Bernanke's Alternative View of the Great Depression

Milton Friedman and Anna Schwartz, in their seminal work A Monetary History of the United States, 1867-1960 (1963), argued that the policies of the Federal Reserve led to the Great Depression. These policies included cheap money during the 20s followed by a precipitous contraction in the money supply during the recession of the late 20s and early 30s. They argue that this prolonged what would have been a relatively short recession. Their view contrasts Keynes's argument view that the because of a liquidity trap, monetary policy by the Federal Reserve would be ineffective at staving off a depression.

Ben Bernanke, current chair of the Fed, has a slightly different view. Although he does acknowledge the Fed's complicity in the Great Depression, he argues that a failure of banks was the root cause:

Bernanke, for one, wasn't satisfied that the Friedman- Schwartz analysis -- with causation running from a contraction in the money supply to falling prices and output -- completely explained 'the financial sector-aggregate output connection,'' as he wrote in a 1983 paper for the National Bureau of Economic Research ("Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression'').

Instead, he theorized that 'the financial crisis of 1930- 33 affected the macroeconomy by reducing the quality of certain financial services, primarily credit intermediation."

Translation: Many commercial banks, considered efficient at allocating credit (they have a knack for differentiating "good" from "bad" credits), failed. The ones that remained solvent wanted to hold liquid assets or, if they were willing to make loans, charged a higher rate of interest.

Then and Now

"t was reported that the extraordinary rate of default on residential mortgages forced banks and life insurance companies to 'practically stop making mortgage loans, except for renewals,'" Bernanke said, citing the work of the late economist A.G. Hart.

Sound familiar? The rate of default isn't extraordinary just yet, but the mortgage market is contracting in leaps and bounds, starting with originations and ending with securitizations. The tentacles of the home-loan market are starting to strangle portions of the debt, equity and even the normally staid money market.

Bernanke is fully sensitized to the collateral damage damaged collateral can cause. Over and over in speeches during his stint as Fed governor from 2002 to 2005, he returned to the subject of the Great Depression, detailing where the Fed went wrong and what the Fed could have done to ameliorate the problems of the banks (provide liquidity or lower interest rates).

What Bernanke thinks about the Great Depression is sort of relevant 1) because at the moment he is responsible for the monetary policy of the US and 2) because we are seeing a lot of commercial banks close in the wake of the collapse of the sub-prime lending market.

The issue may be one of relative contribution. Bernanke clearly understands that even if the Fed didn't cause the Depression it certainly made it worse:

It is perhaps fitting that Bernanke used the occasion of Milton Friedman's 90th birthday to assume institutional responsibility for the Great Depression. He said: "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."

Anyway, just from a historical point of view, I find arguments like this one interesting because the opinions of Fed chairmen on supposedly academic issues have very far reaching consequences. You can find Bernanke's NBER paper here.

UPDATE: The Fed has decided to cut interest rates.