Bernanke Doctoral Dissertation

Some are born radical. Some are made radical. And some have radicalism thrust upon them. That is the way with Ben Bernanke, as he struggles to rescue the American financial system from collapse. Early every morning, weekends included, Bernanke arrives at the headquarters of the Federal Reserve, an austere white marble pile on Constitution Avenue in Foggy Bottom. The Fed, which is as hushed inside as a mausoleum, is a place of establishment reserve. Its echoing hallways are lined with sombre paintings. The office occupied by Bernanke, a soft-spoken fifty-four-year-old former professor, has high ceilings, several shelves of economics textbooks, and, on the desk, a black Bloomberg terminal. On a shelf in a nearby closet sits a scruffy gym bag, which in calmer days Bernanke took to the Fed gym, where he played pickup basketball with his staffers.

At Princeton, where Bernanke taught economics for many years, he was known for his retiring manner and his statistics-laden research on the Great Depression. For more than a year after he was appointed by President George W. Bush to chair the Fed, in February, 2006, he faithfully upheld the policies of his immediate predecessor, the charismatic free-market conservative Alan Greenspan, and he adhered to the central bank’s formal mandates: controlling inflation and maintaining employment. But since the market for subprime mortgages collapsed, in the summer of 2007, the growing financial crisis has forced Bernanke to intervene on Wall Street in ways never before contemplated by the Fed. He has slashed interest rates, established new lending programs, extended hundreds of billions of dollars to troubled financial firms, bought debt issued by industrial corporations such as General Electric, and even taken distressed mortgage assets onto the Fed’s books. (In March, to facilitate the takeover by J. P. Morgan of Bear Stearns, a Wall Street investment bank that was facing bankruptcy, the Fed acquired twenty-nine billion dollars’ worth of Bear Stearns’s bad mortgage assets.) These moves hardly amount to a Marxist revolution, but, in the eyes of many economists, including supporters and opponents of the measures, they represent a watershed in American economic and political history. Ben Bernanke, who seemed to have been selected as much for his predictability as for his economic expertise, is now engaged in the boldest use of the Fed’s authority since its inception, in 1913.

Bernanke, working closely with Henry (Hank) Paulson, the Treasury Secretary, a voluble former investment banker, was determined to keep the financial sector operating long enough so that it could repair itself—a policy that he and his Fed colleagues referred to as the “finger-in-the-dike” strategy. As recently as Labor Day, he believed that the strategy was working. The credit markets remained open; the economy was still expanding, if slowly; oil prices were dropping; and there were tentative signs that house prices were stabilizing. “A lot can still go wrong, but at least I can see a path that will bring us out of this entire episode relatively intact,” he told a visitor to his office in August.

By mid-September, however, the outlook was much grimmer. On Monday, September 15th, Lehman Brothers, another Wall Street investment bank that had made bad bets on subprime mortgage securities, filed for bankruptcy protection, after Bernanke, Paulson, and the bank’s senior executives failed to find a way to save it or to sell it to a healthier firm. During the next forty-eight hours, the Dow Jones Industrial Average fell nearly four hundred points; Bank of America announced its purchase of Merrill Lynch; and American International Group, the country’s biggest insurance company, began talks with the New York Fed about a possible rescue. Goldman Sachs and Morgan Stanley, the two wealthiest investment banks on Wall Street, were also in trouble. Their stock prices tumbled as rumors circulated that they were having difficulty borrowing money. “Both Goldman and Morgan were having a run on the bank,” a senior Wall Street executive told me. “People started withdrawing their balances. Counterparties started insisting that they post more collateral.”

The Fed talked with Wall Street executives about creating a “lifeline” for Goldman Sachs and Morgan Stanley, which would have given the firms greater access to central-bank funds. But Bernanke decided that even more drastic action was needed. On Wednesday, September 17th, a day after the Fed agreed to inject eighty-five billion dollars of taxpayers’ money into A.I.G., Bernanke asked Paulson to accompany him to Capitol Hill and make the case for a congressional bailout of the entire banking industry. “We can’t keep doing this,” Bernanke told Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”

Paulson agreed. A bailout ran counter to the Bush Administration’s free-market principles and to his own belief that reckless behavior should not be rewarded, but he had worked on Wall Street for thirty-two years, most recently as the C.E.O. of Goldman Sachs, and had never seen a financial crisis of this magnitude. He had come to respect Bernanke’s judgment, and he shared his conviction that, in an emergency, pragmatism trumps ideology. The next day, the men decided, they would go see President Bush.

On October 3rd, Congress passed an amended bailout bill, giving the Secretary of the Treasury broad authority to purchase from banks up to seven hundred billion dollars in mortgage assets, but the turmoil on Wall Street continued. Between October 6th and October 10th, the Dow suffered its worst week in a hundred years, falling eighteen per cent. As the selling spread to overseas markets, the Fed’s failure to save Lehman Brothers was roundly condemned. Christine Lagarde, the French finance minister, described it as a “horrendous” error that threatened the global financial system. Richard Portes, an economist at the London Business School, wrote in the Financial Times, “The U.S. authorities’ decision to let Lehman Brothers fail will be severely criticised by financial historians—the next generation of Bernankes.” Even Alan Blinder, an old friend and former colleague of Bernanke’s in the economics department at Princeton, who served as vice-chairman of the Fed from 1994 to 1996, was critical. “Maybe there were arguments on either side before the decision,” he told me. “After the fact, it is extremely clear that everything fell apart on the day Lehman went under.”

The most serious charge against Bernanke and Paulson is that their response to the crisis has been ad hoc and contradictory: they rescued Bear Stearns but allowed Lehman Brothers to fail; for months, they dismissed the danger from the subprime crisis and then suddenly announced that it was grave enough to justify a huge bailout; they said they needed seven hundred billion dollars to buy up distressed mortgage securities and then, in October, used the money to purchase stock in banks instead. Summing up the widespread frustration with Bernanke, Dean Baker, the co-director of the Center for Economic and Policy Research, a liberal think tank in Washington, told me, “He was behind the curve at every stage of the story. He didn’t see the housing bubble until after it burst. Until as late as this summer, he downplayed all the risks involved. In terms of policy, he has not presented a clear view. On a number of occasions, he has pointed in one direction and then turned around and acted differently. I would be surprised if Obama wanted to reappoint him when his term ends”—in January, 2010.

Bernanke and Paulson’s reversals have been deeply unsettling, perhaps especially so for the millions of Americans who have lost jobs or defaulted on mortgages so far this year. And yet, for the past year and a half, the government has confronted a financial debacle of unprecedented size and complexity. “Everyone knew there were issues and potential problems,” John Mack, the chairman and chief executive of Morgan Stanley, told me. “Nobody knew the enormity of it, how global it was and how deep it was.” In responding to the crisis, Bernanke has effectively transformed the Fed into an Atlas for the financial sector, extending more than $1.5 trillion in loans to troubled banks and investment firms, and providing financial guarantees worth roughly another $1.5 trillion, making it global capitalism’s lender of first and last (and sometimes only) resort.

“Under Ben’s leadership, we have felt compelled to create a new playbook for the Fed,” Kevin Warsh, a Fed governor who has worked closely with Bernanke, told me. “The circumstances of the last year caused us to cross more lines than this institution has crossed in the previous seventy years.” Paul Krugman, the Times columnist, a former colleague of Bernanke’s at Princeton, and the winner of this year’s Nobel Prize in Economics, said, “I don’t think any other central banker in the world would have done as much by way of expanding credit, putting the Fed into unconventional assets, and so on. Now, you might say that it all hasn’t been enough. But I guess I think that’s more a reflection of the limits to the Fed’s power than of Bernanke getting it wrong. And things could have been much worse.”

