The Federal Reserve is celebrating its 100th birthday with due modesty, given the Fed’s complicity in generating the recent financial crisis and its inability to adequately resuscitate the still-troubled economy. Woodrow Wilson signed the original Federal Reserve Act on December 23, 1913. Eleven months later, the Federal Reserve System’s twelve regional banks opened for business. But in a sense the central bank was born in the autumn of 1907, when another devastating financial crisis swept the nation, destroying banks, businesses and farmers on a frightening scale.

J.P. Morgan and his fraternity of New York bankers intervened with brutal decisiveness in the efforts to halt the Panic of 1907, choosing which banks would fail and which would survive. Afterward, Morgan was hailed in elite circles as a heroic figure who had saved the country and free-market capitalism. The nostalgia for Morgan was misplaced, however: as insiders knew, the real story of 1907 was that Washington intervened to save Wall Street—the twentieth century’s own inaugural bailout.

When Morgan’s manipulations failed to heal the hemorrhaging banking system, the Morgan men turned to Treasury Secretary George Cortelyou and implored him to send money—lots of it. The next day, some $25 million in emergency federal deposits were sent to New York, and the Morgan team spread the money around among the desperate banks. About the same time, Morgan dispatched two industrialists from US Steel to meet with President Teddy Roosevelt and get his assurance that the government would look the other way as they executed a corporate merger likely to violate anti-trust laws.

The government saved the day, but it was a close call. Wall Street’s wiser heads recognized that the country’s banking system had become dangerously unstable, prone to reckless excess and recurring panics and depressions. Banking needed a safety net. Leading financiers designed one: a central bank empowered to stabilize the financial system and rescue it in times of crisis.

The bankers not only wanted access to the Federal Reserve’s money but insisted on controlling this new institution themselves. They pretty much got what they wanted. The Federal Reserve Banks in twelve major cities would literally be owned by local banks, which would function as private shareholders (they still do). The Federal Reserve Board in Washington, with governors appointed by the president, was a modest concession to democratic sensibilities.

This hybrid institution, in which private economic interests share power alongside the elected government, was founded on an absurd pretense. Decisions at the Federal Reserve, it was said, should be made by disinterested technocrats, not officeholders, and deliberately shielded from the hot-blooded opinions of voters as well as politicians. Representative Carter Glass of Virginia, a leading sponsor, promised “an altruistic institution…a distinctly non-partisan organization whose functions are to be wholly divorced from politics.”

Of course, the claim was ridiculous on its face. Given the enormous size of the Fed’s power to affect economic outcomes and people’s lives, the central bank’s decisions inescapably favor some interests and injure others. By controlling interest rates and the availability of credit, Fed governors necessarily referee the conflicts between lenders and debtors. Whatever you call it, that’s the realm of politics.

The remnant Populists still in Congress in 1913 were not fooled by the talk of political neutrality. Representative Robert Henry of Texas described the new central bank as “wholly in the interest of the creditor classes, the banking fraternity, and the commercial world without proper provision for the debtor classes and those who toil, produce and sustain the country.”

A hundred years later, the country seems to have circled back to the very same arguments. We are confronted again by the financial destructiveness the Fed was supposed to eliminate. Despite some worthy reforms that centralized power in Washington, bankers still run wild on occasion, ignoring restraints and spreading misery in their wake. The Fed still rushes to their rescue with lots of money—public money. And people at large still pay a terrible price for official indulgence of this very privileged sector.

So this is my brief for fundamental reform: dismantle the peculiar arrangement and democratize it. The Federal Reserve has always been a glaring contradiction of democratic values. After a century of experience, we should be able to conclude from events that the system simply doesn’t work. Or rather, it does very well for bankers, but not for ordinary citizens. The economy does require a governing authority—Fed advocates are right about that—but it suffers from the Fed’s incestuous relationship with Wall Street bankers. My solution: throw open the doors, let the people into the conversation and the decision-making. The untutored ranks of citizens are as fallible as any economist, but they often know things about economic reality well before the experts.

