Can the Federal Reserve Help Prevent a Second Recession?
Federal Reserve Board Chairman Ben Bernanke. Reuters/Molly Riley
Despite what you may have read in the newspapers or heard from the president’s cheerful speeches, the economy is not out of the danger zone. Despite some encouraging indicators recently, both the US economy and the world’s remain in perilous condition, still threatened by the larger catastrophe Washington officials thought they had averted. That is, a renewed global recession will compound the losses and can swiftly morph into the big D, for depression.
At least nine of the economies in Western Europe are already contracting. Their euro debt crisis threatens to pull down others. The anemic American recovery remains stalled by its blocked housing sector—there are still too many homeowners drowning in mortgage debt to trigger normal home sales and construction. Private investment is sagging, corporate profits softening too. Even China’s growth is slowing at an alarming rate.
If Congress fails to defuse the threat of the post-election “fiscal cliff,” austerity will be in the saddle for sure. The International Monetary Fund, not usually known for dire forecasts, predicts increased risk of worldwide stagnation, and has warned specifically against the “excessive fiscal consolidation” of austerity measures. Why haven’t the presidential candidates talked about this? Maybe for the same reason they didn’t talk about global warming: they saw no votes in either.
Federal Reserve chair Ben Bernanke, almost alone among influential officials, has been sounding the alarm in his understated, scholarly manner. The former Princeton economics professor is an authority on the Great Depression, and especially on the danger of cutting back government stimulus prematurely before a vigorous recovery is established. Bernanke has vowed that he will not repeat the big mistake the New Dealers made in the 1930s.
It seems out of character for a central banker to make a special plea for the unemployed, but that’s what Bernanke has been doing. In August, he warned a Fed symposium that “the stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.”
Janet Yellen, vice chair of the Fed’s Board of Governors, was more explicit. In her own speech earlier this past summer, she warned about “a number of significant downside risks to the economic outlook…adverse shocks that could push the economy into territory where a self-reinforcing downward spiral of economic weakness would be difficult to arrest.” In other words, an unwinding that cannot be stopped.
The Fed has already created trillions of dollars and pumped that new money into the financial system, hoping that lowering interest rates to near zero would stimulate spending and production. In September, Bernanke tried again with a third round of “quantitative easing,” though many economists are skeptical, since twice before the flood of “easy money” did not fulfill the chairman’s intentions. Bernanke said he would keep trying until the Fed gets it right.
So the Fed chairman is now gingerly searching for other options—interventions that might go beyond the central bank’s usual financial tools and force-feed the economy more directly and tangibly. In particular, he is exploring a special program recently launched by the Bank of England dubbed “funding for lending.” The British central bank will reward commercial banks with favorable rates if they provide more generous credit to help businesses wanting to expand—that is, to create jobs. The scheme will also penalize banks if they fail to meet those goals.
This approach crosses the line into territory that central bankers normally want to avoid: directing bank lending to sectors of the economy starved for credit. But if the legendary Bank of England can do this, maybe that will give political cover for Bernanke to try something similar. The chairman said he is searching for “new programs, new ways to help the economy,” though he gave few specifics.
If he goes down that road, Bernanke is sure to further inflame his harshest critics—the Fed’s traditional allies on the right. Hard-money Republicans and the banking interests they always defend complain bitterly that Bernanke’s already done too much, when he knows he has not yet done enough. His actions are derided as dangerous meddling that threatens to spark inflation (though it currently remains near zero). Mitt Romney has promised that if he’s elected, he’ll dump Bernanke. And Republican congressmen have pushed bills to gut the chairman’s policy-making powers by shifting voting power to the presidents of the twelve regional Federal Reserve Banks, who are typically closer to the private bankers they regulate.
Richard Fisher, the president of the Dallas Federal Reserve, has sneered at Bernanke’s quantitative easing as “monetary morphine” that “hooked” financial players and turned them into addicts. Jeffrey Lacker, president of the extremely conservative Richmond Fed, brazenly claimed no need for further Fed action because the country is already near “maximum employment.”
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Though it is not widely understood, the Federal Reserve has enormous untapped power to directly stimulate or influence the flows of lending and spending that generate jobs. Doing so would fulfill the Fed’s often neglected “dual mandate”: to strive for maximum employment as well as stable money (i.e., low inflation). Fed technocrats often plead that legal or technical barriers won’t allow them to do this, but their objections reflect an institutional bias that favors finance over industry, capital over labor. The central bank, as I will explain, has abundant precedent from its own history for taking more direct actions to aid the economy. And it has ample legal authority to lend to all kinds of businesses that are not banks.
