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For economics nerds only

The seminal event that led to the creation of the study of Macroeconomics is the Great Depression (Bernanke, 1995). It is not surprising that this event would leave such a lasting mark on our national psyche. After all, in the period from 1929 to 1933, the net national income in current prices fell by more than one half, net national income in real prices declined by more than a third, and the number of commercial banks operating in the U.S. dropped by a third (Friedman & Schwartz, 1963). In response to the financial crisis, as one of its first acts, the incoming Roosevelt administration imposed a bank holiday closing all commercial banks in the country for more than a week (Friedman & Schwartz, 1963). Such a disruption did not occur before the Depression nor since. These shocking statistics make it clear why scholars would focus on understanding the causes of this crisis with an aim of avoiding its repetition.

Perhaps the most influential study of the origins of the crisis was the book A Monetary History of the United States by Friedman and Schwartz (1963). Although purportedly covering nearly a century between the end of the Civil War and 1960, the authors make it clear that their primary goal is explaining the Depression. In so doing, they offer several contributions. First, they suggest that although the Depression likely started as a routine cyclical slowdown in the economy, a series of financial crises turned it into a cataclysm. In essence, rather than suggesting that the multiple bank failures were a symptom of the Depression, the authors argue that it was a central cause. Second, they suggest two mechanisms through which the bank failures would have had such a substantial impact. First, the bank failures would have destroyed capital holdings of the banks’ owners, thus decreasing wealth and hurting economic activity. Most importantly, however, the authors suggest that the multiple bank failures would have dramatically reduced the money stock in the United States. Indeed, at a time when the United States still adhered to the gold standard, there was an inflow of gold and an increase in high-powered money from 1929 to 1933, according to the authors (Friedman & Schwartz, 1963). Despite these facts, there was a decline in the money stock due to a tightening of the Federal Reserve’s credit as well as a shift in the deposit to currency ratio resulting from the bank runs. Finally, the authors suggest that the ineptitude of the Federal Reserve’s response to the crisis likely resulted from a power struggle within the organization, one that tied the hands of those most able to respond appropriately. The result was the greatest economic contraction in history.

It appears that the explanation offered by Friedman and Schwartz has been largely accepted (Bernanke, 1983). Indeed, in a paper he authored in 1983, economist Ben Bernanke, who would go on to serve as Federal Reserve Board Chairman during the Great Recession of 2008, expanded upon Friedman and Schwartz’s thesis. In so doing, he accepted their position that the central cause of the Depression was the financial crisis resulting from the bank failures and the ensuing lame response from the Fed. Therefore, Bernanke was familiar with their explanation for the Depression, and in facing his own financial crisis, he was intent on applying the hard-learned lessons from history.

In this paper, I will review in more detail the explanation offered by Friedman and Schwartz for the Depression. Next, I will review Bernanke’s scholarship on the subject. Then, I will review the policy Bernanke put into effect and show how it relied upon his understanding of the Depression’s causes. Finally, I will review one of the most frustrating outcomes of the Fed’s actions, the banks’ apparent unwillingness to lend out excess reserves. It turns out that a similar result was observed during the recovery from the Great Depression, and some analysts have suggested an alternate explanation for this development which draws into question certain fundamental assumptions. We will review these arguments and consider their implications.

THE GREAT DEPRESSION

Many likely think of the Depression as a single event. Friedman and Schwartz, however, point out that it was three financial crises, none of which related to the widely-known stock market crash of 1929. Indeed, it appears that the stock market peak was actually on September 7, 1929, and the weeks after the crash demonstrated little panic until the end of October. Even then, however, Friedman and Schwartz argue that the crash itself confined its effects to the financial markets and had little effect on either the money supply or the faith of depositors in their banks. What changed the character of this cyclical contraction occurred in November 1930, over a year later, when increasing economic unease resulted in runs on some of the nation’s weakest banks: small, local institutions located largely in rural farming communities in Missouri, Indiana, Illinois, Iowa, Arkansas, and North Carolina. These panics resulted in the failure that month of 256 banks with $180 million in deposits. The following month, as the contagion expanded, another 352 banks with $370 million in deposits failed, most notably the Bank of the United States, a large private bank with over $200 million in deposits that was a member of the Federal Reserve. The shock of this failure resulted in increased panic as bank customers sought to convert their deposits into currency. In response, the banks scrambled to remain liquid, resulting in a massive decline in high-powered money (Friedman & Schwartz, 1963).