I know reforming the Fed sounds improbable, especially given our dysfunctional political system. But I have a hunch the case for reform will grow stronger, because the pain continues for most Americans. Despite frequent assurances by the authorities, the broken economic system has not been fixed—not by the Federal Reserve, not by the Obama administration and certainly not by Congress.

Treasury Secretary Jack Lew recently claimed that the Obama administration has eliminated the specter of “too big to fail” banks. Reform-minded critics responded with catcalls. “I’d tell him he’s living on another planet,” said Senator David Vitter, while his colleague Sherrod Brown noted that the four largest banks, after receiving bailout money in 2008, have grown by $2 trillion. They also enjoy below-market interest rates when they borrow from credit markets and other banks because the investors figure Washington won’t let them fail.

An even harsher critic is Sheila Bair, former chair of the Federal Deposit Insurance Corporation, who had to liquidate hundreds of smaller banks during the crisis. “What system were we trying to save, anyway?” she asked in her under-appreciated 2012 book, Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself. “A system in which well-connected big financial institutions get government handouts while smaller institutions and homeowners are left to fend for themselves?…

“Because we propped up mismanaged institutions, our financial sector remains bloated. The well-managed institutions have to compete with the boneheads,” Bair wrote. “A culture of greed and shortsightedness” permeates even the best-managed banks, one that “goes undetected by their executives and boards as well as their regulators.” Bair is a conservative Republican, an insider disgusted with the failure of her fellow regulators.

Part of that failure is because the Fed governors have not been isolated from political influence. Bankers, and their representatives at the twelve Reserve Banks, are very much insiders too. After the recent collapse, they were represented by some 20,000 lobbyists, who swamped federal regulators with formal comments and complaints on the Dodd-Frank reform law, weakening it considerably. But the heavy-handed influence of the banking industry is only part of the problem. Since citizens and their elected representatives have no voice in Federal Reserve decisions, the central bank excludes the issues, and downplays the economic consequences, that matter most to ordinary people. Instead, the monetary debate proceeds in the sanitized language of economic abstractions and is limited to a small group of elites. Self-interested financial-market participants constantly critique monetary policy, a debate reported in the business pages as though Wall Street traders are speaking for the broad public.

This reliance on a narrow frame of reference produces institutional blind spots and gross errors. I don’t doubt the integrity of Fed professionals; they sincerely believe their political isolation is a virtue. I say it is the source of their great failing. The telling evidence lies in what the Fed does not talk about. If you scan the public record over the last generation, you might conclude that the policy-makers were unaware of the grave disorders that were steadily accumulating. Or that they believed the economic pressures assaulting citizens were not relevant to monetary policy. Whatever the explanation, the Fed missed the big story—the steady economic deterioration stalking the middle class—just as it did not see the reckless behavior in banking that would lead to collapse.

After the fall, the extreme inequalities of income and wealth could no longer be ignored and belatedly hit the front pages. How could the Fed—staffed by professional economists who are trained to examine broad trends—have missed the importance of this? Or that industrial wages for hourly workers had been declining in real terms for three decades? Did the governors recognize that global trade and the migration of US jobs overseas destroyed the once reliable link between rising productivity and rising wages? How did the Fed explain the mountainous debt growing inexorably across the economy—not just government debt, but household and business debt too?

Perhaps the Fed did not see the threat posed by these great shifts because the central bank was centrally implicated in causing them. Intentionally or otherwise, Fed policies over many years have consistently favored capital over labor. The results are visible in the stunning statistics on income concentration at the wealthy pinnacle. These developments were sometimes justified in the name of fighting inflation, but the Fed also set out in other ways to improve the profitability of banking and finance.

Some interests, particularly organized labor, understood what was happening and complained aloud. The Fed did not respond to the cries of distress. The mystification of monetary policy is a way of avoiding nasty arguments with the losers.

The Downside

During most of the past three decades, the Federal Reserve was triumphant in Washington, where politicians deferred to the wise arbiter that calmed financial anxieties and fathered good times. Recessions were infrequent and brief. Financial markets were liberated from government restraints and reached extraordinary heights. The Federal Reserve website celebrates this era as “the Great Moderation.”

