On Friday, Federal Reserve Chairman Ben Bernanke “applauded” the passage of a $700 billion financial bailout because it was “a critical step toward stabilizing our financial markets and ensuring an uninterrupted flow of credit to households and businesses”. In addition, he promised that the Fed "will continue to work closely with the Treasury as it undertakes these new initiatives … [and] continue to use all of the powers at our disposal to mitigate credit market disruptions and to foster a strong, vibrant economy." What he didn’t say was that the bailout will do nothing to address the underlying causes of the financial crisis and, instead, will likely make things worse because it grants ever more power to the one institution most responsible for the crisis in the first place – the very entity Bernanke runs.

That’s right campers, despite all the rhetoric to the contrary, the sudden contraction of credit, the real estate fiasco and the ripple effect that these items have had on both Wall Street and Main Street were not the result of corporate greed or excess deregulation or even, at least at the outset, the nature of mortgage lending. The initial cause of the crisis was none other than the irresponsible actions of the Federal Reserve Board. And despite the comments of our come-to-the-rescue Fed Chairman, there is absolutely no doubt that he knows it.

In looking for a cause of the monetary meltdown, much attention has been focused on the policies of the current administration, the disinterest of Barney Frank and Chris Dodd, the endless appetites of mortgage lenders, the irresponsibility of borrowers, etc., but, while there is plenty of blame to go around, ultimately all of these things are merely symptoms, rather than causes. The desire of lenders to initiate mortgages and borrowers to purchase homes is not new. The corruption or inattention or incompetence of public officials is not new. And none of the deregulatory actions undertaken in the last thirty years had anything whatsoever to do with the failure of so many mortgage-backed instruments. What, then, caused these pre-existing conditions to become a suddenly severe economic malady?

What, indeed. While political sound-bytes eagerly compare current conditions to the Great Depression, it is interesting to examine what similarities there are between the two events. Certainly, there is no comparing the severity of the two events. Of the more than 25,000 banks in business in 1929, fewer than 15,000 survived to 1933; unemployment rose to 25% in 1933 (and, after improving, spiked again to 19% in the wake of FDR’s policies); the economy shrank by more than a quarter in just four years – an economic disaster such as the world had never seen. A contraction of that magnitude is, by no means, contemplated now. Fewer banks are expected to fail than during the S&L crisis a couple decades back – also the result of government failure – and unemployment at 6.1% is still below historical norms. What is truly comparable about the current crisis and the Great Depression is the set of actions that triggered them.

As eminent economist Milton Friedman and co-author Anna Schwartz pointed out in their groundbreaking “A Monetary History of the United States 1867-1960”, the Great Depression was caused by a loose monetary policy in the years preceding the Depression - fueling the “roaring 20s” – followed by a sudden contraction of credit that caused a liquidity crisis. Matters were made abundantly worse by banking laws that made it nearly impossible for financial institutions to diversify and a further Fed contraction of credit at a time when banks were going under from lack of funds. Additional insight into these events can be found in James Powell’s “FDR’s Folly” and Murray Rothbard’s “America’s Great Depression”.

Fast forward to 2001. After more than a decade of steadily bringing down interest rates to the approximate historical cost of liquidity, the Fed went on a further spree. Between May and November of 2001, the central bank slashed the Fed funds rate from 4.0% to 2.0%. Not satisfied with that massive infusion of liquidity into the economy, the Fed slashed rates below 2.0% in December and didn’t raise them above that level for three full years.   Liquidity flooded the market faster than the Katrina surge flooded New Orleans.

This influx of cash had an effect on the marketplace that was nothing less than predictable. Low rates create incentives for lenders to lend and borrowers to borrow. That the rates were held artificially low by government fiat does not change the impact that such low rates have on the marketplace. The problem was made worse – by several orders of magnitude – by the actions of Fannie Mae and Freddie Mac, giving a false sense of security to all the actors in the marketplace by essentially endorsing riskier mortgage-backed securities that would not otherwise have been available in the first place. This imprimatur influenced not only borrowers and lenders, but rating agencies and industry analysts. The whole series of malinvestments and market distortions began with the over-abundance of liquidity induced by Fed mismanagement. But that’s only half the story.

Beginning in July 2004, the Fed reversed course and began raising rates. This long-overdue adjustment began to stem the tide of excess cash in the economy. The rate rose to 2.0% by the end of the year; six months passed and it was at 3.0%; another six months passed and it was at 4.0%. Still locked into the interventionist mindset that caused the problem in the first place, however, the Fed kept right on going. Within another six months, the rate had risen to 5.0% and eventually topped out at 5.25%. Where once the rate had been well below the market rate for liquidity, it had now swung too far in the other direction. This is what we call a “credit crisis”. Liquidity disappears, asset values tumble. The economy does not merely correct itself – which, again, was inevitable, it over-corrects.

And the cycle that once created the Great Depression, in this case exacerbated by mismanagement at Fannie Mae and Freddie Mac rather than the disastrous policies of the New deal, repeats itself. The liquidity boom and bust created by the Fed - all-too-frequently mischaracterized as a fundamental aspect of capitalism when nothing could be further from the truth – and so thoroughly described in that seminal work by Drs. Friedman and Schwartz, had once again thrown the economy into chaos.

Back in November of 2002, on the ninetieth birthday of Milton Friedman, Ben Bernanke stated, “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Promises, promises.