Ben S Bernanke: Economic policy - lessons from history
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the 43rd Annual Alexander Hamilton Awards Dinner, Center for the Study of the
Presidency and Congress, Washington DC, 8 April 2010.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Good evening. It is a great pleasure to share a meal with the Center for the Study of the
Presidency and Congress, and especially with the Center's fellows. Doubtless your
participation in the fellowship program as undergraduate and graduate students - writing and
thinking about leadership, governance, and public policy - will prove immensely valuable as
you develop your own intellectual and leadership skills and embark on careers that I hope
will include a period of public service.
I must begin this evening by expressing my appreciation to the Center and to Ambassador
Abshire for selecting me as this year's recipient of the Hamilton Award. I'm truly honored to
join the ranks of such past Center honorees as Sandra Day O'Connor, Robert Rubin, Al
Gore, and Gerald Ford. Thank you also, Chairman Volcker, for your very kind introduction.
As you all know, the award is named after Alexander Hamilton, who of course is best known
as our nation's first Secretary of the Treasury. From my perspective, at least equally
important is that Hamilton, as the founder of the First Bank of the United States, was, in a
sense, also our nation's first central banker.
These days central banking is my line of work as well. Before that, I was an academic
economist and economic historian, with a particular interest in the causes of the Great
Depression. So, given my background and the Center's abiding interest in applying the
lessons of history to today's critical issues, I thought that I would speak to you about the
parallels - and differences - between that crisis and the more recent one, particularly
regarding the responses of policymakers. I draw four relevant lessons from the financial
collapse of the 1930s; I will first list these lessons, then briefly elaborate. First, economic
prosperity depends on financial stability; second, policymakers must respond forcefully,
creatively, and decisively to severe financial crises; third, crises that are international in
scope require an international response; and fourth, unfortunately, history is never a perfect
guide.
The first lesson - economic prosperity depends on financial stability - seems obvious, but
this connection was not always well understood. After the stock market crash of 1929, many
thought a financial and economic crisis was necessary - even desirable - to wring out
speculative excesses that had built up in the 1920s. Remarkably, despite the fact that the
Federal Reserve had been founded to mitigate financial panics, the central bank made
essentially no effort to prevent the wave of bank failures that paralyzed the financial system
at the start of 1930s. Indeed, the Treasury Secretary at the time, Andrew Mellon, believed in
the tonic effects of weeding out weak banks and famously advised President Herbert Hoover,
"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate ... It will purge
the rottenness out of the system."1
Economists themselves have not always fully appreciated the importance of a healthy
financial system for economic growth or the role of financial conditions in short-term
economic dynamics. Even after the Depression, some economists found it useful to think of
the financial system as a "veil," which helped allocate the returns to physical assets but did
little to affect so-called real economic outcomes. In contrast, more recent work on the
subject, to which I contributed, showed that the health of the financial system and the
performance of the broader economy are closely interrelated, both in the short run and in the
long run. Indeed, in a historical context, some of my own research on the Great Depression
showed that countries such as the United States that, for institutional or other reasons,
suffered severe banking problems, had significantly worse depressions than countries in
which the banking system was more stable, such as Great Britain.2
The lesson has been learned. In the current episode, in contrast to the 1930s, policymakers
around the world worked assiduously to stabilize the financial system. As a result, although
the economic consequences of the financial crisis have been painfully severe, the world was
spared an even worse cataclysm that could have rivaled or surpassed the Great Depression.
That lesson brings me to the second one - policymakers must respond forcefully, creatively,
and decisively to severe financial crises. Early in the Depression, policymakers' responses
ran the gamut from passivity to timidity. They were insufficiently willing to challenge the
orthodoxies of their day - such as the liquidationist doctrine of Mellon and others, or the rigid
adherence to the variant of the gold standard adopted after World War I. A key turning point,
in the United States, came with Franklin Roosevelt's commitment to bold experimentation
after his inauguration in 1933. Some of his experiments failed or were counterproductive, but
his decisions to declare a bank holiday upon taking office in March 1933 and to sever the link
between the dollar and gold helped arrest the descent of the U.S. financial system and set off
a strong, albeit incomplete, recovery.
In the Depression, effective policy responses came only after three to four years of financial
crisis and economic contraction. In our own time, policymakers acted sooner and with
greater force than in the 1930s. For example, in October 2008, just weeks after the sharp
intensification of the crisis, the Congress authorized the Troubled Asset Relief Program
(TARP) to support stabilization of the financial system. It was far from perfect legislation, but
it was essential for preventing an imminent financial collapse. For its part, the Federal Open
Market Committee, the monetary policymaking arm of the Federal Reserve, sharply and
proactively cut its target for short-term interest rates from the fall of 2007 through 2008. After
the target could go no lower, the Committee embarked on an unprecedented (for the United
States) program of long-term securities purchases, recently completed, to support private
credit markets, including the mortgage market.
Also, in the spring of 2009, the Federal Reserve led the Supervisory Capital Assessment
Program, known as the bank stress test.3 In some ways, its effect was similar to Roosevelt's
national bank holiday. During the holiday in 1933, banks temporarily shut their doors.
