The Fed’s failure to stabilize and restore aggregate demand meant it was passively tightening. This failure to act was epitomized by the Fed’s decision in September, 2008 to not lower the federal funds rate despite the collapsing economy. This passive tightening is what turned a mild recession into the Great Recession. Note that the financial crisis was a consequence of this failure, not the cause. Just like in the Great Depression, the Fed’s failure to stabilize aggregate demand lead to a severe financial panic. But you will never hear Chairman Bernanke admit it. For it would not be good PR for the Fed to acknowledge its failure. And that is why Bernanke did not discuss the passive tightening of monetary policy in his lecture.
So I´ll just put up a version of a chart Bernanke showed. It´s clear we´ve experienced a miniaturized version of the “Great Depression”. Given what Bernanke says in his talk and DB´s arguments, it´s unfortunate that one of Bernanke´s “passport to fame” was his 1983 AER article “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. It has become the conventional wisdom (see here) and unfortunately so, because the consequence, as argued by DB, is “passive tightening” in steroids, which leads, as Bernanke concludes, to:
We began by noting the two principal tools and responsibilities of central banks
– serving as lender of last resort to prevent or mitigate financial crises
– using monetary policy to enhance economic stability
The Fed and other central banks used both tools extensively in the crisis and its aftermath. These tools helped prevent a repeat of the Great Depression of the 1930s and set the stage for a slow but continuing economic recovery.
Used BOTH tools? The second one has been used at most parsimoniously. Maybe that´s why I keep thinking of Adele´s (Could have had it all) “Rolling in the deep”!