Six and a half years ago, Bernanke was a little-known professor living in Montgomery Township, a hamlet near Princeton. Long hours, enormous stress, and constant criticism have left him looking pale and drawn. “Ben is a very decent and sincere person,” Richard Fisher, the president of the Dallas Fed, told me. “The question is, Is that an asset or a liability in his job? If he were six feet seven, like Paul Volcker”—a former Fed chairman—“that would be a big advantage. If he was a tough S.O.B., like Jerry Corrigan”—a former head of the New York Fed, who successfully managed a previous financial crisis, in 1987—“that would be a big advantage. But you make do with what you have—a prodigious brain, a tremendous knowledge of past financial crises, and a personality that is above reproach. And you surround yourself with good people and use their expertise.”

As Fed chairman, Bernanke inherited an unprecedented housing bubble and an unsustainable borrowing spree. The collapse of these phenomena occurred with astonishing speed and violence. The only precursor for the current financial crisis is the Great Depression, but even that isn’t a very good comparison. In the nineteen-thirties, the financial system was much less sophisticated and interconnected. In dealing with problems affecting arcane new financial products, including “collateralized debt obligations,” “credit default swaps,” and “tri-party repos,” Bernanke and his colleagues have had to become expert in market transactions of baffling intricacy.

Bernanke grew up in Dillon, South Carolina, an agricultural town just across the state line from North Carolina, where, in 1941, his paternal grandfather, Jonas Bernanke, a Jewish immigrant from Austria, founded the Jay Bee Drugstore, subsequently operated by Ben’s father and an uncle. The eldest of three siblings, Bernanke learned to read in kindergarten and skipped first grade. When he was eleven, he won the state spelling championship and went to Washington to compete in the National Spelling Bee. He made it to the second round, but stumbled on the word “edelweiss,” an Alpine flower featured in “The Sound of Music.” He hadn’t seen the movie, because Dillon didn’t have a movie theatre. Had he spelled the word correctly and won the competition, Bernanke tells friends, he would have appeared on “The Ed Sullivan Show,” which was his dream.

In high school, Bernanke taught himself calculus, submitted eleven entries to a state poetry contest, and played alto saxophone in the marching band. During his junior year, he scored 1590 out of 1600 on his S.A.T.s—the highest score in South Carolina that year—and the state awarded him a trip to Europe. In the fall of 1971, he entered Harvard, where he wrote a prize-winning senior thesis on the economic effects of U.S. energy policy. After graduating, he enrolled at M.I.T., whose Ph.D. program in economics was rated the best in the country. His doctoral thesis was a dense mathematical treatise on the causes of economic fluctuations. He accepted a job at the Stanford Graduate School of Business, where Anna Friedmann, a Wellesley senior whom Bernanke married the weekend after she graduated, had been admitted into the master’s program in Spanish.

The couple lived in Northern California for six years, until Princeton awarded Bernanke, then just thirty-one, a tenured position. Settling in Montgomery Township, they brought up two children: Joel, who is now twenty-five and applying to medical school, and Alyssa, a twenty-two-year-old student at St. John’s College. By 2001, Bernanke was the editor of the American Economic Review and the co-author, with Robert Frank, of “Principles of Economics,” a well-regarded college textbook. His scholarly interests ranged from abstruse matters such as the theoretical merits of setting a formal inflation target to historical questions, including the causes of the Great Depression. Even when Bernanke was writing about historical events, much of his scholarship was couched in impenetrable technical language. “I always thought that Ben would stay in academia,” Mark Gertler, an economist at New York University who has known Bernanke well since 1979, told me. “But two things happened.”

In 1996, Bernanke became chairman of the Princeton economics department, a job many professors regard as a dull administrative diversion from their real work. Bernanke, however, embraced the chairmanship, staying on for two three-year terms. Under his stewardship, the department launched new programs and hired leading scholars, among them Paul Krugman, whom Bernanke wooed personally. Bernanke also bridged a long-standing departmental divide between theorists and applied researchers, in part by raising enough money so that the two sides could coexist peaceably, and by engaging in diplomacy. “Ben is very good at respecting minority opinion and giving people the feeling they have been heard in the debate even if they get outvoted,” Alan Blinder said.

The other event that changed Bernanke’s career occurred in the summer of 1999, at the height of the Internet stock boom, when he and Gertler were invited to present a paper at an annual policy conference organized by the Federal Reserve Bank of Kansas City. The topic of the conference—which takes place at a resort in Jackson Hole, Wyoming—was New Challenges for Monetary Policy. Then, as now, there was vigorous debate among economists about whether central banks should raise interest rates to counter speculative bubbles. By increasing the cost of borrowing, the Fed, at least in theory, can restrain speculative activity and prevent the prices of assets such as stocks and real estate from rising excessively.

Bernanke and Gertler argued that the Fed should ignore bubbles and stick to its traditional policy of controlling inflation. If a bubble inflated and burst of its own accord, they said, the Fed could always bring down rates to alleviate damage to the broader economy. To support their case, they presented a series of computer simulations, which appeared to show that a policy of targeting inflation stabilized the economy more effectively than one that targeted bubbles. The presentation got a mixed reception. Henry Kaufman, a well-known Wall Street economist, said that it would be irresponsible for the Fed to ignore rampant speculation. Rudi Dornbusch, an M.I.T. professor (who has since died), pointed out that Bernanke and Gertler had overlooked the possibility that credit could dry up after a bubble burst, and that such a development could have serious effects on the economy. But Greenspan was more supportive. “He didn’t say anything during the session,” Gertler recalled. “But after it was over he walked by and said, as quietly as he could, ‘You know, I agree with you.’ That had us in seventh heaven.”

In December, 1996, Greenspan had warned that investors could fall victim to “irrational exuberance.” Subsequently, though, he had adopted a policy of benign neglect toward the stock market, ignoring warnings that a bubble in technology and Internet stocks had developed. The paper by Bernanke and Gertler provided theoretical support for Greenspan’s stance, and it received a good deal of publicity, something neither of its authors had previously experienced. “Ben was a bit taken aback by the public attention,” Gertler said. “The Economist attacked us viciously.”

In 2002, when the Bush Administration was looking to fill two vacant governorships at the Fed—there are seven in all—Glenn Hubbard, who is the dean of Columbia Business School and who was then the chairman of the White House Council of Economic Advisers, proposed Bernanke. “We needed a strong economist who understood the financial markets, and Ben had expertise in that area,” Hubbard recalled. “He is also an extremely nice person. In terms of getting on with people, he is very affable, and I thought that would help him, too.”

Although the Fed is an independent agency, it is subject to congressional oversight, and Presidents typically appoint people who are sympathetic to their world view. Hubbard knew little about Bernanke’s politics. “I was aware he was an economic conservative, but I didn’t know whether he was a Republican,” Hubbard said. Robert Frank, a liberally inclined economist at Cornell and Bernanke’s co-author on “Principles of Economics,” believed that Bernanke was a Democrat. When the White House announced that it was nominating Bernanke to be a Fed governor, Frank was shocked. “I asked Ben, ‘Why is Bush appointing a Democrat?’ ” Frank told me. “He said, ‘Well, I’m not a Democrat.’ ’’ In writing their book, Frank was impressed not only by Bernanke’s openness to opposing views but also by his wry humor and his lack of ego. “In most situations, he is the smartest guy in the room, but he doesn’t seem too eager to show that,” Frank said.

When Bernanke joined the Fed, it was struggling to revive the economy after the Nasdaq collapse of 2000-01 and the terrorist attacks of September 11, 2001. Between September, 2001, and June, 2003, Greenspan and his colleagues cut the federal funds rate—the key interest rate under the Fed’s control—from 3.5 per cent to one per cent, its lowest level since the nineteen-fifties. Cutting interest rates during an economic downturn is standard policy at the Fed; lower borrowing costs encourage households and businesses to spend more. But Greenspan’s rate reductions were unusual in both their scale and their longevity. The Fed didn’t reverse course until the summer of 2004, and even then it moved slowly, raising the federal funds rate in quarter-point increments.

