Ben Bernanke's Views Affected by Depression

Greg Ip of the WSJ has been doing some research on Ben Bernanke:

Lessons of the '30s: Long Study of Great Depression Has Shaped Bernanke's Views, by Greg Ip, WSJ: In 1983, Mark Gertler asked his friend and fellow economist Ben Bernanke why he was starting his career by studying the Great Depression. "If you want to understand geology, study earthquakes," Mr. Bernanke replied, ... "If you want to understand economics, study the biggest calamity to hit the U.S. and world economies." Mr. Bernanke's fascination with the economic earthquake never abated. ... Mr. Bernanke's interest in the Depression, which dates back to his childhood, is a guide to the evolution of his thinking. In particular, his groundbreaking research on how mistakes by the Federal Reserve compounded the catastrophe is likely to influence how he steers the economy... The Depression, he contends, has taught the importance of avoiding both deflation ... and inflation. It has also shown the threat that falling asset prices -- such as ... in housing -- and weakened banks can pose. Most important, it shows the damage the Fed can do when it follows wrong-headed ideas. ...

Even as a child, Mr. Bernanke ... was intrigued by the Depression. As a child of six or seven, he visited his maternal grandmother ... and sat on her front porch as she described life as a young mother during the 1930s ... Mrs. Friedman, whose husband taught Hebrew and worked in a furniture store, was proud they could buy new shoes for their children each year. But many neighborhood children had to go to school in tattered shoes or barefoot. "Why didn't their parents just buy them new shoes?" young Ben asked. Because their fathers had lost their jobs when the shoe factories closed, she said. "Why did the factories close down?" She replied, "Because nobody had any money to buy shoes." The circularity of her logic, which he later recounted in a textbook, bothered him yet illustrated a key puzzle of the Depression: Why was there so much idle capacity when there were so many unmet needs?...

In "A Monetary History of the United States, 1867-1960," [Milton Friedman and Anna Jacobson Schwartz ] argued that the Depression was far from inevitable, but brought about by an "inept" Federal Reserve. ... Mr. Bernanke read the book as a graduate student at Massachusetts Institute of Technology in the 1970s. "I was hooked, and I have been a student of monetary economics and economic history ever since," ... In 1979, Mr. Bernanke went to Stanford to teach economics. ... The 1970s' high unemployment and inflation had diminished the Fed's reputation, and new economic theories of "rational expectations" and the "real business cycle" held that the central bank could do little to affect growth and jobs. Mr. Bernanke nonetheless threw himself into studying the role of monetary policy in the Depression. ... While the Friedman-Schwartz theory had revolutionized thinking about the Depression, it couldn't fully explain the downturn's length or depth. Theoretically, neither deflation nor inflation ought to affect long-run growth or employment. After a while, people and businesses get used to changing prices. ...

Mr. Bernanke published his first major paper on the Depression in 1983. ... "My theory seems capable, unlike the major alternatives, of explaining the unusual length and depth of the Great Depression." The statement reflected an intellectual boldness that verged on cockiness. Messrs. Bernanke and Gertler began a lengthy collaboration refining what became known as the "financial accelerator" because it explained how the financial system could compound an economic downturn. The two had complementary roles, with Mr. Bernanke usually pushing for a bold statement and Mr. Gertler, he recalls, "telling him what's wrong with the statement." ... Mr. Bernanke's Depression research soon found a U.S. role. Some analysts had called on the Fed to rein in the galloping stock market in the late 1990s. But, ... Mr. Bernanke and Mr. Gertler said the Fed should raise rates if rising asset prices fuel inflation, but not to prick a bubble. "A bubble, once pricked, can easily degenerate into a panic," they said. When the bubble eventually collapses on its own, the Fed should cut interest rates to limit the damage to the financial system and the broad economy. ... As Fed chairman, Mr. Bernanke probably will not be talking much about the Depression, but it is unlikely to be far from his mind. ...

Comments

[anne]

Quite a fine article. Ben Bernanke will be a terrific Federal Reserve chair.

[dryfly]

Ya knowing history - even economic history - can't be a bad thing. One of the best prof's in manufacturing I had when getting my masters was a wiz on economic history... especially relating to automotive manufacturing. He wrote a nice text on 'turn arounds'... studied a number of collapses and looked for similarities that lead to success & failure of the turn around effort.

One thing Bernanke needs to keep in mind is that 'monetarism' isn't the only game in town. He would be wise to brush up on Schumpeter's work... especially about acceleration & deceleration of innovation. I am convinced one of the reasons the depression was so long & severe was because it also coincided with a period of severe innovative deceleration... following the previous decades of higher than normal innovation (the innovation wave associated with the introduction & adoption of the internal combustion engine - truly revolutionary).

When innovation slows, products & processes converge toward low margin commodities... couple that with tight money and you are screaming 'deflation'.

