paul kasriel: A Hayekian Defense of Ben Bernanke

Paul Kasriel takes on Anna Schwartz, defending Ben Bernanke’s post-bust management of the Federal Reserve:

Ms. Schwartz asserts that Bernanke should not be re-nominated because of his sins of commission as well as his sins of omission. It is not clear to me to what Bernanke sin of commission Ms. Schwartz is referring. She alludes to the flooding of the financial system with Fed credit, which drove down the overnight cost of funds in the interbank market to almost zero. But was that a policy sin? Did not Ms. Schwartz co-author with Milton Friedman, a Nobel economics prize winner, a tome (A Monetary History of the United States, 1867 to 1960) of which one of the key conclusions was that the Federal Reserve was too timid in creating credit in the early 1930s? Friedman and Schwartz are associated with the monetarist school of economics. But there was a Nobel Prize winner associated with the Austrian school of economics, Friedrich Hayek, who also advocated a step up in central bank credit creation in situations arguably similar to those experienced in the U.S. in the past year. Hayek identified an economic environment he termed a “secondary depression” or “secondary deflation.”

According to G.R. Steele, an Hayekian scholar, “where bank failures and the resulting monetary contraction are effects (not causes) of an economic downturn, these can trigger a ‘secondary depression’ as goods are unsold, workers are dismissed and prices and wages tend to fall. So, there is a (practically difficult) distinction to be drawn between the structural unemployment that arises in sectors whose unwarranted expansion is the consequence of monetary profligacy, and the general unemployment that is caused by secondary deflation once the inevitable recession is set in train.” (G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” The Quarterly Journal of Austrian Economics, Spring 2005, p.8). Steele goes on to interpret and quote Hayek on this issue (F.A. Hayek, “A Discussion with Friedrich von Hayek,” American Enterprise Institute for Public Policy Research, 1975, p.5): “More generally, intervention by the monetary authorities could bring advantages ‘in the later stages of a depression’ when ‘deliberate attempts to maintain the money stream’ would be justified to counter the ‘cumulative process of secondary deflation.’” As an aside, Hayek even sanctioned “fiscal stimulus” in an environment of a secondary recession.

Again Steele interprets and quotes Hayek (F.A. Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas, published by Routledge and Kegan Paul, p.212): “[B]ut that one measure to offset secondary depression would be to provide ‘employment through public works at relatively low wages so that workers will wish to move as soon as they can to other and better paid occupations.’”

After Lehman failed in mid-September 2008, the interbank lending market shut down. That is, Bank A would not lend on an unsecured basis to Bank B because Bank A did not know whether Bank B would fail the next day. The Federal Reserve was established by an act of Congress in 1913 with the primary mission of providing credit to solvent banks that were having temporary funding difficulties. Whether they were solvent or not is a legitimate question, but there was no question that banks were having funding difficulties immediately after Lehman’s failure. So, the Fed provided funding to banks and other financial institutions via the Fed discount window and via new Fed credit facilities such as the Term Auction Facility (TAF). And bank reserves have mushroomed. But so have excess reserves on the books of banks.

As shown in Chart 1, bank reserves have risen from $43.9 billion in June 2007 to $809.8 billion in June 2009. At the same time, banks’ excess reserves as a percent of their total reserves have gone from 4.0% in June 2007 to 92.8% in June 2009. So, the bulk of reserve credit created by the Federal Reserve in the past two years has ended up as excess, i.e., idle, reserves sitting on the books of banks. Rather than the explosion in reserves at depository institutions leading to an explosion of lending on the part of depository institutions, just the opposite has occurred – an implosion of net lending by depository institutions has occurred .. [click over for graphs and more analysis] ..

Now on to what Ms. Schwartz considers to be Bernanke’s sins of omission. Ms. Schwartz believes that Bernanke misread the need for capital on the part of financial institutions as a need for liquidity. I would argue that financial institutions needed capital and liquidity, but the Fed could only supply liquidity. And, by quickly supplying massive amounts of liquidity, the Fed may have lessened the amount of capital financial institutions ultimately would have needed. As mentioned earlier in this commentary, the market for interbank lending froze up after Lehman’s failure. Had the Fed not stepped up its funding facilities for financial institutions, these institutions en masse would have been forced to liquidate assets, which would have driven down the prices of these assets as well as those remaining on their balance sheets. This would have exacerbated the erosion of capital financial institutions already were experiencing. In other words, otherwise solvent institutions can become insolvent if they simultaneously have funding problems.

But what about Bernanke’s pre-bust actions at the Fed?  Are they a firing offense?  Here’s Kasriel judgment:

I would like to offer up my own argument against the re-nomination of Bernanke as Fed chairman. In my opinion, the seeds of our current economic and financial market problems, if not sown, were fertilized in the early years of this decade, which included Bernanke’s tenure as a Fed governor (2002 – 2005). Never once during his tenure as a Fed governor did Bernanke officially dissent from a majority decision of the Greenspan-led FOMC. Again, in my opinion, this is Bernanke’s disqualifying sin of omission.

Read the whole article in PDF here.

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