Hummel on Bernanke's New Central Planning
By David Henderson
The first two lectures cover the origins and history of the Fed. Mr. Bernanke identifies three primary functions of central banks: to conduct monetary policy (i.e., controlling of the supply of money by setting interest rates); to serve as lenders of last resort (i.e., providing liquidity for important institutions to stave off financial crises); and to regulate the financial system (i.e., limiting the risks that banks and other players in financial markets may take). Yet he hardly discusses the quantity of money in circulation or the Fed’s effect on it. The omission reflects the fact that Mr. Bernanke has dramatically altered the nature of central banking. Under his management, the Fed now tries to determine to which sectors the economy’s savings flow, and monetary policy has become solely about setting interest rates.
To his credit, Mr. Bernanke considers the merits of the classical gold standard, in which the dollar was fully redeemable for a specific quantity of gold. He believes that its gains in long-run price stability were more than counterbalanced by the short-run economic fluctuations it caused. But as University of Georgia economist George Selgin pointed out after the lectures were delivered, the chairman’s argument against the gold standard suffers from some severe weaknesses. For starters, it ignores the path-breaking research of Christina Romer, former chairman of President Obama’s Council of Economic Advisers, which demonstrated that the frequency and severity of recessions weren’t significantly greater before the Fed’s creation in 1913 than after World War II. This casts doubt on the ability of the Fed with its fiat money to tame the business cycle any better than did the gold standard without the Fed’s intrusions. Mr. Bernanke’s case against gold also exaggerates the economic difficulties associated with the mild, long-run deflation of the late 19th century, a period of robust economic growth.
These are two key paragraphs from Jeff Hummel’s review of Ben Bernanke’s book, The Federal Reserve and the Financial Crisis, which appeared this morning in print and last night electronically. The review is aptly titled, “The New Central Planning.” You might wonder why, in these key paragraphs, Jeff doesn’t talk about the financial crisis. The reason is that Jeff reviewed the book, not the book’s title. And key parts of the book are about Bernanke trying to justify the Fed’s existence and its activities.
In his early discussion of Fed history, Mr. Bernanke does concede that the bank exacerbated the Great Depression with its inept response to the banking collapse and caused the Great Inflation of the 1970s with an excessively expansionary policy. 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 hyperinflations of the American Revolution and the Confederacy. This inflation was promptly followed by the U.S.’s highest ever deflation rate in 1920-21. Then, during World War II, the Fed generated an inflation severe enough to inspire comprehensive wage and price controls and government rationing. By any standard, this is hardly an impressive record.
And the three key paragraphs about the financial crisis:
The chairman is more persuasive in his discussion of the recent financial crisis, which begins at the end of the second lecture and continues through the last two. He makes a strong case for a controversial claim: that Fed easing bears little responsibility for the housing boom, which was an international phenomenon driven primarily by capital flows. He also does a good job of explaining how what were essentially runs on investment banks and other financial institutions heavily reliant on short-term borrowing created systemic effects far more serious than total subprime losses.
His detailed account of the Fed’s specific responses to the crisis is illuminating. Mr. Bernanke credits targeted bailouts, starting in December 2007, with providing liquidity almost exclusively to solvent institutions with good collateral. Yet as his graphs demonstrate and his words fail to emphasize, for almost a year Fed sales of Treasury securities offset these injections. In doing so, the Fed was most definitely not acting like a traditional lender of last resort, which calms panics by increasing total liquidity, but was instead merely shifting savings into targeted institutions from other sectors of the economy. As many market monetarists have maintained, Mr. Bernanke’s crisis response was far too tight at the outset. Then, when Mr. Bernanke, running out of Treasurys to sell, finally orchestrated an unprecedented increase in the monetary base in October 2008, he partly offset the 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 Mr. Bernanke acknowledges that “too big to fail” creates perverse incentives, he neither uses the term “moral hazard” nor gives the concept much consideration. He explains the excessive risk-taking that precipitated the crash by saying that “nobody was in charge” and then sings the praises of the Dodd-Frank Act, which, with “more stringent scrutiny,” will somehow help achieve financial stability in the future. This discloses Mr. Bernanke’s astonishing faith in the ability of government to outperform the market in pricing risk.