Before he became chair of the Federal Reserve, Ben Bernanke agreed with the free market economist Milton Friedman that central bank policy played a key role in making the Great Depression the most severe in U.S. history. But the two parted ways on the reason why. And that disagreement goes a long way toward explaining why the financial crisis of 2007-2009 has brought not just a dramatic increase in the powers and activities of the Federal Reserve but a fundamental transformation of its role within the economy.

Friedman viewed banking panics as monetary shocks, in which the checking accounts and other deposits at failing banks wink out of existence, causing a sudden fall in the total money supply. In contrast, Bernanke treats panics as shocks to the flow of savings, causing the failure of firms whose continued existence is crucial for the allocation of credit. Such disparate diagnoses dictate significantly different cures.

If the danger from bank panics is primarily a collapse of the money supply, then the proper response is a general injection of money by the central bank. The survival of particular financial institutions is of secondary significance. On the other hand, if the danger comes from key financial institutions failing and choking off credit, then the proper response is bailing them out.

This isn't just an obscure academic debating point of economic history. The difference has played an enormous role in the response to the financial crisis under both Presidents Bush and Obama. Instead of a sharp increase in Fed-created money that would have calmed the panic and then been quickly reversed, we got targeted bailouts with almost no impact on the effective money supply, despite all the chatter about "quantitative easing." Even more ominously, Bernanke's response resulted in an unprecedented and potentially dangerous expansion of the financial assets on the Fed's balance sheet to nearly $4.5 trillion, a value five times greater than before the crisis.



Alan Greenspan's Crises

The United States has experienced at least two episodes of extensive bank failures unaccompanied by major economic downturns. Throughout the 1920s, inordinate numbers of rural banks failed due to distress in the agricultural sector, even though the '20s were boom times for the U.S. economy overall. During the savings and loan crisis of the otherwise prosperous 1980s, more than 2,000 financial institutions failed, and taxpayers were hit with a $130 billion cleanup bill. (Unlike our more recent bailouts, the S&L money mainly went to cover depositor losses, not to keep insolvent institutions in business.)

A close comparison of the records of Bernanke and his predecessor at the Fed, Alan Greenspan, indicate that Friedman's theory of the Great Depression has much more to recommend it. Many have now forgotten that Greenspan faced three potential financial crises: the October 1987 stock market crash, the fear surrounding Y2K, and the terrorist attack of September 11, 2001. His primary response to all three was not bailing out banks but temporarily flooding the economy with money.

The crash of Black Monday, October 19, occurred almost exactly two months after Greenspan took over the Fed. Before trading began the next morning, he issued a short statement affirming the Fed's "readiness to serve as a source of liquidity to support the economic and financial system." The Fed poured money into the economy by purchasing $12 billion of Treasury securities and obligations of federal agencies. It also increased lending to banks to a little over $2 billion through what is called the "discount window," a facility where banks can borrow Fed-created money when they face a temporary shortage of liquidity.

The most serious threat was centered in the investment banks. Back in 1987, investment banks were not yet engaging in the massive proprietary trading that caused such difficulty in the 2007-08 crisis. But they still depended heavily on money borrowed from major commercial banks. If the lending banks had refused to roll over these loans, which were contractually repayable on demand, the collapse of credit could have cascaded outward. But Greenspan's prompt liquidity response ensured that such lending actually increased during the crisis.

Greenspan at the time did consider taking the additional step of lending directly to investment banks, something Bernanke would start doing in 2008. But this experiment proved unnecessary when the crisis dissipated almost as quickly as it had emerged. In short, while the Fed increased the money supply temporarily in 1987, none of its actions during the crisis involved a Bernankeite bailout of insolvent institutions.

The Y2K threat, arising from fear that computer programs worldwide were unequipped to handle the transition to the year 2000, made the biggest blip in the Fed's monetary base (the sum of currency in circulation plus bank reserves), despite being the least remembered of the potential crises Greenspan faced. But all of the new money he injected was quickly pulled back out when Y2K fizzled into a non-event.

