Financial Crisis Five Years Later: We Don't Know What to Do Next Time.

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And yet experts knew that, at least in an academic sense, prolonged slumps were possible. That's what happened during the Great Depression of the 1930s. Ben Bernanke summed up the conventional wisdom on this point in 2002, in his

tribute speech on Milton Friedman's 90th birthday--back when Bernanke was a Fed governor but not yet running the show. "Regarding the Great Depression," Bernanke said, addressing himself directly to Friedman, "you're right, we did it. We're very sorry. But thanks to you, we won't do it again."

The embedded meaning here: The Depression occurred because the Federal Reserve of the time had allowed widespread bank failures to sharply reduce the amount of money circulating in the country. This shortage of currency led to falling prices, which became a vicious cycle. With prices headed downward, everyone wanted to defer business investments and major purchases as far into the future as possible. That only increased the excess demand for money and intensified the cycle of deflation. The lesson was clear--at all costs, prevent a spiral of bank failures, currency shortage, and falling prices. Get that done, and the system will return to equilibrium.

By this standard, the powers that be have performed quite well. Leading measures of financial system stress spiked during the crisis but rapidly returned to normal. Banks have failed, but the banking system is alive. Ordinary households and businesses have no trouble finding someplace safe to put their money, and creditworthy borrowers can get loans. There's been no cycle of deflation.

Yet the self-correcting economy we were promised hasn't materialized. The unemployment rate remains high, even as the share of the population looking for a job keeps shrinking. And there's no real mystery as to why the labor market has remained sick. Despite the hype about robots and jobless recoveries, employment growth has been about as weak as you'd expect given weak overall GDP growth. This is the deepest and most frightening lesson of the financial crisis--the automatic bounce-back mechanism doesn't actually exist. The need for some extra boost--whether from fiscal stimulus, or monetary policy aimed at deliberately increasing inflation--is deeper and more profound than the Obama administration realized at the time.

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