With cheap financing readily available, a housing boom developed. Families bought homes they couldn’t have afforded at higher interest rates; speculators bought properties to flip; people with modest incomes or poor credit took out mortgages designed for marginal buyers, such as subprime loans, interest-only loans, and “Alt-A” loans. On Wall Street, a huge market evolved in subprime mortgage bonds—securities backed by payment streams from dozens or hundreds of individual subprime mortgages. Banks and other mortgage lenders relaxed their credit standards, knowing that many of the loans they issued would be bundled into mortgage securities and sold to investors.

“The Fed’s easy-money policy put a lot of the wind at the back of some of the transactions in the housing market and elsewhere that we are now suffering from,” Glenn Hubbard told me. Before leaving government, in 2003, Hubbard argued in White House meetings that the Fed needed to start raising rates. “It was particularly striking for the Fed to maintain an accommodative policy after the 2003 tax cut, which gave another boost to the economy,” Hubbard said. “That was a significant error.”

Greenspan dominated the Federal Open Market Committee (F.O.M.C.), which sets the federal funds rate, but Bernanke explained and defended the Fed’s actions to other economists and to the public. In October, 2002, a few months after joining the Fed, he gave a speech to the National Association for Business Economics, in which he said, “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” In other words, it is difficult to distinguish a rise in asset prices that is justified by a strong economy from one based merely on speculation, and raising rates in order to puncture a bubble can bring on a recession. Greenspan had made essentially this argument during the dot-com era and reiterated it during the real-estate boom. (As late as 2004, Greenspan said that a national housing bubble was unlikely.)

As house prices soared, many Americans took out home-equity loans to finance their spending. The personal savings rate dipped below zero, and the trade deficit, which the United States financed by borrowing heavily from abroad, expanded greatly. Some experts warned that the economy was on an unsustainable course; Bernanke disagreed. In a much discussed speech in March, 2005, he argued that the main source of imbalance in the global economy was not excess spending at home but, rather, excess saving in China and other developing countries, where consumption was artificially low. Lax American policy was helping to mop up a “global savings glut.”

“Bernanke provided the intellectual justification for the Fed’s hands-off approach to asset bubbles,” Stephen S. Roach, the chairman of Morgan Stanley Asia, who was among the economists urging the Fed to adjust its policy, told me. “He also played a key role in the development of the ‘global savings glut’ theory, which the Fed used as a very convenient excuse to say we are doing the world a big favor in maintaining demand. In retrospect, we didn’t have a global savings glut—we had an American consumption glut. In both of those cases, Bernanke was complicit in massive policy blunders on the part of the Fed.”

Another expert who dissented from the Greenspan-Bernanke line was William White, the former economics adviser at the Bank for International Settlements, a publicly funded organization based in Basel, Switzerland, which serves as a central bank for central banks. In 2003, White and a colleague, Claudio Borio, attended the annual conference in Jackson Hole, where they argued that policymakers needed to take greater account of asset prices and credit expansion in setting interest rates, and that if a bubble appeared to be developing they ought to “lean against the wind”—raise rates. The audience, which included Greenspan and Bernanke, responded coolly. “Ben Bernanke really believes that it is impossible to lean against the wind on the way up and that it is possible to clean up the mess afterwards,” White told me recently. “Both of these propositions are unproven.”

Between 2004 and 2007, White and his colleagues continued to warn about the global credit boom, but they were largely ignored in the United States. “In the field of economics, American academics have such a large reputation that they sweep all before them,” White said. “If you add to that the personal reputation of the Maestro”—Greenspan—“it was very difficult for anybody else to come in and say there are problems building.”

After years of theorizing about the economy, Bernanke revelled in the opportunity to participate in policy decisions, though he rarely challenged Greenspan. “He wouldn’t have gotten into that club if he didn’t go along,” Douglas Cliggott, the chief investment officer at Dover Investment Management, a mutual-fund firm, told me. “Mr. Greenspan ran a tight ship, and he didn’t fancy people spouting off with their own views.” In January, 2005, Bernanke gave a speech at the annual meeting of the American Economic Association, in which he reflected on his transition from teaching: “The biggest downside of my current job is that I have to wear a suit to work. Wearing uncomfortable clothes on purpose is an example of what former Princeton hockey player and Nobel Prize winner Michael Spence taught economists to call ‘signalling.’ You have to do it to show that you take your official responsibilities seriously. My proposal that Fed governors should signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts has so far gone unheeded.”

A month later, Greg Mankiw, the chairman of the Council of Economic Advisers, announced that he was returning to Harvard, and recommended Bernanke as his replacement. Al Hubbard, an Indiana businessman who headed the National Economic Council, which advises the President on economic policy, wasn’t convinced that Bernanke was the right choice. “When you meet him, he comes over as incredibly quiet,” Hubbard told me. “I wanted to make sure he was somebody who wouldn’t be reluctant to engage in the economic arguments.” After talking with Bernanke, Hubbard changed his mind. “He’s actually very self-confident, and he’s not intimidated by anybody,” Hubbard said. “You could always count on him to speak up and give his opinion from an economic perspective.”

In June, 2005, Bernanke was sworn in at the Eisenhower Executive Office Building. One of his first tasks was to deliver a monthly economics briefing to the President and the Vice-President. After he and Hubbard sat down in the Oval Office, President Bush noticed that Bernanke was wearing light-tan socks under his dark suit. “Where did you get those socks, Ben?” he asked. “They don’t match.” Bernanke didn’t falter. “I bought them at the Gap—three pairs for seven dollars,” he replied. During the briefing, which lasted about forty-five minutes, the President mentioned the socks several times.

The following month, Hubbard’s deputy, Keith Hennessey, suggested that the entire economics team wear tan socks to the briefing. Hubbard agreed to call Vice-President Cheney and ask him to wear tan socks, too. “So, a little later, we all go into the Oval Office, and we all show up in tan socks,” Hubbard recalled. “The President looks at us and sees we are all wearing tan socks, and he says in a cool voice, ‘Oh, very, very funny.’ He turns to the Vice-President and says, ‘Mr. Vice-President, what do you think of these guys in their tan socks?’ Then the Vice-President shows him that he’s wearing them, too. The President broke up.”

As chairman of the Council of Economic Advisers, Bernanke was expected to act as a public spokesman on economic matters. In August, 2005, after briefing President Bush at his ranch in Crawford, Texas, he met with the White House press corps. “Did the housing bubble come up at your meeting?” a reporter asked. “And how concerned are you about it?”

Bernanke affirmed that it had and said, “I think it is important to point out that house prices are being supported in very large part by very strong fundamentals. . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas. And those supply-and-demand factors are a big reason why house prices have risen as much as they have.”

By this time, the President’s ambitious plans to partly privatize Social Security had been stymied by congressional opposition, and his plans to simplify the tax system appeared likely to meet a similar fate. Nevertheless, the White House economics team was searching for market-friendly policy proposals, and Bernanke was happy to contribute. On the flight from Crawford to Washington, D.C., he and Hennessey discussed replacing tax subsidies to employer-based health-insurance plans with a fixed tax credit or deduction that families could use to buy their own coverage. In Washington, they continued to develop the idea, which proved popular with economic conservatives, though some experts have said it would lead to a dramatic drop in employer-provided health plans. “It’s what we proposed, and it’s what John McCain proposed,” Al Hubbard said. “If we can keep health care in the private sector, it is what eventually will happen. Ben and Keith are the guys who came up with it.”