An equally dramatic though somewhat smaller spike in base money took place following the 9/11 terrorist attacks on the World Trade Center and Pentagon. The money was quickly withdrawn after the stock market reopened with orderly trading on Monday, September 17.

No one can be sure what might have happened to the economy without Greenspan's monetary interventions. It's possible they weren't necessary. Yet all three constituted sudden, general injections of liquidity that were just as quickly unwound. None of the money was aimed specifically at any institution facing insolvency.

Greenspan's only significant deviation from the Friedman formula came before 9/11, when he permitted the head of the New York Fed to "godfather" (Greenspan's word) a private bailout of the large hedge fund Long-Term Capital Management after the Russian sovereign default of August 1998 imposed more than $4 billion of losses. Although no Federal Reserve or taxpayer money was involved, the Fed-brokered move was a portentous signal to the financial community. For the first time ever, "too big to fail" was applied to an institution not covered by deposit insurance. Knowing that the Fed was there to backstop their bad decisions gave other financial institutions a greater incentive to take excessive risks.

Redirecting Money vs. Printing It

Bernanke's response to the financial crisis went through two phases. The first began in August 2007, when rising mortgage defaults triggered a financial panic among investment banks. Unlike traditional panics, in which the public makes a run on banks, this was financial institutions creating runs on other financial institutions.

In the past, investment banks had primarily facilitated the transfer of securities between two other parties. To the extent that they owned securities themselves, it was to support such dealing, brokering, and underwriting. Back in 1994, the total financial assets of all investment banks was less than $500 billion, as compared with more than $4 trillion for commercial banks.

But over the next decade, investment banks began acquiring ever larger amounts of assorted securities on their own balance sheets through what is called "proprietary trading," transforming these institutions into major financial intermediaries. By 2007, they held more than $3 trillion in assets, a six-fold increase that made them collectively bigger than such conventional intermediaries as thrifts, money market funds, and finance companies. And that doesn't even include any of the hedge funds managed by investment banks.

How did investment banks finance their expanded portfolios? Over one-third of their borrowing came from repurchase agreements, or repos. Repos can most easily be understood as short-term loans, frequently overnight, with an underlying security pledged as collateral. In other words, just like commercial banks, investment banks were now borrowing short to lend long, in what has been designated the "shadow banking system." Moreover, investment banks were not just using repos to borrow from other types of financial institutions. They were also using them extensively to lend to each other. No one knows precisely how big the gross size of this market became before August 2007, but the peak was probably in the neighborhood of $6 trillion, with investment banks accounting for two-thirds of the total.

In June 2007, Moody's began downgrading its ratings on asset-backed securities containing subprime mortgages because of the rising default rate. Two Bear Stearns-managed hedge funds that had invested heavily in such securities were in danger of shutting down. The growing solvency problems turned into a liquidity run on investment banks, as the repo market began to contract. Between the third quarter of 2007 and the third quarter of 2008, the total amount of net repo borrowing by investment banks fell by around $500 billion. As investment banks were forced to sell assets, the market value of these assets likewise declined.

The panic also affected another type of short-term borrowing: asset-backed commercial paper. Structured investment vehicles (SIVs), another major part of the shadow banking system, were heavily reliant on this source of funds. Set up by commercial banks, SIVs were bank subsidiaries whose debt was officially off the bank's balance sheet. With these funds the SIVs purchased assorted mortgage-backed securities and other financial products. After the August panic hit, this market also collapsed.

The collapse of the repo and commercial-paper markets was not simply a full-fledged run on the shadow banking system. Both financial instruments were short-term, highly liquid quasi-moneys, so their collapse also brought down the money stock, broadly defined.

So what was Bernanke's response? At first glance, it might appear to have been a monetary injection. The central bank first made it easier for commercial banks to get loans through the Fed's discount window. Then, in December 2007, Bernanke created the Term Auction Facility to provide additional loans to banks for periods of up to 84 days. The Fed simultaneously reinstated what are known as currency swaps (exchanging dollars for foreign currencies) with other central banks, an expedient it had employed conservatively in the past.

