It’s hard to be optimistic

James Hartley

The nation likely will drift into a situation in which its central bank will be expanding its regulatory and safety-net coverage, vainly trying to protect everything in the interest of protecting ‘banks.’ The tremendous power it will come to wield not only will be harmful to the structure of the financial system but also will make the Fed an even more formidable foe to those inside and outside the government who believe that it is too powerful already. James L. Pierce, “The Federal Reserve as a Political Power,” 1990
How can the Federal Reserve help you today? A few years ago, such a question would have been rather odd. The Federal Reserve was created a little over a century ago as an independent government agency with a rather small mandate: manage the money supply. It was an important, but limited, role. In normal times, the Fed existed to ensure the money supply grew at a reasonable rate. In times of crisis, the Fed would become the Lender of Last Resort, lending funds to solvent banks to get them through a crisis. But, times have changed. The Fed, no longer tied to the mast, is here to take your order.
This new world is magnificently described in Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis. With impeccable brevity and precision, Menand details how the Fed has abandoned its historical mission, appropriating to itself a new mandate and powers of dubious legality. None of this has been done in secret. Its actions have been front page news, Congress has aided and abetted the unbinding, and as the quotation at the outset notes, it was all predictable in 1990.
Monetary Policy before 2020
“The American Monetary Settlement” is Menand’s term for the world in which we used to live. Private commercial banks provided deposit accounts (both checking and savings) which constituted the bulk of what we used for money. The Federal Reserve System provides currency (also a form of money) and supervises the commercial banking system. The Fed also provides reserve accounts for commercial banks, which are used to transfer funds from one bank to another. By changing the volume of reserves in banks’ accounts, the Fed is able to exercise indirect control over the amount of money in the economy. The system has a remarkable simplicity, easily explained in any first-year economics class.
There have long been cracks in the money creation system. Over time, other types of accounts developed which also functioned as money, but which were easily ignored when discussing the money supply. These other accounts were not provided by domestic commercial banks, and thus existed in what became known as the Shadow Banking system. Menand points to three types of accounts (dealer repo accounts, Eurodollar accounts, and money market funds) which are all highly liquid and reasonably stable, and thus provide something that functions as money but pays a higher interest rate than a traditional deposit account at a commercial bank. Because none of these types of accounts are at commercial banks, the Fed has no regulatory authority over them and there are no precise measures of their size.
The shadow banking system suddenly found itself in the sun in 2008. Once a small part of the financial infrastructure, the shadow banking accounts had grown to be about twice as large as the measured money supply. When an old-fashioned bank run hit the shadow banking industry, there was a grave danger of the entire system falling apart, which would have generated a collapse in the money supply equivalent to that which caused the Great Depression. The Bernanke Fed exercised an enormous array of powers designed to shore up the shadow banking system to prevent such a collapse. It was a moment of genuine monetary peril, and the resulting recession was much milder than it would have been had the Fed done nothing.
In the wake of previous financial crises, Congress inevitably passed a bill creating a new set of regulations to prevent the same thing from happening again. After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis.
The 2020 Financial Crisis
The same crisis hit again in March 2020. With the arrival of Covid and the government lockdowns, the shadow banking system once again found itself reeling. This time, the Powell Fed acted promptly, using the same bag of tricks which the Bernanke Fed had stumbled into discovering. It wasn’t enough, so the Fed’s range of actions expanded. The panic ended and the shadow banking system stayed intact. But, as Menand describes in detail, the American Monetary Settlement was destroyed.
The result has been nothing short of a transformation in the Fed’s role in our society. Not only have its unprecedented actions helped once again to avert economic collapse, but they have also changed what members of Congress and members of the public expect of the country’s central bankers. Today, the Fed is no longer just managing the money supply by administering the banking system. It is fighting persistent economic and financial crises by using its balance sheet like an emergency government credit bureau or national investment authority…
In 2008, the Fed invoked an obscure provision in its charter which allowed it to become the lender of last resort to financial firms other than the commercial banking system. In 2020, when that proved to be insufficient to stem the panic, the Fed tried something new: it started directly buying massive volumes of assets in order to prop up their prices. The Chair of the Fed announced that the Fed would not “run out of ammunition”—that they had unlimited resources to buy as many assets as needed. The rhetoric suggesting financial crises are the equivalent of war is revealing; in wartime, even democratically elected governments appropriate seemingly limitless powers over the economy.
