February 7, 2006


Uncle Miltie’s Ugly Fed Lesson (David R. Henderson, 26 Jan 2006, Tech Central Station)

Let’s begin with the positives.

First, from everything I can tell, Bernanke is a first-rate economist.

Second, Bernanke has a solid understanding of what caused, and what lengthened, the Great Depression. Like Milton Friedman and Anna Schwartz, he understands the important role that contractions in the money supply played in causing the first few years of the Great Depression. One question that had many economists stumped, though, was why the large unemployment of the time didn’t cause real wages to fall more quickly in some important sectors of the economy, making more workers employable. Bernanke, as well as other economists, solved the puzzle. They pointed out that government policies, beginning with President Hoover but especially under Franklin Roosevelt, kept real wages high. Starting in 1933, President Roosevelt’s National Recovery Administration cartelized U.S. industries, keeping prices and wages high and slowing the growth of real output. Then, by 1935, when the Supreme Court ruled that the NRA was unconstitutional, federal labor legislation had given unions monopoly power, which they exploited to keep wages high. The result was that the Depression lasted much longer than it needed to. So the odds that Bernanke would let the money supply shrink enough to cause a major depression are extremely low, and the odds that if a recession started, Bernanke would advocate government policies to keep real wages artificially high, are also low.

The third positive is that Bernanke appears to be an inflation hawk, someone who thinks his main job is to keep inflation low, which means, as noted above, keeping the growth rate of the money supply low.

So, what’s not to like?

Two things. In the introduction to his book Essays on the Great Depression (Princeton University Press, 2000), Bernanke writes: “Those who doubt that there is much connection between the economy of the 1930s and supercharged information-age economy of the twenty-first century are invited to look at the current economic headlines -- about high unemployment, failing banks, volatile financial markets, currency crises, and even deflation.” (italics added.) Recall that in 1933, the worst part of the Great Depression, the unemployment rate was 25 percent. In other words, one of 4 people in the U.S. labor force was out of work. In early 2000, presumably when Bernanke wrote his introduction, the U.S. unemployment rate was about 4 percent. Most economists, if asked the U.S. economy’s “natural” unemployment rate -- when the economy is humming along at so-called “full employment” -- would answer, “About 4 to 6 percent.” If Bernanke believes that 4 percent unemployment is high, what might he do to the growth of the money supply if the unemployment rate is, as it often will be, 4 percent or higher?

Now, you might argue that Bernanke was engaging in hype. But surely, all other things equal, hype is not good.

The second thing not to like is Bernanke’s strong fear of deflation. He has made it clear that he favors price stability, which, he has pointed out, “means avoiding both deflation and inflation.” Economists can tell you why inflation is bad: it’s a tax on money and it’s more hidden than most taxes. But one of the economists who studied the issue most carefully, Milton Friedman, concluded that the optimal growth rate of the money supply is one that yields deflation. Why? Friedman argues that the cost to the government of producing paper money is essentially zero and that, therefore, the cost of holding money should be zero so that people will hold the optimal amount of money. But the cost of holding money is simply the interest you give up by holding it. So the way to get the cost of holding money down to zero is to have a zero nominal interest rate. This would happen if we had deflation whose magnitude equaled the real interest rate -- that is, deflation of about 2 percent per year. By contrast, Bernanke’s fear of deflation, as far as I can tell, is not based on economic reasoning.

There's certainly good deflation, like that we've enjoyed, but you do want to avoid having people stop spending money, no?

Posted by Orrin Judd at February 7, 2006 6:11 AM

I think Mr. Henderson is a bit behind the times. When Friedman wrote that bit about deflations being healthy, the amount of cash held relative to GDP was substantially higher. It no longer applies.

Posted by: Bret at February 7, 2006 11:39 AM