Ben Bernanke's "The Federal Reserve and the Financial Crisis"

Ben Bernanke, in his recent GWU speech, succinctly stated the core trauma narrative that lies at the heart of the well-intended elite hostility toward the gold standard: the belief that it caused the great depression


The Honorable Ben Bernanke, GWU. Photo by, and courtesy of, the author.


From the Honorable Ben Bernanke's "The Federal Reserve and the Financial Crisis," Origins and Mission of the Federal Reserve, Lecture 1, George Washington University School of Business, March 20, 2012.

What caused this colossal calamity, which again I would reiterate, was not just a U.S. problem, but a global problem. ...  So why would--why was there--what happened? What caused the Great Depression? This is a tremendously important subject and has received a lot of attention as you might imagine from economic historians. And as often as the case for very large events, there were many different causes. I mentioned a few here, the repercussions of World War I, problems with the international gold standard, which was being reconstructed but with a lot of problems after World War I, the famous bubble in stock prices in the late 1920s and the financial panic that spread through the world. So there were a number of factors that created the depression.


Alright, so, what I wanted to get into here in the last few minutes is what was the Fed doing during this period? Unfortunately, the Fed met its first great challenge in the Great Depression and it failed, both on the monetary policy side and on the financial stability side. On a monetary policy side, basic bottom line here is that the Fed did not ease monetary policy the way--the way you would expect it to in a period of deep recession for a variety of reasons because it wanted to stop the stock market speculation, because it wanted to maintain the gold standard, because it believes in the liquidationist theory. For a variety of reasons, the Fed did not ease monetary policy, or at least not very much. And so we didn't get the offset to the decline that monetary policy could have provided. And indeed, what we saw was the sharply falling prices, I mean I think, you can argue about causes of the decline and output in employment, but when you see 10 percent declines in the price level, you know monetary policy is much too tight. So the deflation was in fact an important part of the problem because again, it bankrupted farmers and others who relied on to sale products to pay fixed debts. To make things even worse, as I mentioned before, if you have a gold standard, then you have fixed exchange rates. So the Fed's policies were essentially transmitted to other countries which also essentially therefore came under excessively tight monetary policy and that also contributed to the collapse. Now again, as I mentioned, one reason why the Fed kept money tight was because it was worried about a speculative attack on the dollar. Remember in 1931, the British had faced that situation. The Fed was worried that there would be a similar attack that would drive the dollar off gold. So to preserve the gold standard, they raised interest rates rather than lower them. They argued by keeping interest rates high, that would make U.S. investments attractive and prevent money from flowing out of the United States. But again, that was a wrong thing to do relative to what the economy needed. In 1933, Franklin Roosevelt abandoned the gold standard and suddenly, monetary policy became much less tight and there was a very powerful rebound in the economy in '33 and '34.


The other thing that FDR did, although it would--he took a lot of smoke while he was doing it, but basically, he abandoned the gold standard. And by abandoning the gold standard, he allowed monetary policy to be released and allowed expansion of the money supply which ended the deflation and led to a powerful short term rebound in '33 and '34. So the two most successful things that Roosevelt did were essentially offsetting the problems that the Fed created or at least exacerbated by not fulfilling its responsibilities. So, what are the policy lessons? It was a global depression, had many causes, the whole story requires you to look at the whole international system. But policy errors in United States, as well as abroad, did play an important role. And in particular as I said, the Federal Reserve failed in this first challenge in both parts of its mission. It did not use monetary policy aggressively to prevent deflation and the collapse in the economy, so it failed in its economic stability function.

Chairman Bernanke alludes to, but does not draw out, the critical distinctions between the classical gold standard and the interwar gold standard.  Mr. Bernanke alludes to the distinctions in citing that the gold standard was "being reconstructed but with a lot of problems after World War I."  In a 2004 speech at Washington and Lee then-Governor Bernanke made these distinctions -- and pointed out the implications -- with a great deal more intellectual rigor:

The gold standard appeared to be highly successful from about 1870 to the beginning of World War I in 1914.  During the so-called ‘classical gold standard period,' international trade and capital flows expanded markedly, and central banks experienced relatively few problems ensuring that their currencies retained their legal value.

[...U]nlike the gold standard before World War I … the gold standard as reconstituted in the 1920s  proved to be both unstable and destabilizing.”

It was indeed, as Bernanke pointed out eight years ago, the problems of the interwar gold standard -- beginning with Churchill's infamous 1925 blunder of restoring the gold standard at pre-war parity when the prevailing price level had doubled -- and not any defect inherent in the classical gold standard -- that triggered the Great Depression.  The historic value of $20.67/ounce had been shattered beyond retrieval as a stable benchmark by the Great War; the damages inflicted by defining the dollar by a price not in harmony with the markets was dispelled by FDR, astutely advised by economist George Warren based upon a close study of commodity prices, establishing the definition of the dollar at one thirty-fifth of an ounce. 

It was this correction, rather than "abandoning" the gold standard, that powered the rebound of 1933 - 1934.  Elsewhere in his address Mr. Bernanke makes the point that "Part of the problem was intellectual, rather than policy per se," an observation which is profound.  That said, it is submitted that the intellectual problem was not one of, as Mr. Bernanke submits, "liquidationism" but of the failure -- then, and continuing -- fully to grasp and appreciation the profound distinction between the classical gold standard and the interwar gold standard, its "grotesque caricature."


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