The Fed as the U.S. Economy’s New Central Planner

The Federal Reserve emerged from the financial crisis of 2007–2009 with new powers to allocate credit to specific firms, including non-bank institutions. This development in effect makes the central bank the U.S. economy’s central planner. But why did Fed Chairman Ben Bernanke lobby for the new lending powers, rather than rely on the Fed’s traditional tools? The answer goes back to his idiosyncratic views about the Great Depression, argues Jeffrey Rogers Hummel in the lead article in the Spring 2011 issue of The Independent Review.

Bernanke agrees with the late Milton Friedman that the Fed is largely to blame for the bank failures that led to the Depression, but he disagrees about the causal mechanism—and thus about the proper course for the Fed to have followed. Friedman, for example, believed the Fed could have prevented the contraction of the early 1930s by injecting enough money and credit into the banking system to keep the level of total spending in the economy (and the level of prices) unchanged, even if some important banks might still have failed. Bernanke, in contrast, has suggested that this course of action would not have sufficed: in addition to maintaining total spending, he thinks the Fed also should have kept credit flowing to the borrowers of important banks, even if those banks needed targeted bailouts to stay afloat.

Thus, the Fed’s new powers reflect the importance that Bernanke places on preserving existing channels of credit when key banks (and non-bank credit providers) face severe strain. According to Hummel, however, the Fed’s success in handling three potential financial crises since the late 1980s undermines the case for Bernanke’s brand of activism: the stock-market crash of October 1987, the public’s worries about Y2K, and the terrorist attacks of September 11, 2001. The Fed met each challenge without the use of targeted bailouts.

“Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner,” by Jeffrey Rogers Hummel (The Independent Review, Spring 2011)

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[This item was cross-posted in April 19, 2011, issue of The Lighthouse. For a free subscription to this nifty weekly email newsletter, go here.]