As noted in my previous post on this, Tyler Cowen and I have converged: we agree that Bernanke’s and Friedman’s views on the causes of the Great Depression differed and that, although there is some ambiguity, there is no clear evidence that Friedman would have favored the Paulson-Bernanke bailouts.

I’d like to advance the discussion beyond what Bernanke and Friedman believed and discuss, instead, what should have been done, specifically, whether the bailout was a good idea.

I believe that monetary policy alone, without any targeted bailouts, could have prevented Tyler’s “very dire” scenario of “subsequent contagion,” “even more financial institutions insolvent,” and economic collapse. In my view, the key was to prevent sudden deflation caused by either a reduction in the growth of the money supply or by an increase in money demand. Without a serious secondary deflation, bank failures would have remained few, the bank failures that occurred would not have had the serious effects that Tyler projects would have followed without targeted bailouts, and the economy would have been better off than with the policy actually pursued.

The Cowen-Bernanke view is that the financial sector is so central to the economy–more so than any other sector–that bailing out intermediaries takes primacy over increasing the money supply. That’s the only way to understand why Bernanke used monetary policy to sterilize the bailout of Bear Stearns back in the spring of 2008.

In my view, the panic probably wouldn’t have been as serious if Bernanke had started expanding the base before October, and if his October expansion had not been accompanied with the deflationary step of paying interest on reserves.

My confidence in the efficacy of pure monetary policy, I gather, is similar to that of Scott Sumner on his blog. The difference is that Scott believes that monetary policy, if expansionary enough to counter not only sudden deflation but also any decline in the growth of nominal GDP, could have prevented the current recession almost entirely. My view is more modest; I believe monetary policy can prevent sudden deflation and cut off financial panics, but I am very skeptical of using it to fine tune the business cycle.

Also, note that we had some pretty big crises during the Greenspan era. The three were the stock market crash of 1987, an all-time record for a one-day percentage decline, the Y2K fear of late 1999, and the 9/11 crash. In all three cases, Greenspan’s policy was to provide lots of liquidity. And it worked.

1. There was no recession due to the 1987 crash.
2. There was a short recession in 2001 after Greenspan, in early 2000, had reversed the increase in the money supply that he engineered in late 1999, but it was short and shallow.
3. There was no recession after 9/11.

So I think the burden of proof is on those who think that the losses to financial intermediaries would have, without a bailout and without offsetting monetary policy, led to a longer, deeper recession than the one we’re in.