The Federal Reserve and the Financial Crisis.

Hummel, Jeffrey Rogers

The Federal Reserve and the Financial Crisis, by Ben S. Bernanke. Princeton, NJ: Princeton University Press, 2013.

A little over a year ago Ben Bernanke delivered four lectures at George Washington University. Those lectures and Bernanke's answers to some audience questions have now been edited and published in a slim volume entitled The Federal Reserve and the Financial Crisis. (1) Pitched to a general audience, the book is part of the Federal Reserve Chairman's praiseworthy effort to increase Fed transparency. Although economists and others familiar with the subject will find the content a bit elementary, it does offer insight into Bernanke's thinking about the crisis and his justifications for Fed actions. Indeed, a few of the most revealing comments are contained in his responses to student questions.

The first two lectures cover the origins and history of the Fed. Bernanke identifies three primary functions of central banks: monetary policy, lender of last resort, and financial regulation. Yet with respect to monetary policy, what are we to make of an account that never mentions the money supply, except for one brief reference at the book's beginning when discussing the gold standard and a second reference to currency in circulation toward the book's end? The second reference even disingenuously implies that the Fed did not "print" money during quantitative easing, relying upon a literal use of the word "print." For Bernanke, monetary policy is solely about setting interest rates.

To his credit, Bernanke does try to address arguments for the classical gold standard. But as University of Georgia economist George Selgin pointed out at the Free Banking blog when the first lecture appeared online, Bernanke's rejection of the gold standard displays severe weaknesses of its own. It grossly overestimates the resource cost of a gold standard by implicitly assuming no fractional reserve banking; it ignores the pathbreaking research of Christina Romer, former chairman of President Obama's Council of Economic Advisers, that demonstrated the variability of U.S. output was not significantly greater prior to the Fed's creation than after World War II; and it exaggerates the economic difficulties associated with the mild, long-run deflation of the late nineteenth century, seemingly unaware of the work of many economic historians including Milton Friedman and Anna Schwartz in their classic, Monetary History of the United States. To this I would add Bernanke's offhand and misleading characterization of temporary bank suspensions of payments in the pre-Fed period, depicted in one of his charts, as bank failures, obscuring the fact that the number of outright failures was usually far fewer.

Bernanke does concede that the Fed exacerbated the Great Depression and caused the Great Inflation of the 1970s. But he curiously omits any mention of the Fed's equally significant contribution during World War I to the highest rate of inflation in the country's history--outside of the two hyperinflations of the American Revolution and the Civil War (in the Confederacy). This inflation was promptly followed by the U.S.'s highest annual deflation rate in 1920-21. Then, during World War II, the Fed generated another inflation severe enough to inspire comprehensive wage and price controls and government rationing. By any standard, this is hardly an impressive record. Not only did the Fed preside over the worst banking crisis in world history, after being explicitly set up to avoid such panics, but the only time it has performed at all passably is debatably during the remainder of the 1920s and the two decades of the Great Moderation--low inflation with only two minor recessions--under Alan Greenspan.

Bernanke is more persuasive when discussing the recent financial crisis. He makes a strong case for what he concedes is a controversial claim: that Fed easing bears little responsibility for the housing boom, which was an international phenomenon driven primarily by capital flows. Here is where some attention to the money stock could have strengthened his case, given that the rates of growth of all monetary measures were on the decline. He also does a good job of explaining how what were essentially runs on investment banks and other parts of the shadow banking system created systemic effects far more serious than total subprime losses. And his details about specific Fed responses are illuminating.

Bernanke credits these targeted bailouts, starting in December 2007, with providing liquidity almost exclusively to solvent institutions with good collateral. Whether correct or not, he fails to emphasize (although it comes across clearly in his graphs) that for almost a year, Fed sales of Treasury securities sterilized, that is offset, all these injections. That is most definitely not acting like a traditional lender of last resort, which calms panics by increasing total liquidity. As Scott Sumner and other Market Monetarists have maintained, Bernanke's crisis response was far too tight at the outset. Bernanke makes much of the relatively minor economic consequences of the dot-com bust compared with the major panic he faced. But he fails to note that Alan Greenspan's liquidity injection in September 2001 in response to the dot-com bust was not sterilized, causing noticeable but temporary spikes in banks reserves and the monetary base. Moreover when Bernanke, running out of Treasuries to sell, finally orchestrated an unprecedented increase in the monetary base in October 2008, he partly offset any impact by paying interest on bank reserves, thus discouraging bank lending.

In addition to the housing bubble and systemic effects, the third prominent feature of the financial crisis was the widespread mispricing of risk. Although Bernanke acknowledges that "too big to fail" creates perverse incentives, he never uses the term "moral hazard" or gives the concept much consideration. His basic explanation for excessive risk taking is that "nobody was in charge." The book sings the praises of the Dodd-Frank Act, which with "more stringent scrutiny: more supervision, more capital reserves, more stress tests, more restrictions on ... activities" will help achieve financial stability in the future. This astonishing faith in the ability of government to outperform the market in pricing risk discloses Bernanke's fundamental mindset.

As I have argued elsewhere, central banking is becoming the new central planning. Rather than sticking to the prescription of Milton Friedman to merely control the total money supply and permit the market to allocate credit, Bernanke favors credit allocation by the central bank. The evidence for this expanded role is sprinkled throughout the book. It is reflected in Bernanke's obsessive focus on interest rates as the sole indicator of monetary policy, his targeted but sterilized bailouts, his paying of interest on reserves, his expanding Fed assets to include mortgage-backed securities, and his efforts to manipulate the yield curve on Treasuries. In replying to one student, Bernanke cryptically invokes Fed "draining tools." What he has in mind is indirect Fed borrowing--through such arcane mechanism as reverse repos, the newly created Term Deposit Facility, and the Treasury deposits at the Fed that financed its liquidity swaps with foreign central banks--so that it, like Fannie and Freddie, can further determine where savings flows without altering the money stock. Despite the effort of The Federal Reserve and the Financial Crisis to portray Bernanke's actions as merely applications of conventional doctrine, he has in fact dramatically altered the nature of central banking.

JEFFREY ROGERS HUMMEL

Department of Economics

San Jose State University