Anon of 3:39 PM,
I agree we have the possibility of a very serious meltdown if the financial system continues to lose equity and credibility.
In all fairness to Bernanke, he inherited a complete mess.
And unfortunately, he appears to have been too responsive to critics who thought he might be too “academic” and seems to get a lot of his information from people on Wall Street (at least that is the impression given in recent WSJ story on his decision-making).
The lesson that is generally taken from the Depression is that the Fed should have provided increased money supply.
However, according to this comment by Paul Krugman in the New York Review of Books, it’s not accurate.
He notes earlier in the article that the Fed does not control money supply directly, merely the so-called “monetary base”:
In interpreting the origins of the Depression, the distinction between the monetary base (currency plus bank reserves), which the Fed controls directly, and the money supply (currency plus bank deposits) is crucial.
The monetary base went up during the early years of the Great Depression, rising from an average of $6.05 billion in 1929 to an average of $7.02 billion in 1933.
But the money supply fell sharply, from $26.6 billion to $19.9 billion. This divergence mainly reflected the fallout from the wave of bank failures in 1930–1931: as the public lost faith in banks, people began holding their wealth in cash rather than bank deposits, and those banks that survived began keeping large quantities of cash on hand rather than lending it out, to avert the danger of a bank run.
The result was much less lending, and hence much less spending, than there would have been if the public had continued to deposit cash into banks, and banks had continued to lend deposits out to businesses. And since a collapse of spending was the proximate cause of the Depression, the sudden desire of both individuals and banks to hold more cash undoubtedly made the slump worse.
The implication is that the real danger in the public no longer putting their money in banks, due either to loss of faith in the banking system or by getting into a deflationary crisis where interest rates are so low that no one has any incentive to put their money in banks.
Now consider the modern world.
We now have a tremendous amount of credit creation that takes place outside the banking system, via what Mohamed El Erian called “liquidity factories.” They include investment banks, private equity firms, and hedge funds.
Due to deregulation, the system is more highly geared than before.
So what happens? Even banks that aren’t impaired get cautious about lending.
Investors quit putting their money in anything having to do with structured credit. They get more nervous about hedge funds.
And investment banks shrink their balance sheets, both due to damage to their equity bases and new found caution.
The result? I can’t imagine it won’t shrink money in supply, properly measured.
It will at least severely decrease the velocity of money.
That suggests the most important course of action is to try to restore faith in the sorts of financial activity that have become discredited (although CDOs are such a dubious invention I don’t see how it is possible to salvage their now-deserved bad reputation).
For instance : a ot of structured credit is sound.
Velocity Mortgage Capital
How do you restore confidence in it?
In my thinking, the Fed should be focusing much more on how to create greater transparency and what needs to be done to the ratings process so people will believe ratings again so that investors can make sound decisions. But that will take a lot of though, and will also step on a lot of toes. We probably need to have the train wreck to get the powers that be to address the real problems.