How the Fed Flubbed It

On November 8, 2002, on the occasion of Milton Friedman’s 90th birthday, Ben Bernanke took a day off from his job as a governor of the Federal Reserve Board. Escaping the marble corridors of the Fed’s Washington redoubt, he journeyed to the University of Chicago to pay tribute to the great economist, and particularly to his work on the Depression. “You’re right,” Bernanke conceded, alluding to Friedman’s conclusion that the Fed’s foolishly tight policy had been responsible for the appalling hardships of the 1930s. “We did it. We’re very sorry. But thanks to you, we won’t do it again.”

In the dozen years since, Bernanke’s promise to Friedman has been cited repeatedly—and approvingly. By an immense stroke of good fortune, or so the standard story goes, President George W. Bush selected Bernanke to serve as the Federal Reserve chairman in 2006, and so, when the global financial crisis erupted two years later, the nation was blessed with a central banker who understood the Depression and knew how to avoid a repeat of it. Starting in the summer of 2007, and especially after the collapse of Lehman Brothers the following year, Bernanke acted with creativity and urgency: he scooped toxic securities out of failing institutions and refrigerated them in freshly conjured special-purpose vehicles; made dollars available to foreign central banks; and lent directly to commercial firms, a step inspired by Bernanke’s own research on the collapse of the credit market in the 1930s. To be sure, Bernanke attracted criticism from conservatives who feared his activism would spark inflation. But few accused him of a lack of energy. He had delivered on that pledge to Friedman.

Enter Barry Eichengreen, a prolific economic historian at the University of California at Berkeley. The way Eichengreen sees things in his latest book, Hall of Mirrors, the standard story is inadequate: Bernanke failed to act on history’s lessons almost as often as he succeeded. The impressive bouts of interventionism alternated with lulls, and the Fed chairman missed crucial parallels with the interwar period. This, it cannot be stressed enough, is a provocative thesis. In criticizing Bernanke, Eichengreen is singeing a distinguished beard. In doubting the vigor of the Fed, he is disputing one of the few points of consensus in the commentary on the 2008 crisis.

If anyone can get away with this attack, it is Eichengreen. He combines a feel for narrative with a sure grasp of the technical literature on the interwar period, to which he has contributed. He has a record, moreover, of challenging settled views on economic history and toppling them. In Golden Fetters: The Gold Standard and the Great Depression, 1919–1939, the book that did much to establish his reputation, Eichengreen advanced a fresh take on Milton Friedman’s U.S.-centric view of the Depression. By including Europe in his analysis, he drew attention to the role the gold standard played in propagating the disaster. Eichengreen showed that the Fed had kept interest rates too high in order to defend the dollar’s gold parity; and that because exchange rates and therefore interest rates were yoked together under the gold standard, Europe’s central banks mimicked the Fed’s tight policy. Fettered to gold and to each other, the world’s leading economies staggered into the Depression.

In his preface to Golden Fetters, published 23 years ago, Eichengreen confessed, a bit coquettishly, “I like to pretend that these are the final words I will write on the world economy between the wars.” Pretend was right. The crash of 2008 drove Eichengreen to revisit the scene of his first triumph. The result is a double narrative, a rollicking, villain-rich story contrasting then and now: the tale of the interwar economy spliced into an account of the subprime bubble and its aftermath. Both periods feature property speculation in Florida, dimly understood financial innovations, and destabilizing cross-border capital flows whose damage was compounded by fixed exchange rates (the gold standard in the 1930s, the euro in the 2010s). If Bernanke emerges as Eichengreen’s most distinguished whipping boy, he is by no means the only one.

Contrary to popular memory, Eichengreen suggests, the Depression-era Fed deserves at least some sympathy. In the wake of the 1929 crash, the Fed acted immediately to pump liquidity into the markets, saving the banking system from failure. It cut interest rates repeatedly in the first half of 1930, sparking a partial recovery on Wall Street. Confronted with a string of bank runs, which were inevitably common in the era before deposit insurance, the Fed supplied yet more liquidity to fragile banks, staving off a wider crisis. Eugene Meyer, the formidable Fed chairman who later ran the World Bank and bought The Washington Post, drafted the legislation creating the Reconstruction Finance Corporation, the counterpart to the Troubled Asset Relief Program of 2008. When a major Chicago bank, Central Republic, threatened to collapse in June 1932, Meyer used the RFC to mount an unprecedented, $90 million rescue. That was three times the size of all federal loans to the states that year for the relief of the unemployed and homeless.