The decline in deposits, increase in currency, and the resulting overall decline in the money stock is readily apparent in the following chart (Friedman & Schwartz, 1963):

Initially, in response to this crisis, New York Federal Reserve Bank Governor George Harrison moved aggressively to reduce interest rates and lend freely from the discount window. Harrison’s action was not unprecedented. The Fed had learned from their failed response to a recession in 1920 as well as their successful monetary policy throughout the following decade. Unfortunately, Harrison was not an economist and was relatively new to the job, having recently taken over after the retirement and untimely death of former New York Bank Governor Benjamin Strong. Friedman and Schwartz argue that Strong, with his impressive economic background and forceful personality could play the role of a strong leader to push the Fed to act quickly and decisively in response to the crisis. Strong, however, retired in August 1928 and died in October of that year, leaving a power vacuum. The Board, with its representation from across the country, chafed under the superior position of the New York Bank. As a result, with Strong gone, they reacted negatively to Harrison’s actions and limited his discretion (Friedman & Schwartz, 1963).

Despite this weak response, the economy did start to recover from the initial crisis. By 1931, the bank failures had declined and liquidity returned to the system. This change is evidenced by an increase in the deposit to reserves ratio from January to March 1931. Nevertheless, this event did contribute to the subsequent banking crises in more ways than simply increased fears among the banking public. In their quest for liquidity, banks sold off corporate bonds, resulting in a sharp increase in the yields of corporate bonds while yields for government bonds declined. Since much of the banks’ assets were held as corporate bonds, the resulting decline in value of these bonds reduced the value of the banks’ bond portfolios. As a result, when the subsequent crisis occurred, the banks were more poorly positioned to respond, and the bank examiners would have a smaller-valued pool of assets to consider (Friedman & Schwartz, 1963).

Thus, in March 1931, when another group of banks failed, the public and the banks responded quickly based upon their experience just months before: the banks sold assets to improve their liquidity positions while depositors withdrew their funds. For this crisis, however, Harrison knew his actions were constrained by the Board. As a result, the Fed did not increase its credit outstanding from February until mid-August of 1931. The impact of this crisis on the money stock was therefore far more serious than the first, and with the economy in an already weakened condition, defaults continued to rise, only increasing the banks’ financial distress. The crisis was then further exacerbated when the British abandoned the gold standard leading to a large outflow of gold from the United States. The impact on the banks then was twofold. On the one hand, they experienced internal drains from the deposit withdrawals, while on the other hand their gold was being drained externally. These pressures only escalated the banks’ desperate efforts to maintain liquidity, efforts that were not assisted by the Fed (Friedman & Schwartz, 1963).

Ironically, given how history has come to view him, President Hoover acted aggressively to try to stem the crisis. He established the Reconstruction Finance Corporation with the mandate of lending to banks and other financial institutions. He proposed the Glass-Steagall Act with the aim of broadening the collateral banks could use to borrow, thus reducing their reliance on gold, and broadening the circumstances in which they could borrow from the Fed. Indeed, he even proposed a hike in public works projects, although he worried about running a deficit. Similarly, members of Congress pressured the Fed to expand the money supply and called for the government to boost its spending. In light of the actions taken by the political players, one might understand Hoover’s frustration with the Fed’s inaction, which he once expressed saying “I concluded [the Reserve Board] was indeed a weak reed for a nation to lean on in time of trouble” (Friedman & Schwartz, 1963: 7494). Finally, as a result of this pressure, the Fed embarked on large-scale open market purchases which raised its security holdings by roughly $1 billion by early August (Friedman & Schwartz, 1963).

Initially, the open market purchases by the Fed did seem to have a positive effect. According to Friedman and Schwartz, the purchases stemmed the decrease in the money supply, and resulted in improved economic conditions (1963: 7431). Once again, however, the Fed ended the program prematurely, and as a result, the third quarter of 1932 saw a jump in bank failures which spread across the nation in January 1933. Again, this crisis was worse than the two previous ones because as each occurred, the financial sector and the Fed lost even more credibility with the public. Indeed, Friedman and Schwartz argue convincingly that had the Fed engaged in its $1 billion open market purchase program in response to the first crisis, the country would have likely endured a typical cyclical contraction quite unlike the cataclysm that actually occurred. Occurring months after the second crisis, however, this purchase provided only a temporary reprieve. Friedman and Schwartz argue that by the time the third crisis took place, that purchase would have done little if anything. Furthermore, the third crisis was exacerbated by a change in policy at the Reconstruction Finance Corporation. Under a mandate from Congress, it was now required to publish a list of any banks seeking financing. This document quickly became a catalog of banks in trouble, increasing the potential for a run on those institutions. As a result, banks balked at borrowing from the one source readily available to them. The result was an even more severe liquidity crisis leading to a drop in the deposit to currency ratio, culminating in another slide of the money supply as well as further deterioration of economic activity (Friedman & Schwartz, 1963).

