banks to fail. Friedman and Schwartz (1963) also commented on the fact that after the Federal Reserve Act was enacted the informal clearing houses within cities that had acted de facto as lenders of last resort during nineteenth century banking crises were essentially prohibited from acting in that role. So when the Fed failed to provide liquidity there really was no other substitute to help provide support for the banking system.
Are there any lessons from the Great Depression that need to be relearned?
As I said before, the two main lessons which I think have been learned to a large extent, but always can be re-emphasized, are first that a central bank’s primary responsibility is the maintenance of price stability, to provide low and stable inflation in the medium term, to avoid sharp inflations or deflations and particularly to avoid the instability of expectations associated with an unanchored price level.
The second lesson is that the financial industry is a special industry in terms of its role in macroeconomic stability. Major upheavals in the financial system can be extremely disruptive to the economy as a whole and therefore the central bank and other government institutions have a particular obligation to make sure that financial stability is preserved, that banks and other financial institutions are well capitalized and well managed and that there exists a mechanism for responding in the event of crisis, such as the discount window or a deposit insurance system or whatever you need to make sure that the financial system will remain whole even under a great deal of stress.
I always ask everyone at the end two questions. What ended the Great Depression?
We could turn it around and ask why didn’t the Depression end quicker than it did? Once the gold standard was removed, and the banking system was stabilized by the banking holiday and the subsequent actions that Roosevelt took, the two main impediments to recovery were removed and there was evidently some natural tendency of the economy to begin to right itself. Indeed, 1933 and 1934 were years of rapid gains in the stock market and even reasonably good economic growth. So the question is perhaps not what ended the Depression but what thwarted the recovery in the mid and late 1930s? Again I think that the wage and price controls of the NIRA and other interventions that tried artificially to reflate through fiat rather than through monetary forces were a major factor.
There may have been some elements of hysteresis in that once the unemployment rate had gotten to such a high level, people had lost skills or firms were slow to recover and re-employ workers. But, again, broadly speaking, putting the puzzle the other way, why didn’t the economy recover more quickly? Particularly in the early stages after Roosevelt became president it appeared as if things were turning around pretty quickly.
Could it happen again?
Probably not in the same way. But there certainly are risks to international financial markets that could produce very serious instabilities. One scenario that is occasionally described by some economists is a hard landing scenario for the dollar associated with the US current account deficit. I don’t particularly find that persuasive, which means it probably will happen by the time this book is published. So there are stories that one can tell where the financial system comes under an enormous amount of stress due to some sort of shock be it monetary, financial or real, and the financial system is so complex and so inter-related that one can’t rule out the kinds of contagion that were seen in the 1930s.
I do hope that central banks have learned enough in the ensuing years to understand the importance of maintaining price stability and of reacting quickly and effectively to shorten the effects of financial instability. I optimistically think that while we could still have financial crises and bad outcomes in the world economy, policy makers know enough now to short circuit the impact before it becomes anything like the severity of the 1930s. Certainly that’s the hope anyway.
For the entire interview, see: www.ecu.edu/cs-educ/econ/upload/Ben_Bernanke.pdf