By the summer of 2008, Fed lending to banks had climbed to $168 billion, as compared with the trivial amounts of between $30 to $400 million that had prevailed in the past. Other things being equal, this lending would have brought about a substantial bulge in the monetary base. But other things were not equal. For Bernanke was simultaneously pulling money out of the economy by selling off Treasury securities.

Consequently, during the crisis-wracked year ending in August 2008, the monetary base increased by less than $20 billion, a mere 2.24 percent. That was well below its average annual growth of 7.54 percent during Greenspan's 19 years in charge. Moreover, nearly all of the increase was in the form of currency in circulation. Total bank reserves during the first year of the crisis rose from $72.4 to $73.0 billion, less than one percent. Bernanke was not injecting money, just redirecting it.

This offsetting of new loans applied equally to the other Fed initiatives during Phase One. The Primary Dealer and Other Broker-Dealer Credit Facility and the Term Security Lending Facility were both set up in March 2008 to extend discount loans and other financial assistance to investment banks, greatly expanding the Fed's relationship with these institutions. That same month, momentously, the Fed directly bailed out Bear Stearns through a limited-liability company called Maiden Lane, which was set up under the New York Fed.

Bailout Ben

All hell broke loose in September 2008, a little over a year after the panic commenced. The investment bank Lehman Brothers went bankrupt; the government-sponsored mortgage agencies, Fannie Mae and Freddie Mac, were nationalized; a major money market fund called the Primary Reserve Fund "broke the buck," meaning that it could no longer redeem its shares for a dollar; and an enormous thrift holding company, the American International Group (AIG), whose primary subsidiaries sold insurance, was unable to post the requisite collateral against its credit default swaps guaranteeing assorted securities. These developments were all manifestations of the ongoing collapse in the repo and commercial paper markets. The interest-rate spreads between less risky and slightly more risky loans rose from near zero to new highs. As a result, on September 17 Bernanke inaugurated Phase Two of his response.

Along with Congress' Troubled Asset Relief Program (TARP), managed and funded by the Treasury Department, the most obvious feature of Phase Two was an unprecedented expansion of the monetary base, which doubled over a mere four months from $850 billion to $1.7 trillion. Nearly all of this increase was in bank reserves, whose year-on-year growth rate peaked at an astonishing rate of 1,200 percent annually. The increase in the Fed's total assets was even greater, reaching $2.2 trillion. By the time this expansion began to slow down, checking accounts in banks were backed by more than 100 percent reserves.

Over the same period, Bernanke set up a whole slew of new lending facilities: the Commercial Paper Funding Facility, the Money Market Investors Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Term Asset-Backed Securities Loan Facility, and Maiden Lane II and III.

It would seem hard to deny that this response represented a massive injection of liquidity. Yet all was not quite as it seemed. The key to what Bernanke was doing was revealed earlier in 2008, when Fed officials began floating the idea of allowing the Fed for the first time to borrow money by selling its own securities.

The Fed was running out of Treasury securities it could sell to counteract the monetary impact of its targeted bailouts. If the bank could market its own debt, it could increase total assets without affecting the monetary base. The new borrowing would pull money out of the economy on one end of the Fed's balance sheet, and that money could be put back in on the other end through loans to favored firms and purchases of favored instruments.

This is exactly the policy implied by Bernanke's analysis of bank panics. If the concern is that failing intermediaries will harm the economy mainly through the credit channel, then the goal is to bail them out independently of what is happening to the money stock.

Although the Fed has yet to gain the power to borrow explicitly with its own securities, it in fact was already doing some borrowing, through what are somewhat confusingly called reverse repurchase agreements (reverse repos), in which the Fed uses its Treasury securities as collateral to secure short-term loans. (This is confusing because when private institutions such as investment banks borrow the same way, it's called a "repo," and a "reverse repo" is when those banks are the lender, whereas for the Fed the terminology is backward.) The Fed could borrow this way because reverse repos are technically described as selling collateral securities and then buying them back with the interest added in. In the past, the Fed had borrowed with reverse repos, and the amounts had run as high as $20 billion. But at the height of the crisis, the Fed owed through reverse repos a total of $90 billion.

