Regardless of the academic merits, the Nobel prize awarded to Ben Bernanke—as well as to Douglas Diamond and Philip Dybvig—for their work on financial crises, particularly during the Great Depression, will entail a negative effect. It will help reinforce the myth initiated by Milton Friedman, and sustained by the former Fed chairman himself, that the disaster in the 1930s was caused by the central bank´s failure to pump money.
Diamond and Dybvig have written about the risks of “maturity transformation” (the mismatch between demand deposits that clients can withdraw at short notice and long-term loans provided by banks). In the dire context of the early 30s this inherent imbalance, among other factors, led to the collapse of many financial institutions and helped turn the crisis into a depression. Ben Bernanke has also focused on bank failures and their impact on the economy. In his view, during the Great Depression the financial entities helped precipitate the collapse of the money supply because, given their negative expectations, they failed to lend to borrowers who would otherwise have been given loans. The conclusion being, as Bernanke would try to show in practice many decades later, that a major intervention by the central bank (bailouts and other forms of support to the financial system) can prevent this.
This view puts the cart before the horses. It was the economic depression that caused the banks to fail and the surviving financial entities to be extremely prudent with their reserves, not the other way around. The crash of 1929 and the ensuing depression were consequences of the excesses of the prior decade; the depression’s depth and duration, as many authorized voices have argued, had a lot to do with Hoover´s interventionist policies, subsequently taken to suffocating levels by FDR (see, for instance, the seminal works of Lionel Robbins, Murray Rothbard and Robert Higgs). This is why the Fed’s easy-money policy, which, contrary to what many of Friedman’s disciples and followers believed, was quite real, did not work. If the crisis had not set in before those bank failures and the retrenchment of general lending, the financial institutions would have had no reason not to lend, the public would have had no reason to refrain from taking out loans and the system would not have failed.
Bernanke has written that the banks’ decision to stop lending to otherwise worthy borrowers derived from the fall in the value of collateral (real estate, stock, etc.), as if this factor was secondary in nature to the creditworthiness of potential borrowers. No, it was central to the crisis. The economic slump caused the fall of collateral assets and the banks, which were already in trouble, did exactly the same thing that eight decades later, after the financial crisis of 2007, we would see them do again—i.e., try to deleverage.
The money supply naturally went down because one major component of the money supply is bank deposits. This happened not because the Fed failed to pump money, but despite its significant money-pumping efforts. The same thing happened in the new millennium, when the Fed was unable to spur lending for many years despite several rounds of quantitative easing, until the animal spirits eventually sprang into action and the current inflation took off.
Between 1929 and 1933, the critical years, the Fed’s balance sheet increased by 8 percent annually in a major attempt to inject money into the economy. But in the same period the money supply decreased by 7 percent a year, reflecting the banks’ and the public’s financial prudence as they dealt with the debt burden left by the “roaring 1920s.”
Another way to look at it is to see what happened with the bank reserves. If we separate the part that the central bank was able to control from that part that was beyond the Fed’s control, we can notice the banks’ and the public’s tendency to neutralize the central bank’s stimulus by being prudent and deleveraging. Between 1929 and 1931, “controlled” reserves increased by an annual rate of 17 percent and in the last ten months of 1932 by a whopping 72 percent! Given the money that was being pumped, how could the money supply decrease? For one reason only: The “uncontrolled” reserves went down (between 1929 and 1931 at an annual rate of 27 percent), reflecting the behavior of the real world as opposed to the central bank’s world of make-believe.
Depressions and recessions are the real world’s effort to purge the excesses of past years. Trying to remedy this adjustment with new excesses leads to new misfortunes. I fear that the Nobel prize awarded to Bernanke will make it more difficult to see that the current inflationary period is in no small part a consequence of not heeding the lessons of the Great Depression. As we have learned this past year in the midst of the worst inflation in decades—caused by the easy-money policies of the Fed after the financial crisis of 2007 and the Covid pandemic later on—in the field of political economy myths have consequences. And they are never merely academic.
Alvaro Vargas Llosa is a Senior Fellow at the Independent Institute. His Independent books include Global Crossings, Liberty for Latin America, and The Che Guevara Myth.