View From a Height

The monetarists have been hard on the Fed. But understanding why the Fed screwed up 8 years ago or ever 4 years ago is different from understanding what it's trying to do now.

First, everyone go back and re-read (or re-watch) Milton Friedman's explanation of the Great Depression in Free to Choose. Then read remarks by the-Fed Governor Ben Bernanke on the subject. (For dessert, read this article by Princeton professor Ben Bernanke arguing that central bankers shouldn't move interest rates in order to affect stock prices.)

Now with your homework done, we're ready to discuss this stuff, er, rationally. Remember that the monetary aspects of the Great Contraction were essentially a three-act play. In 1928, the Fed, led by NY Governor Ben Strong, left out the punch bowl by keeping rates low. By 1929, the Fed had tightened policy, and was bursting the stock market bubble. But by 1931, the Fed, in a misguided attempt to keep the country on the gold standard, raised interest rates again, furthering the contraction. (A paper by then-Princeton economist Ben Bernanke shows that countries' recoveries were a direct result of going off gold and reflating.)

So here we are in the early 2000s. Act I - Greenspan leaves out the punchbowl, possibly partly in response to the withering criticism he incurred in 1996-1997 when he tapped the brakes. Act II - Bernanke begins to tighten incrementally, not so much to bust the bubble as to bring it down gently. Whether such a thing is possible remains an open question.

What Bernanke is desperately trying to do is to avoid a repeat of Act III. He's not trying to prop up stock prices, though access to credit markets will have that effect. He is trying to prevent another Great Contraction, where nobody lends to anyone else, and the underlying economy suffers mightily. And anyone who thinks that anything else is going on here simply doesn't know what he's talking about.

It's possible that this will work, and it's possible that it won't. Certainly the Fed has been pursuing this policy for over a year now, and the financial crisis has rolled on to clobber bigger and bigger institutions. It may well be that administering the medicine while the patient is still contagious simply won't work. It may be that the risk of moral hazard creates more problems than it solves. And it may be that - with LIBOR jumping up this morning - the credit markets will seize up, anyway.

None of this means that what the Fed is doing now is the right - or the wrong - thing. It is to say that it's trying to do something different from what it did 80 years ago, and maybe we ought to at least be pleased about that.