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PARFAIT (PARTII)

Is Bernanke ready?

By Robert J. Shiller

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 1930’s – 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% between 1929 and 1933, and the unemployment rate topped out in 1933 at 23%.

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% of US farms were behind on mortgage payments in 1933, and in 1934, default rates on home mortgages exceeded 38% in half of US cities. The debt burden destroyed consumer confidence and undermined the banking system, crippling the economy.

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% in 1934, ending deflation (except for minor episodes); but the unemployment rate did not fall consistently below 15% until 1941 and the onset of World War II.

Bernanke will therefore 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.

Of course, this does not mean that we should ignore the past altogether. A 2005 study headed by Guillermo Calvo, Chief Economist for the Inter-American Development Bank, found important similarities between the Great Depression of the 1930’s and economic crises since 1980 in 31 emerging countries. But the study also found important differences.

The fundamental experience of the Great Depression has repeated itself, on a smaller scale, many times and in many countries in recent decades: a shock in financial markets, followed by a sharp decline in gross domestic product. But the behavior of consumer prices in the post-1980 crises is fundamentally different from that seen in the 1930’s. In contrast to the Great Depression, collapsing national output was in recent decades accompanied by accelerating inflation, not deflation. The Calvo study thus concludes that Bernanke’s debt deflation theory of the Great Depression does not generally apply to the more recent crises.

At the same time, Bernanke is inheriting a pair of economic vulnerabilities that are unusual by historical standards, and that did not precede the Great Depression of the 1930’s. We are now in the late stages of the biggest real estate boom in US (or world) history, driven by frenzied market psychology. In contrast, US home prices were uneventful before the Great Depression, and actually fell slightly in real terms between 1925 and 1929. Moreover, we are now experiencing a fundamental change in expectations about oil prices: not only are today’s prices quite high in real terms by historical standards, but the futures markets indicate that prices are expected to remain high for years to come. In contrast, real oil prices were flat leading up to 1929, and down nearly 50% in real terms from the 1925-6 “fuel folly” peaks.

In the near future, substantially higher oil prices, lower real estate prices, or both, could, depending on public reaction, put Bernanke into uncharted territory for economic stress. If confidence declines, his historical understanding of the Great Depression of the 1930’s could leave him ill-equipped to prevent such shocks from sinking the US, and the world, economy. He might find himself pushing on a string.

Robert J. Shiller is Professor of Economics at Yale University, Director at Macro Securities Research LLC, and author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.