In March 1933, President Roosevelt took office, and within days of his inauguration he imposed the national Bank Holiday. Unlike past restrictions on deposit withdrawals — a step often taken in response to pre-Federal Reserve bank runs — this event resulted in a complete stop of the nation’s financial system for six business days. Indeed, Friedman and Schwartz argue that had the banks engaged in withdrawal restrictions in response to the first banking crisis as they had in the past, the damage would have been contained. However, since the Fed was founded in November 1914, banks had come to believe that responding to a liquidity crisis was now the purview of that institution. As a result, the banks did not implement an appropriate response because they believed the Fed would step in, something that really never happened. By contrast, the bank holiday completely closed all banks for at least six business days, many of them never to reopen (Friedman & Schwartz, 1963). That action remains controversial. Friedman and Schwartz seem to argue that its implementation was so severe that it actually set back economic recovery for some time (1963:7502). Bernanke, however, takes a different view, arguing that it was a necessary step to renewing public faith in the system (1983: 257). Either way, recovery was not immediate, and it took years for credit to again become widely available, a delay that both Bernanke and Friedman and Schwartz find puzzling.

BERNANKE’S SCHOLARSHIP AND THE GREAT RECESSION

Bernanke’s relied on the lessons from the Depression as he formulated his response to the financial crisis that precipitated the Great Recession of 2007 to 2009 (Ip, 2005; Madigan, 2009; Wolf, 2014). Bernanke was well aware of Friedman and Schwartz’s work. While working as a scholar at the Stanford University School of Business and the Hoover Institution, he authored a 1983 article for the American Economic Review in which he argued for an extension of Friedman and Schwartz’s theory. While he agrees that the financial crises were the most important causes of the Depression’s severity, and he also agrees that the bank failures’ impact on capital holdings as well as the money supply played a big role, he argues that these effects were insufficient in and of themselves to explain the depth of that crisis. Instead, he points to a third effect of such a financial collapse. Bernanke argues that one of the most important roles banks play is as intermediary between the funds of investors and investments for that capital, namely performing loans (Bernanke, 1983). Thus, he was well aware of the danger the nation faced if financial crises were not addressed promptly as at the onset of the Great Depression.

Bernanke would later characterize the financial crisis leading to the Great Recession as a “classic financial panic” (Bernanke, 2012b: 11). He dismisses those who view the cause of the recession as the housing bubble or excessive mortgage lending. While these factors were triggers to the contraction, they were not vulnerabilities that allowed it to happen, a distinction Bernanke makes explicit. He points out that these losses were simply too small in the context of the American financial system to cause a panic of the magnitude that occurred. In Bernanke’s view, the vulnerability that led to the crisis was the emergence of a “shadow banking” system outside the standard regulations and protections available to traditional banks. Engaging in highly leveraged, speculative derivative investments, these institutions experienced a run on their deposits when it became clear that their risk management had been so poor and that the protections they argued took the place of government safeguards were illusory. These runs are what led to the bankruptcy of Lehman Brothers, the failure of the Primary Reserve money market fund, and the subsequent recession (Bernanke, 2012a, b; Blinder, 2013; Tett, 2009; Turner, 2009).

Friedman and Schwartz were quite explicit about the prescription they recommended for the Fed’s response to a bank run. In addition to staving off bank failures by lending freely and reducing interest rates, they urged central bankers to engage in widespread open market purchases (Friedman & Schwartz, 1963). The goal of both measures would be to avoid the monetary collapse that characterized the Great Depression. Additionally, following Bernanke’s argument, saving the financial system is critical to helping the economy recover since it would ensure that banks could get back to their role as financial intermediaries facilitating the smooth flow of credit (Bernanke, 1983). Fortunately, Bernanke was in a position to offer the strong, decisive leadership that the Fed lacked at the onset of the Depression. Unlike Harrison, Bernanke had the financial background and the credibility to mount such an aggressive response, and he was clearly determined to do so.