If the Depression-era Fed was more muscular than is commonly recalled, Eichengreen makes the case that the Fed of 2008 deserves only modest praise for its activism. He attacks from the opposite direction, too, dwelling on the modern Fed’s errors of omission. These started with the failure to see the crisis coming. U.S. real-estate prices first began to fall in 2006, but as late as March 2007, Bernanke assured the public, “The impact on the broader economy … seems likely to be contained.” And this wasn’t just public cheerleading: even in the semiprivacy of the Fed’s interest-rate meetings, Bernanke and his colleagues remained remarkably upbeat on the economy. The reason for this optimism lay in the conviction that house prices had never fallen everywhere at the same time: “We’ve never had a decline in house prices on a nationwide basis,” Bernanke had stated in 2005. But home prices had fallen by 25 percent between 1929 and 1933. “As an expert on the Great Depression, the chairman was surely aware of the fact,” Eichengreen writes acidly.

Once the financial meltdown got under way, the Fed still struggled to absorb the lessons of history. It staged a rescue of the investment bank Bear Stearns, much as the interwar Fed had done for Central Republic of Chicago. Then, facing a political backlash for bailing out reckless financiers, the Fed and the Treasury allowed Lehman Brothers to go under. As Eichengreen relates, that fateful decision echoed the interwar sequel to the Central Republic rescue, which had provoked similar political recriminations about cosseting bankers. At the start of 1933, the Fed took a hard line on Union Guardian Trust of Michigan. The catastrophe that followed Union Guardian’s failure should have served as a warning: depositor runs quickly spread from Michigan to neighboring states, and soon the banking system was in free fall. The moral, Eichengreen tells us, should have been obvious. The Fed should not have flinched from bailing out Lehman Brothers.

In the aftermath of Lehman’s collapse, Bernanke switched into superman mode, rescuing almost any institution, American or foreign, whose failure might cause contagion. Eichengreen is happy to award points for this, but he still accentuates the negative. The Fed, he argues, ought to have been more aggressive in its monetary stance. Although it launched quantitative easing, the policy of reducing long-term interest rates by buying bonds, it took pains to emphasize this experiment’s limits: the Fed would buy only a fixed number of bonds; there was no “whatever it takes” promise to return the economy to growth and full employment. Much later, in 2012, the Fed finally came out with a statement that it would keep interest rates low until unemployment came down to 6.5 percent. (The rate was then 7.8.) The Fed arrived at the right policy, but only after four years of culpable timidity.

In late 2009, the epicenter of the financial crisis shifted to Europe. Again, Eichengreen contends that history could have guided leaders toward better decisions. Countries such as Spain and Ireland were complacent because their governments boasted a budget surplus; they should have recalled that Britain had enjoyed a similar surplus up until 1930, a fact that did not avert the shock of 1931, when Britain was forced off the gold standard. Spanish and Irish policy makers should have recalled, moreover, that interwar Britain had proved vulnerable for precisely the same reason their own countries were exposed: a strong public budget can be instantly ruined by the need to bail out the financial sector. In 1931, it emerged that London’s top investment banks had sold credit guarantees to investors in German debt. Anticipating the fate of the insurer AIG, they had issued what amounted to credit-default swaps, though that term had yet to be invented.

Eichengreen’s account will feel harsh to most of his protagonists. It is easy, with the benefit of hindsight, to fault Bernanke and his colleagues for allowing Lehman to go under; or to mock Mervyn King, the Bank of England governor, for failing to head off a run on the English lender Northern Rock. Of course, neither decision was straightforward in the chaos of the moment, and Lord King’s objection that a bailout would reward the reckless and penalize the prudent has at least some truth to it. But Eichengreen is severe for a good reason: he is unforgiving about the past because he does not want us to relive it. Just as Milton Friedman taught Ben Bernanke an invaluable lesson, so Eichengreen extends history’s contribution to the decisions of future crisis managers.

Indeed, one welcome consequence of the Great Recession is that Eichengreen-style economic history is enjoying a resurgence. The George Soros–backed Institute for New Economic Thinking is pushing for a redesign of university economics courses. The aim is to lighten up on math-heavy abstractions that fail to capture the messiness of human action, and prod students to contemplate how economies have worked in practice. To read history, to debate history, is to test our assumptions in the laboratory of real events; to learn, in the process, some appropriate humility about our capacity to forestall crises; and to grasp that extraordinary moments generally demand that ordinary assumptions be hurled out the window. Model-based social sciences, with their search for certainties that appear constant in large sets of data, teach neither humility nor flexibility. For this reason alone, a comparative study of the 1930s and 2000s should be part of every economics syllabus.