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.
Once the central bank has established balance sheet connections to all the important financial institutions, including insurance companies and mutual funds, it can engineer the balance sheet conditions that will virtually compel them to unfreeze lending and restart the flows of credit. This does not require spending vast sums of taxpayers' money. It does require the government to abandon the pretense that it is merely assisting troubled private enterprises in these difficult times. Government has to step up to this financial crisis and take charge of the solution, regardless of how it disposes of the so-called zombie banks. Otherwise, Washington, including the Fed, will be restoring a dysfunctional system that can lead to the same scandalous errors.
D'Arista, who taught at Boston University and years ago was on the staff of the House banking committee, is barely known among exalted policy-makers. But her work has a strong following among progressive economists, who recognize the originality of her thinking. For nearly fifteen years with the Financial Markets Center, a monetary policy think tank, D'Arista identified the systemic disorders emerging in domestic and international finance. She proposed timely reforms while admiring economists congratulated the Fed for creating an era of "great moderation." D'Arista, I should add, is also a published poet. Formal economists will scoff, but poets often see realities the bean counters fail to recognize.
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. I have more than once blistered the Fed's inept performance and blamed Greenspan's "free-market" ideological bias. 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.
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.