Long Study of Great Depression
Has Shaped Bernanke's Views
Fed Nominee Learned Perils
Of Deflation, Gold Standard
And Pricking of Bubbles
A Grandmother's Explanation
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
December 7, 2005; Page A1
In 1983, Mark Gertler asked his friend and fellow economist Ben Bernanke why he was starting his career by studying the Great Depression. "If you want to understand geology, study earthquakes," Mr. Bernanke replied, according to Mr. Gertler. "If you want to understand economics, study the biggest calamity to hit the U.S. and world economies."
Mr. Bernanke's fascination with the economic earthquake never abated. "I am a Great Depression buff, the way some people are Civil War buffs," he wrote in 2000. "The issues raised by the Depression, and its lessons, are still relevant today."
Mr. Bernanke's interest in the Depression, which dates back to his childhood, is a guide to the evolution of his thinking. In particular, his groundbreaking research on how mistakes by the Federal Reserve compounded the catastrophe is likely to influence how he steers the economy once he succeeds Alan Greenspan as its chairman early next year.
The Depression, he contends, has taught the importance of avoiding both deflation -- that is, generally falling prices -- and inflation. It has also shown the threat that falling asset prices -- such as, potentially, in housing -- and weakened banks can pose. Most important, it shows the damage the Fed can do when it follows wrong-headed ideas.
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Bernanke's Research
December 7, 2005
Excerpts of Fed chairman nominee Ben Bernanke's research and speeches on the Great Depression
"Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," by Ben Bernanke. American Economic Review, June 1983.
The present paper builds on the Friedman-Schwartz work by considering a third way in which the financial crises (in which we include debtor bankruptcies as well as the failures of banks and other lenders) may have affected output. The basic premise is that, because markets for financial claims are incomplete, intermediation between some classes of borrowers and lenders requires nontrivial market-making and information-gathering services. The disruptions of 1930-22 (as I shall try to show) reduced the effectiveness of the financial sector as a whole in performing these services. As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression.
It should be stated at the outset that my theory does not offer a complete explanation of the Great Depression (for example, nothing is said about 1929-30). Nor is it necessarily inconsistent with some existing explanations. However, it does have the virtues that, first, it seems capable (in a way in which existing theories are not) of explaining the unusual length and depth of the depression; and, second, it can do this without assuming markedly irrational behavior by private economic agents. Since the reconciliation of the obvious inefficiency of the depression with the postulate of rational private behavior remains a leading unsolved puzzle of macroeconomics, these two virtues alone provide motivation for serious consideration of this theory.
"Agency Costs, Net Worth, and Business Fluctuations," by Ben S. Bernanke and Mark Gertler. American Economic Review (vol. 79, issue 1, pages 14-31), 1989.
This paper lays out the formal reasoning behind Bernanke's "financial accelerator" theory, which he used to explain why the Great Depression was so long and deep.
This paper develops a simple neoclassical model of the business cycle in which the condition of borrowers' balance sheets is a source of output dynamics. The mechanism is that higher borrower net worth reduces the agency costs of financing real capital investments. Business upturns improve net worth, lower agency costs, and increase investment, which amplifies the upturn; vice versa, for downturns. Shocks that affect net worth (as in a debt-deflation) can initiate fluctuations.
"The Macroeconomics of the Great Depression: A Comparative Approach," by Ben Bernanke. Journal of Money, Credit & Banking (vol. 27, No. 1), Ohio State University Press, February 1995.
To understand the great depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also -- to an extent that is not always fully appreciated -- the experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.
We do not yet have our hands on the Grail by any means, but during the past fifteen years or so substantial progress toward the goal of understanding the Depression has been made. This progress has a number of sources, including improvements in our theoretical framework and painstaking historical analysis. To my mind, however, the most significant recent development has been a change in the focus of Depression research, from a traditional emphasis on events in the United States to a more comparative approach that examines the experiences of many countries simultaneously. This broadening of focus is important for two reasons: First, though in the end we may agree with Romer (1993) that shocks to the domestic U.S. economy were a primary cause of both the American and world depressions, no account of the Great Depression would be complete without an explanation of the worldwide nature of the event, and of the channels through which deflationary forces spread among countries. Second, by effectively expanding the data set from one observation to twenty, thirty, or more, the shift to a comparative perspective substantially improves our ability to identify -- in the strict econometric sense -- the forces responsible for the world depression. Because of its potential to bring the profession toward agreement on the causes of the Depression -- and perhaps, in consequence, to greater consensus on the central issues of contemporary macroeconomics -- I consider the improved identification provided by comparative analysis to be a particularly important benefit of that approach.
"Monetary Policy and Asset Price Volatility," by Ben Bernanke and Mark Gertler, presented at the Federal Reserve Bank of Kansas City's Jackson Hole symposium in 1999.
[Japanese interest] [r]ates began to rise sharply following the appointment of Governor Mieno in December 1989, and continued to rise until the spring of 1991. The rate increase was undertaken with the intention of curbing the stock market and -- like many other attempts to prick market bubbles, including the U.S. boom in 1929 -- the attempt was too successful for the good of the economy. Asset prices collapsed; and because Japan's financial arrangements were particularly sensitive to asset values (we would argue), the real economy collapsed as well.