The main obstacle standing in Bernanke’s way is political: the fiercely one-sided politics dominated by conservative Republicans and their patrons in banking, both intent on keeping President Obama from a second term. Together, they have cornered the chairman. Discussion of monetary policy is always limited to a rather small circle of influential policy experts and financial interests. Most citizens are clueless and easily ignored by unaccountable decision-makers; so are most elected politicians. If Bernanke proposes controversial measures, he might be standing nearly alone.
What’s missing from Fed politics is the left: the countervailing voices of progressives, liberals and labor, who could make the case for more drastic action by the Fed. In effect, they could put an arm around Bernanke and encourage him to try more aggressive measures. Liberal-labor advocates could also defend the Fed against its right-wing enemies and act as principled critics who can pressure the central bank’s governors and push them further in a sensible direction than they might want to go.
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Joseph Gagnon, a twenty-five-year veteran of monetary policy at the Fed and now an economist at the Peterson Institute, lamented the one-sided nature of elite debate. “What bothers me,” he said, “is one side is nothing but critical of what the Federal Reserve is doing, and the other side is just silent. I just don’t understand. Why aren’t a lot of voices complaining that the Fed isn’t doing enough? The progressive side has been absolutely silent, and yet the conservatives have been jumping up and down. And this totally distorts the Fed’s environment.”
My intention for this article is to provoke a wider argument. I hope it nudges the left to get up to speed on monetary policy and take an aggressive position instead of forfeiting the field to the right-wingers. I want progressive activists to intrude on the privileged circle that talks to the august Federal Reserve and help citizens join the conversation. So long as the insulated central bank maintains its privileged structure—unaccountable to voters but intimately connected to the bankers it regulates—the people are bound to be left out in the cold.
The people on the left side of American politics seem not to have noticed that Bernanke has lately been moving in their direction, pushing for important measures that progressives also champion [see Greider, “The Federal Reserve Turns Left,” April 30]. The chairman’s essential policy approach follows the basic premise of Keynesian economics: in times of deep recession or depression, only the federal government has the ability to reverse things with its interventions. Mitt Romney and the Republican Party, on the other hand, have reverted to the stiff-necked Calvinist doctrine that conservatives espoused after 1929: nothing can be done to relieve economic misery, except to let nature take its course. The New Deal blew away the smugness of the monied interests seventy-five years ago. Now they are back, peddling the same bromides.
Except for Bernanke. A Republican first appointed to the Federal Reserve by George W. Bush, the chairman declines to join President Obama’s happy talk of a promising recovery. It’s true that a small chorus of liberal economists, notably led by Paul Krugman in The New York Times, have criticized the Fed for not moving faster, but their policy prescriptions are mostly tame and within the accepted boundaries of polite discussion. Democrats, with few exceptions, seem to have lost their appetite for provocative ideas, while Republicans are zestfully pushing their crackpot nostrums.
But what else can the Fed chair do? Actually, quite a lot. Instead of pumping more money into the banking system, where much of it feeds speculation, the chairman should figure out how to get it to the sectors of commerce or industry that really need it.
The Fed, for instance, could use its regulatory muscle to unfreeze the risk-averse bankers who are still unwilling to lend—the same bankers whose reckless risk-taking nearly brought down the entire system four years ago. The Fed could create special facilities for directed lending (just as it did for the imperiled banking system) that gets the banks to relax lending terms for credit-starved sectors like small business. If bankers refuse to play, it could offer the same deal to financial institutions that are not banks.
The Fed could help restart the enfeebled housing sector by collaborating on debt reduction for the millions of underwater home mortgages. It could help organize and finance major infrastructure projects, like modernizing the national electrical grid, building high-speed rail systems and cleaning up after Hurricane Sandy—public works that create jobs the old-fashioned way. The Fed could influence the investment decisions of private capital by backstopping public-private bonds needed to finance the long-neglected overhaul of the nation’s common assets.
These are plausible examples of what the central bank might do if it truly tries to fulfill its dual mandate. Orthodox monetary economists will be horrified by such talk: these alternatives, they will say, are technically impossible, maybe even illegal. A few of the suggestions would probably require clarifying legislation and congressional cooperation. But the Fed can carry out direct interventions to help the economy recover, because it has done them before. In the 1920s, believe it or not, the Federal Reserve even underwrote the bonuses promised to World War I veterans when private banks wouldn’t honor their certificates of service.
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During the Great Depression, the Federal Reserve was given open-ended legal authority to lend to practically anyone if its Board of Governors declared an economic emergency. This remains the law today. The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firms. The Fed made thousands of direct loans to private businesses during the New Deal, and the practice continued for twenty years. Only in more recent times has the reigning conservative doctrine insisted that this cannot be done.
The original authorizing legislation for such lending was enacted in 1932 as Section 13.3 of the Federal Reserve Act, and the wording was left deliberately vague. An emergency was defined as “unusual and exigent circumstances.” Whatever did that mean? In practice, it meant whatever the Board of Governors decided it meant. Fed governors must now get approval from the treasury secretary, but they do not have to ask Congress for permission.