That promise opened the floodgates. With unlimited access to the printing press, there seemed to be no limit to what the Fed could do. The financial panic of March 2020 subsided, but the economic problems were only beginning. Those problems extended far beyond the financial sector, so Congress passed the CARES Act, one provision of which was to allow the Fed to lend directly to businesses, both for-profit and non-profit. Suddenly the Fed found itself with the power to lend funds to whatever firm or industry it deemed worthy.
The Fed did not stop there, however. Being the Lender of Last Resort by definition means the Fed is imposing an obligation to have the loans repaid at some point. That creates burdens on firms to whom the Fed has lent funds. To stimulate economic activity, and not incidentally to keep the interest rates low on government debt, the Fed began what commentators quickly dubbed QE Infinity. In effect, this was an open-ended commitment to keep buying as many financial assets as necessary to maintain low-interest rates.
What exactly now sets a limit on the Fed’s activity? With literally an unlimited amount of money at its disposal, and a mandate which has seemingly broadened to “do good things for the economy,” what should be its priorities? Now that the Fed has crossed the Rubicon by purchasing bonds from AT&T, Verizon, CVS, Comcast, GE, Apple, Microsoft, and so on, why not also your place of work or your favorite non-profit? Now that the Fed has lent to local municipalities, why not get free Fed money for your local school or community center? Is it any wonder that people are now seriously talking about what the Fed can do on the Climate Change agenda?
The world of the Unbound Fed is rife with peril. Menand barely scratches the surface of a world in which an unelected independent agency seemingly can create money to accomplish any goal it wants. We have entered a strange regulatory world in which it is no longer clear which rules the Fed must follow. Obviously, the Fed no longer is restrained to its traditional role of managing the money supply. What else is it now able to do, either legally or with Congress looking the other way?
Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight. The now implied promise always to backstop the shadow banking system operating outside of the normal regulatory framework is a recipe for disaster.
Using the money supply to finance whatever initiatives Congress wants to accomplish has already resulted in unprecedented growth in the money supply and the inevitable inflationary consequences.
Favoritism is inevitable. In the old days, the Fed avoided favoritism by lending to any commercial bank with good collateral. The only asset it purchased when it wanted to create more bank reserves was US government debt.
In 2008, the Fed had to decide which parts of the shadow banking system it wanted to aid in order to prevent a collapse of the money supply (Lehman Brothers: no; AIG: yes). After 2020, the Fed no longer has to restrict itself to financial firms or concerns about the money supply. It will inevitably play favorites.
What Next?
Having laid out the reasons for, and the problem with, the Fed Unbound, Menand naturally enough turns to solutions. Alas, this is where the book founders. We should not fault Menand too much, though; it is not at all clear that there is an easy solution.
He offers two routes forward. First, he asserts the need for “a healthier macroeconomic policy mix.” It is hard to argue with that. After all, the most important reason to have an independent central bank is to prevent the legislature from having access to the printing press to fund every spending idea which comes along. Menand himself illustrates the problem. This discussion is one of the places for Menand’s periodic odd and inexplicable intrusion of his own vaguely leftist political agenda into the book. If the author of a book warning against the dangers of an unbound Fed cannot resist introducing his own legislative agenda into the argument, why should we expect members of Congress to keep their own legislative ambitions separate from a seemingly easy way to finance them?
Secondly, Menand suggests reining in the new financial world. Looking back to the world before 2008, it seems like we could return to those halcyon days gone by “enforcing the regulatory perimeter.” If the problem is types of accounts that function as money but are created outside the traditional commercial banking system, then why not either eliminate the possibility of such accounts or bring them under Fed supervision? Theoretically, that is possible. But, given that the shadow banking system is twice as large as the currently supervised banking system, this is not a small disruption to the monetary system. There is simply no way to predict the economic impact of trying to rewrite the rules on what types of accounts can be offered by what types of financial firms.
The problem with reining in the financial world is complicated by technological developments which have made it easier to create new types of accounts, using new types of assets (e.g. cryptocurrency), which may or may not end up functioning like money in limited sets of markets. No matter where you set the regulatory perimeter, there will be enormous financial incentives to set up shop right on the other side of that border.
These sorts of questions compound the longer you think about this new world of money. Unfortunately, the government does not have a good record when it comes to thinking through the monetary implications of the shadow banking industry.
Will they sort this out before the next crisis, as they failed to do in 2008 and 2020? It’s hard to be optimistic, but, if you are not yet troubled by this new world, get a copy of The Fed Unbound.