Did Bernanke save us from another Great Depression?

Until the late summer of 2008, the Fed responded to what was really a solvency crisis as if it were a liquidity crisis, establishing the Term Auction Facility in December 2007 and dramatically lowering its interest rate target. Yet while it was taking these steps, the evidence pointed not to a liquidity shortage, but to fears of counterparty exposure to losses on mortgage-backed securities, as the cause of the credit squeeze. The Fed's actions, both on its own and in conjunction with the US Treasury, did nothing to allay those fears.

On the contrary: they compounded them by throwing good money after bad, rewarding imprudent financial firms at the expense of their more prudent rivals, including prospective buyers, while unsettling financial markets all the more by suggesting that even Bernanke himself was tossing in the towel on old-fashioned monetary policy.

Starting in the late summer of 2008, the Fed erred the other way. Thanks partly to its (and the Treasury's) previous missteps, including scare tactics used to cow Congress into approving the Treasury's bailout plan, a genuine liquidity crisis had taken hold by then. Yet the Fed resisted a much-needed loosening of monetary policy until early October. Then, although it finally took steps to aggressively expand bank reserve credits, it undermined the potential stimulus effect of doing so by starting a new policy of paying interest on bank reserves. In short, the Fed behaved much as it had back in 1936-37 when, fearing inflation (of all things), it decided to double bank reserve requirements, plunging the US back into the Great Depression from which it was struggling to emerge.

In many ways, Bernanke was dealt a tough hand when he became chairman. The Fed made lots of mistakes earlier this decade – primarily, holding interest rates too low for too long – that weren't entirely his fault.

But when the crisis hit during his watch, he faced a choice: He could have stuck to orthodox rules that would have helped sever the link between the housing market collapse and recession, by keeping Fed firmly focused on the goal of preserving the overall availability of liquidity to the banking system. Instead, he took the lead in developing wasteful, ad-hoc handouts to individual banks that often didn't need or weren't worthy of them. A strict focus on its traditional duty of maintaining sound banks' access to funds would also have kept the Fed from actually undermining bank solvency by subsidizing imprudent firms.

If Congress really wants to encourage Bernanke to successfully combat future recessions, it needs to take steps to force him to stick to traditional monetary policy procedures, instead of congratulating him for innovations that may well have done more harm than good. After all, no one congratulates Granny, and she never did anyone any harm.

George Selgin is a professor of economics at the University of Georgia's Terry College of Business and a senior fellow at the Cato Institute in Washington.

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