Section 13.3 is often depicted as antique legislation left over from the New Deal, but the provision is very much alive and active. It was invoked repeatedly at the height of the recent crisis, when the Bernanke Fed intervened massively to rescue the financial system, directing aid to corporations, individual investors and other nonbank businesses. When Bear Stearns collapsed in the spring of 2008, the Fed declared “unusual and exigent circumstances” to legitimize its rescue of the failed brokerage, with the New York Fed lending $29 billion to grease the JPMorgan Chase takeover of Bear Stearns. The Fed was rescuing a failed brokerage house, not a bank (and when Lehman Brothers went belly-up a few months later, investors there were outraged that the investment house didn’t get the same treatment).
In the fall of 2008, as Wall Street’s crisis accelerated, Section 13.3 was again invoked to justify a far more controversial intervention: the $180 billion bailout of American International Group. AIG is not a bank but a giant insurance company, and it was obviously insolvent. Normally, a failed corporation would proceed to bankruptcy court, where its creditors would fight over what was left. In this case, the Fed stepped in to save AIG because among its leading creditors facing huge losses were the nation’s largest financial institutions: Goldman Sachs, Citigroup, JPMorgan Chase and others. The Fed used its Section 13.3 authority many more times during the crisis, creating liquidity loans and guarantees to protect investors across broad markets—mutual funds, commercial paper, primary dealers, securities lending and others.
The AIG bailout left a very bad odor with Congress, which later tightened the terms of Section 13.3 modestly in order to prevent another such rescue. The Fed can still lend to “individuals, partnerships and corporations” if they are “unable to secure adequate credit accommodations from other banking institutions.” But it can no longer create a special lending facility to protect a single insolvent company. Whether or not these interventions were justified, the point here is that the central bank was willing to save certain corporate enterprises when it believed the consequences of their failure would threaten the largest banking institutions. Yet the Fed declined to do something similar for the overall economy and help millions of indebted homeowners and unemployed workers.
The Federal Reserve had no such inhibitions during the Depression. It became an active lender to nonbank businesses, even to very small mom-and-pop enterprises. Additional New Deal legislation expanded the Fed’s role, authorizing direct industrial loans; it was expected to become the government’s lead agency. “The entire Federal Reserve System has almost $280,000,000 to lend for working capital, constituting virtually a revolving fund of that amount for the use of industrial and commercial units,” a Minnesota Federal Reserve Bank pamphlet boasted during the Depression.
The Fed did make a lot of loans, but it was swiftly eclipsed by the Reconstruction Finance Corporation, a more aggressive and effective New Deal agency that supervised corporate workouts, much like the Obama administration’s rescue of the auto industry. The Fed’s industrial lending was eventually halted in the 1950s, but the practice appeared again in 1970, when the Nixon administration urged the Fed to intervene on behalf of the debt-ridden Penn Central Railroad. The administration and the central bank worried that the collapse of this industrial corporation would spark a financial crisis. So the Fed assured bankers it would back them up. Some critics say the Penn Central rescue was an early harbinger of the “too big to fail” phenomenon.
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Bernanke should draw upon the Fed’s New Deal experiences to demonstrate what is possible now and what to avoid. Of course, our current troubles are not nearly as bad as the horrendous unwinding that occurred from 1929 to 1933. But this crisis is not over, as Bernanke knows. He is anxious to avoid a bloody repeat of the full catastrophe. But the central bank has a blind spot. It knows a lot about macroeconomics and the daunting complexities of finance, but not so much about the everyday business savvy needed to succeed in the real economy.
The Federal Reserve’s most distinctive asset is money—its awesome and somewhat mysterious power to create money and inject it into the economy by buying financial assets of one kind or another. If that power is abused, it can destabilize society. In an economic crisis, however, the money-creation power can be harnessed to public purposes and used to restore order and justice. That is essentially what Bernanke’s Fed attempted during the recent crisis when it created those surplus trillions for banking. The fact that the strategy did not entirely succeed suggests that maybe this power should be applied in a different direction.
Fed money is not exactly “free,” but it has this great virtue for government: it doesn’t cost the taxpayers anything. Fed expenditures do not show up in the federal budget, nor do they add anything to the national debt. In a sense, this freshly created money belongs to the people—all of us—and can be used in unusual ways to advance the shared public interest. Lincoln did this when he printed “greenbacks” during the Civil War. Various Fed governors have done it when they were faced with “unusual and exigent circumstances.” There are worthy opportunities awaiting the Fed’s attention.
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Joseph Stiglitz, a Nobel Memorial Prize–winning economist at Columbia University, and Mark Zandi, chief economist at Moody’s Analytics, propose an excellent use for Fed-created money: funding a massive refinancing of home mortgages, which would cut monthly payments dramatically and free personal income for consumption. “Housing remains the biggest impediment to economic recovery, yet Washington seems paralyzed,” the two wrote in an August 13 New York Times op-ed.