From the moment Bernanke went to work for Bush, he was seen as a likely successor to Greenspan, who was due to retire in January, 2006. Shortly after Labor Day, 2005, at Bush’s request, Al Hubbard and Liza Wright, the White House personnel director, compiled a list of eight or ten candidates for the Fed chairmanship and interviewed several of them. The selection committee eventually settled on Bernanke. “An important part of the Fed job is bringing people along with you, on the F.O.M.C. and so on,” Hubbard told me. “He had the right personality to do that. Plus, Ben is a very powerful thinker. We were impressed with his theories of the world and the way he thinks. He believes in free markets.”

Some press reports have suggested that the public controversy over the abortive nomination to the Supreme Court of Harriet Miers, the White House counsel, helped Bernanke’s chances, because it put pressure on the Administration to appoint a nonpartisan figure to the Fed. “That was never even discussed,” Hubbard insisted to me. “We didn’t take account of Harriet Miers or anything else. There was no politics involved.” On October 24, 2005, President Bush nominated Bernanke as the fourteenth chairman of the Fed, saying, “He commands deep respect in the global financial community.” After thanking the President, Bernanke said that if the Senate confirmed him his first priority would be “to maintain continuity with the policies and policy strategies established during the Greenspan years.”

F or more than a year, Bernanke kept his word. In the first half of 2006, the F.O.M.C. raised the federal funds rate in three quarter-point increments, to 5.25 per cent, and kept it there for the rest of the year. But cheap money was only part of Greenspan’s legacy. He had also championed financial deregulation, resisting calls for tighter government oversight of burgeoning financial products, such as over-the-counter derivatives, and applauded the growth of subprime mortgages. “Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risks posed by individual applicants and to price that risk appropriately,” Greenspan said in a 2005 speech.

Bernanke hadn’t said much about regulation before being nominated as the Fed chairman. Once in office, he generally adhered to Greenspan’s laissez-faire approach. In May, 2006, he rejected calls for direct regulation of hedge funds, saying that such a move would “stifle innovation.” The following month, in a speech on bank supervision, he expressed support for allowing banks, rather than government officials, to determine how much risk they could take on, using complicated mathematical models of their own devising—a policy that had been in place for a number of years. “The ongoing work on this framework has already led large, complex banking organizations to improve their systems for identifying, measuring, and managing their risks,” Bernanke said.

It is now evident that self-regulation failed. By extending mortgages to unqualified lenders and accumulating large inventories of subprime securities, banks and other financial institutions took on enormous risks, often without realizing it. Their mathematical models failed to alert them to potential perils. Regulators—including successive Fed chairmen—failed, too. “That was largely Greenspan, but Bernanke clearly shared an ideology of taking a hands-off approach,” Stephen Roach, of Morgan Stanley Asia, said. “In retrospect, it is unconscionable that the Fed didn’t really care about regulation, or didn’t show any interest in it.”

Bernanke was more concerned about inflation and unemployment, the Fed’s traditional areas of focus, than he was about the growth of mortgage securities. “The U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding years to a more sustainable, average pace of growth,” he told the Senate banking committee in February, 2007. By then, home prices in many parts of the country had begun to drop. At least two prominent economists—Nouriel Roubini, at N.Y.U., and Joseph Stiglitz, at Columbia—had warned that a nationwide housing slump could trigger a recession, but Bernanke and his colleagues thought this was unlikely. “You could think about Texas in the nineteen-eighties, when oil prices went down, or California in the nineteen-nineties, when the peace dividend hit the defense industry, but these were regional things,” one Fed policymaker told me. “A national decline in house prices hadn’t occurred since the nineteen-thirties.”

On February 28, 2007, Bernanke told the House budget committee that he didn’t consider the housing downturn “as being a broad financial concern or a major factor in assessing the state of the economy.” He maintained an upbeat tone over the next several months, during which two large subprime lenders, New Century Financial Corp. and American Home Mortgage, filed for bankruptcy, and the damage spread to Wall Street firms that had invested in subprime securities. On August 3rd, the day after American Home Mortgage announced that it was shutting down, the Dow fell almost three hundred points, and CNBC’s Jim Cramer, in a four-minute rant that is still playing on YouTube, accused the Fed of being “asleep.”

“Bernanke is being an academic,” Cramer bellowed. “He has no idea how bad it is out there! . . . My people have been in this game for twenty-five years, and they are losing their jobs, and these firms are going to go out of business, and he’s nuts! They’re nuts! They know nothing!”

Four days later, the F.O.M.C. met, but left the federal funds rate unchanged. In a statement, the committee acknowledged the housing “correction” but said that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.” Looking back on this period, Bernanke told me, “I and others were mistaken early on in saying that the subprime crisis would be contained. The causal relationship between the housing problem and the broad financial system was very complex and difficult to predict.” Relative to the fourteen trillion dollars in mortgage debt outstanding in the United States, the two-trillion-dollar subprime market seemed trivial. Moreover, internal Fed estimates of the total losses likely to be suffered on subprime mortgages were roughly equivalent to a single day’s movement in the stock market, hardly enough to spark a financial conflagration.

One of the supposed advantages of securitizing mortgages was that it allowed the risk of homeowners’ defaulting on their mortgages to be transferred from banks to investors. However, as the market for mortgage securities deteriorated, many banks ended up accumulating big inventories of these assets, some of which they parked in off-balance-sheet vehicles called conduits. “We knew that banks were creating conduits,” Don Kohn, the Fed’s vice-chairman, told me. “I don’t think we could have recognized the extent to which that could come back onto the banks’ balance sheets when confidence in the underlying securities—the subprime loans—began to erode.”

On August 9, 2007, the crisis escalated significantly after BNP Paribas, a major French bank, temporarily suspended withdrawals from three of its investment funds that had holdings of subprime securities, citing a “complete evaporation of liquidity in certain market segments of the U.S. securitization market.” In other words, trading in the mortgage securities market had ceased, leaving many financial institutions short of cash and saddled with assets that they couldn’t sell at any price. Stocks fell sharply on both sides of the Atlantic, and the following day Bernanke held a conference call with members of the F.O.M.C., during which they discussed reducing the interest rate at which the Fed lends to commercial banks—the “discount rate.” Since the Fed was founded, it has had a “discount window,” from which commercial banks may borrow as needed. In recent years, however, most banks had stopped using the window, because they could raise money more cheaply from investors and other banks.

The Fed decided to keep the discount rate at 6.25 per cent but issued a statement reminding banks that the discount window was open if they needed money. Seven days later, however, after more wild swings in the markets, the Fed voted to cut the discount rate by half a point, to 5.75 per cent. It declared that it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”

Bernanke now realized that the subprime crisis posed a grave threat to some of the country’s biggest financial institutions and that Greenspan-era policies were insufficient to contain it. In the third week of August, he made his second visit as head of the Fed to Jackson Hole, where he invited some of his senior colleagues to join him in a brainstorming session. “What’s going on and what do we need to do?” he asked. “What tools have we got and what tools do we need?”

Submitted by David Stockman via Contra Corner blog,

In explaining to the FT’s Martin Wolf why he bailed out the Wall Street gamblers at Goldman Sachs and Morgan Stanley while crushing millions of ordinary American savers and retirees, Bernanke typically repaired to his go to argument. It had nothing to do with the mild excesses of inventories and labor that had built up in the main street economy owing to the Greenspan housing and credit boom, as explained in Part 1.

That’s because Bernanke was not aiming to ameliorate the mild economic liquidation that ensued after the Lehman event; and which, as previously demonstrated, would have runs its course and self-corrected without any help from the Fed in any event.

