How Milton Friedman Is Shaping US Monetary Policy

"The most important factor shaping Mr. Bernanke's monetary policy is his great knowledge of economic history."

Ben Bernanke has presided over more dramatic changes in US monetary policy than any other central bank governor of the modern era. As a result of the collapse in the US housing market and over $500 billion of loan losses at banks, he has slashed the Fed’s core lending rate from 5.25% to 2.0%. He has pumped over $300 billion of liquidity into the financial system by swapping the Fed’s holdings of government debt for mortgage-backed securities. He allowed the Fed to provide a credit in the JP Morgan rescue of Bear Stearns during March.

As Mr. Bernanke had spent most of his career as an academic before becoming a Fed governor during 2002, few could have anticipated how decisively he would respond to the US financial crisis of the past 12 months. But Mr. Bernanke himself provided strong hints of how he would behave during a speech he made during November 2002 at a University of Chicago party celebrating the 90th birthday of Milton Friedman. At the Friedman birthday party, Mr. Bernanke reviewed the history of monetary policy during the early years of the Great Depression as outlined in Dr. Friedman’s own history books. His comment about the 1930’s provided useful insights into how he has conducted policy during the past year.

Mr. Bernanke suggested the Fed’s first great error was to target asset prices during 1928-1929. The Fed was concerned about the growth of broker loans and large increases in equity prices. There was a debate about whether to use moral suasion or higher interest rates to restrain broker lending. Under the influence of the New York Fed, the Fed raised the discount rate to 5%, the highest level since 1921. As the Fed moved, there were clear signs of the economy sliding into recession but the Fed sustained its policy of restraint because of the stock market boom. This policy error helps to explain why Mr. Bernanke did not favor raising interest rates as the US housing boom took off during 2003 and 2004.

The second great policy error came in September-October, 1931. Britain was forced to abandon the gold standard because of a mutiny by the royal navy. There was an immediate attack on the dollar and a gold drain from New York. The Federal Reserve responded by hiking interest rates twice from 1.5% to 3.5%, the largest increase in the Fed’s history. The interest rate hike reinforced the crisis in the domestic banking system and 522 banks closed during October, alone. The events of 1931 explain why Mr. Bernanke has been prepared to allow large dollar devaluation. He recognizes that dollar stabilization would require him to hike interest rates and increase the danger of bank failures in the US. As his overwhelming goal is to stabilize the domestic financial system, he is prepared to let the exchange rate suffer.

Mr. Bernanke also reviewed how ineffective the Fed was in preventing bank failures. Before the creation of the Federal Reserve, banks had helped each other by recycling liquidity during periods of crisis. The Congress had created the Fed during 1913 in order to help provide an alternative lender of last resort but the Fed refused to play this role during the early 1930’s. It instead subscribed to Andrew Mellon’s liquidationist thesis that it was necessary to weed out weak banks from the system. Mr. Bernanke has been providing unprecedented amounts of liquidity to the financial system because of memories of how the Fed failed to carry out its responsibilities during the 1930’s.

The final issue Mr. Bernanke reviewed was the Fed’s personalities. Friedman had argued there would not have been the Great Depression if Benjamin Strong had not died during 1928. Friedman believed the death of Strong had left the Fed without an effective leader while power shifted to regional presidents who were unsophisticated and did not understand the role of central banks. This history is a reminder of the important role which individuals can play in the conduct of monetary policy and the danger of allowing power to pass to the regional presidents. Senator Christopher Dodd (D-CT) has increased the risk of leadership problems by refusing to hold confirmation hearings for any of the three vacancies which now exist on the F.O.M.C. The regional presidents now have as many votes as the governors in Washington and some oppose Mr. Bernanke’s monetary policies. Mr. Bernanke has resisted the demands of regional presidents for monetary tightening because of his perception that the country faces a grave financial crisis which could ultimately prove deflationary.

The most important factor shaping Mr. Bernanke’s monetary policy is his great knowledge of economic history. He concluded his 2002 speech at the University of Chicago by arguing that the Fed would never again repeat the mistakes of the 1930’s. The conduct of US monetary policy during the past nine months has been a legacy of his birthday promise to Milton Friedman.

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