They think they dodged a deflationary bullet in the dot.bomb bust... well while innovation was clearly slowing (in IT) by then... it hadn't stalled completely. So maybe their 'results' at fighting deflation weren't as much about when they did it as what they did...

And since it appears to me that innovation is continuing to slow (more commoditization less new revolutionary products & processes)... my guess is the risk continues to grow... and if they tighten money aggressively it could blow up on them faster than they realize. The next time he tries to fight deflation it might be far more difficult and unstable than the dot.bombs were...

I hope he keeps those helicopters ready.

[William Polley]

I suspect a curiosity about the Great Depression has inspired many an economist to turn his or her attention to macro. As the period recedes into history, perhaps it will cease to be the case. In a way that's sad.

Whatever happened to making economic history a requirement at the graduate level?

[Mark Thoma]

William - I agree wholeheartedly. The loss of the history of thought in graduate programs as a means of dealing with budget cutbacks is a big loss. We at least teach it at the undergraduate level (Tim Duy and I teach the course, Tim has been doing it for several years), I know some programs have dropped that as well.

[anne]

Agreed. Galbraith and Galbraith have talked about the narrowing of perspectives in economics studies, and, yes, this is a social study as I prefer to think of the range of what most term social sciences. Not that social studies are less significant than biology or chemistry, but calling for different approaches even as these science call for different approaches.

[anne]

The idea that innovation was slowing before the Depression is interesting, but by anecdote and productivity numbers during the Depression not evident to me. Interesting idea to think about, however.

[ilsm]

I have had an ongoing discussion about monetarism and the depression with an economist acquaintance. I am not an economist, I am a consultant though.

The issue which needs to be looked into is: if printing money were the answer in 1933 what stopped them?

I think the fact that the gold standard was in force and that no one in the world had any spare 'monetary capacity' to lend to us made printing more money the same as commanding the economy to raise prices with no other expected outcome.

Now we have the Chinese using the dollar as reserve currency, allowing fee prining of dollars, so it seems that Friedman and Schwartz are correct.

I am not convinced.

[Spectator]

What this discussion misses is that depression via deflation is not the only bad outcome. It may be hard to believe, but hyperinflation is a lot worse and it will turn the entire society upside down. It is a revelation to read stories of pre-war Germany. Think of a society losing it's soul. Just because the US has not experienced it, does not mean there is no risk of it occurring here.

As with any confidence game, problems will not show up as long as buyers accept the premise. Printing money is such an appealing solution, and as long as it does not affect confidence it will be justified by hook or crook. Unfortunately, pretty much every such game ends in tears, unexpectedly and abruptly.

[Anon]

That WSJ article is just going to make Bernanke's job harder. It made Bernanke sound like a guy who has learned that asset price inflation is unrelated to monetary policy and the nation's economic woes can always be cured by inflation. I expect that his views are more nuanced than the article's representation of them.

If bond market investors ever do get nervous about inflation, Bernanke and the country will be better off if the media hasn't fallen all over itself to represent him as an inflation dove.

[Mark Thoma]

Anon: Good comment. I agree.

[anne]

The problem with increasing the money supply during a period of deflation is generating use of the money. The deflation in Japan was marked by exceedingly low interest rates but little in the way of loans being extended and too little demand for loans. Finally loans are being extended and taken readily in Japan.

[dryfly]

The problem with increasing the money supply during a period of deflation is generating use of the money. The deflation in Japan was marked by exceedingly low interest rates but little in the way of loans being extended and too little demand for loans. Finally loans are being extended and taken readily in Japan.

::::

use of the money... good point. That too is a result of slowing innovation & the commoditization of available product offerings... even if interest rates are zero and money falls from helicopters... if you don't have something interesting to do with it (either something new to buy or invest in)... then why even bend over to pick it up? Just use what you already have 'in hand' until it wears out.

That is a simple analogy but hits to the point of the argument... 'yes' people have infinite wants... but some of those wants are more powerful than others. Innovation drives demand (and then that demand in turn drives further innovation)... until the changes are so incremental as to be not worth the effort to continue chasing the changes unless the existing product you own is exhausted (commodities never seem to obsolete)...

Example: software & hardware upgrades... they yin-yanged each other for many years... and people upgraded both systems & hardware way before they were worn out (exhusted)... they were considered obsolete well before they failed because the next rev was so much more powerful.

Now the benefit of upgrade for both software & hardware is pretty marginal... they are commodities. Now the machine on your desk has to stop running before you buy a new one... and only then do you acquire new software to run on it.

I realize it isn't that stagnent yet... There is still some innovation happening (in gaming or in wireless telecomm & networking for example)... but it is clearly slowing. As a result the products compete far more on price than on feature differentiation... just compare Dell & HP or Verizon & Nextel. Feature & performance differences are pretty minor in both examples... and as a result margins in both commodities are squeezed thin as price offerings also converge.