No, Ben S. Bernanke will be someday remembered as the world’s most destructive battleship admiral. Not only was he fighting the last war, but his whole multi-trillion money printing campaign after September 15, 2008 was aimed at avoiding an historical Fed mistake that had never even happened!

As Bernanke explained it:

I should have done more (to mitigate anti-Fed sentiments). But I was very much engaged in trying to put out the fire. So I don’t know what to say. It was kind of predictable. The Federal Reserved failed in the 1930s. I think we did much better than in the 1930s.

The claim that the Fed resorted to “extraordinary policies” of ZIRP and QE because it was fighting a recurrence of Great Depression 2.0 is completely, profoundly, unequivocally and destructively wrong.

It is the giant fig leaf that obscures what really happened during and after the crisis. Namely, that the main street economy recovered on its own, and that the flood of money generated by Bernanke never left the canyons of Wall Street, thereby causing the destruction of honest price discovery in the financial markets once and for all.

So doing, the Fed and other central banks have turned financial markets into dangerous, unstable casinos. In the name of precluding the contra-factual——that is, Great Depression 2.0—-they have generated the mother of all financial bubbles.

There is no other possible outcome than another thundering crash after upwards of 90 months of free money subsidy to the carry trade gamblers and upwards of $19 trillion of rank monetization of the public debt and other existing assets by the Fed and its central bank fellow travelers.

At the end of the day, however, the monetary mayhem that was unloosed in September 2008 is the responsibility of two professors of economics who got the causes of the 1930-1933 collapse of the US economy completely wrong. In the excerpts below from the Great Deformation, I refute the two great myths that still pop out of journalists’ keyboards whenever the events of September 2008 are touched upon.

To wit, first, the Fed did not cause the banking crisis of 1930-1933 by failing to undertake a massive bond-buying campaign; and secondly, the banking system was rotten to the core with bad loans and insolvency after the artificial boom of World War I and the follow-on bubbles of the Roaring Twenties. It could not have been fixed with a 1930s version of QE or any other massive intrusion of the central bank.


At the end of the day, Friedman jettisoned the gold standard for a remarkably statist reason. Just as Keynes had been, he was afflicted with the economist’s ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.

There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.

Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers (e.g. Greenspan and Bernanke) to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconven- ience of funding more government with more taxes.

Friedman also said democracy would thrive better under a regime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more antidemocratic than Keynes’ methods. Fiscal policy action was at last subject to the deliberations of the legislature and, in come vague sense, electoral review by the citizenry.

By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged speculators——-and against savers, wage earners, and equity financed businessmen——-the latter had no recourse from its baleful policy actions.

The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.

Consequently, the difference between a “banker’s bank” running a discount window service and a central bank engaged in continuous open market operations was fundamental and monumental, not merely a question of technique. By facilitating a better alignment of liquidity between the asset and liability side of the balance sheets of fractional reserve deposit banks, the original “reserve banks” of the 1913 act would, arguably, improve banking efficiency, stability, and utilization of systemwide reserves.

Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy. Obviously, such a discount window–based system could have no pretensions at all as to managing the macroeconomic aggregates such as produc- tion, spending, and employment.

In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates. The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington.

Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1?

There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed during 1929–1933 had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash.

Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank.

Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves. Conse- quently, commercial banks were not constrained at all in their ability to make loans orgenerate demand deposits (M1).

But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. And this post facto academician’s edict went straight to the heart of the open market operations issue.

The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits. By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.

Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. Needless to say, the historic data show this proposition to be essentially farcical, and that the real-world ex- ercise in exactly this kind of bank reserve flooding maneuver conducted by the Bernanke Fed forty years later has been a total failure—a monumental case of “pushing on a string.”


The historical truth is that the Fed’s core mission of that era, to rediscount bank loan paper, had been carried out consistently, effectively, and fully by the twelve Federal Reserve banks during the crucial forty-five months between the October 1929 stock market crash and FDR’s inauguration in March 1933.

And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.

More crucially, the “excess reserves” in the banking system grew dramatically during this forty-five-month period, implying just the opposite of monetary stringency. Prior to the stock market crash in September 1929, excess reserves in the banking system stood at $35 million, but then rose to $100 million by January 1931 and ultimately to $525 million by January 1933.

In short, the tenfold expansion of excess (i.e., idle) reserves in the banking system was dramatic proof that the banking system had not been parched for liquidity but was actually awash in it.The only mission the Fed failed to perform is one that Professor Friedman assigned to it thirty years after the fact; that is, to maintain an arbitrary level of M1 by forcing reserves into the banking system by means of open market purchases of Uncle Sam’s debt.

As it happened, the money supply (M1) did drop by about 23 percentduring the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits (the bulk of M1) did not represent a squeeze on money. It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period.

As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. Bank loans outstanding, in fact, had grown at manic rates during the previous fifteen years, nearly tripling from $14 billion in 1914 to $42 billion by 1929. As in most credit- fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October 1929.

Consequently, during the aftermath of the crash upward of $20 billion of bank loans were liquidated, including billions of write-offs due to business failures and foreclosures. As previously explained, nearly half of the loan contraction was attributable to the $9 billion of stock market margin loans which were called in when the stock market bubble collapsed in 1929.

Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production. Again, this was the passive consequence of the bursting industrial and export sector bubble, not something caused by the Fed’s failure to supply sufficient bank reserves. In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank.

In fact, there has never been any wide-scale evidence that bank loans outstanding declined during 1930–1933 on account of banks calling performing loans or denying credit to solvent potential borrowers. Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression.

Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Since the wholesale price level had fallen sharply during the forty-five months after the crash, they claimed that “real” interest rates were inordinately high after adjusting for deflation.

Yet this is academic pettifoggery. Real-world businessmen confronted with plummeting order books would have eschewed new borrowing for the obvious reason that they had no need for funds, not because they deemed the “deflation-adjusted” interest rate too high.

At the end of the day, Friedman’s monetary treatise offers no evidence whatsoever and simply asserts false causation; namely, that the passive decline of the money supply was the active cause of the drop in output and spending. The true causation went the other way: the nation’s stock of money fell sharply during the post-crash period because bank loans are the mother’s milk of bank deposits. So, as bloated, insolvent loan books were cut down to sustainable size, the stock of deposit money (M1) fell on a parallel basis.

Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. It would have been required to purchase and monetize nearly every single dime of the $16 billion of US Treasury debt then outstanding.

Today’s incorrigible money printers undoubtedly would say, “No problem.” Yet there is no doubt whatsoever that, given the universal antipathy to monetary inflation at the time, such a move would have triggered sheer panic and bedlam in what remained of the financial markets. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.

Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in 1965 that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth.

In actual fact, by the bottom of the depression in 1932, interest rates proved the opposite. Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from credit-worthy borrowers.

The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. In September 1929 member banks borrowed nearly $1 billion at the discount windows, but by January 1933 this declined to only $280 million. In sum, banks were not lending because they were short of reserves; they weren’t lending because they were short of solvent borrowers and real credit demand.

In any event, Friedman’s entire theory of the Great Depression was thoroughly demolished by Ben S. Bernanke, his most famous disciple, in a real-world experiment after September 2008. The Bernanke Fed undertook massive open market operations in response to the financial crisis, purchasing and monetizing more than $2 trillion of treasury and agency debt.

As is by now transparently evident, the result was a monumental wheel-spinning exercise. The fact that there is now $2.7 trillion of “excess re- serves” parked at the Fed (compared to a mere $40 billion before the crisis) meant that nearly all of the new bank reserves resulting from the Fed’s bond-buying sprees have been stillborn.

By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in 1930–1932.

By contrast, the real cause of the Great Depression was the massive and unsustainable expansion of credit and bank lending during the Great War of 1914-1918, and the financial boom of 1924-1929.

