Monday, April 21, 2014

Bernanke vs. Friedman: Financial Intermediation Shock or Medium of Exchange Shock?

In preparing for a talk, I reread Jeffrey Rodgers Hummel's article comparing Ben Bernanke to Milton Friedman. It was good to look over it again. Hummel makes the case that Bernanke saw the crisis as a financial intermediation crisis where Friedman would have viewed it as a medium of exchange crisis. These two different perspectives imply different policy prescriptions. The Bernanke Fed focused on saving the financial system at any expense, including creating distortions in the credit market. The first phase of the Bernanke Fed response, for example, was to manipulate (but not expand) the asset side of its balance as a way to support distressed financial firms. This phase began in the fall of 2007. The Fed eventually did began to expand its balance sheet with QE1 in late 2008, but even then the emphasis was on 'credit easing' not stabilizing total dollar spending. The Fed's later QE programs, though better, also lacked the full commitment and predictability needed to fully restore total dollar spending to its full employment level.

The Friedman approach would have been to avoid picking winners and losers in the financial system and instead commit to adding as much liquidity as needed to maintain a stable level of total dollar spending. This medium of exchange approach would have let some banks fail while preventing a wholesale collapse in aggregate demand. Recall that the widespread bank run on the shadow banking system was not inevitable. As Hummel reminds us, we had severe banking crisis in the 1920s and in the 1980s with the S&Ls and yet there were no sharp economic downturns. The same could have happened in 2008-2009. One can look to how Australia fared over the past five years to see how things could have been done differently. The key to this approach is credibly committing to maintaining the level of nominal GDP in a predictable, rule-based fashion. From this perspective, the worst part of the financial crisis in 2008-2009 was the consequence of the Fed failing to stabilize expected path of total dollar spending.

In short, Bernanke viewed the crisis as result of a large shock to financial intermediation while Friedman would have seen it as a large shock to the medium of exchange. This echoes Bernanke and Friedman's differing views on the Great Depression. The former saw the 1930's banking collapse as the key catalyst behind the Great Depression while the latter saw the Fed's failure to stabilize expected total dollar spending growth as the reason for the banking collapse and resulting fall out in the broader economy. 

Read the Hummel's paper for more on this distinction.


  1. Bernanke as Fed Chair was in a position to 'promote' his preffered view - credit channel of monetary policy. It was a resounding failure. It shouldn´t survive, but unfortunately will!

    1. Great post Marcus. It can't be said enough that there is a big distinction between these two views. Your graphs illustrate it well.

  2. Interesting article! Here is something equally interesting: Huawei exec: 'Word of mouth' will beat Apple and Samsung in Europe. Full story here: