In an interview on The Lessons of the Great Depression

So what else should I be reading on the Great Depression?

There’s Ben Bernanke’s research in the 1980s – that’s probably his most important contribution in terms of macroeconomics and financial economics.

Yes, I saw the Dow Jones Newswires quote on Bernanke’s book, Essays on the Great Depression, which made me laugh: “With some observers saying that the ongoing financial crisis could be the worst since the Great Depression, the greatest living expert on that period is getting the chance to apply its economic lessons.”

Well Bernanke was thinking that way in April 2008. I remember talking to him at the time, just after the Bear Stearns initial intervention. I got a chance to ask him a question about why they were so aggressive at that time when things didn’t look so bad. And his response was that basically he was worrying about a Depression-type scenario – and trying to act early to nip that in the bud.

So what is the thrust of his book and why is it important?

It’s focusing on the Great Depression as a credit implosion, not so much the money supply, which Friedman and Schwartz had emphasized, but a somewhat related phenomenon, which is credit availability. That had been imploding from 1929 through to the trough, early in 1933. So it’s really focusing on the credit aspects and trying to measure that, particularly by looking at patterns in interest rates.

Today, for example, if you look at the spread between lower quality bonds – like B-rated corporate bonds, say – and compare those to treasury yields, that’s a good indicator of the extent of stress in the credit markets. And actually the recent period is going back to the kinds of spreads that you saw in the early 1930s. Well, perhaps not quite as much, but certainly reminiscent of that. So he’s focused on that as a measure of the extent of the credit stress, and on the other side he focused on how what turned things around was when the credit problems were being eased.

People often think that the US economy stagnated in the Depression all the way through the 1930s, and didn’t at all get out of that until World War Two – and that really is not accurate, it’s not what the data look like. In fact the growth rate of the US economy from 1933 until 1937 is extremely rapid. It’s actually the fastest growth period of any peacetime period of that length in the whole history. Maybe it’s not as fast as you would have hoped for or wanted, given how big the contraction was, but it’s very rapid – and then it’s unfortunately interrupted by a pretty big recession, 1937-8, which was probably caused by the Federal Reserve doubling the reserve requirement in 1937. It’s pretty unbelievable that they did that actually.

The Fed was probably the reason, though people have advanced other possibilities. But then it starts again, from 1938-41, there’s also very rapid growth, before the US is into the war and has a lot of expenditures. 1941 is the first year where there is a lot of big federal US expenditure related to the war, there’s not really much of a build-up in 1939-40, which is also kind of surprising.

In an interview on Learning from the Great Depression

Your next book is a collection of essays by the current chairman of the Federal Reserve, Ben Bernanke, who was previously a professor of economics at Princeton University. Please explain how this book, and in particular the paper “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”, has added to our understanding of financial downturns.

Chairman Bernanke has written a number of important papers about the Great Depression. The one that really stands out is the paper you mentioned. Friedman and Schwartz showed that banking panics caused a decline in the money supply, which likely depressed output by raising real interest rates. Bernanke argued that a financial crisis also has negative effects working directly through the decline in credit availability. When a financial panic causes banks to go out of business or makes them unwilling to lend, that can have an impact on the economy above and beyond any effects on the money supply. He found evidence from the Great Depression that such non-monetary effects of a banking crisis could be very large.

Bernanke’s focus on the non-monetary effects of financial crises turned out to be incredibly important. It started a whole literature on how credit matters, above and beyond what's reflected in interest rates. He changed our view of how monetary policy affects the economy.

How did Bernanke’s theories impact the understanding and handling of the 2008 crisis?

His work and the subsequent research it inspired made us realise how important it is in a financial crisis not to just prevent the money supply from falling, but also to make sure that credit keeps flowing. We learned from the Great Depression that when credit dries up it has devastating consequences.

That idea had a huge impact on the Federal Reserve's behaviour in the most recent crisis. In response to the financial crisis in the fall of 2008, the Fed not only followed the conventional central bank remedy – flood the system with liquidity and make sure there's plenty of cash out there – but they also took extraordinary actions to keep credit flowing. When they saw credit markets were not functioning, the Fed was incredibly creative in finding ways to make sure that firms could get credit. For example, many businesses issue commercial paper to cover payroll and finance day-to-day operations. When that market stopped functioning and no one was willing to buy commercial paper, the Fed said, we'll buy it.

These aren’t the type of actions that the public has historically associated with central banks. Has monetary policy evolved a lot? What is it?

Conventionally, monetary policy refers to Federal Reserve decisions about setting interest rates. We're used to the Fed saying they're going to push the federal funds rate up or down. But this crisis was so extreme that the Fed had to be much more aggressive and creative. In addition to reducing the funds rate to zero, the Fed has taken a number of actions to keep credit flowing and to reduce interest rates other than the funds rate. Whether you call that monetary policy or credit policy or quantitative easing is somewhat arbitrary. Since all the policies are being conducted by the central bank, I tend to lump them under the broad term of monetary policy.

A lot of people have second-guessed the Obama administration’s fiscal policy response to the “Great Recession”. Would you care to second-guess the monetary policy response?

We often think of the financial crisis as beginning with the collapse of Lehman Brothers, but there was real strain in financial markets starting from late 2007, with the meltdown in subprime mortgages. The Fed worked very hard throughout 2008 to mitigate the consequences of falling house prices and credit contraction. They were very proactive. Then when the crisis hit in the fall of 2008, the Fed was essential in helping to prevent a much more catastrophic meltdown. They kept the financial crisis from being much worse than it otherwise would have been. It's hard to second-guess them on that part of their response.

Where I think you can second-guess them is once we got through the immediate crisis. By the fall of 2009, the financial system had stabilised but the rest of the economy was still reeling from the fallout and unemployment was heading up to 10%. Instead of further aggressive moves to encourage faster recovery, such as more quantitative easing or a bold communications policy, the Fed essentially took a breather. That was a mistake.