*  *  *

Ironically, both of these credit bubbles were financed by the newly created Federal Reserve, as outlined in the additional sections from The Great Deformation. Indeed, even the famous banking crisis of 1933 was not what it is cracked-up to be. As explained below, both the recession and the banking crisis were over by the summer of 1932; a Hoover Recovery had actually begun.

Indeed, the banking holiday declared by FDR upon his inauguration was the result of a 10-day run on the banks that had been caused by his actions during February 1933. In short, Bernanke has spent the last 7-years claiming he stopped a bank run like that of the 1930s, when, in fact, the actual pre-Roosevelt bank run had nothing whatsoever to do with policy actions by the Federal Reserve:


FDR’s mortal blow to international monetary stability and world trade is the pattern through which the New Deal was shaped. Once Roosevelt went for domestic autarky, the New Deal was destined to be a one-armed bandit. It capriciously pushed, pulled, and reshuffled the supply side of the domestic economy, but it could not regenerate the external markets upon which the post-1914 American prosperity had vitally depended.

Herbert Hoover had been correct: the US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated. Indeed, the American economy had been thoroughly internationalized after August 1914 and had grown by leaps and bounds as a great export machine and prodigious banker to the world.

While it lasted, the export boom of 1914–1929 generated strong gains in growth had averaged nearly 4 percent annually, a rate that has never again been matched over a comparable length of time.

The trouble was that this prosperity was neither organic nor sustainable. In addition to the debt-financed demand for American exports, stock market winnings and the explosion of consumer debt generated exuberant but unsustainable household purchases of big-ticket durables at home. So when the stock market finally broke, this financially fueled chain of economic expansion snapped and violently unwound.

The first victim was the foreign bond market, which was the subprime canary in the coal mine of its day. Within a few months of the crash, new issuance had dropped 95 percent from its peak 1928 levels, causing foreign demand for US exports to collapse. Worse still, the price of the nearly $10 billion of foreign bonds outstanding also soon plunged to less than ten cents on the dollar, meaning that the collapse was of the same magnitude and speed as the subprime mortgage collapse of 2008.

Foreign debtors had been borrowing to pay interest. When the Wall Street music stopped in October 1929, the house of cards underlying the American export bonanza collapsed. By 1933, US exports had dropped by nearly 70 percent.

The Wall Street meltdown also generated ripples of domestic contraction which compounded the export swoon. Stock market lottery winners, for example, had been buying new automobiles hand over fist. But after sales of autos and trucks peaked at 5.3 million units in 1929, they then dropped like a stone to only 1.4 million vehicles in 1932. Needless to say, this 75 percent shrinkage of auto sales cascaded through the auto supply chain, including metal working, steel, glass, rubber, and machine tools—with devastating impact.

The collapse of these “growth” industries also caused a withering cutback in business investment. Plant and equipment spending tumbled by nearly 80 percent between 1929 and 1933, while nearly half of all the production inventories extant in 1929 were liquidated over the next three years. This unprecedented liquidation of working inventories—from $38 billion to $22 billion—amounted to nearly a 20 percent hit to GDP before the cycle reached bottom.

Overall, nominal GDP had been $103 billion in 1929 but by 1933 had shrunk to only $56 billion. Yet the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and equipment, and consumer durables. These components declined by $33 billion during the four years after 1929 and accounted for fully 70 percent of the decline in nominal GDP.

The underlying story in these data refutes the postwar Keynesian narrative about the Great Depression. What happened during 1929–1932 was not a mysterious loss of domestic “demand” that was somehow recoverable through enlightened macroeconomic stimulus policies. Instead, what occurred was an inevitable shrinkage in the unsustainable levels of output that had been reached by exports, durables, and a once-in-a-life-time capital investment boom, not unlike the massive China investment cycle of 1994–2015.

It was not the depression bottom level of GDP during 1932–1933 that was avoidably too low; it was the debt and speculation bloated GDP peak of 1929 that had been unsustainably too high. Accordingly, the problem could not be solved by macroeconomic pump-priming at home. The Great Depression was therefore never a candidate for the Keynesian cure which was inherently inward looking and nationalistic.

The frenetic activity of the first hundred days of the New Deal, of course, is the stuff of historians’ legends. Yet when viewed in the context of this implosion of the nation’s vastly inflated export/auto/capital goods sector, it’s evident that the real cure for depression did not lie in the dozens of acronym-ridden programs springing up in Washington.

Contrary to the long-standing Keynesian narrative, therefore, the New Deal contributed virtually nothing to the mild recovery which did materialize during the six-year run-up to war in 1939. In fact, the modest seesaw expansion which unfolded during that period had been already set in motion during the summer of 1932, well before FDR’s election.


The New Deal hagiographers never mention that 50 percent of the huge collapse of industrial production, that is, the heart of the Great Depression, had already been recovered under Hoover by September 1932. The catalyst for the Hoover recovery was not Washington-based policy machinations but the natural bottoming of the severe cycle of fixed-asset and inventory liquidation after 1929.

By mid-1932, the liquidation had finally run its course because inventories were virtually gone, and capital goods and durables production could hardly go lower. Accordingly, nearly every statistic of economic activity turned upward in July 1932. From then until the end of September, the Federal Reserve Board index of industrial production rose by 21 percent, while rail freight loadings jumped by 20 percent and construction contract awards rose by 30 percent.

Likewise, the American Federation of Labor’s published count of industrial unemployment dropped by nearly three-quarters of a million persons between July 1 and October 1. Retail sales and electrical power output also rose smartly in the months after July, and some core industry which had been nearly prostrate began to spring back to life.

Cotton textile mill manufacturing, for example, surged from 56 percent of capacity in July to 97 percent in October, and mill consumption of wool nearly tripled during the same period. Likewise, the giant US Steel Corporation, which then stood at the center of the nation’s industrial economy, recorded its first increase in sixteen months in its order backlog.

Related indicators also confirmed a broad and vigorous recovery. Wholesale prices rose by nearly 20 percent from their early 1932 bottom, marking the first sustained uptick since September 1929. The stock market quickly grasped the picture and rebounded from its depression low on the Dow Jones Index of 41 on July 7, 1932, to 80 in early September, before fears of a Roosevelt victory set it back.

The most important sign of economic rebound, however, was in the be- leaguered banking sector. After having experienced nearly three hundred bank closings per month for much of the post-1929 period, bank failures dropped sharply to only seventy to eighty closings a month after June.

Indeed, for the period of July through October 1932, deposits held by banks which were reopened during that interval exceeded those of newly failed banks, a complete break with the month-after-month deposit losses that had occurred until then. In a similar vein, the United States experienced five straight months of gold inflows after July, indicating that the panicked gold flight that had commenced after the British default of Sep- tember 1931 had decisively reversed.

As one careful journalistic reconstruction of events published during this period noted, “With the defeat of all threatening inflationary legislation in June . . . [and] the complete restoration of foreign confidence in the American gold position—the breath of recovery began to be felt over the land.”

No less an authority on the national mood than Walter Lippmann, then at the peak of his game and influence, later summarized, “There is very good statistical evidence . . . that as a purely economic phenomena the world depression reached its low point in mid-summer 1932 and that in all the leading countries a very slow but nevertheless real recovery began.”

By election time, however, the rebound had cooled. Subsequently, all the indicators of economic and financial activity weakened sharply during the long interregnum between Election Day and the March 4, 1933, inauguration.

As outlined below, there is powerful evidence that this setback can be attributed to a “Roosevelt panic” in the gold and banking markets that was avoidable and the result of FDR’s numerous errors and provocations during the presidential interregnum. The fact is, every other major industrial country in the world also began to recover in July 1932, but none had a relapse back into depression during the winter of 1932–1933.


The Hoover recovery has largely been omitted from the history books, fostering the impression that the American economy had continuously plunged after October 1929 until it reached a desperate bottom on exactly March 4, 1933. That rendition of events was far from accurate, but it did mightily burnish the Roosevelt miracle legend; namely, that FDR decisively reopened the frozen banking system, restarted the wheels of commerce, and restored a heartbeat to capitalism through the swarm of acronyms which flew out of New Deal Washington during the Hundred Days.

But the received version of the March 1933 banking crisis is an invention of Arthur Schlesinger Jr. and other postwar commentators who postulated FDR’s “bank holiday” as the dividing line between Hooverian darkness and the Roosevelt miracles. By contrast, the most savvy and erudite financial observers at the time saw it far differently, and for a very good reason: on the Friday evening before Roosevelt’s inauguration most of the US banking system was still solvent, including the great money center banks of New York: the Chase National Bank, First National City Bank, the Morgan Bank, and many more.

Indeed, the latter had to be practically coerced into agreeing to the New York State banking holiday signed into effect by Governor Lehman at 4:30 a.m. in the wee hours before FDR’s inauguration. As it happened, the governor was a scion of the banking house bearing his name, but the circumstances of 1933 were the opposite of those which accompanied its demise in 2008.

Back then there had been no bank runs in the canyons of Wall Street because the great banks had largely observed time-tested standards; that is, they had been fully and adequately collateralized on their stock loans and were sitting on cash reserves up to 20 percent of deposits. The stock market crash of 1929–1930 had been brutal, of course, but in those purportedly be- nighted times officialdom had the good sense to allow Mr. Market to make his appointed rounds.

Accordingly, stock market punters by the thousands had been felled quickly and cleanly when upward of $9 billion of margin loans were called after Black Thursday. Indeed, the banks and brokerages liquidated in a matter of months the massive margin loan bubble—$1 trillion in today’s economy—that had built up under the stock averages in the final years of the mania.

The fact that none of the great New York money center banks closed their doors during the four years between the crash and FDR’s inauguration points to the real story; namely, that the bank insolvency problem had been in the provinces and countryside, not the nation’s money center.

In fact, the run of bank failures was largely contained within the borders of the oversized 1914–1929 agricultural and industrial export economy. As the latter collapsed, overloaned banks in industrial boom towns like Chicago, Detroit, Toledo, Youngstown, Cleveland, and Pittsburgh had taken heavy hits.

In the case of the agricultural hinterlands, the Great Depression had started to roll in a decade before the crash, owing to the unique farm country boom and bust which had accompanied the Great War. The unprecedented total industrial-state warfare of 1914–1918 had drastically disrupted European agricultural production and markets, inducing an explosion of export demand, high prices, and soaring output in the American farm belt. There soon followed an orgy of speculation in land and real estate that ex- ceeded in relative terms even the sand-state housing boom of 2002–2007.

Once the agricultural lands of Europe came back into production, how- ever, the great American granary lost much of its artificial war-loan export market, causing farm prices to abruptly plunge in 1920–1921 and then to continue sinking for the next decade. Not surprisingly, thousands of one-horse banks dotting the countryside had been caught up in the wartime frenzy and then suffered massive, unrelenting losses during the long post- war deflation of the farm bubble.

Overall, about 12,000 banks failed during 1920–1933, but 10,000 of these were tiny rural banks located in places of less than 2,500 population. Their failure rate of more than 1,000 per year throughout the 1920s makes for eye-catching historical statistics, but they were largely irrelevant to the nation’s overall GDP.

Losses at failed US banks during the entire twelve-year period through 1932, in fact, accumulated to only 2–3 percent of deposits.This extended wave of failures was an indictment of the short-sighted anti-branch banking laws that rural legislators had forced upon the states, as well as a reminder that wartime inflation and disruption had cast a long shadow on the future.

The crucial point, however, is that these thousands of failed banks were insolvent and should have been closed. They were not evidence of some fundamental breakdown of the banking system, or failure of the Fed to supply adequate liquidity, or a systemic crisis of capitalism.

Even after the 1929 crash, when the failure rate accelerated to about 2,400 in the twelve months ending in mid-1932, the periodic spurts of bank closures were not national in scope. Instead, they struck with distinct regional incidence in the agricultural and industrial interior. And almost without exception, these regional bank failure breakouts were centered on cities or banking chains which had indulged heavily in speculative real estate lending and other unsound practices.

That was certainly the case with the first significant outbreak of bank runs in November 1930 when the Caldwell banking chain collapsed. A speculative pyramid of holding companies which controlled more than a hundred banks in Tennessee, Arkansas, and North Carolina, it failed when real estate values fell sharply in the upper Cotton Belt. While there was some spillover on local banks, the runs did not spread beyond the region and quickly burned out because deposits were moved to sounder banks, not to mattresses.

The most powerful evidence of the noncontagious nature of the pre–February 1933 bank failures occurred shortly thereafter with the famous collapse of the Bank of the United States in December 1930. An upstart New York City bank, the Bank of the United States, grew by leaps and bounds in the late 1920s through serial mergers, aggressive real estate lending, and pyramiding of holding company capital.

The bank had been a stock market rocket ship, rising from $5 per share in 1925 to a peak of $230 before the crash. But its promoter, one Bernard Marcus, who had been the Sandy Weill of his day, had been more adept at making deals than making sound loans, and thereby soon rendered his hastily assembled banking empire insolvent. Yet there was virtually zero spillover to other New York banks when state banking supervisors shut- tered what was then the city’s third-largest institution with around seventy branches and deposits on the order of $30 billion on today’s scale.

The same pattern occurred the following June in Chicago. There had been a giant real estate bubble in the Chicago suburbs during the 1920s, but owing to Illinois’s particularly restrictive anti-branch-banking law the Great Loop banks had been sidelined, leaving the suburban real estate lending spree to poorly capitalized newbies.

Chicago had been an epicenter of the 1914–1929 agricultural/industrial/export boom, so when the party ended abruptly after the stock market crash, the region’s economy was hit harder than any other industrial center outside of Detroit. Real estate prices experienced a particularly devastating collapse in the newly developed suburban communities, triggering a wave of defaults in loan portfolios which were heavily laden with commercial and residential mortgages.

Yet with one exception a year later, the Great Loop banks remained solvent and experienced no lines at their teller windows. By contrast, the “runs” on the suburban banks were both swift and warranted because they were deeply insolvent.

In short, the Chicago case further illuminates the fact that the wave of bank failures during 1930–1932 was not the result of irrational public sentiment and “contagion,” or a fundamental breakdown of bank liquidity, but instead was evidence of a discriminating, rational flight of depositors from unsound banks and markets.

Even when surges of bank failures extended eastward, such as in the Philadelphia runs of October 1931, there was far more rationality to the pattern than the conventional narrative acknowledges. In this case, the overwhelming share of failures was concentrated among newly formed “trust banks” which had been chartered under state law with far less stringent requirements for capital and cash reserves than was the case with national banks.

Again, the late 1931 wave of bank failures in Philadelphia quickly burned out after deposits had moved from the lightly regulated trust banks, which had been on the leading edge of real estate lending and securities speculation, to the far better capitalized national banks. Indeed, the fundamental solvency of the US banking system was dramatically evidenced during this same period when the Fed raised the discount rate in mid-October.

This Fed action is habitually and roundly criticized by contemporary advocates of central bank money printing, but it was actually the proper move under then-extant gold standard rules. Specifically, the initial impact of the British default on September 1931 had been a run on US gold out of fear that the United States would be the next to default. So a discount rate hike was necessary to stop the outflow and, in fact, the rate of gold losses fell sharply in the months ahead and eventually reversed to an inflow by mid-1932.

