David R. Henderson  

Hummel on Bernanke's New Central Planning

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The first two lectures cover the origins and history of the Fed. Mr. Bernanke identifies three primary functions of central banks: to conduct monetary policy (i.e., controlling of the supply of money by setting interest rates); to serve as lenders of last resort (i.e., providing liquidity for important institutions to stave off financial crises); and to regulate the financial system (i.e., limiting the risks that banks and other players in financial markets may take). Yet he hardly discusses the quantity of money in circulation or the Fed's effect on it. The omission reflects the fact that Mr. Bernanke has dramatically altered the nature of central banking. Under his management, the Fed now tries to determine to which sectors the economy's savings flow, and monetary policy has become solely about setting interest rates.

To his credit, Mr. Bernanke considers the merits of the classical gold standard, in which the dollar was fully redeemable for a specific quantity of gold. He believes that its gains in long-run price stability were more than counterbalanced by the short-run economic fluctuations it caused. But as University of Georgia economist George Selgin pointed out after the lectures were delivered, the chairman's argument against the gold standard suffers from some severe weaknesses. For starters, it ignores the path-breaking research of Christina Romer, former chairman of President Obama's Council of Economic Advisers, which demonstrated that the frequency and severity of recessions weren't significantly greater before the Fed's creation in 1913 than after World War II. This casts doubt on the ability of the Fed with its fiat money to tame the business cycle any better than did the gold standard without the Fed's intrusions. Mr. Bernanke's case against gold also exaggerates the economic difficulties associated with the mild, long-run deflation of the late 19th century, a period of robust economic growth.

These are two key paragraphs from Jeff Hummel's review of Ben Bernanke's book, The Federal Reserve and the Financial Crisis, which appeared this morning in print and last night electronically. The review is aptly titled, "The New Central Planning." You might wonder why, in these key paragraphs, Jeff doesn't talk about the financial crisis. The reason is that Jeff reviewed the book, not the book's title. And key parts of the book are about Bernanke trying to justify the Fed's existence and its activities.

Another excerpt:

In his early discussion of Fed history, Mr. Bernanke does concede that the bank exacerbated the Great Depression with its inept response to the banking collapse and caused the Great Inflation of the 1970s with an excessively expansionary policy. But he curiously omits any mention of the Fed's equally significant contribution during World War I to the highest rate of inflation in the country's history--outside of the hyperinflations of the American Revolution and the Confederacy. This inflation was promptly followed by the U.S.'s highest ever deflation rate in 1920-21. Then, during World War II, the Fed generated an inflation severe enough to inspire comprehensive wage and price controls and government rationing. By any standard, this is hardly an impressive record.

And the three key paragraphs about the financial crisis:
The chairman is more persuasive in his discussion of the recent financial crisis, which begins at the end of the second lecture and continues through the last two. He makes a strong case for a controversial claim: that Fed easing bears little responsibility for the housing boom, which was an international phenomenon driven primarily by capital flows. He also does a good job of explaining how what were essentially runs on investment banks and other financial institutions heavily reliant on short-term borrowing created systemic effects far more serious than total subprime losses.

His detailed account of the Fed's specific responses to the crisis is illuminating. Mr. Bernanke credits targeted bailouts, starting in December 2007, with providing liquidity almost exclusively to solvent institutions with good collateral. Yet as his graphs demonstrate and his words fail to emphasize, for almost a year Fed sales of Treasury securities offset these injections. In doing so, the Fed was most definitely not acting like a traditional lender of last resort, which calms panics by increasing total liquidity, but was instead merely shifting savings into targeted institutions from other sectors of the economy. As many market monetarists have maintained, Mr. Bernanke's crisis response was far too tight at the outset. Then, when Mr. Bernanke, running out of Treasurys to sell, finally orchestrated an unprecedented increase in the monetary base in October 2008, he partly offset the impact by paying interest on bank reserves, thus discouraging bank lending.

In addition to the housing bubble and systemic effects, the third prominent feature of the financial crisis was the widespread mispricing of risk. Although Mr. Bernanke acknowledges that "too big to fail" creates perverse incentives, he neither uses the term "moral hazard" nor gives the concept much consideration. He explains the excessive risk-taking that precipitated the crash by saying that "nobody was in charge" and then sings the praises of the Dodd-Frank Act, which, with "more stringent scrutiny," will somehow help achieve financial stability in the future. This discloses Mr. Bernanke's astonishing faith in the ability of government to outperform the market in pricing risk.

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COMMENTS (11 to date)
Ted Levy writes:

Given the normal length of a WSJ book review, and your comments above, many of your readers might wonder, so I'll clarify: It IS true; the ENTIRE review is composed of key paragraphs!

[And I mean this sincerely. It's a GREAT analysis.]

David R. Henderson writes:

@Ted Levy,
True. There's no fluff.

John S writes:

Does Bernanke distinguish between a centrally managed gold standard and a laissez-faire (or "free") banking system in which gold is used as base money for interbank clearing and banks are free to issue as much currency as they like? I doubt it.

Why do Krugman and Bernanke have so much difficulty understanding Free Banking? The concepts are childishly simple.

Great Selgin interviews: http://www.youtube.com/watch?v=U_0CNwgL8Rw


Scott Sumner has a nice post on the path to free banking.

1. NGDP target
2. End too big to fail
3. End deposit insurance
4. Allow free banking


John S writes:

Scott Sumner lays out the plan for monetary freedom:

1. Institute NGDP level targeting rule
2. End too big to fail
3. End deposit insurance
4. Allow free (ie laissez-faire) banking


Bernanke (and Krugman) can't seem to understand there's a big difference between a gold standard managed by a central bank and a Free Banking system where gold is used for interbank clearing.

Why do they botch the basics of Free Banking? The main concepts are childishly simple?