Still more revealing were the currency swaps with foreign central banks. By the beginning of 2009 such trades, coordinated with the U.S. Treasury, had soared to more than half a trillion dollars. Yet less than half of this total lending represented actual money creation. The Treasury Department created a Supplementary Financing Account that issued as much as $400 billion worth of securities not for the purpose of financing government expenditures; instead the money raised was deposited at the Fed. In essence, the Treasury was borrowing money from the general public and lending it to the Fed, which then re-lent it to foreign central banks.

The Treasury, through its deposits at the Fed, withdrew money from circulation, while the Fed's purchase of foreign currencies put it back in. The foreign currencies acquired as assets therefore showed up on the Fed's balance sheet but made no net contribution to the monetary base. These Treasury deposits explain why the increase of the balance sheet so greatly exceeded the increase of the base.

But the most important way the Fed began borrowing and continues to borrow to this day is indirect: by paying interest to banks on their reserves. Bernanke received authorization to do this with TARP. So in effect he was creating money, then borrowing it back from the banks by paying them interest. To be sure, other central banks, including the European Central Bank, were already paying interest on reserves to help them hit their interest-rate targets more closely, which was also a major motivation for the Fed doing so. Even Milton Friedman once advocated this step, to facilitate the imposition of a 100 percent reserve requirement on banks. Potential justifications are several, but Bernanke clearly requested this power to also help the banks.

The banks in turn partly financed these implicit loans to the Fed by allowing their reserves to increase and reducing their loans to the public by almost $500 billion as of the last quarter of 2009. Thus, the result was partly a net wash, with a shuffling of assets from the private sector to the Fed. The payment of interest on reserves was tantamount to borrowing back the full $800 billion increase in reserves, and more. This explains why the explosion of the monetary base had so little effect on the broader monetary measures that include bank deposits, and did not unleash inflation.

Who were the recipients of the funds that the Fed was assiduously borrowing? In addition to all the lending facilities mentioned above, Fed loans to depositories doubled to half a trillion dollars before falling back down to zero in mid-2010. The Fed also restored its holdings of Treasury securities to approximately the same dollar level it held before the panic began, but with a much heavier proportion of long-term Treasury notes and bonds, as compared to short-term Treasury bills. Finally, the largest asset on the Fed balance sheet became mortgage-backed securities, at over one trillion dollars in face value by March 2010. This was a type of security that the Fed had never purchased before January 2009.

An amped-up Fed was now bailing out such firms as Bear Stearns and AIG, lending extensively to a new array of institutions including investment banks and money market funds, and purchasing large amounts of such new financial instruments as commercial paper and mortgage-backed securities. Over half of that activity was financed not by issuing any new money but by borrowing from the private sector, directly or indirectly.

Phase Two of Bernanke's policies transformed the Federal Reserve from a central bank confined primarily to managing the money supply into an institution that is now a giant government intermediary borrowing massive sums in order to allocate credit. In that respect, the Fed has become similar to Fannie or Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.

Almost nothing the Fed has done during either phase can be accurately described as an effort to expand the broader money stock. Whatever the ostensible rationale, everything was directed at propping up failed institutions.

Central Banking = Central Planning

As the financial crisis subsided, the Fed phased out most of its new lending facilities. But its balance sheet continued to grow even as Janet Yellen replaced Bernanke as Fed chair in February 2014. Yellen's policies have remained virtually identical to Bernanke's. All of the discussion about "tapering" since her ascendance relates to slowing the growth of the Fed's balance sheet, not reversing it in any way. Thus, the Fed press release after the meeting of its Open Market Committee on September 16-17 announced merely that it would reduce purchases of new securities from $25 billion per month to $15 billion per month.

