John Cochrane recently wrote that Milton Friedman and Ben Bernanke were wrong to claim the Great Depression was caused by a shortage of money. He called the idea “unintentionally hilarious” and said it “gets the correlation vs. causation gold star.”
Ok, not really. Cochrane actually said these things regarding a column at Forbes.com by Lois Woodhill about how the Fed’s policy of paying banks interest on their reserves (IOR) caused the economy to “tank.” But to see how Woodhill’s statement is equivalent to Friedman and Bernanke’s, let’s think about the events of the Great Depression and the Great Recession.
In the 1920s, the Fed’s easy money policies caused an artificial boom in the housing and financial markets. The bubble burst in 1929, plunging the economy into recession. The Fed refused to rescue failing commercial banks, which created a shortage of money in the economy. This inhibited economic activity and turned a normal recession into the Great Depression
In the 1920s early 2000s, the Fed’s easy money policies caused an artificial boom in the housing and financial markets. The bubble burst in 1929 2007, plunging the economy into recession. The Fed refused to did rescue failing commercial banks, which created a shortage of money in the economy (through its IOR policy). This inhibited economic activity and turned a normal recession into the Great Depression Recession.
So what caused the Great Depression? The boom and bust of the 1920s led to a depression, but the shortage of money is what made it “great.” The Fed’s failure on this front is commonly referred to by economists as the cause of the Depression. As Ben Bernanke famously told Milton Friedman, “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
If Bernanke and Friedman are correct that a shortage of money caused the Great Depression, shouldn’t we say the Fed’s IOR policy caused the Great Recession?
I think Cochrane would agree with my summary of the Great Depression but perhaps disagree with my description of the Great Recession. His comment about correlation vs. causation indicates he believes a lack of economic activity caused banks to hold more reserves, not that higher bank reserves caused the decline in economic activity. This position, however, seems to indicate money has been too loose since the financial crisis rather than too tight as described by Scott Sumner and other monetary economists.
Cochrane may be correct that reserves aren’t deflationary, but they are “disinflationary.” As explained in my previous blog post, the new money created by the Fed since 2008 was intended to stimulate the economy, but it never entered circulation because of IOR. “Over 84% of the base money created by the Fed’s QE spending was absorbed onto banks’ balance sheets as reserves rather than entering the economy through bank loans.”
Because it prevented new money from entering the economy, the Fed’s IOR policy is at least a partial cause of the Great Recession.