Fixing the Fed
How to Restore Credit--and Credibility
In the past six months, the Fed seems to have reversed course, because bank reserves suddenly jumped tenfold in September, then doubled again by December. Skeptics may conclude that it has created a safe haven for bankers. When everything else is collapsing, banks are given risk-free assets by the Fed; then they collect income from the central bank instead of lending the funds to risky customers. If reserve balances keep growing, the deal will begin to look like hoarding.
These distorted arrangements are what D'Arista thinks must be changed to break out of the downward spiral. The all-encompassing requirement she proposes--liability reserves--would give the central bank the mechanism to inject stimulus into the credit system, into banks and nonbanks alike, funding the Fed can withdraw later if the economy no longer needs a boost. The Fed would first purchase a variety of sound financial instruments from the lending institutions and create an interest-free account that would be posted as a "liability" on the institutions' balance sheets--an obligation owed to the Fed. In order to balance this liability against the loss of income-earning assets on their books, the banks and other firms would have to use the Fed-injected money to make new loans to companies and consumers or to other banks. Either way, the Fed injection would spur lending and help unlock the paralysis in credit markets.
In this arrangement, the Fed would remain in control, because all these transactions would be covered by a repurchase agreement requiring the bank to buy back what it sold to the Fed, on a fixed date and at the same price. The Fed could demand its money back or renew the repurchase contract at its choosing (a standard practice in Fed open-market operations). Thus, if the bank does nothing with its newly injected funds to create loans and generate more income, it will be in trouble when the repurchase contract comes due. The Fed is likewise inhibited from buying worthless junk from banks because that would ruin its balance sheet, the base for the money supply. Instead of earning risk-free income by holding idle reserves, the banking industry would abruptly feel the lash of the central bank's policy decisions--open up your wallets and start lending to more borrowers, or face consequences down the road.
But where does the Fed find the money to make all these transactions? Essentially, it creates the money. That is basically what occurs routinely whenever the central bank decides to inject new reserves into the banking system. It is accomplished with a computer keystroke crediting the money to the private bank's account (and money is extinguished whenever the Fed withdraws reserves). The mystery of money creation defies common reason, but it works because people believe in the results. The money supply relies on the "full faith and credit" of the society at large--pure credit from the people who use the currency. The public's faith can be enlisted in the national recovery, a far better option than spending the hard-earned money that comes from taxpayers.
D'Arista's solution would create the scaffolding to impose many other regulations on the behavior of lending and borrowing. But it does not resolve the problem of what to do with zombie banks. Some of them deserve to die--right now--because they are "too big to save," as the Levy Institute puts it. Other institutions in trouble can be tightly supervised by regulators for years to come, without relieving them of their rotten assets. This will require a kind of silent forbearance that lets the bankers slowly work off their losses, but it does not dump the losses on the public. D'Arista points out that the government has done this many times in the past. The closest comparison is the Third World debt crisis during the 1980s, when some of the same major banks were under water as Latin American nations threatened massive loan defaults. A lengthy, methodical workout was managed by the Fed under Paul Volcker. It wasn't pretty, nor was it just, but the public was not really aware of the deal-making. This time, the deal is too big to hide. People see it happening and are rightly enraged.
The great virtue of D'Arista's approach is that it's forward-looking. Her focus is not on saving the largest and most culpable names at the pinnacle of the financial system but on creating the platform for a financial order composed of thousands of smaller, more deserving institutions that can serve the country more reliably. To achieve this, the Federal Reserve will have to submit to its own reckoning. By its very design, the cloistered central bank is an offense to democratic principles--and now the Fed's secretive, unaccountable political power has failed democracy again. The question of how to democratize the temple or whether to tear it down has to be on the table too, the subject of future discussion.