‘As an official representative of the Federal Reserve, I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You’re right, we [the central bank] did it’, was how Ben Bernanke ended his speech at the celebration of the 90th birthday of the ‘father of monetarism’ at the University of Chicago and added, ‘We’re very sorry. But thanks to you, we won’t do it again’.
One of the three co-winners of the 2022 Nobel Prize in Economics (link in Russian), Bernanke learned well the lessons of the collapse of the money supply during the Great Depression – it was the monetary mechanism going wrong that caused the economic collapse of the 1930s, as shown by Friedman and Schwartz in ‘A Monetary History of the United States’. The impression of the ‘worst economic catastrophe in American history’, as he described it, has been with Bernanke throughout his professional career, therefore he was in the right place at the right time. Today Bernanke is known as the head of one of the central banks that saved the global economy from the 2007–2009 financial crisis. However, prior to becoming a ‘financial paramedic’, Bernanke had to learn about the nature of the banks that helped him obtain his Nobel Prize for research on banks and financial crises.
‘The main unit of observation is man’
After winning a high-school spelling bee in South Carolina, Bernanke grew up to become an influential economist. He has been interested in the search for solutions to large-scale problems since his youth. In 1975, at the age of 22, Bernanke wrote his undergraduate thesis at Harvard University on the energy market crisis. In the 1970s soaring oil prices were the number one problem. In his college thesis, ‘An Integrated Model for Energy Policy’, Bernanke demonstrated the benefits of deregulating prices for natural gas using a simple computational model. That thesis won him Harvard’s award for best undergraduate economic paper, and a few years later the US government liberalised the domestic natural gas market. ‘I would say that the government pretty much followed our recommendation,’ recalled Dale Jorgenson, the economics professor who advised Bernanke on his undergraduate thesis. ‘Not because we were in a position to have any influence over the outcome, but that’s just the way things worked out.’
Unlike mainstream economics, which in his youth was sort of a mathematical guise for simple ideas, Bernanke remained a humanitarian by nature. ‘No matter how sophisticated the theory behind an estimated equation, the equation is always naive,’ he wrote, concluding, ‘This is particularly problematical in the social sciences, when the basic unit of observation is so often that political, free-willed, unpredictable character, the individual human.’
This conviction was reflected in his choice of research tools and his preference for economic history over constructing abstract models. As Bernanke recollected, that he was ‘hooked’ when he first read ‘A Monetary History of the United States’ by Milton Friedman and Anna Schwartz in his graduate school years at MIT, and he has been a student of monetary economics and economic history ever since. Bernanke had every reason to believe that the set of equations was no more than a starting point calling for further development.
Nevertheless, the humanitarian practised mathematical modelling in economics, which paved the way for his academic career. According to his fellow students, in his freer hours, Bernanke alternated between games of bridge and advanced maths classes. During his few years in graduate school, he wrote papers on optimal investment timing amid high uncertainty, the reallocation of excessive capacity, unemployment in a two-sector economy, underemployment contracts, capital, and sources of unemployment.
Bernanke’s success was also facilitated by his environment. He found himself in the midst of some of the most brilliant economists of his time. His principal faculty advisor at MIT was Stanley Fischer (future first deputy managing director of the IMF from 1994 to 2001, chairman of the Bank of Israel from 2005 to 2013 and deputy chairman of the US Federal Reserve from 2014 to 2017). His thesis was reviewed by Rudiger Dornbusch (one of the key developers of New Keynesianism) and Robert Solow (winner of the 1987 Nobel Prize in economics), as well as future Nobel Prize co-winner Professor Douglas Diamond. As a result, Bernanke wrote a doctoral thesis entitled ‘Long-term Commitments, Dynamic Optimization, and the Business Cycle’, which he defended at MIT in 1979. The thesis linked microeconomic decision-making models with macroeconomic consequences, in particular, the business cycle.