An unsanctioned history would tell a less flattering story, in which the Fed contributed to the destructive forces—sometimes inadvertently, sometimes to enhance banking profitability, sometimes in pursuit of other goals. A thumbnail sketch of the action can fill in some blanks for untutored citizens who do not read The Wall Street Journal.

At the dawn of the Reagan era, while the president was cutting taxes, Fed chair Paul Volcker (a Carter appointee) was pursuing an allied goal: wage suppression. Volcker set out to break accelerating inflation (triggered mainly by increasing OPEC oil prices) by shutting down the economy with a long, harsh recession. His principal target was wages; in fact, he carried around a little card that noted the latest union contract settlements, and he told politicians the recession could not end until he had broken wages and commodity prices.

Volcker’s “wage deceleration” (his mild label) was the starting point for a seismic shift in winners and losers across the economic landscape. Labor lost the battle; but capital also won the war. During the bloodletting, when farmers were devastated, a delegation of farm-state legislators complained to Volcker. The Fed chair told them, “Look, your constituents are unhappy; mine aren’t.”

Volcker’s campaign was different from previous recessions induced by the central bank because he did not let up after the economy recovered. Inflation had subsided by the time Volcker ended the recession, but the Fed kept interest rates at elevated levels to squeeze out more concessions from labor. Reagan supported the Fed’s harsh medicine all the way. Republicans attributed the booming stock market to the “miracle” of supply-side economics.

The advent of globalization and the migration of US manufacturing to low-wage countries helped the central bank hold down wages at home. In return, the Fed played an important supporting role in globalization by maintaining a strong dollar, which enabled US capital to invest abroad. When the United States became a debtor nation in 1985, the strong dollar reassured foreign creditors that loans to the US Treasury would be repaid in full.

During this profound shift, the central bank lost control of its central function: regulating the availability of credit. The result was a stunning run-up of debt, which has now become a mountain. Economist Jane D’Arista found that in the single decade of the 1980s, the debt of all US borrowers—total borrowing by federal, state and local governments, as well as by households, businesses and the financial sector—doubled. The nation’s total accumulated debt since the beginning of the Republic was $5 trillion in 1980. By 1990, it had reached $10 trillion. Reagan’s tax cuts contributed mightily to the buildup, but so did Volcker’s monetary policies. Commercial banks lost lending functions to unregulated financial markets, but the Fed’s regulatory system did not keep up.

“The central bank created monetary conditions that resulted in a debt bubble,” D’Arista wrote in her 2013 essay on the Fed at 100. “The failure to analyze what the cumulative effect of debt might be on the real economy was the Fed’s greatest failure since, in the aftermath of crises, debt remains a major impediment to the revival of economic activity.” She attributed the Fed’s weakening hold on credit expansion to relaxed regulatory enforcement. The debt bubble is what collapsed in 2008.

Among elites, a popular explanation for the swollen debt burden was to blame the moral failings of consumers seduced by credit-card culture, but that ignores the deeper causes. The faltering US economy, now faced with global competition, and the long-running trend of declining wages and disappearing jobs produced the squeeze on middle-class families. People were falling behind and trying to hang on to their standard of living. For years, they worked at more jobs and, yes, borrowed more money. Nothing provided relief, and millions lost their valiant struggle.

A stronger explanation for the mountain of debt was financial deregulation, which the Fed itself had championed. Central bankers periodically scolded the debtors and urged them to shape up, but Fed officials seldom accepted any blame. As Fed chair, Volcker supported the deregulation in 1980 that repealed legal limits on interest rates. Afterward, he acknowledged that loosening the caps on rates undermined the Fed’s ability to control the expansion of credit. “The only restraining influence you have left is interest rates, restraint which works ultimately by bankrupting the customer,” Volcker lamented. Sure enough, bankruptcy of the borrowers flourished in this new era of unregulated lending.

Volcker the skeptic was succeeded in 1987 by Greenspan the true believer. Alan Greenspan was an ideologue with inflated confidence that markets would sort things out better than the government. He became Wall Street’s powerful cheerleader and set out to liberate the financial industry from government regulation. Instead of formulating new rules to govern the emerging “shadow banking” system, Greenspan led the charge to abolish old rules. As Fed chair, he engineered dubious legal premises in the 1990s to let Citigroup violate the Glass-Steagall Act, which had imposed a firewall between investment banking and commercial banking, even before Congress repealed that New Deal law. Bill Clinton tagged along like a happy puppy.