The consensus view is that the government response to the start of the crisis, although at times halting and unfocused, likely staved off a much more severe crisis, one comparable to the Great Depression (Blinder, 2013; Congressional Oversight Panel, 2009). The numbers are truly shocking. At the start of the crisis, world trade declined by 20%, double that of the decline in the Great Depression. Similarly, the equity markets fell more than twice as far as they fell in the crash of 1929–1930 (Wolf, 2014: 32). Wealth of American households and nonprofits declined by $12.7 trillion, just shy of the value of our entire Gross Domestic Product of $14.3 trillion (Congressional Oversight Panel, 2009: 18). Given that the economy appears to be finally on the mend, it is easy to forget how truly desperate our situation was at the time.

Bernanke was adamant that we not repeat the tightening of fiscal and monetary policies in the early 1930s that likely increased the depth and the length of that contraction (Wolf, 2014). Indeed, we might have faced a similar prospect had we relied solely upon the efforts of Congress, the President and the Treasury Department. Congress authorized the Treasury Department to spend $700 billion on the Troubled Asset Relief Program (TARP) — an amount Treasury never came close to spending — and in fact, according to the Congressional Budget Office (CBO), the final net cost of TARP will likely be $19 billion (Congressional Budget Office, 2011). In 2009, Congress passed a stimulus act that dedicated $787 billion to reviving the economy, a sum many economists deride as too small, but Lawrence Summers described as the most the President could get through Congress (Blinder, 2013). Given that approximately a third of those funds were directed at infrastructure investment, they would only enter the economy over a number of years, providing little relief in the face of the crisis (Blinder, 2013: 232). Contrast that tepid response with that of the Fed. In addition to reducing interest rates to near zero, the Fed within months increased the size of its balance sheet by over a trillion dollars, essentially doing whatever was necessary to prop up the financial sector (Admati & Hellwig, 2013: 137; Congressional Oversight Panel, 2009: 51). Many steps taken by the Fed during that period were legally questionable, such as the unprecedented rescues of investment banks and other members of the shadow banking system which do not fall under the Fed’s authority (Congressional Oversight Panel, 2009; Permanent Subcommittee on Investigations, 2011). Because of Bernanke’s credibility, he was able to take those steps much as Strong might have done had he survived into the Depression. Now, there are few who disagree with the proposition that the Fed’s actions were necessary and likely saved our financial system from collapse.

Friedman and Schwartz’s explanation of the Great Depression reveals why the Fed’s actions in the wake of this crisis were so important. While most credit the Fed’s actions with propping up the banking system (Blinder, 2013; Congressional Oversight Panel, 2009), the most important role the Fed played was to avoid a severe drop in our money supply. With what essentially amounted to a run on the banks in the wake of the credit ratings agencies simultaneously reducing the rating on thousands of AAA rated securities, the banks faced a liquidity crisis (Permanent Subcommittee on Investigations, 2011). Given the importance of money to our system, had the Fed not stepped in and created money in the place of the banks by buying bonds on the open market (Blinder, 2013: 206), our nation’s economic activity would have essentially ground to a halt. Therefore, the Fed in taking the steps it did not only propped up the finance sector, but actually saved the entire economy.

The response to this crisis was global. Central banks in Canada, the United Kingdom, Sweden, New Zealand and Japan, among others, joined the Fed in responding by lowering interest rates to all-time lows and providing long term forward guidance that such interest rates would persist (Bernanke, 2012a). This traditional approach, however, represents only one of the tools employed by the Fed and others. The U.K. in particular, aggressively expanded its balance sheet by purchasing government securities on the open market from private parties (McLeay, Radia, & Thomas, 2014). The United States also engaged in this approach and thus increased the money supply at the same time that lending dried up (Blinder, 2013). Evidence of this strategy can be seen in Chart 1 in the Appendix. Unlike the U.K., however, the Fed also upped its purchase of government bonds directly from the Treasury, as well as from other agencies (Bernanke, 2012a). Traditionally, purchases of agency bonds had not been a tactic of the Fed. Bernanke, however, wanted to ensure that yields on all government bonds would remain low, thus increasing the incentive for financial players to invest their funds in vehicles that would have a greater impact on economic activity, such as corporate bonds or equities (Bernanke, 2012a). Chart 2 details the success of this method, revealing the massive yield spread that opened up between Baa corporate bonds and Treasuries. Some of that gap is certainly due to a flight of capital from riskier assets due to fears of losses (Bernanke, 1983), but the sheer size of that divide is another measure of the Fed’s success in addressing the crisis.

