Bernanke's 'Essays'

It should also be emphasized, though, that not just the existence of financial difficulties during the 1920s but also the policy response to those difficulties was important. Austria is probably the most extreme case of nagging banking problems being repeatedly "papered over." That country had banking problems throughout the 1920s, which were handled principally by merging failing banks into still-solvent banks. An enforced merger of the Austrian Bodencreditanstalt with two failing banks in 1927 weakened that institution, which was part of the reason that the Bodencreditanstalt in turn had to be forcibly merged with the Creditanstalt in 1929. The insolvency of the Creditanstalt, finally revealed when a director refused to sign an "optimistic" financial statement in May 1931, sparked the most intense phase of the European crisis.

– Ben S. Bernanke, "Essays on the Great Depression," p. 96.

One of the benefits of having an intellectual at the helm of the Federal Reserve during this ongoing economic crisis is that intellectuals tend to leave a paper trail. Bernanke, famous for being a student of the Great Depression, is without question very well-informed on the relevant historical issues. His book reveals an intelligent and scholarly mind that does not shirk from the details but, rather, leaps without hesitation into statistical analysis of the most technical economic minutiae. The book simply wallows in charts, equations and log changes; the net result is impressive, especially when compared with his predecessor's lightweight, revisionist chronicle, "The Age of Turbulence."

On the one hand, it is reassuring to know that there is a genuinely intelligent man in full possession of the significant historical information at the helm of the monetary authority right now. On the other, Bernanke's "Essays" serves as a reminder that even the most brilliant man's abilities are limited by the conceptual models he is using to understand the situation as well as by the data available for plugging into those models. For example, on several occasions Bernanke resorts to utilizing proxies, and in one case, a proxy for a proxy, when the data required by the model cannot be found. While this is perfectly understandable, it necessarily raises questions about the reliability of his conclusions even if one assumes that his model is flawless. The Misean calculation problem does not only apply to socialists.

As one reads the book, four things about the present situation gradually become clear. The first is the recognition of the tremendous shock that the financial crisis must have given the Fed chairman. Because he places the greater portion of the blame for the Great Depression on mismanagement of the historical gold standard, it's fairly clear that he did not – and perhaps still does not – genuinely believe that another economic contraction of similar size is theoretically possible in its absence.

"If the monetary contraction propagated by the gold standard was the source of the worldwide deflation and depression, then countries abandoning the gold standard (or never adopting it) should have avoided much of the deflationary pressure. This seems to have been the case. ... In summary, data from our sample of twenty-four countries support the view that there was a strong link between adherence to the gold standard and the severity of both deflation and depression." (pp. 78-84)

The second noteworthy item is Bernanke's misunderstanding of debt deflation. He wrongly describes it as "the increase in the real value of nominal debt obligations brought about by falling prices." But he has it backward, as it is the refusal of borrowers to take on additional debt that collapses the demand required to support price levels. The Cash for Clunkers program was not enacted and the extension of the federal homebuyers credit of $8,000 was not proposed to decrease the real value of nominal debt obligations, they were designed specifically to increase those debt obligations and thereby increase both demand and prices. This misunderstanding indicates that Bernanke is unlikely to recognize the problematic nature of stopping the deleveraging process that has seen TOTLL, total loans and leases by the commercial banks, fall from $7.2 trillion to $6.8 trillion in the three months from June through August.

The third point is the explanation for Bernanke's focus on the banks rather than the consumer or even the private and commercial mortgage holders. While Bernanke follows Barry Eichengreen's lead in blaming the gold standard as the primary source of monetary contraction in 1930 and 1931, he views "sharp declines in money multipliers (reflecting problems in the commercial banking sector)" as one of the major causal factors responsible for extending the depression after 1931. While those who understand that the problem is too much debt, not too little money, will rightly be skeptical of both Bernanke's historical diagnosis and current prescriptions, this does explain some of his otherwise inexplicable actions in supporting loan modification programs that help the banks rather than the defaulting homeowner.

The fourth is the recognition that the Federal Reserve is not omnipotent and that Bernanke's ability to act is rigidly constrained by the economic circumstances. As the quoted paragraph about the Austrian banking problems of the 1920s shows, Bernanke is perfectly aware of the way that merging failing banks with still-solvent ones imperils the entire banking system, and yet the Federal Reserve and the FDIC have been addressing the failures of Bear Stearns, Washington Mutual, Merrill Lynch, Wachovia, and dozens of smaller banks in exactly the same way.

The fact of the matter is that the global economy is far too large and complicated for any one man, no matter how intelligent and informed, or any one institution, no matter how rich and powerful, to control. The debt deflation scenario must play out eventually, and the sooner that Ben Bernanke and the Federal Reserve accept this and work to speed up the process rather than fight it, the better off the American public will be. It is far too late to save the banks, as they sealed their fate when they increased the average amount of loans and leases per bank from $71.4 million in 1980 to $854.2 million today.