Fixing the Beast: The Fed Has to be Transformed for a Healthy Financial System

Congress and the Obama administration face an excruciating dilemma. To restore the crippled financial system, they are told, they must put up still more public money -- hundreds of billions more -- to rescue the largest banks and investment houses from failure. Even the dimmest politicians realize that this will further inflame the public's anger. People everywhere grasp that there is something morally wrong about bailing out the malefactors who caused this catastrophe. Yet we are told we have no choice. Unless taxpayers assume the losses for the largest financial institutions by buying their rotten assets, the banking industry will not resume normal lending and, therefore, the economy cannot recover.

This is a false dilemma. Other choices are available. Throwing more public money at essentially insolvent banks is like giving blood transfusions to a corpse and hoping for Lazarus -- or, as banking analyst Christopher Whalen puts it, pouring water into a bucket with a hole in the bottom. So far Washington has poured nearly $300 billion into the bucket, and Treasury Secretary Timothy Geithner has suggested it may take another $1 trillion or more to complete the banks' resurrection. The president has budgeted $750 billion for the task. Morality aside, that sounds nutty.

Here is a very different way to understand the problem: to restore the broken financial system, Washington has to fix the Federal Reserve. Though this is not widely understood, the central bank has lost its ability to govern the credit system -- the nation's overall lending and borrowing. The Fed's control mechanisms have been severely undermined by a generation of deregulation and tricky innovations that have substantially shifted credit functions from traditional banks to lightly regulated financial markets. When the Fed tried to apply its old tools, starting in the 1980s, the credit system perversely produced opposite results -- an explosion of debt the policy-makers could not restrain. In its present condition, the Fed may even make things worse.

Instead of frankly acknowledging the problem, Fed governors proceeded in the past two decades to engineer exaggerated swings in monetary policy -- raising interest rates, then lowering them, in widening extremes. This led to the series of bubbles in financial prices -- first stocks, then housing and commodities -- that collapsed with devastating consequences, climaxing in the present crisis. In other words, the central bank's weakened condition and its misguided policy decisions have been a central factor in destabilizing the American economy. More to the point, the Fed's operating disorders are directly threatening to recovery; the economy is not likely to get well if the dysfunctional Fed is not also reformed.

In this crisis the central bank has so far flooded credit markets and financial institutions with trillions of dollars in new liquidity and loan guarantees, which may help to stabilize credit markets. But the Fed has been unable to engineer what the economy desperately needs -- renewed lending to companies and consumers that can finance renewed growth. The confused purpose of monetary policy stands in the way. The Fed could not restrain credit expansion when it was exploding, and now it cannot stimulate credit expansion when it is frozen.

This analysis is drawn from the work of Jane D'Arista, a reform-minded economist and retired professor with a deep conceptual understanding of money and credit. D'Arista proposes operating reforms at the central bank that would be powerfully stimulative for the economy and would also restore the Fed's role as the moderating governor of the credit system. The Fed, she argues, must create a system of control that will cover not only the commercial banks it already regulates but also the unregulated nonbank financial firms and funds that dispense credit in the "shadow banking system," like hedge funds and private equity firms. These and other important pools of capital displaced traditional bank lending with market securities and collaborated with major banks in evading prudential rules and regulatory limits. "Shadow banking" is, likewise, frozen by crisis.