Fixing the Fed
Leaning With the Wind
To understand D'Arista's reform ideas, start with her devastating critique of the central bank. The Federal Reserve, she explains, has failed in its most essential function: to serve as the balance wheel that keeps economic cycles from going too far. It is supposed to be a moderating force in American capitalism on the upside and on the downside, the role popularly described as "leaning against the wind." By applying its leverage on the available supply of credit, the Fed can slow down a boom that is dangerously overwrought or, likewise, stimulate the economy if it is sinking into recession. The Fed's job, a former chairman once joked, is "to take away the punch bowl just when the party gets going." Economists know this function as "counter-cyclical policy."
The Fed not only lost control, D'Arista asserts, but its policy actions have unintentionally become "pro-cyclical"--encouraging financial excesses instead of countering the extremes. "The pattern that has developed over the last two decades," she wrote in 2008, "suggests that relying on changes in interest rates as the primary tool of monetary policy can set off pro-cyclical foreign capital flows that tend to reverse the intended result of the action taken. As a result, monetary policy can no longer reliably perform its counter-cyclical function--its raison d'être--and its attempts to do so may exacerbate instability."
Anyone familiar with the back-and-forth swings of monetary policy during recent years will recognize her point. On repeated occasions, the Fed set out to tighten the availability of credit but was, in effect, overruled by the credit markets, which instead expanded their lending and borrowing. The central bank would raise short-term interest rates to slow things down, only to see long-term borrowing rates fall in financial markets and negate the Fed's impact. These recurring contradictions were familiar to financial players but not to the general public. Fed chair Paul Volcker was stymied by expanding credit when he raised rates in 1982-84. His successor, Alan Greenspan, experienced the same frustration in 1994-95 (the beginning of the great debt bubble) and again at the end of the decade. The contradiction became more visible in 2005: Greenspan kept raising short-term interest rates in gradual steps, yet long-term rates kept falling, feeding the bubble of borrowing and inflating prices.
"Rather than restore its ability to exert direct influence over credit expansion and contraction," D'Arista wrote, "the Fed adhered to outdated tools and policies that became increasingly counterproductive. Too often its actions tended to exacerbate cyclical behavior in financial markets rather than exert countercyclical influence." (For her full critique, read "Setting an Agenda for Monetary Reform," a 2008 lecture at the Levy Economics Institute of Bard College, posted online at the Political Economy Research Institute's website. )
Most politicians do not even know the Fed is broken. The central bank's awesome authority is an intimidating mystery to most elected officials, and they typically defer to its oracular pronouncements. But the Federal Reserve, like all human institutions, is subject to folly and error. In fact, it has experienced colossal failure once before in its history. After the stock market crash of 1929, the Fed was utterly disgraced because its response led directly to the Great Depression. Fed governors were motivated by conservative orthodoxy and their desire to protect the profitability of the largest banks, but they misunderstood the mechanics of monetary policy and also stuck to outdated theory that produced the disastrous results. D'Arista's analysis is chilling because she suggests the modern central bank, albeit in very different circumstances, may again be pursuing wrongheaded theory, blinded by similar political biases and obsolete doctrine (for the history, see my book Secrets of the Temple: How the Federal Reserve Runs the Country).
When deregulation began nearly thirty years ago, some leading Fed governors, including Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer." Yet the Fed supported deregulation, partly because its most important constituency, Wall Street banking and finance, pushed for it relentlessly. Working Americans felt greater pain as a result. The central bank braked the real economy's normal growth continually in a roundabout attempt to slow down the credit markets.
The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets. Greenspan became an aggressive advocate of the so-called modernization that created Citigroup and the other hybridized mega-banks--the ones in deep trouble. Old-line banks lost market share to nonbanks, but they were allowed to collaborate with unregulated market players as a way to evade the limits on borrowing and risk-taking. In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.
The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly--witness the soaring debt burden and subsequent defaults. Greenspan, celebrated as the wise wizard, never acknowledged Wall Street's inflation of debt. Indeed, he attempted to slow down the economy in order to constrain the financial system's bubbles. That did not succeed either. As Nation readers may recall, I have more than once blistered the Fed's inept performance and blamed Greenspan's "free-market" ideological bias [see "The One-Eyed Chairman," September 19, 2005]. D'Arista's analysis goes deeper and attributes the systemic malfunctioning to the Fed's weakened control mechanisms.
Central bankers attempted to fix the problem, but they may have made it worse. In the late '80s, the Fed and Wall Street leaders, joined by foreign central banks, created an international regulatory regime that requires banks to hold greater levels of capital instead of bank reserves. Reserves are the Fed's traditional cushion for ensuring the "safety and soundness" of the system. Banks were required to post non-interest-bearing accounts on their balance sheets to backstop deposits and as the means for the central bank to brake bank lending. It was assumed that the new capital requirements would do the same. Instead, the so-called Basel Accords (named for the Bank of International Settlements in Basel, Switzerland) applied very little restraint on lending but created an unintended vulnerability for banking. The new rules have acted like a pro-cyclical force--driving banks into a deeper hole as the crisis has spread because bank capital is destroyed directly by the mounting losses from market securities. The more banks lose on their rotten assets, the more capital they have to borrow from wary investors, who understandably refuse to play. That spreads the panic and failure that governments are trying to cure with public money.
Meanwhile, acting at the behest of bankers, the Fed has practically eliminated the old safety cushion by allowing reserve levels to fall nearly to zero. Bankers complained that reserves were a drag on profits and were no longer needed given the capital rules. In a shocking new arrangement, the Fed, with approval from Congress, has started to pay interest to the banks on their reserves. The commercial banks already enjoyed privileges and protections from the government that were unavailable to any other business sector. Now they insist on getting paid for their public subsidy.