Mises Daily November 5, 2010

November 5, 2010

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Bernanke's Solutions Are the Problem
by Mark Thornton on November 5, 2010

[Speech given at The Economic Recovery: Washington’s Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.]

Ben Bernanke, the man who purports to be the savior of the economy today, was actually deeply involved in creating the housing bubble, encouraging people to invest in toxic assets, and orchestrating the cover-up after the bubble collapsed. Now he is bludgeoning the economy into depression. Just like his predecessor Greenspan, his statements are replete with misleading, convoluted, and inconsistent claims, all designed to disguise the role of the Fed in the economic calamity.

Ben Bernanke went to Harvard University, where he received his undergraduate degree in economics. He then went to graduate school at the Massachusetts Institute of Technology, MIT, where he received his PhD in economics. His thesis adviser was Stanley Fischer, and his committee consisted of Fischer, Rudiger Dornbusch, and Robert Solow, a Nobel Prize winner. (He also thanked Harvard University professors Dale Jorgenson and Peter Diamond [Nobel laureate 2010] in his dissertation.) It is safe to say that he had an elite education in mainstream economics.

Bernanke has taught at Stanford University, New York University, and Princeton University, where he served as chairman of the department from 1996 to 2002. Bernanke has authored major textbooks, has served as the National Bureau of Economic Research’s director of monetary economics, and was an editor of the American Economic Review. He is still considered to be one of the top 20 authors of all time in academic economics journals despite having been out of academia for almost a decade.

Bernanke was appointed to be a member of the Federal Reserve Board of Governors in 2002. He was then appointed by President Bush to be Chairman of the President’s Council of Economic Advisors in 2005. He was then appointed by Bush to be the chairman of the Federal Reserve in 2005 and subsequently renominated by President Obama in 2009. In 2009, Time magazine named Bernanke its “person of the year.” Not a bad run-up in fame and influence for a boy from rural South Carolina.

Just to be clear, Bernanke received a top notch education in mainstream economics at Harvard and MIT under the direction of leading professors in the economics profession. He also taught at premier institutions and held key leadership roles in the profession. He is considered one of the most important researchers and publishers of his generation and is best known for his research on the Great Depression, where he added a distinction to the contributions of Milton Friedman and Anna Schwartz.

For Bernanke, the Great Depression was less about the Federal Reserve reducing the money supply (which is the Friedman and Schwartz hypothesis) and more about the bank failures that increased the cost of credit and decreased its availability, leading to a decline in aggregate demand and creating the Great Depression. For Bernanke, a downturn can lead to bank failures, which curtail credit. This can cause a further reduction in economic activity that spirals into a vicious cycle ending in economic depression. I will further address his distinction, because it is critical, in my closing remarks.

And Now for His Record

Here I will survey his record working for the Federal Reserve. In the interest of time, this survey is not comprehensive, but I feel almost certain that we could find problems in all of his testimony and speeches. In fact, I have become cynical enough to believe that every speech presented by the entire Board of Governors is designed to inject at least one untrue point into public discourse, mostly for purposes of maintaining “confidence.”

Bernanke served as a member of the Board of Governors of the Federal Reserve System from 2002 to 2005. In one of his first speeches as a governor, entitled “Deflation: Making Sure It Doesn’t Happen Here,” he outlined what has been referred to as the Bernanke doctrine.[1] This doctrine holds that deflation, or a general decline in prices, is a highly destructive phenomenon, but one that is unlikely to occur in the United States. However, if it were to occur the Federal Reserve must resort to the printing press and several unconventional policy procedures if a zero-interest-rate policy fails to reverse the deflation. This would involve increasing the money supply, ensuring liquidity in financial markets, lowering the interest rate to zero, controlling the rates on private bonds and securities, devaluing the dollar, lowering the exchange-rate value of the dollar, and assisting the Treasury to buy equity stakes in private companies. He would do anything necessary to prevent the failure of major financial firms. At the time, it all seemed farfetched, but not anymore. According to Bernanke,

The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress.

If all we know is that a collapse in aggregate demand is the source of deflation, then its cause remains a mystery because aggregate demand does not illuminate what sectors in the economy are collapsing or why they are collapsing. Only in a footnote does Bernanke suggest that an increase in aggregate supply (a good thing also known as economic growth) can cause deflation. “For the most part,” Bernanke thinks that deflation is the cause of severe economic troubles.

Incidentally, Bernanke at times sounded Marxist with his statement that if the government controls the means of production in money production then it will have the ability to prevent deflation. You should also note that he was a big admirer of Franklin Delano Roosevelt, and this might be reflected in his use of acronyms for all his various “vehicles” (TARP, TAF, TSLF, PDCF, TALF, TDF, etc.).

The problem with Bernanke is that he is working with mainstream theory and ignoring history. He thinks deflation is bad, but unlikely to happen. If it does happen he will use weapons of mass economic destruction to stop it. In reality, deflation of prices is a normal aspect of the market economy as the production of goods outstrips the production of money resulting in higher real wages in a growing economy. The healthiest of economies will exhibit falling prices.

