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We can beat this crisis

Be as cynical as you want, but Bernanke & Co. really have learned from history - and they have plenty of options left.

Last Updated: October 13, 2008: 7:37 AM ET

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The crisis: A timeline The crisis: A timeline The crisis: A timeline
A shocking series of events that forever changed the financial markets.

(Fortune Magazine) -- On Nov. 21, 2002, just two months after leaving Princeton University's economics department for a spot on the Federal Reserve Board, Ben Bernanke gave a speech in Washington on the topic of deflation. At the time, stock prices had been falling for almost two years straight, inflation was just 2%, and there was widespread worry that it would drop into negative territory. The specter of Japan, beset for a decade by falling prices and economic stagnation, was on the minds of many. In his speech, Bernanke even brought up a far worse deflationary spiral - the Great Depression.

But his intent was to reassure. "I am confident that the Fed has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief," Bernanke said. Quoting economist Milton Friedman, he described one such policy instrument - a tax cut accompanied by mass Federal Reserve purchases of Treasuries - as equivalent to a "helicopter drop of money."

The helicopter line got a lot of attention, and critics have derided Bernanke as "Helicopter Ben" ever since. But the most important takeaway from his speech was that economists and central bankers had things pretty well figured out. They knew how to prevent a depression - and they had the "tools," a word Bernanke used a lot.

Those tools haven't looked so useful lately. Bernanke is now chairman of the Fed, and together with Treasury Secretary Hank Paulson he has spent the past year battling what is now by almost unanimous agreement the worst financial crisis to hit the world since the one that unleashed the Depression.

There's no deflationary spiral, at least not yet. But there is a collapsed U.S. housing market, a global financial system on the brink, and an economy that has gone into a stall. Despite all the tools that Bernanke and Paulson have wielded and in some cases invented to fight the crisis, it keeps getting worse.

They've tried easy money, plus increasingly creative ways to get it into the hands of banks and corporations. They've bailed out some struggling financial institutions and let others fail. They've persuaded Congress to hand the Treasury $700 billion with which to fight the crisis. And yet stock markets have kept on sliding. Credit markets have remained stuck. Hurt is everywhere.

Does that mean Bernanke and Paulson have failed? No. They're not done yet. We'll leave root causes for another day; here we're discussing how to get out of this mess.

There's still much that Bernanke and Paulson, Congress, and the next President can pull out of the toolbox in coming months, and growing signs that officials are getting ready to employ some seriously heavy machinery. But it is true that the financial excesses now unwinding have turned out to be far vaster and more complicated than all but a few economists ever imagined.

"Like people in financial markets, we macroeconomists tended to congratulate ourselves too much," says Barry Eichengreen, a professor at the University of California at Berkeley and a leading scholar of the Depression. Still, Eichengreen doesn't completely despair. "I doubt that we'll be able to avoid double-digit unemployment, but I'm still confident we can avoid 24% unemployment like in 1933."

Learning from the worst case

We know: Massive unemployment, depression ... economists aren't known for saying the most comforting things. (Three out of four Americans should be able to keep getting a paycheck! Swell!) But it's worth delving into the dismal science because economists have played such a huge role over the years in shaping how we respond to financial crises. History's important too: The terrible first months of 1933 are ground zero for those who study financial panic and economic depression.

It was a time, as one historian put it, of "near-total banking eclipse." As lame-duck President Herbert Hoover dithered, depositor runs endangered even the strongest banks. State authorities shut down the banks in New York and Chicago. When Franklin Roosevelt declared a four-day national bank holiday on March 5, a day after he took office, he was merely confirming financial reality.

The country - and the world - had been through bank panics before. In Britain, for example, the Bank of England was long established as the "lender of last resort" - during bank runs, it would step in and provide otherwise solvent financial institutions with cash to tide them over. In the aftermath of a 1907 bank panic, Congress finally gave the U.S. a central bank, albeit in the decentralized form of the Federal Reserve System.

After the creation of the Fed, the U.S. economy chugged along panic-free for years. But the Fed was not up to the challenge of ending the wave of bank failures that began about a year after the 1929 stock market crash. By the time Franklin Roosevelt took charge in 1933, it wasn't just the banking system that was in shambles but the entire economy. Millions of Americans had lost their savings, tens of millions had lost their jobs, borrowing money was mostly out of the question for both businesses and households, and farms and factories were producing a bare minimum.

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