Examiners were dispatched to evaluate them, and banks that were declared sound reopened
to renewed depositor confidence. In the 2009 stress tests, multidisciplinary teams of
examiners, economists, financial experts, and other specialists calculated how much capital
19 of the nation's largest bank holding companies would need to remain healthy and
continue lending during a hypothetical worse-than-expected economic scenario. The
Treasury Department committed to supplying additional capital as necessary from the TARP.
Critics had warned that the stress test could backfire, but as it turned out, the release of the
results last May helped restore confidence in banks, and many institutions have since been
able to raise capital from investors and repay the capital the government had injected.
Then as now, the financial and economic crisis was global, underscoring the third lesson:
International crises require an international response. Contemporary Americans' impressions
of the Depression have been shaped by iconic photos of bread lines, hungry Dust Bowl
migrants, and the milling crowds on Wall Street on Black Monday. We think of it as an
American episode. We forget it was a truly global event. But the depth of the Depression in
Germany exceeded that even of the United States, and the failure in 1931 of a large Austrian
bank, Credit Anstalt, was an important trigger of a wave of bank failures that affected many
countries, including the United States. Unfortunately, authorities then were ill-positioned to
coordinate an effective international response, as years of bitter wrangling over World War I
international debts and reparations had all but destroyed the mutual trust upon which
coordination depends.
In the recent episode, policymakers, bankers, and business people recognized that the
world's economies and financial systems would sink or swim together. I recall talking with
bankers and business people while attending an international meeting in Brazil. They told me
that, in September 2008, what had been a healthy pace of business activity and lending in
Brazil suddenly plummeted. They described the impact of the crisis as being like that of a
"cold wind" that appeared out of nowhere. Similar stories, I am sure, can be told in many
other countries. Because the world's policymakers understood the potentially devastating
effect of the financial crisis for the global economy, they and we worked urgently to stabilize
the situation. In October 2008, in an unprecedented display of coordination, six central banks
- the Federal Reserve, European Central Bank, Bank of England, Swiss National Bank,
Bank of Canada, and the central bank of Sweden - acted together to cut short-term interest
rates. A few days later, after watershed meetings in Washington of finance ministers and
central bank governors, many countries, including the United States, announced
comprehensive plans to stabilize their banking systems. And at the Federal Reserve,
because we were well aware that turmoil in dollar funding markets overseas hurts our own
financial markets, we also established temporary liquidity swap lines that enabled 14 central
banks around the world to calm their markets by lending dollars in their jurisdictions.
I'll conclude with the cautionary fourth lesson - history is never a perfect guide. It is a
principle acknowledged by the words etched on the wall of the Center's conference room,
attributed to Mark Twain, "History does not repeat itself, but it can rhyme." As an example,
bank runs in many countries, including the United States, were common in the Depression.
In the most recent crisis, retail runs - depositors lining up in the streets - were thankfully rare
because of deposit insurance and other changes in our financial system.4 Although ordinary
small depositors by and large did not run, we nevertheless experienced the equivalent of
runs on the network of nonbank financial institutions that has come to be called the shadow
banking system. In the shadow banking system, loans, instead of being held on the books of
banks as was virtually always the case in the 1930s, were packaged together in complex
ways and sold to investors. Many of these complex securities were held in off-balance-sheet
vehicles financed by short-term funding. When the housing slump shook investors' faith in
the values of the loans underlying the securities, short-term funding dried up quickly,
threatening the banks and other financial institutions that explicitly or implicitly stood behind
the off-balance-sheet vehicles. This was a new type of run, analogous in many ways to the
bank runs of the 1930s, but in a form which was not well anticipated by financial institutions
or regulators. In an additional variation on the theme of the bank run, in September 2008
money market mutual funds saw massive outflows after one prominent fund suffered losses
related to the failure of Lehman Brothers.
The Federal Reserve, with its discount window, was well positioned to provide liquidity to
banks by making short-term, collateralized loans. (The discount window was the tool the
Federal Reserve could have used, had it chosen, to stem the banking panics of the 1930s.)
However, our traditional tools, developed in an earlier era, were of little use in addressing
panic in the shadow banking system or in the money market mutual fund industry. So, we
engaged in what I call "blue sky thinking" - generating many ideas. Most were discarded,
but, crucially, some led to the development of new ways for the Federal Reserve to fulfill the
traditional stabilization function of central banks. Using emergency authority last employed
during the Depression, we created an array of new facilities to provide backstop liquidity to
the financial system (and, as a byproduct, coined many new acronyms). Thus, we were able
to help restore the flow of credit to American families and businesses by shoring up important
financial markets, such as those for commercial paper and securities backed by consumer
loans.
Undoubtedly, researchers and scholars will devote considerable energy in the years ahead
to expanding and refining the lessons this most recent crisis has provided us. I hope that
some of you might contribute to that endeavor. I congratulate the Center fellows whose work
is also being recognized this evening and thank you, once again, for honoring me with the
Hamilton Award.