Historically, deflation was a common feature of the American economy, particularly before the establishment of the Federal Reserve. The one time that there was significant deflation and economic decline was the Great Depression.

Two economists published a study in the American Economic Review in 2004 that examined the association of deflation with depression. They looked at 17 countries and over 100 years of data and concluded that “beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”[2] Michael Bordo’s work on this topic also suggests no clear linkage between deflation and depression. The only conclusion we can reach is that Bernanke, like his Princeton University colleague Paul Krugman, suffers from “apoplithorismosphobia,” a term I coined (with the help of a Greek translator) to label the psychological and irrational fear of deflation.

In 2004, during the housing bubble, Bernanke addressed the phenomenon referred to as the “Great Moderation.” It refers to the reduction in volatility in inflation and output that had occurred over the previous two decades. Bernanke found that improvements in monetary policy have not been given their due credit for bringing about this development.

The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years, is a striking economic development. Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed. I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. … This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.

I have put my case for better monetary policy rather forcefully today, because I think it likely that the policy explanation for the Great Moderation deserves more credit than it has received in the literature.[3]

Obviously, changes in monetary policy could bring about less volatility in the economy. However, if those changes brought about less volatility from 1984 to 2004, then what about the increased volatility from 2006, when Bernanke took over as chairman of the Federal Reserve, until today? Was it the previous policies still in place that caused the increased volatility or was it changes in monetary policy brought about by Bernanke that caused the increased volatility? Which was it?

Possibly the worst of Bernanke’s statements occurred in 2006, near the zenith of the housing bubble and at a time when all the exotic mortgage manipulations were in their “prime.” This was the era of the subprime mortgage, the interest-only mortgage, the no-documentation loan, and the heyday of mortgage-backed securities. At the time, the new Fed chairman admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates.

Bernanke stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real-estate appraisal practices have improved.”[4] This is the equivalent of the Federal Reserve seal of approval being applied to mortgage lending at the pinnacle of the housing bubble.

Bernanke, the former economics professor from Princeton, gave an address to the annual meeting of the American Economic Association in January 2007.[5] He is the first chairman of the Federal Reserve from academia to do so since Arthur Burns. It was Burns who helped take us off the gold standard. Who knows where Bernanke is taking us.

In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Fed’s access and ability to use information and data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He described the Fed as a type of superhero for financial markets. In discussing the Fed’s role as chief regulator of financial markets, he made powerful claims concerning the Fed’s ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.

Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions. …

In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities.

In other words, the Fed knows everything about financial markets. But it gets worse:

In my view, however, the greatest external benefits of the Fed’s supervisory activities are those related to the institution’s role in preventing and managing financial crises.

In other words, the Fed can prevent most crises and manage the ones that do occur.

Finally, the wide scope of the Fed’s activities in financial markets — including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy — has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains. (emphasis added)

In other words, the Fed is an experienced, forward-looking preventer of financial crises. This is a strong claim, given Bernanke’s own abysmal record of forecasting near-term events.

Chairman Bernanke is infamous on the internet because of the YouTube video that chronicles his rosy view of the economy from 2005 to 2007. He denied there was a housing bubble in 2005, he denied that housing prices could decrease substantively in 2005 and that it would affect the real economy and employment in 2006, and he tried to calm fears about the subprime-mortgage market. He stated that he expected reasonable growth and strength in the economy in 2007, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the market in general.

In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. How many times have we heard about green shoots over the last two years, when possibly as many as 40 percent of Americans families have experienced unemployment, bankruptcy, foreclosure, or are currently in jeopardy of foreclosure?

Remember, Austrians were writing about the housing bubble, its cause, and the probable outcomes as early as 2003. Bernanke and others have denied that you can predict bubbles and crises, and when prodded about the predictions of Austrian economists the familiar retort is the “broken-clock effect.” That is, even a broken clock gets the time right twice a day. But not so fast, I have seen a list of about 40 people who made reasonably correct predictions about the housing bubble, and about three-fourths of them were from followers of Austrian economics. Given that Austrians make up a tiny percentage of all economists, it would seem that there is more to this than a broken clock.


Bernanke has the credentials of a mainstream economist of the highest rank, as well as the highest titles for economists working in government. His defining contribution in economics is the distinction he drew with regard to the Friedman and Schwartz analysis of the Great Depression. Where they found that the economy went into a “great” depression because of a decline in the money supply, Bernanke found the cause to be the collapse of the banking industry that resulted in restricted and higher-priced credit.

