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Credit Hunch
January/February 2010


On 12 July 2002, at a 90th birthday reception organised by the University of Chicago, one leading economist promised another economist of even greater fame: "Regarding the Great Depression, you're right. We're very sorry. But, thanks to you, we won't do it again." 

The leading economist was Ben Bernanke, who at that time had been a governor of the US Federal Reserve for four months. He was making a commitment, on behalf of the Fed, to Milton Friedman that it would not repeat its blunders of the Great Depression. Friedman and his co-author, Anna Schwartz, had shown in the classic A Monetary History of the USA that an almost 40 per cent fall in the quantity of money had been responsible for the drastic plunges in US output and employment in the early 1930s. 

When Bernanke made his promise, he could not have known that in late 2008, the US would be confronted by a crisis in financial markets with some resemblances to that of late 1929. As Bernanke is thought to admire Friedman, he would have been expected to follow his advice to prevent a slump. Friedman died in 2006, but every economist knows a key message of the Monetary History. This was that the Fed should have organised expansionary open-market operations (i.e. operations to boost the quantity of money) in the early 1930s and that, if again confronted by a comparable challenge, expansionary open-market operations should be the first item on the agenda. 

In the heat of the immediate crisis, Bernanke behaved as if the Monetary History were his favourite bedtime reading. Between September 2008 and January 2009, the Fed purchased hundreds of billions of dollars of commercial paper, causing rapid expansion of both the quantity of money as such (currency and bank deposits held by the public) and the monetary base (the banks' own cash reserves). 

For nearly all his career, Friedman had focused on the M2 money measure as the lynchpin of macroeconomic analysis. In the five months from mid-September 2008, M2 jumped by 7.5 per cent. That may not sound like much, but — if that post-September pace of monetary growth had continued for a full year — M2 would have been up by more than 20 per cent. If the lessons of history meant anything, 2009 would not be like 1930. Full marks to Bernanke and his Fed colleagues. 

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