Sunday, October 6, 2013

Bernanke, banking crashes and recessions

by Michael Roberts

Back in 2002, current Federal Reserve chairman Ben Bernanke made a speech in honour of monetarist economist, Milton Friedman on the occasion of his 90th birthday.  Bernanke praised the work of Friedman and his colleague Anna Schwartz.  Their seminal work (A Monetary History of the United States, 1867–1960) argued that the Great Depression of 1929-33 was caused by the bad decisions of the Federal Reserve.  The Fed had let a credit bubble build up by allowing money supply to outstrip GDP growth and then the Fed cut money supply and raised interest rates too soon and engendered a banking crash and thus a deep depression. 

Bernanke ended his speech with the words:  “What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman’s words, a “stable monetary background”–for example as reflected in low and stable inflation.  Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Bernanke had famously argued in 1983 that bank failures in effect caused the Great Depression and this explains why he pushed for sufficient funding of bank bailouts, quantitative easing and other ‘unconventional’ monetary measures to avoid another depression arising from the Great Recession. The question is: is it right to claim that the Fed’s management of the money supply is crucial to causing or avoiding slumps as Friedman claimed and so plentiful supplies of credit or money can avoid banking collapses that engender slumps in the economy?

In a new paper (Bank failures and output during the Great Depression,, Jeffrey Miron and Natalia Rigol do not think so.  They found “little indication that bank failures exerted a substantial or sustained impact on output during this period.”   They conclude that “At the broad-brush level, an impact of bank failures on output does not leap from the graphs. Industrial production fluctuated significantly during parts of the interwar period that experienced few bank failures. In particular, industrial production declined 28.8 percent over a span of fifteen months, from the cyclical peak in July, 1929 to the first wave of bank failures in November,1930. That magnitude decline – almost half the overall drop – makes it plausible that bank failures were partly a response to adverse economic conditions, whether or not failures contributed to output losses.”  In other words, the Great Depression kicked off with a fall in industrial output which then led to bank failures that exacerbated the crisis, but not vice versa.

What this suggests is that bailing out the banks would also do nothing to end a capitalist slump but simply preserve the interests of the financial sector.  And also that pumping money into the banks through measures like QE would have little effect on restoring investment and industrial output.  After all, the strategy has proved pretty abysmal at doing anything other than expanding the narrowest measures of money supply, or for that matter propping up banks and asset markets.  That is because  bank lending is demand-driven and when the demand for investment is not there, there is no demand for bank lending.  It is not really a supply issue (see  That means bank failures are more a symptom rather than a cause of crises.

That is also suggested by a comparison of the recovery from the Great Recession by the major capitalist economies.  In the graph below (produced by the Bank of England), we can see that recovery from recessions on average is achieved within four quarters (red line).  If a banking crisis is also involved, then it takes up to 12 quarters (green line).  But the Great Recession has been much worse, with only the US getting anywhere near an average recovery (purple line), while the Eurozone and the UK in particular are still way behind.
GDP and recesions
Tony Northfield, at his excellent blog ( and in a recent paper (Tony Norfield on derivatives and the crisis), explains well why banking crises and, in particular, the global financial crash, made the Great Recession worse than others, but is not the main cause for the slump.  “The rĂ´le of derivatives in the latest crisis was to help extend the speculative boom. In that sense, they made the crisis worse than it might otherwise have been, especially since the deals spread far beyond the US, overcoming any more local barriers. However, derivatives did not cause the crisis, they merely gave it a peculiar intensity and financial form. Low growth and low profitability were the reasons for the boom in derivatives-trading and ‘financial innovation’.  Alongside other aspects of the credit-system, derivatives can help promote capital-accumulation by saving companies transaction-costs, by giving the impression that risks are lower than in reality, by appearing to represent wealth that can be used as collateral for loans and by generating recorded profits based on speculation-driven prices.  A blip in the system, a loan that does not get repaid as expected, can then trigger a financial collapse as it calls into question the assumptions behind a myriad of other deals. This is what is really meant by a ‘lack of confidence’ in financial markets: a fear that the expected values are illusory. The financial collapse impacts upon the ‘real’ economy, as credit is withdrawn and the funds lent by banks dry up, even to previously viable companies. The end-result is a worse crisis, when it finally occurs.”

A banking crisis can make a recession worse but also make a recovery weaker.  There is a lot of evidence that the root of Japan’s lacklustre performance after its credit crunch and banking crisis in 1989 was the failure to ‘cleanse’ the banks of an overhang of debt. The bad debt problem was finally dealt with by two government-backed agencies which were established to dispose of soured loans and restructure troubled corporate borrowers, but not until the late 1990s.

In a previous post (13/02/14/japans-lost-decades-unpacked-and-repacked/), I showed how Japan’s rate of profit was raised during the 1980s by a massive credit and property boom.  But that could not last.  After the great credit bubble burst in 1989, the average rate of profit in the Japanese economy fell nearly 20% during the 1990s.  But from 1998 to 2007, it rose nearly 30%.  During the 1990s, the corporate sector deleveraged by 15%, laying the basis for profitability to recover.  Average real GDP growth eventually came back (relatively) because Japanese corporates had written off old capital enough and Japanese banks were finally in better shape to lend again – of course only after a lost decade of income and jobs for its population in the 1990s, culminating in the dire deflationary slump of 1998.

Capitalist economic recovery will only take place if capital (both tangible and fictitious) is written down and profitability is sufficiently restored.  Pumping in more money Bernanke-style merely delays that process and thus produces a weak and slow recovery at best.  But Bernanke persists in order to try and avoid a deflationary slump as in the 1930s.

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