A Crash Course for Central Bankers

A Crash Course for Central Bankers

<table border="0" cellpadding="0" cellspacing="0" width="100%"> <tr> <td width="80%">By Ben S. Bernanke </td></tr></table>

September/October 2000

<table width="300"><tr><td>Difference maker: Bernanke (right) believes central bankers hold the key to preventing painful economic crashes. </td></tr></table>

A collapse in U.S. stock prices certainly would cause a lot of
white knuckles on Wall Street. But what effect would it have on the
broader U.S. economy? If Wall Street crashes, does Main Street follow?
Not necessarily. Consider three famous episodes: the U.S. stock market
crash of 1929, Japan’s crash of 1990-1991, and the U.S. crash of 1987.The
1929 U.S. crash and the sharp decline in Japanese stock prices were
both followed by decade-long economic slumps in each country. (The
Japanese depression, despite much whistling in the dark by the
country’s policymakers, still lingers.) By contrast, the macroeconomic
fallout from the 1987 tumble on Wall Street was minimal. Why the
difference?
A closer look reveals that the economic repercussions of a
stock market crash depend less on the severity of the crash itself than
on the response of economic policymakers, particularly central bankers.
After the 1929 crash, the Federal Reserve mistakenly focused its
policies on preserving the gold value of the dollar rather than on
stabilizing the domestic economy. By raising interest rates to protect
the dollar, policymakers contributed to soaring unemployment and severe
price deflation. The U.S. central bank only compounded its mistake by
failing to counter the collapse of the country’s banking system in the
early 1930s; bank failures both intensified the monetary squeeze (since
bank deposits were liquidated) and sparked a credit crunch that hurt
consumers and small firms in particular. Without these policy blunders
by the Federal Reserve, there is little reason to believe that the 1929
crash would have been followed by more than a moderate dip in U.S.
economic activity.The downturn following the
collapse of Japan’s so-called bubble economy of the 1980s was not as
severe as the Great Depression. However, in some crucial aspects, Japan
in the 1990s was a slow-motion replay of the U.S. experience 60 years
earlier. After effectively precipitating the crash in stock and real
estate prices through sharp increases in interest rates (in much the
same way that the Fed triggered the crash of 1929), the Bank of Japan
seemed in no hurry to ease monetary policy and did not cut rates
significantly until 1994. As a result, prices in Japan have fallen
about 1 percent annually since 1992. And much like U.S. officials
during the 1930s, Japanese policymakers were unconscionably slow in
tackling the severe banking crisis that impaired the economy’s ability
to function normally.
Central bankers got it right in the United
States in 1987 when they avoided deflationary pressures as well as
serious trouble in the banking system. In the days immediately
following the October 19th crash, Federal Reserve Chairman Alan
Greenspan—in office a mere two months—focused his efforts on
maintaining financial stability. For instance, he persuaded banks to
extend credit to struggling brokerage houses, thus ensuring that the
stock exchanges and futures markets would continue operating normally. (U.S.
banks, which unlike their Japanese counterparts do not own stock, were
never in any serious danger from the crash.) Subsequently, the Fed’s
attention shifted from financial to macroeconomic stability, with the
central bank cutting interest rates to offset any deflationary effects
of declining stock prices. Reassured by policymakers’ determination to
protect the economy, the markets calmed and economic growth resumed
with barely a blip.There’s no denying that a
collapse in stock prices today would pose serious macroeconomic
challenges for the United States. Consumer spending would slow, and the
U.S. economy would become less of a magnet for foreign investors.
Economic growth, which in any case has recently been at unsustainable
levels, would decline somewhat. History proves, however, that a smart
central bank can protect the economy and the financial sector from the
nastier side effects of a stock market collapse.


Ben S. Bernanke is Howard Harrison and Gabrielle Snyder Beck
professor of economics and public affairs and chair of the department
of economics at Princeton University.