Business Times - 28 Mar 2012
Bernanke out to prevent repeat of Great Depression
By LEON HADAR
IT is one of the decisions made by the US Federal Reserve in the past that has intrigued contemporary economic historians. The tightening of credit by Marriner Eccles, the head of the Fed in 1936-37 has been blamed for the collapse of the US stock market in 1937 and the ensuing return of the Great Depression - after several years during which the New Deal policies pursued by President Franklin D Roosevelt had been leading the economy towards recovery.
One of the economists who have studied the ramification of that Eccles decision has been former Princeton professor Ben Bernanke who, in his current job as the Fed chairman, seemed to be trying to apply the lessons of his academic research.
Mr Bernanke has stated in the past that he considered Mr Eccles' decision to tighten monetary policy - at the time when the US economy was showing signs of getting out of the depression - to be a colossal mistake and insisted that as the head of the US central bank he was not planning to follow in the footsteps of his predecessor.
Mr Eccles and his colleagues at the Fed were worried that rising wages of American workers by more than 10 per cent at the time were igniting inflationary pressures and responded by tightening monetary policy (by doubling reserve requirements by banks).
The Fed policies were mirrored by the fiscal approach embraced by the federal government in 1936-37 which concluded that against the backdrop of an economic recovery it was time to bring an end to the policy of deficit spending and take steps to balance the budget.
'The war against the Depression had required deficit spending,' then treasury secretary Robert Morgenthau said. 'But the emergency is ending, and the domestic problems we face today are essentially different from those which faced us four years ago,' he stated. 'We want private business to expand. We believe that one of the most important ways of achieving these ends is to continue toward a balance in the federal budget.'
Economists continue to debate whether the stock market crash of 1937 and the Great Depression II were the result of the Fed's tightening monetary policy or the attempt by the Roosevelt Administration to balance the budget. Or perhaps both were to be blamed for what happened.
What is becoming clear, however, is that history seems to be repeating itself. As the American economy is starting to recover from the Great Recession much of the debate in Washington seems to be focusing now not on whether to start cutting the federal deficit - but on how big that cut should be (with Republicans demanding a big cut as opposed to the Democrats who are pressing for a small one).
No leading Republicans or Democrat is calling for more deficit spending in the form of a new economic stimulus. They are all sounding like Mr Morgenthau did in 1936.
So that may explain why Mr Bernanke doesn't want to sound like Mr Eccles did in that year and be blamed for creating tightened monetary conditions that would exacerbate the effects of the deficit contraction policies of Washington which, in turn, could bring about a Great Recession II. It is from that perspective that one needed to examine Mr Bernanke's comment on Monday that improvement in the US labour market might not be able to be sustained - a clear indication that inflation doves were in charge in the Fed and would continue to maintain an expansionary monetary policy.
And Mr Bernanke may be right. The slight improvement in the nation's labour market last month could be temporary and may not be a sign that the American economy was entering into a sustainable recovery. Wages are certainly not rising. That could happen in the future, he said, but 'we have not seen that in a persuasive way yet'. 'And I think it remains important for us to remain cautious and see how the economy develops.'
In fact, Mr Bernanke was sending a message to investors who may have been confused by the recent rhetoric coming from the inflation hawks in the Fed and was hinting that the central bank would be even open to a new round of quantitative easing (QE3). It was certainly not ready to put its foot on the monetary brakes.
But what if much of the recent economic growth has been driven by fiscal policy and that the Fed's loose monetary policy would have very little effect on the economic recovery - and may actually ignite some inflationary pressures? In that case, the conditions of the American economy would look less like that of the 1930s and more like that of the 1970s when the explosive mix of economic recession and inflation brought us the dreaded 'stagflation'. That would certainly be a case study that would intrigue future economic historians.
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