I was very pleased to see that Ben Bernanke was awarded the Nobel Prize in Economics. Bernanke had a major influence on my thinking in several different areas. Here I will focus on Bernanke’s 1995 JMCB paper on the Great Depression. This excerpt (discussing the interrelationship of bank runs and exchange rate crises) is particularly important:
A particularly destabilizing aspect of this process was the tendency of fears about the soundness of banks and expectations of exchange-rate devaluation to reinforce each other (Bernanke and James 1991; Temin 1993). An element that the two types of crises had in common was the so-called “hot money,” short-term deposits held by foreigners in domestic banks. On one hand, expectations of devaluation induced outflows of the hot-money deposits (as well as flight by domestic depositors), which threatened to trigger general bank runs. On the other hand, a fall in confidence in a domestic banking system (arising, for example, from the failure of a major bank) often led to a flight of short-term capital from the country, draining international reserves and threatening convertibility. Other than abandoning the parity altogether, central banks could do little in the face of combined banking and exchange-rate crises, as the former seemed to demand easy money policies while the latter required
monetary tightening.From a theoretical perspective, the sharp declines in the money-gold ratio during the early 1930s have an interesting implication: namely, that under the gold standard as it operated during this period, there appeared to be multiple potential equilibrium values of the money supply. Broadly speaking, when financial investors and other members of the public were “optimistic,” believing that the banking system would remain stable and gold parities would be defended, the money-gold ratio and hence the money stock itself remained “high.” More precisely, confidence in the banks allowed the ratio of inside money to base to remain high, while confidence in the exchange rate made central banks willing to hold foreign exchange reserves and to keep relatively low coverage ratios. In contrast, when investors and the general public became “pessimistic,” anticipating bank runs and devaluation, these expectations were to some degree self-confirming and resulted in “low” values of the money-gold ratio and the money stock. In its vulnerability to self-confirming expectations, the gold standard appears to have borne a strong analogy to a fractional-reserve banking system in the absence of deposit insurance: For example, Diamond and Dybvig (1983) have shown that in such a system there may be two Nash equilibria, one in which depositor confidence ensures that there will be no run on the bank, the other in which the fears of a run (and the resulting liquidation of the bank) are self-confirming.
These ideas run through much of my 2015 book on the Great Depression. For instance, in the spring of 1932, the Fed implemented a QE program with the goal of spurring recovery from the Great Depression. Unfortunately, this policy triggered fears of currency devaluation, which led to an outflow of gold from the US. This is one example of what Bernanke calls “multiple monetary equilibria”. As a result, under an international gold standard an expansionary policy initiative might actually end up having a contractionary impact on the economy, especially if it triggers a loss of confidence in the currency.
In the same article, Bernanke discussed evidence that sticky nominal wages may have contributed to the Great Depression:
Using data from ten European countries for 1935, Eichengreen and Sachs showed that Gold Bloc countries systematically had high real wages and low levels of industrial output, while countries not on gold had much lower real wages and higher levels of production (all variables were measured relative to 1929).
In a recent paper, Bernanke and Carey (1994) extended the Eichengreen-Sachs analysis in a number of ways: First, they expanded the sample from ten to twenty-two countries, and they employed annual data for 1931-1936 rather than for 1935 only. Second, to avoid the spurious attribution to real wages of price effects operating through non-wage channels, in regressions they separated the real wage into its nominal-wage and price-level components. Third, they controlled for factors other than wages affecting aggregate supply and used instrumental variables techniques to correct for simultaneity bias in output and wage determination. . . .
Most importantly, the coefficient on nominal wages is highly significant and approximately equal and opposite in magnitude to the coefficient on the price level, as suggested by the sticky-wage hypothesis. In particular, equation (2) indicates that countries in which nominal wages adjusted relatively slowly toward changing price levels experienced the sharpest declines in manufacturing output.
Sticky nominal wages also played a big role in my 2015 book, and more broadly the way I think about business cycles.
PS. I am currently traveling, but will have more to say about Bernanke when I return home later in the week.
PPS. Two members of what I call the “Princeton School of Monetary Economics” have now won Nobel Prizes. Who’s next?
PPPS. To those who say it’s not really a Nobel Prize, I have only two words: Get a life.
Wait, is that three?