The Federal Reserve was created 100 years ago in response to the harsh recession associated with the Panic of 1907. Comparing that recession with the Great Recession of 2007–09 suggests the Fed can mitigate downturns to some extent. A statistical analysis suggests that if a central bank had lowered interest rates during the 1907 panic the same way the Fed did during the 2008 financial crisis, gross domestic product would have contracted two percentage points less than it actually did.
And if the 1907 Panic would have been less severe, maybe there would have been no Fed created — at least not in 1913. And if no Fed, then would the Great Depression — or Great Contraction, as monetarists often describe it — have been merely a Great Recession, if that? As Ben Bernanke admitted to Milton Friedman: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
And if no Great Depression, then no New Deal? That’s the conclusion of Lawrence Stratton and Paul Craig Roberts in a 2001 Hoover Institution essay: “The great depression and its offspring, the New Deal, could both have been avoided if the Federal Reserve had performed the task assigned to it. … The Great Depression occurred because the Federal Reserve missed every opportunity to take active measures to ease the internal drain on bank reserves.”
The Great Depression shattered public faith in free markets, increased faith in big government. Indeed, market monetarists have made a similar point, arguing that big economic downturns frequently get blamed on free-market failure with government fiscal stimulus riding to the supposed rescue. Then again, conservative amnesia about the role of monetary policy in dealing with economic shocks has left the field to the Keynesian spenders. If Ben Bernanke really did have a time machine and could use it only once, maybe bringing Friedman to 2013 would be its best use.