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A depressing lesson

30 January 2015 By Edward Chancellor

No event in economic history has been more closely studied than America’s Great Depression. The last chairman of the U.S. Federal Reserve was even an acknowledged expert on the subject. Yet Ben Bernanke was unable to foresee, let alone forestall, the financial calamity which struck in 2008. In fact, his flawed narrative of the Great Depression informed the policies which produced the global financial crisis. For monetary policymakers, the one thing more dangerous than ignoring the lessons of history is trying to implement them.

In “Hall of Mirrors,” Berkeley economist Barry Eichengreen finds commonalities between the periods leading up to the Great Crash of 1929 and to the bankruptcy of Lehman Brothers in 2008. Both eras were characterised by a belief that the Fed had ended the cycles of boom and bust. Both periods were marked by the appearance of real estate bubbles. In both the 1920s and 2000s, low interest rates in the United States encouraged irresponsible lending to countries on the periphery of the global financial system.

Also, both booms ended after the U.S. property market turned down and the Fed hiked rates. The market collapses were both followed by multiple bank failures and prolonged economic weakness.

Considering the similarities between these two periods, it seemed like the right person was in charge of America’s monetary policy and regulating its banking system in 2008. After all, Ben Bernanke, the former head of the Princeton economics department, was the author of the 2000 book, “Essays on the Great Depression.”

Despite impeccable academic credentials, however, Bernanke appeared oblivious to the risks accumulating in the financial system in the early years of the millennium. Asked about the housing market in 2005, he claimed that U.S. home prices had never fallen nationally. In truth they declined by around 25 percent after 1929. “As an expert on the Great Depression,” Eichengreen says, “the [Fed] chairman was surely aware of the fact.”

Why did Bernanke and so many other economists get things so wrong? The best answer is their intellectual framework, which assumed that people behave rationally and that markets are generally in equilibrium. Asset bubbles were considered all but impossible and the ill consequences of credit booms were ignored.

Taking his lead from the enormously influential “Monetary History of the United States” by Milton Friedman and Anna Schwartz, Bernanke believed that the Great Depression was primarily due to the failure of the Federal Reserve to prevent the onset of deflation in the early 1930s. He paid little attention to the role of the irresponsible actions of Wall Street in the 1920s.

Indeed, Bernanke and Alan Greenspan, his predecessor at the head of the central bank, turned out to be unwitting supporters of financial excess. After the dotcom bust in 2002, Bernanke – at the time a recently installed Fed governor – saw a risk of self-reinforcing deflation. He promised to avoid falling prices by any means necessary, up to dropping cash out of helicopters. This easy money policy was intended to avoid a repetition of the Great Depression. Instead, Greenspan and Bernanke delivered the Great Recession.

Although the global financial crisis came as a surprise to Bernanke and his colleagues, their knowledge of history informed the dramatic policy response. The Fed pushed interest rates towards zero and vastly expanded its balance sheet, acquiring hundreds of billions of dollars of dodgy financial assets. Successive bouts of massive bond-buying, known as quantitative easing, inflated asset prices whilst pushing down the value of the dollar, which boosted the competitiveness of U.S. industry.

Nor did the U.S. government emulate the fiscal stringency of the early 1930s. After Lehman’s failure, Washington ran record peacetime deficits. As a result, the United States avoided a 1930s-style deflationary bust.

The great institutional difference between the Fed in the early 1930s and its current incarnation is that the U.S. central bank is no longer bound by golden fetters. The absence of the gold standard in the modern age gave American policymakers greater flexibility to respond to the Lehman shock.

Europe’s policymakers were less fortunate. Once the global financial crisis had struck, members of the euro zone found themselves in a similar position to adherents of the gold standard in the 1930s. Economies which had lost competitiveness, such as Greece and Spain, couldn’t devalue their currencies. Internal devaluation, or deflation, was the only alternative. This problem was exacerbated by the reversal of capital flows as money was sucked out of Europe’s periphery.

The European Central Bank, bound by its restrictive founding charter, also had less freedom than the Federal Reserve to respond to Europe’s crisis. In fact, the gold standard had a singular advantage over Europe’s single currency. It was easy to jettison, as Britain demonstrated in 1931. The euro zone, by contrast, turned out to be a roach motel; countries could check in, but there was no way to check out.

In “Hall of Mirrors,” Eichengreen does a good job showing how both the Great Depression and Great Recession followed from credit abuses on Wall Street and the key role played by monetary policy in fuelling both booms. His analysis of the aftermath of the global financial crisis, however, is less satisfactory.

Eichengreen asserts that the Fed should have pursued even more extreme monetary measures. Yet not once, in nearly 400 pages, does he consider the potential ill consequences of such policies.

Bernanke has avoided repeating the Fed’s errors of the 1930s only to produce a novel set of problems. The reflation of asset prices has exacerbated inequality, both at home and abroad. Low interest rates have encouraged the return of irresponsible lending practices, as evidenced by recent record issuance of leveraged loans in the United States. Investors seeking higher yields have poured capital into emerging markets, helping to fuel an almighty credit bubble in China.

Interest rates are still at all-time lows, the Fed’s balance sheet remains bloated and China’s economy is faltering. It is far too early for a definitive judgment on monetary policy in the wake of the Lehman bust.


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