Read the full paper1.
"What Happens When Greenspan Is Gone?" by Ben S. Bernanke, Frederic S. Mishkin and Adam S. Posen. The Wall Street Journal, Jan. 5, 2000.
[I]nflation targeting is particularly good insurance against the threat of falling prices. Deflation has been associated with deep recessions or even depressions, as in the 1930s and recently in Japan. Targeting an annual inflation rate a couple of percentage points above zero, as all inflation targeters have done, commits the central bank to maintaining a floor under price level movements (as well as a ceiling over them).
Read the full commentary2.
"Japanese Monetary Policy: A Case of Self-Induced Paralysis?" by Ben Bernanke. Included in "Japan's Financial Crisis and Its Parallels to U.S. Experience," edited by Adam S. Posen and Ryoichi Mikitani. The Institute for International Economics, September 2000.
[Z]ero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer-term credit, than the economies of the nineteenth century… Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was 100 years ago…
A target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime but also that it intends to make up some of the price-level gap created by 8 years of zero or negative inflation. Further, setting a quantitative inflation target now would ease the ultimate transition of Japanese monetary policy into a formal inflation-targeting framework -- a framework that would have avoided many of the current troubles, I believe, if it had been in place earlier…
Perhaps not all those who cite the beggar-thy-neighbor thesis are aware that it had its origins in the Great Depression, when it was used as an argument against the very devaluations that ultimately proved crucial to world economic recovery. A yen trading at 100 to the dollar or less is in no one's interest…
Franklin D. Roosevelt was elected president of the United States in 1932, with the mandate to get the country out of the Depression. In the end, his most effective actions were the same ones that Japan needs to take -- namely, rehabilitation of the banking system and devaluation of the currency. …
Roosevelt's policy actions were, I think, less important than his willingness to be aggressive and to experiment -- in short, to do whatever it took to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done. Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn't more happening? To this outsider, at least, Japanese monetary policy seems to be suffering from a self-induced paralysis. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn't absolutely guaranteed to work. Perhaps it's time for some Rooseveltian resolve in Japan.
Read the full article3.
Preface to "Essays on the Great Depression" by Ben S. Bernanke. Princeton University Press, 2000.
My particular research specialty is macroeconomics, not economic history. Nevertheless, throughout my academic career, I have returned many times to the study of the vertiginous economic decline of the 1930s, now known as the Great Depression. I guess I am a Great Depression buff, the way some people are Civil War buffs. I don't know why there aren't more Depression buffs. The Depression was an incredibly dramatic episode -- an era of stock market crashes, bread lines, bank runs, and wild currency speculation, with the storm clouds of war gathering ominously in the background all the while. Fascinating, and often tragic, characters abound during this period, from hapless policymakers trying to make sense of events for which their experience had not prepared them to ordinary people coping heroically with the effects of the economic catastrophe. For my money, few periods are so replete with human interest.
I have enjoyed studying the Great Depression because it is a fascinating event at a pivotal time in modern history. How convenient for me, then, professionally speaking, that there is also so much to learn from the Depression about the workings of the economy. (Those who doubt that there is much connection between the economy of the 1930s and the supercharged, information-age economy of the twenty-first century are invited to look at the current economic headlines -- about high unemployment, failing banks, volatile financial markets, currency crises, and even deflation. The issues raised by the Depression, and its lessons, are still relevant today.)
"A Crash Course for Central Bankers," by Ben Bernanke. Foreign Policy, September/October 2000.
A closer look reveals that the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers. After the 1929 crash, the Federal Reserve mistakenly focused its policies on preserving the gold value of the dollar rather than on stabilizing the domestic economy. By raising interest rates to protect the dollar, policymakers contributed to soaring unemployment and severe price deflation. The U.S. central bank only compounded its mistake by failing to counter the collapse of the country's banking system in the early 1930s; bank failures both intensified the monetary squeeze (since bank deposits were liquidated) and sparked a credit crunch that hurt consumers and small firms in particular. Without these policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in U.S. economic activity.
Read the full article4.
"Principles of Economics," by Robert Frank and Ben Bernanke, 2001.
Labor statistics tell the story of the Great Depression from the worker's point of view. Unemployment was extremely high throughout the 1930s, despite government attempts to reduce it through large-scale public employment programs. At the worst point of the Depression, in 1933, one out of every four American workers was unemployed. Joblessness declined gradually to 17 percent of the workforce by 1936 but remained stuck at that level through 1939. Of those lucky enough to have jobs, many were able to work only part-time, while others worked for near-starvation wages.
In some other countries conditions were even worse. In Germany, which had never fully recovered from its defeat in World War I, nearly a third of all workers were without jobs, and many families lost their savings as major banks collapsed. Indeed, the desperate economic situation was a major reason for Adolf Hitler's election as Chancellor of Germany in 1933. Introducing extensive government control over the economy, Hitler rearmed the country and ultimately launched what became the most destructive war in history, World War II.
