Friday, October 5, 2012

Does Bernanke Owe Friedman Another Apology?

Caroline Baum says yes.  She is referring to the 2002 speech where Fed Chairman Ben Benarnke told Milton Friedman that the Fed would not make the same mistake it did during the Great Depression.  The only problem, though, is that Bernanke saw the Great Depression more from a financial crisis perspective than a shortage of money (i.e. excess money demand) perspective.  Consequently, he approached the 2008-2009 crisis from that perspective.  Baum notes he focused so intently on saving the financial system that he lost sight of the excess money demand problem.  In terms of the equation of exchange, Bernanke was so concerned about the collapse in the money multiplier (or financial intermediation) that he failed to prevent the decline in velocity.  As a result, aggregate nominal spending experienced its sharpest decline since the Great Depression. So to some degree, Bernanke did repeat the mistakes of the Great Depression.

Baum also has this to say:
The similarities don’t end there. During both the Great Depression and the 2007-2009 recession, policy makers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves, the deposits banks hold at the central bank over and above what is required. The Fed unwittingly aborted the mid-1930s economic recovery when it raised reserve requirements in 1936-1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.

What did the banks do in response? They cut lending so they could rebuild their excess reserves to desired levels.

Lesson learned? Apparently not. Fast forward seven decades, and the Fed started paying interest on excess reserves, “increasing the incentive for banks to hold more excess reserves, just as it did in 1936-1937,” says David Beckworth, an assistant professor at Western Kentucky University in Bowling Green, Kentucky.

He said that in a blog post in October 2008. Beckworth is part of a group of market monetarists who advocate a nominal gross domestic product target for the Fed. Nominal GDP plummeted in 2008-2009. And in the last four years it has grown at the slowest pace since the Great Depression.
New Assessment

It has taken your humble correspondent a few more years than Beckworth to come around to the view that the Fed isn’t running a recklessly easy policy. As I said in an Aug. 1 column, I have started to rethink monetary policy, partly in response to the results it has produced (lousy) and partly in response to recent research (provocative). Because the economy is stuck at sub-2 percent growth, and because the only bang from fiscal policy comes from monetary policy -- unless the Fed monetizes the spending, it’s just a transfer of resources -- the Fed must bear primary responsibility.  
Exactly.  The Fed has effectively kept monetary policy tight over the past four years.  We call this a passive tightening of monetary  policy. 

Let me also note that while I believed the adopting of IOER in late 2008 tightened money policy and probably helped push the economy over the cliff, lowering it today may not have the opposite effect for reasons laid out here.  Also, in fairness to Bernanke and the Fed, I was actually critical of the Fed for being too easy in 2007 and most of 2008.  I though the Fed was pandering to Wall Street and the Jim Cramers of the world.  In retrospect, I was wrong and only gradually began to change my views in late 2008.  So I should not be too hard on the FOMC for its stance of monetary policy through late 2008, even though in hindsight it was too tight. I suspect Scott Sumner had it right all along.

1 comment:

  1. I liken Bernanke´s actions to a neutron bomb. That´s the one that only kills people (workers) but keeps "financial houses" standing and intact