More importantly, there was no acceleration of bank failures after the discount rate hike, and within weeks the failure rate slackened dramatically while discount borrowings actually increased. This was proof positive that banks were failing not because they were illiquid or could not get emergency funding from the Fed but because they were, alas, bankrupt.

Indeed, Herbert Hoover’s unfortunate banking cure at the time—the emergency enactment of the Reconstruction Finance Corporation (RFC) in January 1932—was designed to alleviate insolvency, not provide emer- gency funding or replace hoarded deposits. Accordingly, the RFC went on to become a paragon of crony capitalism, rescuing dozens of busted railroads and recapitalizing several thousand insolvent banks.

Yet the outcome was perverse: the stock and bondholders of bailed-out institutions were rescued, competitors were harmed, and the nation’s economy was left to slog it out with far too much railroad capacity and way too many banks that were deeply insolvent.

*  *  *

The Banking Crisis Was Over Before FDR Got Started

…..The trigger for the pre-election panic, in fact, did not occur until the morning of February 14, when the governor of Michigan capriciously declared a one-week bank holiday owing to a funding crisis at Detroit’s second-largest banking chain. The Guardian Trust Group consisted of about forty banks controlled by Edsel Ford and included Goldman Sachs among its principle stockholders.

It was another of the late-1920s banking pyramids that had been organized with a modest $5 million of capital in 1927 and had grown to a $230 million holding company two years later, through a spree of mergers and stock swaps. These maneuvers elevated the stock price from $20 per share to $350 at the 1929 peak.

Unfortunately, the bank’s principle assets consisted of loans to insiders to buy the bank’s own stock and loans to both real estate developers and homeowners in the red-hot Detroit auto belt. Propelled by a population explosion from 300,000 to 1.6 million in the previous three decades, the volcanic price gains in the Detroit real estate market eclipsed the current era’s Sunbelt booms by orders of magnitude.

Consequently, when auto production dropped by 75 percent and triggered mass layoffs, and the Guardian Group’s stock price plummeted by 95 percent, the bank’s loan book became hopelessly impaired. However, what might have been embarrassing investment liquidation for Edsel Ford and his cronies became a national headline when the Guardian Group crisis turned into a brawl between Henry Ford and his despised erstwhile partner and then Michigan Democratic senator, James Couzens.

Senator Couzens was the Tyler Winklevoss (he and his twin brother were involved in the origins of Facebook) of his day and believed that he had been bilked out of his share of Ford Motor Company by Henry Ford. He could not abide a move afoot to have the RFC ride to the rescue of Edsel Ford’s mess, so he mustered his considerable weight as US senator and put the kibosh on the deal.

President Hoover unhelpfully got himself in the thick of the brawl. However, he did quickly recognize that the Detroit headlines were becoming a catalyst for a financial panic that was already brewing due to a complete breakdown of transition cooperation and FDR’s studied silence on his prospective financial policies.

Indeed, the increasing flow of hints and leaks from FDR’s radical brain trusters—such as Columbia professor Rexford Tugwell and secretary of agriculture designate Henry Wallace—that the incoming president would depreciate the dollar and pursue other inflationary schemes had already begun to trigger a run on gold and currency.

Therefore, on February 18 Hoover penned an eloquent private letter to FDR outlining the peril from these developments and the urgent need for a reassuring statement from the President-elect outlining his policies with respect to gold, currency, banking and the budget…..

By Monday morning February 27, Tugwell’s leak spread far and wide in the financial markets. The panic was on.

As Professors Nadler and Bogen noted in their classic 1933 history of the banking crisis, the “gold room” of the New York Federal Reserve Bank soon became a center of pandemonium: “As the panic week [February 27 to March 3] progressed, long lines formed to exchange ever larger amounts of gold there, until finally the metal was being carried away in large boxes and suitcases loaded on trucks.”

During the next five days approximately $800 million, or 20 percent, of the US gold stock was withdrawn by citizens, earmarked by foreign central banks, or implicitly purchased by speculators who took out a massive short position on the dollar. The lessons of the British default of September 1931 were still fresh, and as the smart money took aggressive actions to defend itself, the knock-on effect was almost instantly felt.

As Wall Street historian Barrie A. Wigmore noted in his magisterial history of the Great Depression, owing to the gold hemorrhage “the lender of last resort [i.e., the Fed] for the banking system was in doubt. Frightened depositors lined up for cash, the only working substitute for bank deposits.”

Wigmore’s point is dispositive. What financially literate citizens knew at the time, and was never grasped by postwar Keynesians, is that Federal Reserve currency notes were then required by statute to be backed by a 40 percent gold cover. The public therefore realized that only a few more days of the panicked gold drain could cause a sharp constriction of both the hand-to-hand currency supply and the banking system overall.

Accordingly, the daily currency figures provide ringing evidence of FDR’s culpability for the crisis. By February 23, the daily increase in currency out- standing had risen from the $8 million early February level to about $40 million, and then in the crisis week soared to nearly $200 million on Monday and hit $450 million on Friday, March 3, the day before the inauguration.

All told, the great bank teller window run and currency-hoarding crisis caused currency outstanding to rise from $5.6 billion to a peak of $7.5 billion. Yet $1.5 billion, or nearly 80 percent, of this gain occurred during the last ten days before FDR took office; that is, in the interval between the day Carter Glass said no and the morning FDR took the oath.

Barrie Wigmore’s work consists of seven hundred pages of massive documentation and only occasional viewpoints and judgments. But on the question of culpability for the banking crisis he left no doubt: “Roosevelt exacerbated the crisis. If he had handled the ‘lame duck’ period differently, there would have been no Bank Holiday . . . the banking system was un- usually liquid prior to the bank crisis, and [the] recovery from it was unusually rapid . . . [proving] that the peculiar circumstances of Roosevelt’s transition were the cause of the crisis.”

Four days after FDR officially closed the nation’s 17,000 banking institutions, the Senate approved, after seventy-five minutes of debate and no written copy of the bill, the Emergency Banking Act, which empowered the secretary of the treasury “to re-open such banks as have already been as- certained to be in sound condition.”

But there was no New Deal magic in the bill at all. It had been drafted by Hoover holdovers and was a content-free enabling act which required no change whatsoever in bank procedures in order to obtain a license to “re- open,” and included no standards for review or approval by the Treasury Department.

In fact, the legislation was the first of many FDR ruses. Once Hoover had been implicitly saddled with the blame for what appeared to be a frozen banking system and prostrate economy on March 4, FDR simply moved along to another topic, having had no intention of closing or reforming any banks.

Accordingly, with such dispatch as would have made Internet-era number crunchers envious, the White House began opening banks the next Monday (March 13th), and by Wednesday 90 percent of the deposit basis among national banks had been reopened.

Within the following ten days nearly all of the $2 billion in hoarded currency had flowed back into the banking system, and the Fed’s gold reserves soon reached pre-crisis levels. By early April, fully 13,000 banks with $31 billion of deposits were open and more than 2,000 more quickly followed after they had been given RFC capital injections.

By contrast, at year-end 1933 only a thousand mostly tiny rural banks with aggregate deposits of less than $1 billion had been closed, thus demonstrating that at the time of FDR’s banking crisis only 3 percent of the nation’s bank deposits were still in insolvent institutions.In effect, the severe business cycle liquidation of the Great Depression was over even before Roosevelt was elected, and within weeks of his self-instigated banking crisis the US economy had resumed its natural rebound.

By June 1933, economic activity levels attained in the previous September had been regained and a slow upward climb ensued, led by the steady replenishment of fixed assets and working capital. To be sure, recovery was greatly attenuated by the shutdown of international trade, but in a process that was drawn and halting, nominal GDP eventually reached the $90 billion level by 1939. After seven years of New Deal medication, the nation’s money income was still straining to reach its 1929 level.

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