How could such an economic catastrophe have happened? One often-heard hypothesis is that the Great Depression was caused by wild speculation on Wall Street, which provoked the stock market crash. But though stock prices may have been unrealistically high in 1929, there is little evidence to suggest that the fall in stock prices was a major cause of the Depression. A similar crash in October 1987, when stock prices fell a record 23 percent in 1 day -- an event comparable in severity to the crash of October 1929 -- did not slow the economy significantly. Another reason to doubt that the 1929 stock market crash caused the Great Depression is that, far from being confined to the United States, the Depression was a worldwide event, affecting countries that did not have well-developed stock markets at the time. The more reasonable conclusion is that the onset of the Depression probably caused the stock market crash, rather than the other way round.
Another explanation for the Depression, suggested by some economists in the 1930s, was that free-market economies like those of the United States and Germany are "naturally" unstable, prone to long periods of low production and high unemployment. But this idea too has fallen out of favor, since the period after World War II has generally been one of prosperity and economic growth throughout the industrialized world.
What did cause the Great Depression, then? Today most economists who have studied the period blame poor economic policymaking both in the United States and in other major industrialized countries. Of course, policymakers did not set out to create an economic catastrophe. Rather, they fell prey to misconceptions of the time about how the economy worked. In other words, the Great Depression, far from being inevitable, could have been avoided -- if only the state of economic knowledge had been better. From today's perspective, the Great Depression was to economic policymaking what the voyage of the Titanic was to ocean navigation.
Remarks by Governor Ben S. Bernanke at the Conference to Honor Milton Friedman on his Ninetieth Birthday, University of Chicago, Nov. 8, 2002.
For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background" -- for example as reflected in low and stable inflation.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. 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.
Read the entire speech5.
"Deflation: Making Sure "It" Doesn't Happen Here," Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., Nov. 21, 2002.
Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation….
Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation….
In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
Read the entire speech6.
"Balance Sheets and the Recovery," remarks by Governor Ben S. Bernanke at the 41st Annual Winter Institute, St. Cloud State University, St. Cloud, Minn., Feb. 21, 2003.
Just as a strong financial system promotes growth, adverse financial conditions -- for example, a weak banking system grappling with nonperforming loans and insufficient capital, or firms and households whose creditworthiness has eroded because of high leverage, poor income prospects, and assets of declining value -- may prevent an economy from realizing its potential. A striking contemporary case is that of Japan, where the financial problems of banks and corporations have contributed substantially to a decade of subpar growth. Likewise, the severity of the Great Depression of the 1930s was greatly increased by the near-collapse of banking and financial systems in a number of major countries, including the United States.
Read the entire speech7.
"Some Thoughts on Monetary Policy in Japan," remarks by Governor Ben S. Bernanke Before the Japan Society of Monetary Economics, Tokyo, Japan, May 31, 2003.
One benefit of reflation would be to ease some of the intense pressure on debtors and on the financial system more generally. Since the early 1990s, borrowers in Japan have repeatedly found themselves squeezed by disinflation or deflation, which has required them to pay their debts in yen of greater value than they had expected. Borrower distress has affected the functioning of the whole economy, for example by weakening the banking system and depressing investment spending. Of course, declining asset values and the structural problems of Japanese firms have contributed greatly to debtors' problems as well, but reflation would, nevertheless, provide some relief.
A period of reflation would also likely provide a boost to profits and help to break the deflationary psychology among the public, which would be positive factors for asset prices as well. Reflation -- that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level -- proved highly beneficial following the deflations of the 1930s in both Japan and the United States.
Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years. In both cases, the turnaround was amazingly rapid. In the United States, for example, prices fell at a 10.3 percent rate in 1932 but rose 0.8 percent in 1933 and more briskly thereafter. Moreover, during the year that followed Roosevelt's inauguration in March 1933, the U.S. stock market rallied by 77 percent.
Read the entire speech8.
"Money, Gold, and the Great Depression," remarks by Governor Ben S. Bernanke at the H. Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Va., March 2, 2004.
Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.
Read the entire speech9.
Interview with Gov. Ben Bernanke in the Region magazine, published by the Federal Reserve Bank of Minneapolis, June, 2004.
Q: What are the lessons we should learn from the Great Depression? What do you as a governor of the Federal Reserve System take away from that calamity?
A: The lessons one learns from that are, first, that monetary stability and price stability are incredibly important for generating overall macroeconomic stability, and second, that financial stability also is of major importance. Because financial instability can generate real instability, maintaining a sound and stable financial system should be a high priority for the central bank and the government.
Those are the two broadest lessons I would draw from it. I think it's important to understand that the deepest cause of the Depression, as [Massachusetts Institute of Technology economic historian] Peter Temin once said, was World War I and the Peace of Versailles that followed it. These left the world not only in an economically fragmented and unbalanced situation but also in a highly contentious political situation. Powerful political forces prevented the kinds of economic cooperation that might have prevented some of the problems that later occurred. So there was a confluence of political and economic factors that made the Depression as severe as it was. But again, if I had to narrow it to two main lessons, I would stress the crucial importance of both monetary and financial stability. |
