Fixing the Fed
by William Greider
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. (Read her recent essay, "Setting an Agenda for Monetary Reform.") 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. 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.
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.
This article can
be found on the web at:
http://www.thenation.com/doc/20090330/greider