The total value of Fed assets in September 2014 stands at $4.4 trillion, as compared with less than $900 billion prior to the crisis. Over half is funded with borrowed money, most in the form of interest-earning bank reserves. The Treasury has emptied its Supplementary Financing Account but is still depositing more money at the Fed than it ever did before the crisis. The Fed has even expanded its reverse repos by borrowing from money market funds and government-sponsored enterprises, such as Fannie and Freddie. Bernanke's intention to continue down this path became apparent on April 30, 2010, when the Fed announced the creation of the Term Deposit Facility. This is a mechanism through which banks can convert their reserve deposits at the Fed into deposits of fixed maturity at higher interest rates.

On the asset side of its bloated balance sheet, the Fed is still holding $1.7 trillion worth of mortgage-backed securities. The Fed has replenished its portfolio of Treasury securities to the tune of $2.4 trillion. But none of this includes any short-term Treasury bills. In fact, only about $3 billion worth of these securities has a remaining maturity of one year or less. This portfolio would make it difficult to reduce the Fed's balance sheet back to normal once the economy fully recovers, even if the Fed wanted to do so. Sudden sales of large amounts of these securities might disrupt financial markets and impose capital losses on the Fed.

But the Fed doesn't actually have to sell off a single asset if interest rates start to rise. All it has to do is raise the interest rate on reserves and its other forms of borrowing. Banks will continue to earn enough on reserves to discourage them from making new loans that increase their deposits, and the Fed will continue to attract funds from other lenders. By thus either draining reserves or locking them up in the banks, the Fed will perpetuate its enormous impact on the allocation of savings without changing the money supply.

Many economists appear not to fully appreciate just how drastic the changes in Fed practice have been since the financial crisis. When Rep. Ron Paul (R-Texas) introduced his proposal to audit the Fed in 2009, hundreds of economists interpreted this as a threat to the institution's independence and rallied to its defense. Granted, the independence of a central bank that is primarily confined to monetary policy may provide an important safeguard against inflation and political business cycles. But independence for a swollen central bank that has taken it upon itself to redirect credit flows into privileged markets and firms on a grand scale is a different matter. Any institution with such an enlarged command over the financial system must not be free from close oversight. The excesses of Fannie and Freddie should have taught us that.

And let's not kid ourselves about the Fed's promise to "normalize" its balance sheet once the economy fully recovers. Although most of the new Fed facilities have been temporarily disbanded, they have set dangerous precedents. When in the history of government agencies have newly acquired authority and reach been easily, entirely, and voluntarily relinquished? The Dodd-Frank Act, while expanding further the Fed's regulatory authority over investment banks and other financial institutions, has supposedly limited its ability to bail out insolvent institutions. Yet not only will this paper restriction become a dead letter during any future financial crisis, real or imagined, but it also does nothing to rein in the Fed's $4 trillion-plus balance sheet, which must inevitably lead to significant credit misallocation.

Central banking has become the new central planning. Under the old central planning, government attempted to manage production and the supply of goods and services. Under the new central planning, the Fed attempts to manage the financial system and the supply and allocation of credit.

In the 1950s and '60s, even when Keynesianism held broad economic sway, few people paid much attention to the Federal Reserve. No wonder: The central bank's activities were fairly limited by modern standards. Today, the Fed's conspicuous targeting of interest rates has major economic players sitting on the edge of their chairs, waiting for the latest inscrutable pronouncements from the Open Market Committee. Friedrich Hayek taught us long ago that central planners, whether lodged in the Fed or some other government bureau, always lack the dispersed knowledge necessary to make economically rational decisions. For a well functioning economy that directs investment to its most efficient uses, rather than to vested interests and wasteful boondoggles, the market must allocate credit and determine interest rates.

As the prolonged and incomplete recovery from the Great Recession suggests, the Fed's new central planning, just like the old central planning, will ultimately prove unfortunate, and possibly disastrous.