After receiving his doctorate, Bernanke devoted himself to research. Several years as an assistant professor at Stanford University turned out to be very fruitful and boosted his future recognition. The paper ‘Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression’ is considered his best-known work, and it was written at Stanford when he was 30. It is this very paper that the Nobel Committee believes to be the main achievement of Bernanke’s academic career. In this paper, you will not find any complex equations or modelling, at most it presents a comparison of several aggregate statistical series and regressions describing US banks in the 1930s.
Having analysed the banking crisis during the Great Depression Bernanke arrived at fairly simple conclusions. The macroeconomic turmoil was caused not solely and not so much by monetary policy mistakes made by the US Federal Reserve, as the early monetarists Friedman and Schwartz believed (the so-called ‘monetarist view’ of the causes of the Great Depression). While sharing this view, Bernanke arrived at the conclusion that the massive bank bankruptcies were the real cause: it was the credit squeeze that led to the failure of the monetary mechanism. Today banks are often called the ‘circulatory system’ of the economy, but back then it was not so obvious; rather boldly, Bernanke argued that banks played an independent role in the economy and did not act as its extension. Costs, income distribution and economic growth depend on the state of the banking system.
Bank closures led to the loss of information about borrowers and higher credit risk premiums. Growing interest rates contributed to a squeeze in credit supply and aggregate demand and eventually resulted in a to a prolonged recession. As Bernanke noted, both banks and borrowers acted rationally, but information asymmetry had played a cruel joke, as it were, on both groups.
Normally, well-functioning banks can become counterproductive when exogenous shocks or policy mistakes throw the economy off course, and so Bernanke concluded that the economic crash of the 1930s was a result of bank failures, not the other way around.
Banks and macroeconomics
His next several years as a professor at Princeton University before 2002 shaped his career as an expert on macroeconomics and monetary policy and prepared him for his future work at the US Federal Reserve. In total, the Nobel Committee has identified nine key papers by Bernanke written between his ‘main publication’ and his taking up the position of chair at the Federal Reserve. They were generally devoted to banks’ agency costs and the effect of banks’ collateral impairment. Jointly with Princeton University professor Alan Blinder (the future Vice Chairman of the US Federal Reserve in 1994-1996), Bernanke studied the agency costs of banks, which he later called ‘credit intermediation costs’. Bernanke and Blinder were among the first scholars to introduce credit supply alongside the money supply into the classical Keynesian IS-LM model (the classical macroeconomic model describing the interaction of the commodity market with the money market), and as a result of which the credit demand shock became as important in explaining macroeconomic dynamics as the demand for money.
Moving forward, Bernanke looked into banks’ costs as the main macroeconomic factor of the credit supply. Together with New York University professor Mark Gertler, he described in what way the net asset value of a borrower determines banks’ agency costs. During the business cycle, the net asset value fluctuates, affecting banks’ costs, which in term determines the mutual influence of the business and credit cycles. Banks’ costs comprise the cost of screening (selecting borrowers amid asymmetric information), monitoring their financial standing and record keeping, as well as expected losses, which are covered by provisioning from interest income. Banks maintain operational procedures aimed at minimising agency costs. In unfavourable condiions, they either increase loss provisions, thereby increasing risk premiums and interest rates, or ration credit, i.e. stop dealing with unreliable borrowers. Thus, the cost of credit is increased, while credit supply is reduced.
Together with Gertler, Bernanke concluded that banks should be supported to avoid rising agency costs. This would ensure financial stability and would help avoid deteriorating credit conditions and a macroeconomic slump. They called financial stability policy the ‘transfers that maintain or increase the net worth of potential borrowers’.
The second major theme studied by Bernanke was devoted to financial accelerators. He describes the multiplicative process of increasing unfavourable credit conditions that worsen a borrower’s financial position, leading to a further aggravation of the economic downturn and the emergence of an inverse correlation with the banks’ standing. The basis for the financial accelerator idea can be found in the debt deflation hypothesis proposed by the American economist Irving Fisher during the Great Depression.