John S writes:

A lot of conservatives botch the gold standard arguments as well by favorably citing the 19th century deflation as a good thing.

Deflation per se isn't bad; but the 19th century US deflation was artificially exacerbated by the requirement that banks back new currency issues with purchases of federal debt.

Given that the US govt retired a lot of debt in the post Civil War years, that caused the monetary supply to contract more than it did in Canada, where a Free Banking system (with private, competitive note issue) was in place.

Selgin explains this wonderfully here from 15:30

If you really want an effective indictment of the Fed's central planning (though it's Tim Geithner and Hank Paulsen who take most of the heat) during the financial crisis, you could do much worse than The AIG Story by Hank Greenberg--as told to Lawrence Cunningham.

Just read the second half to see how the little snowball Eliot Spitzer started rolling downhill in 2005 turned into an avalanche in late 2008. Anyone who appreciates the rule of law will be appalled by the story.

Shayne Cook writes:

From Jeffrey R. Hummel's "review":

"Then, during World War II, the Fed generated an inflation severe enough to inspire comprehensive wage and price controls and government rationing." [emphasis mine.]

Really? The Fed was the sole cause of all the U.S. economic aberrations and the sole cause of government interventions such as wage/price controls and rationing during WWII? Wow.

Jeff seems to have carefully selected a few facts from history (and others research), then wrapped them in his own contrived and narrow context and perspectives in this article - in several instances, this one being one of the most glaring.

Facts are wonderful things. I love facts. But I've found that even absolute, unequivocal facts - such as the government interventions during WWII - when presented this far out of context with the very much larger reality, are misinformation at best.

And I consider such use of facts completely unworthy of an authoritative source such as Jeff Hummel - not to mention annoying. Suffice to say, I'll be reading Ben Bernanke's new book, and "The AIG Story" (thanks, Patrick R. Sullivan), but probably not any more of Jeff Hummel's "work".

tom writes:

"every major crisis since 1913 was caused/exacebated by the Fed, except this last one that I presided over"
- Bernake

Jeff Hummel writes:


As I'm sure you're aware, a short review in a major newspaper cannot include all the qualifications and nuances of a scholarly article. As it happens, the WSJ edited down my review of Bernanke's book from a much longer and more detailed original draft.

That said, even Bernanke agrees that the Fed should be responsible for holding inflation in check and has had the ability to do so. You may wish to argue that the inflation of World War II was desirable given other factors, but isn't that a different issue? My statement that you quoted states that the Fed-caused inflation "inspired" wage and price controls and rationing: that's hardly blaming the wage and price controls on the Fed. Rather, it's blaming inflation on the Fed, and the mention of wage and price controls is there simply to illustrate how severe the inflation was considered at the time.

Moreover, the claim that the Fed from its founding was primarily responsible for fluctuations in the price level is not original with me. It comes from Milton Friedman and Anna Schwartz's well-respected classic, A Monetary History of the United States (1963).

James Bailey writes:

"monetary policy has become solely about setting interest rates"

This is a very odd thing to say about the Fed Chair who started Quantitative Easing.

Shayne Cook writes:


Whatever plausibility your assertion regards the cause/effects of inflation "inspiring" government action might have depends upon the identical ceteris parabus condition existing before, during and after the Second World War periods. That is NOT the case.

The "inspiration" for Federal Government interventions - wage/price controls and rationing - from December 1941 through 1945 had nothing whatsoever to do with "inflation".

In December 1941, when the U.S. declared war on the Axis powers, the U.S. economy was commanded by the Federal Government into a total war mobilized state. A total war mobilization meant that every single factor of production in the U.S. economy, and ALL economic output of those factors of production, were either in-fact designated, or subject to being designated, war materiel - NOT FOR PUBLIC CONSUMPTION.

General Motors, Ford Motor Company, Willys and the rest of the U.S. auto industry did NOT stop manufacturing automobiles for public purchase during the war years due to "inflation". Tobacco companies did NOT change the colors of the cigarette packaging ("Lucky Strike Green Goes to War!") due to "inflation". The Federal Government did NOT impose a national 35 mph speed limit, or ration public consumption of every other product of the U.S. economy due to "inflation".

ALL of those measures were implemented by the Federal Government specifically and exclusively in order to divert the maximum possible amount of U.S. economic output to support the war effort. And not just to support the U.S. military efforts, but the efforts of Britain, France, Russia, China, and many other allied countries.

If anything "inflation" was a result rather than a cause or even an "inspiration" of Government interventions.

And that statement is perfectly consistent with the work and conclusions of Friedman and Schwartz. They concluded that price fluctuations are at once and always a monetary phenomena. In the case of inflation, too much money, relative to the amount of goods/services available to purchase,. And that is true regardless of whether the "money" is a fiat currency, or "backed" by a shiny metal. Whatever money supply existed prior to December 1941 became "too much", relative to the goods/services available for consumption from that date through 1945 - as a result of war mobilization.

I consider that a significantly more relevant explanation of whatever "inflation" may have occurred during the Second World War than anything the then Federal Reserve leadership and governors may or may not have done.

But I do NOT expect you to concur with what I think. I welcome new information and new perspectives even more than I love facts.

What I do expect is that an "authoritative source of information" in the field of economics at least address the possibility that a significant difference in the ceteris paribus assumption at least may be an alternative explanation for the facts. Failure to do so is a gross error of omission that I consider unworthy of an authoritative source of information - in any discipline.

Jeff, your name appears as the author of that "review" published in the Wall Street Journal. If indeed that gross error of omission was the result of the Wall Street Journal editorial staff, rather than your own, then I would recommend you contact those folks and request your name be removed as author. You have earned the right to be considered an authoritative source in the field of economics. But you, and only you, have the duty and responsibility to preserve that status.

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