Figuring Out Prof Ben's Fed

Worrisome inflation reports and rising un employment have left economic pundits asking if the Federal Reserve and the Bush administration learned anything from the Great Stagflation of the 1970s - other than the Great Depression, the worst economic crisis of the 20th century. They ask: Are plummeting Fed funds rates and the president's stimulus package a 2008 script for an economic policy episode of "That '70s Show"?

It's an odd question. Fed Chairman Ben Bernanke knows the history of the '70s as well as anyone and surely doesn't want a rerun. To see what he's actually up to, forget congressional testimony or Fed Board minutes - look at his scholarly writings.

Here is what Professor Bernanke tells us about Chairman Bernanke:

1) There are two "expectional" levels of money. In his academic writings, Bernanke argues that there are always two possible levels of money, "one in which depositor confidence ensures there will be no run on the bank, the other in which [there are] fears of a run." In the first case, banks can and do loan out much higher multiples of their reserves, putting more money in circulation.

And if confidence collapses (or soars), a country can "jump from one expectational equilibrium to another." The question Bernanke must confront now is whether America is near or (in the midst of) such a jump - and how to stop it, or prompt a jump back.

Today's "banking" system reaches far beyond banks, into the market for structured financial instruments for mortgages and other debt. The subprime crisis has seen shrinking cash reserves, as various financial institutions have taken write-offs that may exceed $100 billion. The result, as one top Wall Street analyst recently told a reporter: As of last month, "A major structured deal has not gotten done in seven months . . . The receptivity of investors to buy anything that's not plain vanilla high-grade debt is as bad as I've ever seen it."

In effect, we're seeing the first bank panic of the modern (non-bank bank and structured finance) era. And as Professor Bernanke notes, "banking panics in a country significantly reduce M1 money stock" - that is, they shift us toward the lower "expectational" level of money, where financial institutions can't confidently lend out (and so won't lend out) as much, meaning less money in circulation.

In this turmoil, neither Bernanke nor anyone else can be confident about the size of the money supply - a first in modern economic policymaking.

2) In unprecented times, the Fed must be ready to junk even the most revered past practices. The most sacred monetary principle in the 1930s, for example, was adherence to the gold standard. Yet Professor Bernanke notes that "countries leaving the gold standard had greater freedom to initiate expansionary monetary policies" than those who did not - that is, they were better able to deal with the collapse of the money supply that was one of that era's greatest problems.

In the current crisis, Chairman Bernanke and his colleagues have broken from the past in decreeing an unprecedented combination of almost cliff-like drops in the Fed funds rate - by 75 basis points (the biggest single reduction in nearly a quarter century) in late January, followed eight days later with a 50 basis point cut.

In another shift, Bernanke has given support (at the very least) for nearly $37 billion in infusions of bank reserves from sovereign wealth funds in Singapore, Kuwait and Saudi Arabia.

If, as Professor Bernanke has written, the goal is confidence, then the drama of Chairman Bernanke's rate cuts and of the sovereign-wealth-fund infusions were as important as the actual added liquidity.

3) Monetary officials must pay attention to more than banks and money.

Professor Bernanke found that "nonindexation of financial contracts may have provided a mechanism through which declining money stocks and price levels could have had real effects on the US economy in the 1930s." In other words, the whole economy felt an impact from financial contracts - including mortgages - that had been written for an entirely different level of interest rates than the one that existed in the Depression. It was a problem for the whole nation, not just the contracting parties.

That insight underlies Chairman Bernanke and the Bush administration's actions in "meddling in private contracts" (as the critics put it) as parts of their package for resolving the subprime crisis - e.g., by setting up mortgage-workout programs and moving to stop some mortgages from resetting to higher rates.

Professor Bernanke also noted: "The observed effects of panics on output and other real variables are operating [in the 1930s] largely through nonmonetary channels, for example, the disruption of credit flows." Today, with the much touted "seizing up" of the banking system, in which many banks cut back on lending not just to consumer and business customers but to other banks, one way to deal with the disruption of credit flows is to bypass the banking system entirely, in other words inject money directly into the economy. This is what the administration's stimulus package (which Bernanke has supported) does. In that sense, the package is monetary rather than fiscal policy.

Professor Bernanke's study of the '30s has clearly guided Chairman Bernanke's prescriptions for 2007-08. But today's economy - the banking system, the volume and speed of international financial flows, the US place in the global economy - is vastly different. The ultimate question is: Are lessons of that time the right ones to employ today?

Clark S. Judge is managing director of the White House Writers Group Inc.