Ben Bernanke and the Great Depression

Ben Bernanke and the Great Depression


December 10, 2005



Although I said I would talk about 1972 this week, the wonderful Cedric Muhammad of asked me to write a little something on the recent WSJ article on Ben Bernanke. Cedric is a Big Brain, by the way, and you should take a look at his wonderful website.


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An interesting article popped up in the Wall Street Journal on December 7, 2005, called “Long Study of Great Depression Has Shaped Bernanke’s Views.” Let’s take a look at what it says, and what that may mean for us going forward.


There are basically three views of the Great Depression popular today. They are:


1) It was a Great Deflation, caused by monetary mismanagement. This was not a common theory in the 1930s, and indeed virtually nobody at the time, including John Maynard Keynes, claims such a thing. It became more common in the 1960s, popularized by Milton Friedman. I would say probably 80% of economists (and enthusiasts of economic history) today subscribe to some form of this notion. Oddly enough, the conclusion from these “blame the Fed” theories is typically that there should be more government monetary management.


2) It was a Great Inflation, caused by monetary mismanagement. “Blame the Fed.” This was also not a common theory in the 1930s. It was popularized mostly by Murray Rothbard, also in the 1960s. Perhaps 15% of economists would fall into this camp. These “blame the Fed” theories typically are used to support the idea that there should be less (or no) government monetary management.


3) There were no great monetary influences either way at the onset of the Depression (that is, until the dramatic devaluations beginning in the summer of 1931). You could call this the default opinion of people living at the time, as they did not identify either a Great Inflation or a Great Deflation at the onset of the Depression, and did not blame the Fed, but were, instead, puzzled. Today, maybe 5% of economists hew to some form of this idea, including me.


We don’t have the space to deal with all of these theories in depth. That would take at least a book, not to mention familiarity with the previous books that outline these notions. So let’s try to make things very, very simple.


The oddest thing is that there is any disagreement at all. There is not the slightest disagreement that the 1970s were a decade of Inflation. Certainly nobody living at the time could have missed the inflation taking place, even if they may not know what caused it. I haven’t seen a single economist, columnist, or other commentator try to make the argument that the 1970s were a decade of horrific Deflation. The 1990s in Japan, on the other hand, were indeed a decade of Deflation. Certainly nobody would dare say that there was wild inflation in Japan in the 1990s.


The point is that Inflation and Deflation, of the scale that causes serious economic hardship, are very, very obvious, even if their causes and solutions may be more obscure. However, as noted above, nobody living in the 1930s recognized either monetary Inflation or monetary Deflation at the onset of the Depression (until the devaluations of 1931), of the sort that could be caused by monetary mismanagement. Sure, prices were falling, as everybody knew, but they did not associate this with monetary Deflation. This is not because they didn’t understand monetary Deflation, which was taking place in Britain in the mid-1920s, as was well recognized by Keynes and others.


This should make the casual observer think that maybe hypotheses #1 and #2, which date from the 1960s, are not quite on, and maybe hypothesis #3, shared by those living in the 1930s, may be more on track. People today who are in the #3 camp point mostly to humungous tax hikes worldwide, plus monetary turmoil beginning in 1931, for the deterioration of the 1930 recession into what is now know as the Great Depression. If I mention that Herbert Hoover raised the US’s top income tax rate from 24% to 63% in 1932, along with inheritance taxes, gift taxes, and business taxes, does the story become clearer? This sort of thing was going on worldwide at the time.


I wrote a paper covering some of the monetary happenings in the early 1930s, with many more details, which can be found in the “Long Papers” section, accessed by the link at the top of the page. In short, it argues that all the major currencies of the world were pegged to gold in the 1929-1931 period, and no sudden, sharp Great Inflation nor Great Deflation has ever happened under a gold standard. This was well known to those in the 1930s as well. To explain a Great Inflation or Great Deflation, the later economists had to do some serious mental gymnastics. Indeed, the 1930s–but not the 1920s–were actually a period of monetary Inflation, beginning with the German devaluation in the summer of 1931 and the British and Japanese devaluations in the latter part of 1931. If monetary Deflation were indeed the problem, then a little corrective monetary Inflation (aka “reflation”) would have solved it, especially as it was applied at the relatively early date of 1931. However, the Depression dragged on throughout the 1930s.


