In Bernanke´s response to Krugman´s comments on his paper presented at the Brookings Conference on 10 years after Lehman, Bernanke begins:

Why was the Great Recession so deep? Certainly, the collapse of the housing bubble was the key precipitating event; falling house prices depressed consumer wealth and spending while leading to sharp reductions in residential construction.

Was the collapse of the housing bubble the key precipitating event? Apparently not. Sweden, for example also experienced a similar rise in house prices, but there was no “collapsing bubble”.

However, the recession in Sweden was “greater” (or deeper) than in the US.

Bernanke goes on:

However, as I argue in a new paper and blog post, the most damaging aspect of the unwinding bubble was that it ultimately touched off a broad-based financial panic, including runs on wholesale funding and indiscriminate fire sales of even non-mortgage credit. The panic in turn choked off credit supply, pushing the economy into a much more severe decline than otherwise would have occurred.

As we saw, the decline in Sweden, which had no collapsing bubble, was even stronger. Monetary policy, as gauged by the growth of nominal spending (NGDP), is consistent with the comparative results.

The fall in NGDP growth was steeper and deeper in Sweden.

Bernanke adds:

Certainly, a reduction in credit supply will affect normally credit-sensitive components of spending, like capital investment, as Krugman notes. But a broad-based and violent financial panic, like the one that gripped the country a decade ago, will also affect the behavior of even firms and households not currently seeking new loans. For example, in a panic, any firm that relies on credit to finance its ongoing operations (such as major corporations that rely on commercial paper) or that might need credit in the near future will face strong incentives to conserve cash and increase precautionary savings.

Conserve cash” is the key idea. That means velocity falls (money demand increases), maybe substantially. To maintain nominal stability, the Fed has to increase the money supply to offset, as closely as possible the fall in velocity.

Bernanke´s Fed did the opposite. It bottled money!

For a short time, Sweden experienced a more robust recovery.

Again, monetary policy explains the difference.

Towards the end, Bernanke returns to his “credit view”, emphasizing the “panic”:

The fact that forecasts still badly underestimated the rise in unemployment and the depth of the downturn suggests that some other factors—the financial panic, in my view — would play an important role in the contraction.

Here, also, Sweden provides a counterpoint.

In 2014, Lars Swenson, who had quit the Monetary Policy Committee of the Riksbank in disgust, wrote:

Four years ago, Sweden appeared to be a model for the global recovery. A monetary policy innovator, it had brought in negative interest rates in 2009. Having already cleaned up its banks and taken strenuous efforts to spruce up a hitherto overtaxed economy, it was rewarded with growth above 6 per cent.

It looked as though the Swedes would show others the way out of recession. Sweden did indeed provide an example, but not one that others should follow.

From 2010 the Riksbank started to tighten monetary policy. Initially the reason was concern about rising prices, but as inflation fell the Riksbank appeared to downplay its statutory objective of keeping inflation to “around 2 per cent per year”, and instead started to set interest rates with an eye on high levels of household debt.

The NGDP and RGDP level trend charts provide a clear illustration of the damage done when monetary policymakers decided to focus on “financial stability” (or debt levels). The recovery was aborted.

Meanwhile, the Fed never tried to recover. It failed from the get go!

Concluding his piece, Bernanke writes:

The failure of conventional economic models to forecast the effects of the financial panic relates to another point made by Krugman in a more recent post, in which he argues that the experience of the crisis and the Great Recession validates traditional macroeconomics.

On many counts—such as the prediction that the Fed’s monetary policies would not be inflationary — I did and still do agree with him. However, as I discuss in my paper, current macro models still do not adequately account for the effects of credit-market conditions or financial instability on real activity. It’s an area where much more work is needed.

The lesson of Sweden´s pursuit of “financial stability” should be headed.


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