Monetary Policy: A Lesson Learned

The Federal Open Market Committee (FOMC) recently ended another round of large-scale asset purchases, so now is a good opportunity to take stock of what Fed policy has achieved since the peak of the financial crisis in fall 2008.

Back in 2002, then-Governor Ben Bernanke gave a speech entitled “Deflation: Making Sure "It" Doesn't Happen Here.” His message was that the experience of the 1930s taught us the importance of using aggressive monetary accommodation to avoid deflation. As Chairman of the Federal Reserve Board during the financial crisis of 2007-2009, Bernanke and his colleagues took actions that their 1930s predecessors had not. The result was a Great Recession, not another Great Depression.

The depth and duration of these “Great” downturns differ markedly. During the Great Depression, consumer prices and output each plunged by nearly 30% from their 1929 peak to their 1933 trough. And, it took until 1936 for real GDP to regain its pre-Depression level. By contrast, in the Great Recession, the consumer price index fell by 3.2% during the second half of 2008, but then quickly regained its previous level in less than a year. Output fell by 4.2% from end-2007 to mid-2009, but again it regained its pre-crisis peak by late 2010.

We credit the Federal Reserve with preventing another depression, and thank them for it. To see why, let’s compare the evolution of reserves in the U.S. banking system over the two periods. Reserves are the deposits of commercial banks at the Federal Reserve. The Fed controls the volume of aggregate reserves through its purchase and sale of securities.

Focusing first on the Great Depression, the top chart shows that the Fed held aggregate reserves (the blue line) roughly constant from 1928 to 1933. During this period, the financial system was unraveling: nearly 40% of U.S. banks failed. The mix of Fed policy and widespread banking failures led to a collapse in the quantity of money, bringing prices, output and employment down with it.

To see this, consider the bottom chart, which shows the ratio of M2 to the monetary base (reserves plus currency in the hands of the public). We call this ratio the “M2 money multiplier.” It is a measure of the banking system’s ability and willingness to convert reserves into money. Note that the blue line declines steadily starting around the time of the first banking crisis in October 1930. Over the following 3½ years, this M2 multiplier fell by nearly half. Meanwhile, M2 itself plunged by 36% from its peak in 1929 to its trough in 1932.

The contrast with the recent episode could not be more striking. Looking at the level of reserves (the red line in the top chart), we see that immediately following the Lehman collapse in mid-September 2008, the Fed expanded the supply of reserves from $45 billion to more than $800 billion in a matter of weeks. Over the next four years, the Fed continued this massive expansion of reserves. Today, U.S. banks hold nearly $3 trillion in reserves (see our earlier post on the size of central bank balance sheets). This rise is what analysts commonly refer to as “quantitative easing” (QE).

Looking at the bottom chart, again focusing on the more recent period, we see that this time, the money multiplier fell by two-thirds! That is, during the recent financial crisis the ability and willingness of the banking system to convert reserves into loans and deposits fell even more sharply than it did in the 1930s.

However, there was far less damage. The Federal Reserve’s dramatic QE operations, and the efforts of monetary and fiscal policymakers to stabilize the banks, prevented another collapse of the money supply. Instead, over the past six years, the money supply (measured by M2) has expanded by a cumulative 46%, while annual CPI inflation averaged 2.2%, virtually in line with the FOMC’s long-run objective.

Total Reserves in the Banking System (Billions of dollars)

Sources: Federal Reserve and Friedman and Schwartz, A Monetary HIstory of the United States.

Sources: Federal Reserve and Friedman and Schwartz, A Monetary HIstory of the United States.

Money Multiplier (Ratio of M2 to the Monetary Base)

Sources: Federal Reserve and Friedman and Schwartz, A Monetary HIstory of the United States.

Sources: Federal Reserve and Friedman and Schwartz, A Monetary HIstory of the United States.

The post-crisis actions of the Fed and responses of the banks have a very important implication. Quite a few observers argued that a massive increase in reserves would lead to an uncontrolled inflation. Had the money multiplier in the bottom chart been stable, they would have been right. However, when a financial crisis impairs the banking system, reserve increases do not translate into money creation, so they are not inflationary. In fact, as the experience of the 1930s taught us, in the absence of aggressive actions by the Federal Reserve, the financial crisis probably would have led to deflation and a second Great Depression.

Returning to where we started, on November 8, 2002, then-Governor Bernanke spoke on the occasion of Milton Friedman’s 90th birthday. He described the contribution of Friedman and Anna Schwartz’s A Monetary History of the United States, and how it provided us with an understanding of the connection of money and monetary policy to growth and employment. Bernanke closed his remarks with the following:

“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.”

And, they didn’t!