Then think how much money Bernanke would have to throw at you to increase consumption of these goods over what you use now... I mean would zero interest rates make you want to use more than 43,000 minutes of wireless a month? or buy another computer if the one you have does fine?

They almost have to give them away... causing deflation.

[Anon]

Anne, why do you think there weren't loans being extended in Japan during the deflation? Admittedly this is more like gossip than data, but the WSJ repeatedly ran stories about borrowers in Japan being kept from bankruptcy by cheap credit. The picture they painted was that credit was available, but it was being used to keep Japanese companies from ending bad investments rather than to support new investment.

[anne]

Nicely comments. As Japan chose to protect employment through the deflation, Japan's banks carried large amounts of commercial loans that were in technical default. Part of this stems from interlocking asset ownership of companies, part from a tactly approved wish to keep large employers going, part from a wish not to have to write off bad debt. But, there was relatively little new loan extension through the deflation no matter the remarkably low interest rates. Month after month, prices for goods and assets fell and borrowing at any interest rate for investment in Japan was not considered necessary. I became interested in Japanese assets when I noticed selective real estate development in Tokyo.

[anne]

Too soon possible to be cheery about Japan, though the Japanese avoid ever being too cheery, but it is remarkable how will Japan's middle class was protected through the deflation. I would argue for a while about whether Japan was even democratic for there was so little overt government response to the minimal growth, but the middle class was protected. Wall Street wished Japan to allow a fierce recession that would force business to newly structure. I thought this absurd. But, Japanese business was slowly slowly adapting and I am moderately confident we will be worrying about a too robust Japan again :)

[pgl]

It is a fine article but it will give the gold bugs over at the National Review a heartache over the notion that the FED will pay more attention to keeper the economy close to full employment v. their singular policy goal - a stable price for gold. Well - at least the NRO will finally make up their mind whether they should have endorsed or condemned Bernanke's appointment to the FED!

[James Kroeger]

Anne, why do you think there weren't loans being extended in Japan during the deflation?

I'm not Anne, and I haven't studied the numbers, but I do know that generally speaking---and I think this is especially true in Japan---the spending that drops the most during recessions is investment by firms. Lowering the cost of borrowing was not enough to persuade a sufficient number of Japanese firms to invest substantial amounts of Yen in Japan, itself.

I'd be willing to bet, however, that the amount of Yen Japanese firms were investing overseas continued to grow throughout Japan's long recession.

[Robert]

But, there was relatively little new loan extension through the deflation no matter the remarkably low interest rates

James Kroeger is correct in asserting that Japanese co.'s continued to invest abroad. What observers miss is the path-dependant nature of Capex: bouts of over-investment are followed by cutbacks. Japan, in the decade through to 1992 invested enormous amounts, topped by what was virtually free-money from 1988-91. Depreciation was thus extraordinarily high, but cash-flow remained robust despite the domestic malaise. Most of the well-run and disciplined major international firms, excepting the most profligate, could fund additional investment from internal cash generation.

Oberservers seem to ignore the condition that nearly everyone who wanted to add new capacity did, and anyone who desired to upgrade machinery did, and anyone who wanted to build condos, a golf-course, a resort hotel did, and the hangover was severe, as it should have been, following a period of yes - call it what it was - OVERINVESTMENT resulting from excess cheap capital. That is a Wiile E. Coyote momennt when you;ve completed your 72 unit project at the same time as 100 others in the same ward have been completed.

You would have had to be certifiably insane to want or think that you could profitable acquire the land (at inflated prices) plan and build a new office building profitably, when existing vacancy rates were ballooning and rents falling dramatically from oversupply. Companies weren't fewer, unemployment wasn't higher, it was supply. The same could be said for steel, or oil refining, or naptha production, wires, cables, cement or paper. But little to none of this was taken out of production. They continued to lend to keep the enterprises afloat, even ones operating at just breakeven (or worse). Eventually they [banks & MiTI] encouraged mergers, and cuts through attrition, all the while intl companies hollowed and moved to abroad to remain competitive. But for domestic companies (Steel, chemicals, bldg mats, firebricks) etc.) but wasn't until China started bubbling in 2001 that prices firmed sufficiently to finally get over the hump of past investment.

In the US Depression, there was plenty of potential demand, but not sufficient money or will/desire/confidence. In Japan's deflation, there no potential demand because demand had been satiated twice over. It was NOT about waiting for prices to fall. It was not something confiodence could overcome except for the most mental of entrepreneuirs in brand new emerging sectors. No, it was about waiting for demand to increase to a sufficient level to overcome the excess supply in so many sectors and segments. This was like waiting for Godot, and only saved by external forces (China-related Asian demand) to raise BOTH quantity demanded and prices, in order to justify and warrant a new round of capex sufficient to make a dent in the macro-economy.