Together with Gertler and Simon Gilchrist (who at the time served as a staff economist at the US Federal Reserve’s Board of Governors and then as a professor at New York University), Bernanke formalised the definition of a financial accelerator. The risk premium is inversely proportional to the net assets of the borrower. The authors defined net assets as liquid assets and the collateral value of the borrower’s other assets. The impairment of assets and collateral leads to higher premiums, worsening in the borrower’s financial position, and then again to a reduction in access to credit and impairment of assets and collateral. According to the economists, the financial accelerator reflects endogenous changes in banks’ agency costs over the business cycle. Maintaining the value of assets and collateral is one of the ways to address the credit crunch issue.
An academic in politics
The financial stability themes studied by Bernanke brought him to work in the central bank and later to head it. From 2002 to 2005, he was a member of the US Federal Reserve Board of Governors, and from June 2005 to January 2006, he headed the US President’s Council of Economic Advisers. When President George W. Bush presented him as a candidate for the position of Federal Reserve chairman, Bernanke was known only in the fairly narrow professional community. The public perceived him as a cold-blooded academician with a gloomy look. Colleagues described Bernanke as a modest-looking person with an odd sense of humour. He is a man of brilliant intellect, shrewd, and a master of simple and clear language, able to explain complex things. In other words, not at all like his predecessor, Alan Greenspan, who elevated the vagueness of public speaking to an art.
With his reputation in academic circles, Bernanke was very different from all previous Federal Reserve heads, who usually came from Wall Street. Despite the fact that he was expected to stick to Greenspan’s style, Bernanke introduced several revolutionary changes to the Federal Reserve’s policies. While his predecessor rejected inflation targeting, Bernanke set an official inflation target, believing that such a target would contribute to economic growth and stability. With Bernanke as its head, the Federal Reserve became open and transparent in its communications. As he observed himself, the ability to shape market expectations of future policy through public statements is one of the most powerful tools the Federal Reserve has: ‘Monetary policy is 98% talk and only 2% action’.
Bernanke was Chairman of the Board of Directors of the Federal Reserve for two terms, from 2006 to 2014, when he had to deal with a crisis which was no less severe than the Great Depression. He had fully learned the lessons of his inspiration, Milton Friedman, and flooded the economy with money, conducting unprecedented experiments with quantitative easing by maintaining interest rates ultra-low and buying back debt securities from the market. Banks’ agency costs were minimised, while the value of liquid assets and collateral was preserved.
‘The world was incredibly lucky to have Ben Bernanke sitting in the Federal Reserve during the crisis,’ said his co-laureate Douglas Diamond to the Nobel Foundation. Bernanke described his impressions of anti-crisis policies in his 2019 memoirs ‘Firefighting: The Financial Crisis and Its Lessons’ (link in Russia) co-authored with Henry Paulson (former US Treasury Secretary) and Timothy Geithner (former head of the Federal Reserve Bank of New York). In their opinion, the financial crisis had psychological causes: panic turned into chaos and triggered a crisis of confidence in the financial sector. ‘The world will face the threat of financial crises […] as long as human remain human’, concluded the three ‘firefighting chiefs’.
The span of Bernanke’s ideological influence over the US Federal Reserve’s policy remained in place for several years after his departure. Under President Donald Trump, macroeconomists left the Board of Governors of the Federal Reserve for political reasons and, for the first time in history, a professional lawyer, Jerome Powell, headed the world’s leading central bank. The new team could not come up with anything other than to continue with Bernanke’s course until, in tandem with other factors – ultra-soft fiscal policy and high international commodity prices – this accelerated US inflation to 8% (as of September 2022). They managed to avoid a new Great Depression at the expense of a Great Inflation, the end of which is still unknown.
As for Bernanke, he resumed his beloved analysis of economic history at the Brookings Institute and continued to write articles and books. In 2022, before he was awarded the Nobel Prize, Bernanke published a new book, ‘21st Century Monetary Policy’, which focuses on the economic forces and ideas underlying the Federal Reserve’s activity and how they have evolved in recent decades.
