Ben Bernanke versus Milton Friedman: The Federal Reserve's Emergence as the U.S. Economy's Central Planner

By Hummel, Jeffrey Rogers | Independent Review, Spring 2011 | Go to article overview

Ben Bernanke versus Milton Friedman: The Federal Reserve's Emergence as the U.S. Economy's Central Planner


Hummel, Jeffrey Rogers, Independent Review


Both Ben S. Bernanke and Milton Friedman are economists who studied the Great Depression closely. Indeed, Bernanke admits that his intense interest in that event was inspired by reading Milton Friedman and Anna Jacobson Schwartz's Monetary History of the United States, 1867-1960 (1963). Bernanke agrees with Friedman that what made the Great Depression truly great rather than just a garden-variety depression was the series of banking panics that began nearly a year after the stock-market crash of October 1929. And both agree that the Federal Reserve (the Fed) was the primary culprit by failing to offset, if not by initiating, that economic cataclysm within the United States (Ip 2005). As Bernanke, while still only a member of the Fed's board of governors, said in an address at a ninetieth-birthday celebration for Friedman: "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again" (2002b).

This seeming similarity, however, disguises significant differences in Friedman's and Bernanke's approaches to financial crises, differences that have played an enormous yet rarely noticed role in the recent financial crisis. Not only have those differences resulted in another Fed failure--not quite as serious as the one during the Great Depression, to be sure, yet serious enough--but they have also resulted in a dramatic transformation of the Fed's role in the economy. Bernanke has so expanded the Fed's discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner. In short, despite Bernanke's promise, the Fed did do it again.

Conflicting Lessons of the Great Depression

The banking panics associated with the Great Depression were not only the worst in the history of the United States, but also the largest in the history of the world. The differences between Bernanke and Friedman center on why those panics generated economic catastrophe. For Friedman and Schwartz, the causal mechanism was the resulting changes in the money stock and therefore in the equilibrium price level. The panics brought about a collapse of the broader measures of the money stock over the four years from 1929 to 1933: a one-third fall in M2 and a one-fourth fall in M1. This collapse induced, in their view, a further fall in money's velocity (or in what is the same thing, an increase in the portfolio demand for money), requiring an enormous contraction in nominal income. Without full and immediate flexibility of all prices and wages, a one-third contraction in the economy's real output was the consequence. In other words, Friedman conceives of the bank panics as an enormous shock to aggregate demand.

This analysis leaves unanswered the prior questions of what triggered the banking panics in the first place and why the U.S. banking system was so uniquely vulnerable after so much government intervention to prevent such a crisis. Friedman and Schwartz attribute the panics to inept Fed policy, along with legal restrictions on the issue of money substitutes by private clearinghouses, but other economists have come up with myriad alternative explanations, ranging from the Smoot-Hawley tariff to misplaced adherence to the gold standard or a collapse of Keynesian animal spirits. Despite disagreement about what initiated the panics, however, there is a fair consensus that the collapse of the banking system, once under way, made the Depression far more severe than it otherwise would have been.

Yet, in contrast to Friedman's analysis, Bernanke's major article on the Great Depression, originally published in American Economic Review, is titled "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression" (1983, reprinted in Bernanke 2000a, emphasis mine). Banks were the economy's premier financial intermediaries, channeling savings from households to firms, which used the savings to maintain and accumulate capital, and to other households engaged in consumption. …

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