One can find evidence of these actions in the charts attached as appendices. Charts 3 and 4 show the dramatic increase in assets acquired by the Fed as it engaged in aggressive open market operations. Chart 5 shows the dramatic drop in the M1 money multiplier as a result of the Recession. In effect, it was this drop that the Fed sought to counter with its asset acquisitions and provision of liquidity to financial institutions of all kinds. Finally, chart 6 shows the initial decline in assets experienced by commercial banks at the onset of the Recession, followed by a dramatic spike as the Fed embarked on its rescue effort. In this way, the heroic efforts of the Fed in response to this crisis are readily visible.

THE CONTINUING CREDIT CRUNCH

This praise, however, leads us to our first criticism of the government’s response. It appears that the Fed’s response aimed at reinvigorating lending (Congressional Oversight Panel, 2009). In this effort, the Fed resorted to its most frequently used tool: reducing interest rates on its lending to banks. In fact, the Fed became especially aggressive in its interest rate reductions, moving interest rates to essentially zero (Board of Governors of the Federal Reserve System (US), 2015). Unfortunately, despite Bernanke’s efforts, the banks responded to this crisis by reducing their lending. Some argue that they instead availed themselves of an arbitrage opportunity, borrowing funds from the Fed at virtually no interest and using those funds to invest in Treasury bonds which, though yielding low interest at the time, still yielded higher interest than the Fed was charging (Congressional Oversight Panel, 2009). Some argue that this is why the banks performed so well while the rest of the country was struggling with a serious recession (Wolf, 2014). It is likely why the banks that had been the beneficiaries of support from the federal government were able so quickly to buy back the stock the government invested in them (Johnson & Kwak, 2013). This behavior of the banks, however, while it improved their own prospects, has been blamed by Bernanke for actually exacerbating the depth of the recession (Congressional Oversight Panel, 2009: 117).

Certain analysts have proposed an alternative explanation for this dynamic, one that questions the basis of our theory regarding the money supply in a fractional reserve banking system. According to the generally-accepted approach, banks receive deposits which form the basis for deposits they make with the Fed. The amount of these deposits then determines how much money the banks can lend out. By determining the total amount of Fed deposits, as well as vault cash, and applying the requisite reserve ratio, one can determine the money stock using the money multiplier (Sheard, 2013). The implication of this analysis, as stated by Bernanke to Congress (Congressional Oversight Panel, 2009: 117), is that given the excess reserves in the hands of banks since the recession (See chart 7), the banks have failed to play their role in revitalizing the economy (Keister & McAndrews, 2009). In fact, this apparent dilemma has led to a number of proposals aimed at pushing the banks to lend out these reserves, including proposals to tax excess reserves and to even place a cap on them (Keister & McAndrews, 2009). Analysts at Standard and Poor’s, the Bank of England and the New York Federal Reserve Bank, however, have suggested that this conclusion draws upon an incorrect analysis of the banking system as a whole, an interpretation could lead to flawed policy (Keister & McAndrews, 2009; McLeay et al., 2014; Sheard, 2013).

These analysts have argued that the excess reserves of the banking system as a whole are a reflection of central bank policy, and not inequitable behavior on the part of the individual banks. Their argument suggests that while it is true that an individual bank can hold excess reserves, the system in aggregate cannot. The argument suggests that the traditional way of teaching the money multiplier essentially does the analysis backward. Banks create deposits through lending, not vice versa. In essence, a bank will determine what lending it can profitably undertake. It will then lend out those funds by simply increasing the balance in the borrowers’ deposit accounts. Then, the bank will calculate the needed reserves and obtain them by borrowing from the central bank. The central bank seeks to maintain a specific interest rate, but if it declined to lend requested funds, the interest rates would rise. As a result, requests to borrow funds from the Fed are generally approved. Thus the first policy implemented by the Fed, lowering interest rates, essentially guarantees that funds will be available if a bank decides it is economically feasible to lend. Second, when the Fed and other central banks purchase bonds on the open market, they do so by simply adding to the balance of the Federal Reserve deposit account of the bank where the bond seller has its deposit accounts. Thus this policy of the Fed results in increases of the Fed deposit accounts of banks, something that constitutes high-powered money, but it simultaneously results in an equivalent liability of the bank to the seller. This liability does not eat up the full amount of liability the bank could take on based upon the infusion of high-powered money. This infusion, however, has nothing to do with the bank’s lending. It is simply a reflection of the fact that the Fed is using the bank as an intermediary to purchase bonds on the open market. Finally, the Fed may purchase bonds directly from the bank. In so doing, it again will simply credit the Federal Reserve deposit account of the bank for that sale and take assets from the bank in return. This transaction will again change a certain amount of the bank’s assets from regular money to high-powered money that can be used as reserves, and it will do so without regard for the bank’s lending. In theory, such a transaction may push the bank to invest funds in loans to earn a higher interest rate than the Fed deposit does, but unless the opportunity arises that provides an economically feasible opportunity for lending, the banks will not do so. The fact that they know they can simply borrow the needed funds from the Fed means that the amount of reserves they have on hand will not be taken into consideration in their lending decision (Keister & McAndrews, 2009; McLeay et al., 2014; Sheard, 2013).