Both agree that there was a decline in aggregate demand that could have been averted by prompt action by the Federal Reserve and the government. However, the type of action required is different. Friedman and Schwartz argued that the Federal Reserve should have acted to increase the money supply or to have at least prevented it from falling. In contrast, Bernanke believes that the Federal Reserve should have acted to prevent the collapse of banks. The Friedman and Schwartz solution would have allowed some banks to fail, although presumably fewer than did fail due to the increase in the money supply and liquidity. Bernanke, in contrast, would have acted to bailout most banks from failing in order to maintain the availability of credit in the economy, but would have been less concerned with the overall money supply.

Whether either of these policies would have worked is dubious because, as Murray Rothbard wrote, other interventionist policies by the Hoover administration were also preventing the economy from correcting — a view that is gaining adherents even within mainstream economics. The relevant issue for today is that Bernanke essentially believes that it is the Federal Reserve’s job to bail out financial institutions in order to maintain the channels of credit and to prevent other “nonmonetary” factors from negatively impacting aggregate demand. This explains Bernanke’s swift acting to bail out financial firms like Bear Sterns and AIG, the nationalization of Fannie Mae and Freddie Mac, backstopping whole markets such as money-market mutual funds, and absorbing vast quantities of toxic assets onto the Federal Reserve’s balance sheet.

In preparing for this lecture, I began to realize just how obvious a choice Bernanke was for chairman of the Fed. From the point of view of banks, corporations, and Wall Street — also known as the “corporatocracy,” a government run for the interests of big corporations — who would be better than someone who literally wrote the book on bailing out the banks and Wall Street during a financial crisis?

Another example of Bernanke’s suitability as Fed chairman is his willingness to drive down the value of the dollar. It means higher prices for you and me, but hey, it is great for exports, which again is largely the corporatocracy’s gain. When you realize that the Fed is the major engine that enriches the corporatocracy at the expense of Main Street, you can fully understand the ongoing actions of the Fed and certainly of Bernanke.

A third example is Bernanke’s use of forced low interest rates. Banks benefit. Corporations benefit. But how about Main Street, small business, and savers? Lowering interest rates hurts savers, retirees, and even small-town banks who cannot access the monetary pumping from the Fed and must rely on their depositors. According to the president of the Federal Reserve Bank of Dallas it would seem that the Fed is only helping the corporatocracy move overseas before the whole US economy crashes and burns.

In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places. Far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please.[6]

As we enter the fourth year of this economic crisis, we should not be surprised to see additional moves from Bernanke. He admired FDR for his bold and innovative policy making and has replicated FDR’s approach at the Fed, even down to the use of acronyms. So do not be surprised to see more “quantitative easing” with each successive downturn in the economy.

I end with a quotation from Murray Rothbard that captures my own conclusion about the coming consequences of Bernanke’s rule at the Fed.

As we face the future, the prognosis for the dollar and for the international monetary system is grim indeed. Until and unless we return to the classical gold standard at a realistic gold price, the international money system is fated to shift back and forth between fixed and fluctuating exchange rates with each system posing unsolved problems, working badly, and finally disintegrating. And fueling this disintegration will be the continued inflation of the supply of dollars and hence of American prices which show no sign of abating. The prospect for the future is accelerating and eventually runaway inflation at home, accompanied by monetary breakdown and economic warfare abroad. This prognosis can only be changed by a drastic alteration of the American and world monetary system: by the return to a free market commodity money such as gold, and by removing government totally from the monetary scene.

Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute in Auburn, Alabama, and is the book review editor for the Quarterly Journal of Austrian Economics. He is the author of The Economics of Prohibition, coauthor of Tariffs, Blockades, and Inflation: The Economics of the Civil War, and the editor of The Quotable Mises, The Bastiat Collection, and An Essay on Economic Theory. Send him mail. See Mark Thornton’s article archives.

This article is excerpted from the transcript of a speech given at The Economic Recovery: Washington’s Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.

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[1] “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. November 21, 2002.

[2] Andrew Atkeson and Patrick Kehoe, “Deflation and Depression: Is there an Empirical Link?” American Economic Review: Papers and Proceedings, Vol. 94 (May 2004) pp. 99–103.

[3] “The Great Moderation,” Remarks by Governor Ben S. Bernanke at the meetings of the Eastern Economic Association, Washington, DC, February 20, 2004

[4] Bernanke, Ben S. 2006a. Speech to the Independent Community Bankers of America National

Convention and Techworld, Las Vegas, Nevada, March 8; Bernanke, Ben S. 2006b. “Reflections on the Yield Curve and Monetary Policy.” Remarks before the Economic Club of New York, March 20.

[5] “Central Banking and Bank Supervision in the United States.” Speech given at the Allied Social Science Association Annual Meeting, Chicago, January 5, 2007.

[6] Richard W. Fisher, “To Ease or Not to Ease? What Next for the Fed? (With Reference to Bill Frenzel, Alan Greenspan, Masaaki Shirakawa, Sherman Maisel and Raghuram Rajan),” Remarks before the Economic Club of Minnesota, Minneapolis, Minnesota, October 7, 2010.