David Warsh: Thanks to them, we avoided a second Great Depression

SOMERVILLE, Mass.

A Monetary History of the United States 1867-1960 (National Bureau of Economic Research,1962), by Milton Friedman and Anna Schwartz, is a most intimidating book. A heavy-lifting 860 pages, packed full of tables and charts, some of them old-fashioned fold-outs. It introduces itself as an “analytical narrative” of changes of the stock of money in the  U.S. over slightly less than a century.

It begins with a quotation from the great 19th Century economist Alfred Marshall, a sly swipe at the short equation-filled “papers” that, since the 30’s, had become standard:

“Experience in controversies such as these brings out the impossibility of learning anything from the facts till they are examined and interpreted by reason; and teaches that the most reckless and treacherous of all theorists is he who professes to let the facts and figures speak for themselves, who keeps in the background the part he has played, perhaps unconsciously, in selecting them and grouping them, and in suggesting the argument post hoc ergo propter hoc’’ {after this, therefore because of this.”]

One day in the late ‘70’’s, MIT graduate student Ben Bernanke went to see his adviser, Prof. Stanley Fischer. Bernanke had finished his field examinations; he was seeking a topic for a dissertation. At one point, Fischer handed him a copy of A Monetary History and said, “Read this. It may bore you to death. But if it excites you, you might consider doing monetary economics.”

The book fascinated him, Bernanke wrote in 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to Covid -19 (Norton, 2022). “It got me interested not only in monetary economics, but also in the causes of the Great Depression of the 1930s, a topic I would return to frequently in my academic ‘writings.” Friedman and Schwartz had showed, he wrote, “that central bankers’ outmoded doctrines and flawed understanding of the economy had played a crucial role in that catastrophic decade, demonstrating the power of ideas to shape events.”

In 1983, Bernanke published ‘‘Non-monetary Effects of the Financial Crisis in the Propagation of the great Depression,” a comparative study – an analytic narrative of the macroeconomics of the Great Depression, “macroeconomics” being the research field that had been brought into existence by the event itself.

About the same time, Douglas Diamond and Philip Dybvig set out to describe, in a series of mathematical models, the purposes that banks serve in economies of all sorts, and then explored their mathematical model of the purposes that banks serve in economies and the circumstances that sometimes lead to their collapses via bank runs.

Thirty-nine years later, the three men were recognized with Nobel Memorial Prizes for their early work on central banking, the interplay of central banks, commercial banks, and “shadow” banks that had been at the heart of the global financial crisis of 2007-08 and the lengthy recession that followed.

A footnote in the Nobel Committee’s Scientific Background to the awards notes:

“Keynes (1936) argued that recessions were primarily due to drops in aggregate demand, moving economic output below the production capacity of the economy. According to this view, governments should counter recessions through an expansionary fiscal policy that boosts aggregate demand.”

In his General Theory of Employment, Interest, and Money, Keynes gives short shrift to central banking.

Between times, Bernanke, in particular, had led an interesting life. For a decade he taught at Stanford University’s Graduate School of Business, conducting further research on banking, financial markets, labor markets, and business cycles, before moving to Princeton University, in 1995.

In 2002, he was appointed to the seven-member Board of Governors of the Federal Reserve Board, and 2005, became chairman of President George W. Bush’s Council of Economic Advisers. A year later Bush nominated him to chair the Federal Reserve Board.

The president later joked that he had chosen Bernanke from among several other suitable candidates because he would sometimes come to White House briefings wearing white socks with his business attire. A more satisfying explanation was supplied by Wall Street Journal columnist Greg Ip, who later wrote that, beginning with the time he chaired Princeton’s economics department, Bernanke had developed a “knack for eliciting cooperation from those with bigger egos and sharper elbows.”  An MIT professor recalled, “Until 2002, we hadn’t even known that he was a Republican.”

Also in 2002, as an expert on the Great Depression, Bernanke offered to a star-studded birthday party for Milton Friedman a short but incisive review of the reception of A Monetary History by the economics profession. He concluded, speaking directly to Friedman and Schwartz, “You were right, Milton, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

In 2006, as Fed chairman, Bernanke began organizing behind the scenes the complicated web of emergency measures that ultimately enabled the Fed, in concert with the central banks of 10 other first-rank nations, to avoid turning a banking panic into a second Great Depression, as bad, perhaps even worse, than the first.

Not everyone agrees – see, for example, Paul Krugman – but if the Nobel Committee in 1976 had enjoyed the gift of perfect foresight, they might have stressed the contribution of A Monetary History more forcefully than they did in awarding Friedman the prize, and they might have offered a medal to Schwartz as well.

It could have gone better. As governor of Israel’s central bank, Stan Fischer, in different circumstances, avoided the mortgage collapse almost entirely – but the results of the Panic of 2008 in New York could have been worse – much, much worse – had Friedman and Schwartz not spent 12 years writing their old-fashioned 860-page book. A readable edition of the key chapter of the book The Great Contraction, about 1929-33, appeared 2008, with a new preface by Schwartz, and a new introduction by Peter Bernstein.

David Warsh, a veteran columnist and an economic historian, is proprietor of Somerville-based economicprincipals.com, where this essay originated.