The flowering of Wall Street in the Greenspan era spawned the spectacle of proliferating billionaires. By shifting rewards from labor to capital and removing restraints on financiers, the Federal Reserve helped to engineer a fantastic transformation of economic life. In 1982, when the deep recession of that time ended, the Dow Jones average was at 800. The “super bull market” peaked at 14,000 twenty-five years later. The Dow’s value multiplied seventeen times, while the overall economy grew only five times.

That contrast defines the basic economic disorder: a great shift of wealth from the many to the few, from production and consumption to the financial sector. In the early 1980s, the financial industry’s profits were about 10 percent of all corporate profits. By 2007, it was claiming 40 percent. The value of all financial assets used to average a bit more than four times the Gross Domestic Product. By 2007, financial assets were ten times the GDP.

Then the music stopped.

The Fed’s Dilemma

In the early months of 2007, on the eve of catastrophe, most members of the Federal Open Market Committee seemed oblivious to the crisis about to seize the financial system. In March of that year, Fed chair Ben Bernanke said he was “puzzled” that financial markets were roiled by the collapsing value of subprime mortgages. After all, he told FOMC members, “the actual money at risk is on the order of $50 billion from defaults on subprimes, which is very small compared with the capitalization of the stock market. It looks as though a lot of the problem is coming from bad underwriting as opposed to some fundamentals in the economy.”

Bernanke’s remarks show that he did not grasp the nature of the threat or understand how the interconnections of modern finance would swiftly spread the panic from one troubled credit market to others. The Fed chair was not embarrassed by this ignorance because his remarks were made behind closed doors, at the FOMC meetings that set monetary policy. The transcripts of those 2007 meetings were not made public until five years later—long after the disclosures could have had an impact on financial markets or public opinion. The Fed’s narrow-gauge thinking and its fallibility were, as usual, protected from timely public scrutiny.

Some of Bernanke’s colleagues voiced similar complacency. “We don’t see the current situation as precipitating a cyclical downturn in aggregate activity,” said David Stockton, the director of Fed research, in reporting the staff forecast in March 2007.

Jeffrey Lacker, president of the Richmond Federal Reserve Bank, seconded this overconfident view. “My overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies,” he said at the same meeting. “Realization of that risk seems to be playing out in a fairly orderly way so far.”

Michael Moskow, president of the Chicago Fed, also grossly misjudged reality. “Given the ample liquidity in financial markets, it seems unlikely that the subprime problem will cause major changes in overall credit availability or pricing,” he said.

The transcripts of the 2007 policy meetings quoted here destroy the Fed’s popular reputation as economic soothsayer. Some FOMC members worried about inflation or oil prices or the home-building industry; others clung to business-as-usual optimism, even as the market news got more disturbing, with Bear Stearns and Countrywide and others sliding toward their fatal reckoning. It took six or eight months, and more violent market disturbances, for the FOMC to wake up, despite prodding and pleading from a few strong voices.

One such voice was Janet Yellen, who recently began her tenure as the new Fed chair. In March of 2007, she was the first to warn that financial stability could be threatened. By August, she sounded a bit impatient with slow-moving colleagues. “We seem to be repeatedly surprised with the depth and duration of the deterioration in these markets,” Yellen observed, “and the financial fallout from developments in the subprime markets, which I now perceive to be spreading beyond that sector, is a source of appreciable angst.”

As the pace quickened, William Dudley, manager of the open-market desk at the New York Fed (and now its president), was a levelheaded sentinel and tutor, warning about “a danger of forced liquidation” and trying to educate FOMC members on the complexities of collateralized debt obligations and other Wall Street exotica. “The magic of structured finance and the corporate rating agencies,” Dudley explained, had been used to convert low-rated debt paper into triple-A investments. Now the investors who had bought the stuff were discovering that the assurances were false. As they started dumping failed investments, they began to wonder what else was phony, and the panic spread.

