Dr. Bernanke has referred to the understanding of the forces behind the Great Depression as the “Holy Grail of Economics.” But was the Great Depression chiefly the consequence of post-crash policy mistakes, as conventional thinking has come profess? Was it really a case of the Federal Reserve having grossly failed in its responsibility to expand the money supply? Or did the previous “Roaring Twenties” Bubble sow the seeds of a major down-cycle and collapse?
Having in the past carefully read through Bernanke’s writings on the twenties and subsequent depression, it was clear his analysis had a fundamental flaw: it disregarded momentous market dynamics that unfolded following the creation of the Federal Reserve system and recovery following the first world war.
The unprecedented buildup of speculative leverage throughout the twenties boom played an instrumental role in systemic liquidity abundance that fueled both financial distortions and economic maladjustment. Confidence in the Federal Reserve’s capacity to sustain marketplace liquidity was instrumental in bolstering a progressively speculative market environment that culminated in the 1927 to 1929 speculative blow-off.
There are those who believe the Federal Reserve should have acted even more aggressively when subprime cracked in mid-2007. More aggressive stimulus measures (why not QE in 2007?) and a Lehman bailout would have averted the “worst financial crisis since the Great Depression.”
As the late Dr. Kurt Richebacher would often repeat, “the only cure for a Bubble is to not let it inflate.” Certainly, the longer Bubbles expand the greater the underlying fragilities – ensuring timid central bankers unwilling to risk reining in excess. This was the problem in the late-twenties and in 2006/2007. I would argue this has been a fundamental dilemma for central bankers persistently now for going on a decade. Especially after the Bernanke Fed targeted risk assets as the key reflationary mechanism, central banks have been loath to do anything that might risk upsetting the markets. Remember the 2011 “exit strategy” – promptly scrapped in favor of another doubling of the Fed’s balance sheet to $4.5 TN (by 2014). (more…)