While this analysis does help explain the amazing increase in excess reserves shown in Chart 7, it does not entirely explain or excuse the banks’ reduced lending. As can be seen in Chart 8, bank lending came to a near standstill upon the onset of the Recession and did not resume until the third quarter of 2011, over three years later. This fact is particularly alarming when one considers Charts 9 and 10 which show that the delinquency rates for both business and consumer loans were not excessively high on a historical basis, especially when one considers the length and depth of the Recession. Instead, it appears that the banks, as stated above, took advantage of the arbitrage opportunity the Fed’s actions presented rather than aggressively investing back into the economy. Indeed, many of the same authors who praise the government’s response to the banks severely criticize its failure to substantively help homeowners (Blinder, 2013). Rather than behaving as if the taxpayers had rescued them and as a result that they owed something to the country as a whole, the bankers took very good care of themselves, acting as if the cash infusions were simply cheap capital with which they could do what they want, awarding themselves excessive bonuses, and spending lavishly to lobby against reform efforts (Johnson & Kwak, 2013). I would contend that had the bankers behaved differently upon receiving their rescue packages, taking steps to increase lending, working to reduce foreclosures, and limiting their income at least until the economy recovered, the American public would have been very forgiving. Instead, their apparently selfish behavior and arrogance has resulted in a level of public furor that is warranted.

In a way, however, it is hard to blame the bankers for behaving in this fashion. After all, it was the political leaders who treated them differently from everyone else. Not only did the government do little to nothing to address the foreclosure crisis, but when they “rescued” other entities such as WAMU, AIG, General Motors, Chrysler, and hundreds of smaller banks, these bailouts included severely punitive provisions: stockholders were wiped out, management was replaced, bondholders frequently took haircuts, and employees suffered from layoffs and wage and benefit reductions (Congressional Oversight Panel, 2009). At the same time as the government took the position that it would not involve itself in the management of the large banks despite the large equity stake it took in them, it exerted considerable control over the reorganization efforts of the automakers. In truth, such punitive measures, although individually debatable, were probably warranted given the level of government intervention provided (Congressional Oversight Panel, 2009; Wolf, 2014). But none of these steps were taken with the largest banks. Instead, at the urging of Treasury Secretary Tim Geithner, the largest banks’ bondholders and even stockholders were paid off 100% (Blinder, 2013). No executives were fired, and no controls were put on their extravagant compensation packages. Even the bank executives were shocked at the weak demands (Johnson & Kwak, 2013). Instead, they were simply handed a blank check and urged to spend it as they saw fit — something they were happy to do (Johnson & Kwak, 2013).

LONG TERM CONCERNS

Despite this criticism of the analysis offered by Standard and Poor’s, the Bank of England and the New York Federal Reserve Bank, there is an important point they are addressing: the fear of runaway inflation as the economy fully recovers. One can see where the present situation would raise such concerns. Currently, given the banks’ excess reserves, there is a lot of high powered money out there that is just waiting to be leant out. If that were to happen in a relatively short period of time, the money stock would explode creating a big hike in inflation. The above analysts, however, make it clear that such concerns are without basis. They argue that just as the Fed could rapidly increase the amount of high powered money in the system by buying bonds, it can just as easily undo that measure by selling the bonds. In this way, the Fed and other central banks could extract the money from the economy just as easily as they infused it. Thus, inflationary fears are likely overstated (Keister & McAndrews, 2009; McLeay et al., 2014; Sheard, 2013).

