Bernanke's History Lesson

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Will Bernanke keep the emphasis on fighting the financial crisis and economic slowdown even if inflation continues to be a problem? One clue comes from his academic work on the Great Depression, which oddly enough posed a similar dilemma for the newly formed Fed. Bernanke has written that the Federal Reserve itself worsened what would have been an ordinary recession beginning in August, 1929. The Fed, he said in a 2002 speech, ignored severe troubles in the banking system and kept rates high to keep gold from escaping abroad.

Is History Repeating Itself?

The parallels between the Great Depression and now are instructive, if inexact. In the 1920s there was a stock market surge, a tech craze (in radio), and a real estate bubble (in Florida). The Fed should have cut rates aggressively after the recession began in 1929, but instead it kept them high and even raised them in the mistaken belief that it was essential to keep the dollar's link to gold (high rates encouraged foreigners to hold dollars instead of exchanging them for gold). In his research at Princeton University, Bernanke showed that the longer countries remained on the gold standard during the 1930s, the deeper their depressions were. Back then, the hawks argued for staying on the gold standard.

The equivalent argument today is inflation should be Public Enemy No.

1. And the equivalent policy mistake would be keeping rates too high to fight price hikes. Bernanke may well lean away from making that mistake because his intuitions have been shaped so strongly by his long study of similar errors in the 1930s. "Bernanke is highly aware of the central bank's role as a lender of last resort to prevent serious disruptions to the financial system," says Barry Eichengreen, a University of California, Berkeley, economist.

That's not to say the Fed chief's choice is easy. He's also acutely aware that if higher inflation becomes entrenched, the Fed will eventually be forced to raise rates even more to beat it back down. Under the Fed chairmanship of Paul Volcker, it required lifting the federal funds rate to 19% and a pair of punishing recessions from 1980 to 1982 to break the inflation fever of the 1970s. And complex financial innovations such as securitization make it harder for the Fed to get a read on financial conditions, let alone influence them. So anything's possible. Says Eichengreen, "Central bankers are kind of making things up as they go."

Leadership May Lie in Cutting Rates

The Fed under Bernanke has been innovative in keeping the banking system well supplied with money. It has lent money to banks for longer terms and accepted more kinds of collateral from a broader range of institutions. It cut the federal funds rate by 1.25 percentage points in January alone. As bad as financial conditions are, they would probably be worse without some of the Fed's creative measures.

But the lower the funds rate gets, the more resistance Bernanke will face. Richard W. Fisher, president of the Federal Reserve of Dallas, was the lone dissenter to the bank's Jan. 30 cut. In a Feb. 7 speech in Mexico City he likened easy money to "truly great tequila"—tasty but dangerous. The question is how much Bernanke will defer to dissenters who oppose rate cuts. He once said the Depression occurred in part because "the central bank of the world's economically most important nation in 1929 was essentially leaderless and lacking in expertise." If that's his attitude, he may decide that leadership lies in cutting rates as long as needed to steer the economy clear of danger.

Coy is BusinessWeek's Economics editor.