Ben Bernanke is, it appears, firmly in the #1 camp, as are virtually all academics. While I have not read any of Bernanke’s writings on the Depression, the WSJ article quotes Bernanke as saying of Friedman’s 1963 book:


Mr. Bernanke read the book as a graduate student at Massachusetts Institute of Technology in the 1970s. “I was hooked, and I have been a student of monetary economics and economic history ever since,” he recalled at a 2002 conference honoring Mr. Friedman’s 90th birthday. Mr. Bernanke, by then one of the Fed’s seven governors, told Mr. Friedman: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”


I don’t criticize Bernanke overly for making his “helicopter” comments in 2002, when the US was indeed in a mild Japan-style monetary deflation, which could be (and ultimately was) solved by what might be broadly called a “loose” monetary policy. Come to think of it, I was making similar arguments myself. I also saw Bernanke speak in Washington DC a few weeks ago, and got the impression that he is a bright fellow not a nutter. However, judging by this article (and any person’s thinking is much more nuanced than can be explained by Greg Ip in 800 words), Bernanke shows a strong belief that the Fed has a role in preventing a recession or asset-price decline from turning into a decade-plus disaster. His observations on Japan’s experience seem to have reinforced this notion. (For information on what happened in Japan during the 1990s, see my paper in the Long Papers section.)


There is a school of thinking, related to the Great Depression and Japan in the 1990s, that even a minor decline in the official CPI, even so much as -0.2% over the course of a year or so, can lead to major recessionary forces in an economy. (Another notion I disagree with.) This too stems from the Great Depression, and today’s notion of a “2% core rate of inflation” as a target is not far off from Paul Samuelson’s notion form the 1950s that a 3% annual rate of inflation is welcome to keep the Deflation Monster at bay.


The Fed knows full well that the CPI is a lagging and imprecise indicator. Thus, the Fed, and other central banks, tries to predict what the CPI might be in the future, and perhaps takes action today to prevent that future from happening.


It is not too difficult to imagine a scenario where asset prices in the US are falling rather dramatically, as the country enters a recession–with the most likely cause the combination of stagnant wages plus the end of consumer credit expansion. A Bernanke Fed might interpret this to mean that the CPI of the future will be depressed, and perhaps the Deflation Monster may threaten to re-emerge. As a Fed governor, Bernanke has already played out this scenario to some degree, following the tech-stock collapse.


As mentioned last week, the fact that it now takes more than $500 to buy an ounce of gold indicates rather significant risk of inflation going forward. It can be stopped, but only if the right steps are taken. If the incipient inflation worsens from here (to $550/oz. or $600/oz.), I expect that more dramatic steps would have to be taken to correct the situation.


If the Fed takes a strategy of “easy money” to counteract recessionary forces going forward–even just going on “hold” as is now expected–the inflation would likely worsen considerably. Then we could see the dollar’s value plummeting such that it may take $1000 or more to buy an ounce of gold. Within the Fed’s present operating framework, the only real way to counteract these inflationary pressures is to raise the interest rate target. There are other options if the Fed changes its operating methodology, as many other central banks including the Fed have done, but that has taken place only after serious trauma. Raising the interest rate target to something like 7%–yes, that’s what I’m talking about here–would likely blow a hole in the asset markets, whether stocks, bonds, or real estate. It is the sort of thing that Paul Volcker did (when asset prices were already at rock-bottom and inflation was a long-standing crisis), but Bernanke may not like to do, as the result would be that everyone would blame the Fed for the ensuing recession! (Isn’t this what he promised “we won’t do again”?)


During 2006 a lot of these notions may play out. We are still trying to learn–failing to learn, apparently–from the Great Depression. Keep your eye on the dollar/gold price. By the time this is all over, people may be ready to return to the Gold Standard, which worked so well in the 1950s and 1960s. But to do that, there needs to be people around who can actually design and operate a gold standard. We will work on that over time.


In the meantime, try to get used to the idea that the dollar is floating in value, and may sink in value dramatically. If it takes four times as many dollars to buy an ounce of gold (let’s call that $2000/oz.), that means that the value of bank accounts, bonds, etc. denominated in dollars has fallen by 75%. There is real risk of serious inflation and even hyperinflation over the next 24 months, although nothing can be said with certainty. Given this risk, you may want to hold some wealth in the form of gold and silver. Inflation may particularly affect pension payouts. While Social Security is indexed to the CPI (manipulated by the government), many corporate programs are based on nominal salary levels. They could become worthless, which may not necessarily be considered a bad thing by corporations with pension problems. It may not be considered a problem by overleveraged homeowners and real estate speculators either, who might like to pay their debts back in confetti currency. At the same time, while the regular US income tax system is now indexed to the CPI (after the horrors of 1970s bracket creep), the alternative minimum tax–and capital gains tax–are not. If the AMT extension, now being discussed by Congress, does not pass (and it is not certain), the incidence of the AMT could rise from 4 million households this year to 21 million households in 2006. This could be exceedingly painful in an environment of serious inflation.