“I got along with him fine. But Ben Bernanke thinks he’s the smartest guy in the room, and wanted everyone to know it,” remarked an acquaintance who used to sit in policy meetings with him. I recalled the remark when I read that Bernanke would become the first Federal Reserve Chairman to hold press conferences after meetings of the Federal Open Market Committee (FOMC). What if the smartest guy in the room doesn’t get it?
Before becoming a Federal Reserve Board governor, Bernanke specialized at Princeton University in the causes of the Great Depression. His basic approach was a variation of Milton Friedman’s, who with co-author Anna Schwartz argued in A Monetary History of the United States that the Great Depression was primarily the result of domestic monetary policy mismanagement by the U.S. Federal Reserve.
As Bernanke summarized, “the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of policymakers, particularly central bankers. After the 1929 crash, the Federal Reserve mistakenly focused its policies on preserving the gold value of the dollar rather than on stabilizing the domestic economy. By raising interest rates to protect the dollar, policymakers contributed to soaring unemployment and severe price deflation. The U.S. central bank only compounded its mistake by failing to counter the collapse of the country’s banking system in the 1930s . . . Without these policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in economic activity.”
At a conference in their honor, Bernanke addressed Friedman and Schwartz, saying, “Regarding the Great Depression. You’re right, we [the Federal Reserve] did it. We’re very sorry. But thanks to you, we won’t do it again.”
Like Friedman, Bernanke erred in restricting the meaning of “money” to domestic while ignoring foreign central-bank liabilities. In doing so, Bernanke ignored the contemporaneous, empirically grounded explanation of the Depression by Jacques Rueff, an architect of France’s successful return to gold in 1926 (which contrasted painfully with Great Britain’s botched effort in 1925). As the French economic attaché in London, Rueff had observed the expansion and tried to warn of the collapse of the post-World War I gold-exchange standard. Under that system, experts had tried in vain to maintain the pre-war gold value of the pound and dollar, despite the tripling of the British wage and price levels and the doubling of the American wage and price levels.
By expanding foreign exchange reserves, Rueff explained, “the gold-exchange standard increase[s] . . . the money supply in the receiving market, without reducing in any way the money supply in the market of origin.” Conversely, selling official foreign exchange reduces the money supply in one country without increasing it in another. “As a result, the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.”
As the nearby chart shows, the U.S. stock market rose and fell step for step with the expansion and contraction of foreign dollar reserves invested in New York. Though certainly not the only factor, as the chart shows, these changes were the dominant factor in the 1920s and 1930s.