NCPA - National Center for Policy Analysis

The Expanding Role of the Federal Reserve

April 8, 2011

Both Ben S. Bernanke and Milton Friedman are economists who studied the Great Depression closely.  Bernanke agrees with Friedman that what made the Great Depression truly great rather than just a garden-variety depression was the series of banking panics that began nearly a year after the stock-market crash of October 1929.  And both agree that the Federal Reserve (the Fed) was the primary culprit by failing to offset, if not by initiating, that economic cataclysm within the United States, says Jeffrey Rogers Hummel, an economics professor at San Jose State University.

This seeming similarity, however, disguises significant differences in Friedman's and Bernanke's approaches to financial crises -- differences that have played an enormous yet rarely noticed role in the recent financial crisis.

The differences between Bernanke and Friedman center on why the banking panics associated with the Great Depression generated economic catastrophe.

  • For Friedman, the causal mechanism was the resulting changes in the money stock and therefore in the equilibrium price level.
  • Yet, Bernanke believes that during the Great Depression "banking panics contributed to the collapse of output and prices through nonmonetary mechanisms" by "creating impediments to the normal intermediation of credit.
  • These two explanations for the Great Depression's severity are admittedly not mutually exclusive, but very different policies are implied, depending on which effect is primary.

As a result, Bernanke has added to the Fed's traditional function of simply manipulating the money supply and letting the market determine where the credit will flow, the function of centrally allocating credit, much of which it has borrowed.  He has so expanded the Fed's discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner, says Hummel.

As the prolonged and incomplete recovery from the recent recession suggests, however, the Fed's new central planning, like the old central planning, will ultimately prove an unfortunate and possibly disastrous failure.

Source: Jeffrey Rogers Hummel, "The Federal Reserve's Emergence as the U.S. Economy's Central Planner," Independent Review, Spring 2011.

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