Penn Bullock has written a piece for Reason explaining that, despite being called such by the popular press, Bernanke is not a Keynesian. Quite the contrary, Bernanke is following the prescriptions laid out in Friedman and Schwartz’s Monetary History of the United States. Unfortunately, while Bullock is correct in claiming that Bernanke is following Friedman’s economics, he gets the story regarding The Great Contraction wrong. (Two Notes: First, The Great Contraction is a text that was released after F&S’s monetary history. However, it is actually just the chapter on the Great Depression. Henceforth, all references will be referred to as F&S. The second point is that it is a bit unfair for me to criticize Bullock here as he is not an economist and therefore I do not expect him to be acquainted with some of the literature that I reference. Nonetheless, it is my view that certain points raised in his piece need a proper rebuttal.)
Bullock begins his argument as follows:
Friedman and Schwartz, however, denied that speculation had ever posed a problem, or that there had even been a credit bubble in the 1920s. In their narrative, a paranoiac Federal Reserve had needlessly constricted the money supply and thereby crashed an otherwise prosperous economy.
After the Great Crash of 1929, the Federal Reserve drastically cut interest rates; but, on occasion, the Fed was forced to abruptly raise them again in complicated maneuvers to stem outflows of gold into Europe. Friedman and Schwartz blamed these sporadic interest rate hikes for smothering several incipient recoveries, opening a vortex of deflation, and turning a recession into the Great Depression.
Friedman and Schwartz’s overarching thesis was that the Depression would have never happened if the Federal Reserve had inflated the American economy.
Bullock makes three specific points here. First, he states that F&S reject the claim that there was a credit bubble in the 1920s. I suppose that this depends on how one defines a credit bubble. Nonetheless, most consider the rising stock market as the impetus behind the Fed’s decision to tighten monetary policy. People routinely mock the great Irving Fisher for claiming that the stock market was at “what looks like a permanently high plateau” and claiming that stocks would likely move higher shortly before the stock market crash. The question regarding whether the stock market was overvalued, however, is not as crystal clear as many perceive. For example, Eugene White’s JEP paper entitled, “The Stock Market Boom and Crash of 1929 Revisited”, shows that the Dow Jones Index closely tracked dividends throughout the 1920s until roughly April of 1928. More recently, Ellen McGrattan and Ed Prescott have suggested that Irving Fisher was correct at the time that he made his statements.
Bullock’s next point is that while the Federal Reserve reduced interest rates, there were times when they raised interest rates and that is what F&S attribute as the Fed’s failure. This is incorrect. In fact, what F&S emphasize (as Bullock mentions later in the article) is the decline in the money stock. From 1929 – 1933, the money supply fell by one-third. Thus, the main failure of the Federal Reserve was to allow the money stock to decline so drastically. What’s more, what F&S are really emphasizing is that the Fed’s actions were often too little and too late in responding to shocks. In essence, the stock market crash, a series of banking failures, and Britain’s abandonment of the gold standard produced declines in the currency-deposit ratio thereby resulting in multiple deposit destruction and a decline in broader measures of the money supply (broader, that is, than the monetary base). It is F&S’s view that the Fed could have expanded the monetary base to offset the increase in the demand for base money. (Paul Krugman recently argued that such an increase would not have been possible given the fact that the US was on the gold standard in the Journal of Monetary Economics, which Anna Schwartz and Ed Nelson thoroughly refuted in the same publication.) Thus, while F&S mention the initial policy failure of a tightening of monetary policy as well as other policy errors, the main error that they emphasize is the failure to prevent the decline in the money stock, not changes in the interest rate. In fact, monetarists have long argued that the nominal interest rate was not a reliable indicator for evaluating the stance of monetary policy. Frederic Mishkin’s paper on real interest rates provided empirical support to this point by showing that real interest rates were quite high. Taking this point further, Allan Meltzer has shown that the behavior of real money balances is a better gauge for the business cycle than the real interest rate.
Bullock’s final point mentioned above is that the Federal Reserve needed to inflate the American economy. This is either a misuse of terms or an incorrect view of inflation. The context suggests the latter as he quotes Anna Schwartz:
“What the Fed had to do was increase the money supply. By taking that action, it would’ve revived the economy. That’s the lesson of the Great Depression.” In The Great Contraction, she and Friedman argued that the Fed had an infinite capacity to inflate. “The monetary authorities,” they wrote, “could have prevented the decline in the stock of money — indeed, could have produced almost any desired increase in the money stock.”
The concept of inflation is defined by a sustained increase in the price level. What F&S were emphasizing was not inflation, but rather increasing the monetary base to prevent a decline in more broadly defined money stocks.
So while Bullock is largely correct to consider Bernanke a follower of Friedman, his description of the work of F&S is somewhat lacking in specific areas. While it is not my intention to come across as criticizing Bullock, I do nonetheless believe that these points are all fundamentally important to assessing Ben Bernanke’s performance as Federal Reserve chairman. Thus, it is imperative that we get these facts correct.