Like Tim Geithner’s Stress Test, Ben Bernanke’s upcoming The Courage to Act is a long form defense of the decisions he made and the actions he took during the financial crisis.  In both books, the author paints himself as a hero in taking decisive action which, as Mr. Bernanke says on his book’s splash page,

prevented an economic collapse of unimaginable scale.

Sounds great doesn’t it!  Who could possible deny what heroes these two individuals are and disprove this heroic claim as we clearly did not have an economic collapse of unimaginable scale.

In Transparency Games, I point out one small problem with this claim.  It assumes the actions they took were the only ones available at that time that would not have prevented an economic collapse of unimaginable scale.

On the surface, this assumption is unwarranted as it implies during the Great Depression policymakers didn’t take any steps to put in place a policy response that would have prevented a future economic collapse of unimaginable scale.  Without even looking at the legislative history, we know this assumption is false.  Even a divided Congress in 2010 managed to pass legislation, the Dodd-Frank Act, intended to prevent a future economic collapse of unimaginable scale.

So what legislation was passed during the Great Depression that put in place a policy response that might have prevented an economic collapse of unimaginable scale?

The original legislation guaranteeing deposits.

How does this legislation put in place a policy response to prevent an economic collapse of unimaginable scale?

The legislation allows policy makers to contain the problem of excess debt in the financial system.  Policy makers can use bank capital accounts as the sink hole for absorbing the losses on the excess debt and by doing so protect the real economy.  The real economy is protected by making the banks recognize the losses on the excess debt.  As a result, debt is written down to what the borrower can afford to repay and the real economy is not slowed downed or impaired by the burden of this excess debt.

But doesn’t making the banks recognize the losses on the excess debt make the banks insolvent?

Yes, but because of deposit insurance, an insolvent bank is not a bank that is subject to runs by its depositors or out of business.  After all, a depositor who is covered by a deposit guarantee doesn’t care about the financial condition of the bank.  As a result of the deposit guarantee, so long as a bank is viable (it can generate earnings after recognizing its losses) it can remain open and restore itself to solvency by retaining these earnings.

But wait a moment, after taking the losses these banks would have no capital?

Actually, because of deposit insurance, these banks would have massive amounts of capital.  Deposit insurance effectively makes the taxpayer the banks silent equity partner when banks have to recognize losses on the excess debt in the financial system.

Of course, central banks have to be willing to act as a lender of last resort to facilitate these banks’ ongoing operation and liquidity as they gradually rebuild their book capital and restore themselves to solvency.

Geithner and Bernanke’s claim that it was their actions that prevented an economic collapse of unimaginable scale is simple false.  The financial system was redesigned in the 1930s to prevent exactly this from occurring and to allow actions to be pursued that wold result in a better outcome for Main Street.

What Geithner and Bernanke did achieve through their actions was they managed to protect Wall Street rather than Main Street from the damage caused by the excess debt.

That Bernanke’s actions were knowably wrong when he first started taking them in September 2008 was spelled out in an October 2008 Wall Street Journal interview with Anna Schwartz.  Ms. Schwartz wrote the definitive book on monetary policy with Milton Friedman and, at the time of the interview, was the foremost economic expert on the Great Depression.

In the interview, Ms. Schwartz observed Mr. Bernanke was fighting the wrong war.  The problem according to Ms. Schwartz was opacity and Mr. Bernanke was acting as if the problem was a liquidity crisis.

I hope Mr. Bernanke’s book sheds some light on why he didn’t listened to Ms. Schwartz.  Did he not listen as a result of theory-induced blindness?  After all, he was a self-proclaimed Great Depression scholar.

Unlike Mr. Bernanke’s book with his defense of his actions, Transparency Games is focused on what we can do now to end the crisis and restore confidence to both the financial system and the real economy.