A plan proposed by Oregon Senator Jeff Merkley, they explained, could boost disposable income for some 20 million families with underwater mortgages, including those not backed by the government-sponsored housing enterprises Fannie Mae and Freddie Mac. A “government-financed trust” would buy up the refinanced mortgages, thus giving private lenders the capital to make more loans. Several federal agencies could handle this, but Zandi told me that using the Federal Reserve would be the most efficient way. “The biggest impediment is the banking system,” Zandi said. “The pipeline for origination of lending has shrunk—a lot of midsize banks and mortgage companies got out—so the big banks now account for even more of the volume. They manage the flow by raising their eligibility standards. That’s why they are making so much money.”
The Federal Reserve could change that, Zandi said, but he added, “I think the Fed would never go down this path unless the national economy is sliding back into recession.”
Jane D’Arista, author of The Evolution of U.S. Finance and a leading reform advocate, insists that the central bank has numerous levers to drive reluctant bankers to support a vigorous recovery with more plentiful lending. “The Federal Reserve as an instrument of credit policy is weak, and right now we need it to be strong,” she said.
The Fed could alter reserve requirements to punish bankers or reward them. It could stop paying interest on the enormous idle reserves banks are now sitting on and start charging a penalty rate for banks that won’t use their lending capacity. The Fed can steer banks to neglected categories of lending—small businesses, for instance—by lowering the reserve requirement on those loans. Above all, D’Arista believes, the Fed can simultaneously begin to reform the banking system from the bottom up.
“Let’s forget the big guys,” she said. “They’re hopeless. We’re not going to get anywhere with them. However, the community bank is an engine of growth, and here is a way to help them. Community banks are naturally skittish. They need real reassurance for the kind of lending that isn’t corporate-scale. This could also involve them in infrastructure projects initiated by state and local governments. That’s where the Fed’s discount window could come in and help. It is a way of backstopping the little community bank and the medium-sized bank.” She envisions consortiums of small banks participating in big projects. The Fed could help organize them.
Stephen Sleigh, a labor economist and director of the national pension fund for the International Association of Machinists and Aerospace Workers union, has similar ideas about how the Fed can persuade private capital investment to finance major infrastructure projects. “Part of Bernanke’s strategy of pushing down interest rates, both short-term and long-term, is to force conservative money into investments like construction,” Sleigh observed. “That makes perfect sense, but the capital is not flowing. It’s still on the sidelines. I would love to see the Fed start talking about infrastructure. The Fed needs to be working on new tools and find ways to get the conservative money off the sidelines and start rebuilding the American economy.”
Conservative investors like pension funds and insurance companies lost an important source of income when the Fed lowered interest rates drastically. Sleigh explained: “As a pension fund manager, I need investments that are going to provide reliable, steady income that can sustain our long-term assumptions. Traditionally, the ten-year Treasury bond was a way to pay the bills, but it doesn’t do that anymore, because it is trading now at less than 2 percent.”
A solution Sleigh envisions would involve bond borrowing for public-private infrastructure projects that would be “labor-intensive and great for long-term economic growth and would absolutely help us meet our obligations, because these bonds are going to yield 6 to 8 percent on our investments.” The Federal Reserve’s blessing and its willingness to accept the infrastructure bonds as collateral on the Fed’s lending could be a powerful lure for capital investors—including China, which owns a mountain of low-yielding US Treasuries.
“Wouldn’t that be an amazing story,” Sleigh said, “if the Chinese, instead of holding Treasury notes, invested $100 billion in building high-speed rail in the United States?” These ideas sound farfetched to the usual experts who dominate monetary politics. But stay tuned. As Bernanke surely understands, the economic crisis is not over. We are still at risk of things turning worse. If that occurs, these and other proposals for action will become highly relevant.
Bernanke’s term as chairman expires in January 2014. If the economy subsequently spins out of control, he will be the scapegoat. Something similar occurred between 1929 and 1933, when the Federal Reserve suffered a historic disgrace. After the market crash, some Fed governors saw the peril and pushed for stronger action. But conservative bankers prevailed. They let nature take its course.
We are threatened by a similar tragedy. To avert that possibility, citizens need to force their way into the conversation. Reach out to Federal Reserve governors, by phone or e-mail (see the sidebar on page 22). Share your concerns and ideas about what the Fed should do. If you ask respectful questions, you may be surprised to get respectful answers. Reforming the Federal Reserve and the financial system is a long-term challenge. It cannot begin until the people find their voice and we, as citizens, reclaim our right to be heard.
Make your voice heard by the Federal Reserve! William Greider provides the e-mail addresses of the board’s members.