There is another concern, however, that has remained largely unaddressed. As Bernanke pointed out, the excessive mortgage lending characteristic of the housing bubble of the early 2000s was at least a trigger of the financial panic that resulted in the Great Recession (Bernanke, 2012b). One factor that enabled institutions to engage in such lending was an increase in adjustable interest rate mortgages (Permanent Subcommittee on Investigations, 2011). Unfortunately, Charts 11 and 12 show that such mortgages still make up a substantial portion of the outstanding mortgage debt. Of particular concern, as shown in Chart 11, is a jump in adjustable rate mortgages in late 2013 to early 2014. The concern is that per Chart 1, interest rates remain historically low. Such interest rates cannot continue forever. One wonders if once interest rates rise again it will result in another spike in mortgage defaults as a result of the ensuing payment increases homeowners will face. This concern could be dismissed if the vulnerabilities Bernanke pointed to had been addressed. At this time, whether that is the case is yet to be determined. What is clear is that the financial industry exerted enormous effort to water down the reform proposals Congress considered in the wake of the crisis (Johnson & Kwak, 2013). As a result, analysts are split as to whether these vulnerabilities have been addressed or not (Admati & Hellwig, 2013; Blinder, 2013; Johnson & Kwak, 2013; Wolf, 2014). One wonders, then, what will be the result of another round of mortgage defaults.

CONCLUSION

The Great Recession that started at the end of 2007 was historic in its depth and duration, comparable only to the Great Depression of the early 1930s. Interestingly, these two catastrophes have something else in common: they were essentially the product of runs on the banks. In the Depression, there were three subsequent financial crises that resulted in the unprecedented Bank Holiday of March 1933. In the Great Recession, it was a run on the assets held by a “shadow” banking system that dwarfed the size of our actual commercial banking system. These largely unregulated institutions had engaged in massive investments in financial derivatives based upon American mortgage debt holdings. The assumption was that such investments were ideal because they offered a higher rate of return while being backed by supposedly safe U.S. residential mortgages. As a result, when it became clear that the reliability of these mortgages might be a question, a massive run on the shadow banks resulted in the collapse of the Lehman Brothers investment bank and the Reserve Primary money market fund was forced to “break the buck” and pay less than 100 cents on the dollar to its investors. As the financial panics in the early 1930’s resulted in a severe economic contraction, the same occurred in 2008.

Unlike in the Great Depression, however, in this Recession we were fortunate to have someone with the credibility and economic background to lead the Fed in its response. Ben Bernanke has been widely hailed for his work addressing the crisis, and in mapping a strategy, he relied largely upon the scholarship of Friedman and Schwartz which he had previously studied. As a result, Bernanke took aggressive steps to make sure that the financial system did not collapse as it did in the Great Depression, and to make sure that the money stock did not decline as precipitously as it did back then.

Despite the prompt action of Bernanke and others, however, a severe contraction did occur. Could it have been worse without such intervention? Perhaps, but Bernanke and others argue that the behavior of the banks in failing to lend sufficiently likely did not help. While some have argued that the apparent excess reserves of the banks are not an indication of this problem, the amount of time it took them to start lending again certainly is. Indeed, one can argue that the bad behavior of the banks in the wake of receiving such unprecedented aid are a big part of what has led to the wholesale anger among American taxpayers.

The good news is that the economy now appears to be on the mend, although not growing at the rate one might hope. Furthermore, concerns about explosive inflation as a result of the banks’ excess reserves seem to be unfounded. Nevertheless, there still remain a large number of adjustable rate mortgages — the same vehicles that prompted the crisis in the first place — and efforts to reform the systematic vulnerabilities Bernanke pointed to have met with mixed success. Whether enough has been done to avoid a repeat of the 2007 crisis, or at least another contraction, remains to be seen.

APPENDIX

Chart 1

Chart 2

Chart 3

Chart 4

Chart 5

Chart 6

Chart 7

Chart 8

Chart 9

Chart 10

Chart 11

Chart 12

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Bernanke, B. S. 2012a. The Effects of the Great Recession on Central Bank Doctrine and Practice. B E Journal of Macroeconomics, 12(3): 11.

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Board of Governors of the Federal Reserve System (US). 2015. Effective Federal Funds Rate [FF], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/FF/, March 19, 2015.

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Friedman, M., & Schwartz, A. J. 1963. A monetary history of the United States, 1867–1960. Princeton: Princeton University Press.

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