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Did Bernanke save us from another Great Depression?

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Even a severe downturn can be followed by rapid recovery without aggressive central bank intervention. In the 1921 recession, wholesale prices, industrial production, and manufacturing employment all fell by 30 percent or more within a year. Yet by early 1922, the US economy had recovered fully from its mid-1921 low. What's more, it did so with no help from the Fed, which was determined to let the recession take its course, so as to hasten the restoration of the prewar gold standard.

Bernanke, in contrast, has been praised for taking bold, innovative measures to tame a supposedly unprecedented economic collapse. But his innovations included errors of both commission and omission that almost certainly deepened the recent downturn, making it last that much longer.

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.

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