The question arose in the FOMC’s meetings: What should it tell the people? This is always the fundamental dilemma for a central bank used to deliberating in private. Does a public institution that sees a threatening storm have an obligation to inform the public at large—that is, give citizens fair warning of what’s about to happen to them? Or would that only make things worse? To put it another way, in a public-private institution, who gets to know the secrets? As events darkened in 2007, the dilemma nagged policy-makers.

“I am worried that we will be asked publicly at different intervals and perhaps starting now what our opinions and perspectives are,” Richard Fisher, president of the Dallas Fed, said in August. “I’m also worried about giving the wrong answer.”

William Poole, president of the St. Louis Fed, likewise asked Dudley if the New York Fed has “what I would call material nonpublic information about firms that would suggest there is more difficulty than we see in newspapers.” Poole nevertheless said, “My own bet is that the financial market upset is not going to change fundamentally what’s going on in the real economy.”

Eric Rosengren, president of the Boston Fed, was not so sure: “Some of the Boston hedge fund managers have observed that one dependable correlation has been that the announcement of no problem seems to be highly correlated with the actual problem’s occurring with a lag of one to two weeks,” he said. There was laughter around the boardroom table, the transcript reported.

The anxious queries were clearly about what to tell the financial markets, but the same point ought to apply to informing the public. If a government agency knows that bad things are about to happen to innocent citizens, doesn’t it have a duty to tell them—in language they can understand?

Timothy Geithner, then president of the New York Fed and later Obama’s treasury secretary, strongly warned FOMC members not to say much of anything to anyone, lest they become the trip wire for catastrophe. “The challenge, of course, is to figure out a way to acknowledge and to show some awareness of these changes in market dynamics without feeding the concern, without overreacting,” Geithner said.

The Fed more or less stuck to Geithner’s advice and essentially said nothing and did nothing. It was overtaken by events. By that point, it was not clear what, if anything, it might have done to forestall the crash. A timely warning might have helped some people get out of the way, or it might have exploded the bubble.

Yet Fed vice chair Donald Kohn still thought the dangers were exaggerated. “The most likely outcome,” he said in August 2007, “is that [the correction] will be limited in duration and effect.” How wrong was he? By September, FOMC chair Bernanke sounded less sure. Whatever the Fed did, he joked, it was sure to be criticized. “We are not in the business of bailing out individuals or businesses,” he said. “As long as we make that distinction, I think we’re fine, but it may be history that agrees to that rather than the newspapers.”

Wrong again. A year later, the Federal Reserve and Congress were bailing out the banks.

The Reform Imperative

One hundred years is enough. the main trouble with the Federal Reserve is not incompetence or bias. The problem is more fundamental. The institution is a governing antique, designed for circumstances that no longer exist. It resembles a narrow-gauge railroad built in the age of steam engines and industrial capitalism, while the world has moved on to jet travel, smartphones and instant global banking. The Fed regularly flounders because everything has changed—except the central bank.

Congress created the Federal Reserve, and Congress can change it whenever the elected representatives get serious about reform. Clearly, that is not now the case, but stay tuned. Citizens are still absorbing the shock of what they learned about the bailouts. People are still bleeding while governing elites congratulate the central bank for “saving” the country.

Reform begins by eliminating obvious contradictions. Get the money lenders out of the temple. Create a new public institution that truly understands that its obligation is to society, not money markets. A new Fed charter would establish an agency surrounded by numerous webs of public accountability, not only to elected officeholders but also to citizens, interests and social aspirations now excluded from the monetary debate. The new Fed would be required to coordinate with fiscal policy-makers in Congress and the White House instead of ridiculously pulling in the opposite direction, as it has done in recent years. Careful cooperation with the fiscal side of government can harness the Fed’s money creation and lending powers to help finance major public objectives like infrastructure and college loans and greater employee ownership. These and other great goals are now blocked by the tyranny of outdated thinking.

Some will object that these reforms would politicize the Federal Reserve. Yes, it’s true. That’s the idea: listen to the people. The Fed, after all, is already politicized. It’s only the people who get left out.