Ben Bernanke, the nominee to replace Alan Greenspan this month as chairman of the US Federal Reserve Board, is a highly capable economist who has devoted his professional life to understanding the historical role of central banks and the problems that they have faced. His views represent, as much as can be expected, a consensus among those who have studied the issues carefully.
But that does not mean that Bernanke is prepared to ensure that healthy economic growth continues in the US in the coming years and provide the kind of leadership that the world needs. By the standards of what is generally understood today, he will do a good job. Unfortunately, that may not be enough.
John Maynard Keynes once said that monetary policy may work like a string. A central bank can pull the string (raise interest rates) to rein in an economy that is galloping ahead unsustainably. But it cannot push the string up: If economic growth stalls, as when confidence is seriously damaged, lowering interest rates may not be enough to stimulate demand. In that case, a recession can occur despite the central bank's best efforts.
Bernanke made his name as an economist by analyzing the worldwide Great Depression of the 1930s -- good expertise to have, since preventing such disasters is a central bank head's most important job. The Great Depression, which followed the stock market crash of 1929, saw unemployment rise sharply in many countries, accompanied by severe deflation. In the US, consumer prices fell 27 percent between 1929 and 1933, and the unemployment rate topped out in 1933 at 23 percent.
According to Bernanke's "debt deflation" theory, the collapse in consumer prices was one of the causes of the Great Depression, since deflation raised the real value of debts, making it difficult to repay loans. As Bernanke pointed out, 45 percent of US farms were behind on mortgage payments in 1933, and in 1934, default rates on home mortgages exceeded 38 percent in half of the US cities. The debt burden destroyed consumer confidence and undermined the banking system, crippling the economy.
No gold standard
Bernanke's research also stressed that the sooner a country abandoned the gold standard, the better off it was. Adhering to the gold standard during the Great Depression implied a deflationary monetary-policy bias, since it required keeping interest rates relatively high to encourage investors to hold deposits in banks rather than demanding the gold that backed them. Once a country eliminated convertibility into gold, it was free to pursue monetary expansion, and deflation tended to end.
But Bernanke's impressive research on the Great Depression does not mean that he can prevent the next recession or depression, for stopping deflation hardly solves all problems. After all, the US went off the gold standard in 1933, and the Fed cut the discount rate to 1.5 percent in 1934, ending deflation (except for minor episodes); but the unemployment rate did not fall consistently below 15 percent until 1941 and the onset of World War II.
Bernanke will thus have to be careful about over-generalizing from his past research, just as medical specialists must be careful not to over-diagnose diseases in their own specialty and military strategists must be careful not to over-prepare to fight the last war.