The Federal Reserve Bank was founded in an act of Congress in 1913, with its primary directive to “furnish an elastic currency.” Its mission was expanded in the aftermath of the Great Depression to include responsibility for operating monetary policy in a manner to help stabilise the economy. After World War II, Congress directed the Fed to pursue a dual mandate, long interpreted to mean full employment and reasonable price stability. The Fed has been left to decide how to implement policy to achieve these objectives and has over time experimented with a variety of methods including interest rates, reserves, and money aggregate targets.
While some central banks have adopted explicit inflation targets, the Fed has argued that this would reduce its ability to respond in a flexible manner to disruptions, and would not be consistent with its dual mandate. Note also that none of the subsequent amendments to the original 1913 Act have supplanted the Fed’s directive to act as lender of last resort or manager of the national payments system, providing an “elastic currency.” Finally, the Fed has always been responsible for regulating and supervising member banks—a responsibility it shares with Treasury.
When the global financial crisis began in 2007, the Fed reacted by providing liquidity through its discount window and open market operations, later supplemented by a number of extraordinary facilities created to provide reserves as well as guarantees. Some estimates place the total amount of government loans, purchases, spending, and guarantees provided during the crisis at more than $20 trillion—much greater than the value of the total annual production of the nation. Only a very small portion of this was explicitly approved by Congress, and much of the detail surrounding commitments made—especially those made by the Fed—was clouded in secrecy.
A few days ago the Fed finally released on its website some data on its behind-closed-doors deal-making. In coming weeks I will provide more comments on what has been revealed. In this column I will only raise questions concerning the appropriateness of secret bail-outs that were provided to financial institutions, nonfinancial firms, and even individuals. Fed critics from both the right and the left have been arguing it is time to reign-in the Fed and it is certain that the next Congress will return to this issue.
Democratic Accountability and Transparency of the Fed
In this crisis, the Fed’s role has dominated, with the Treasury taking a back seat. While the Fed committed many trillions of dollars to its rescue of Wall Street, the Treasury’s total fiscal stimulus packages for Main Street amounted to about one trillion. Yet unlike the Treasury—whose purse strings are directly controlled by Congress–those in charge of monetary policy are not subject to the same degree of democratic accountability. Further, while the Fed’s actions have become more transparent since 1994 (when Representative Gonzalez caught Chairman Greenspan in a subterfuge, leading to substantial reduction of its secrecy to comply with Congressional demands), most of its deliberation remains behind closed doors. At best, it informs Congress of its decisions after the fact. Fed officials are not elected, and by design are not subject to the will of the voters. While the Fed is a creature of Congress, current law does not provide substantive control.
Since 2007 the Fed has mounted an unprecedented effort to stabilise the financial system and the national economy. Faced with the worst crisis since the Great Depression, the Fed found that traditional monetary policy—lowering interest rates and standing by as lender of last resort to the regulated banking system—was impotent in the face of collapsing asset prices and frozen financial markets. The Fed created an “alphabet soup” of new facilities to provide liquidity to markets. It worked behind the scenes to bail-out troubled institutions. It provided guarantees for private liabilities. It extended loans to foreign institutions including central banks. The Fed’s on-balance sheet liabilities grew to $2 trillion, while its off-balance sheet contingent promises amounted to many trillions more.
Congress and the public at large have become increasingly concerned not only about the size of these commitments but also about the shroud of secrecy. For the most part, the Fed simply refused requests for greater transparency. Ironically, when the crisis first hit, Treasury Secretary Paulson submitted to Congress a vague request for rescue funds that was rejected precisely because it lacked details and a mechanism to give Congress oversight on the spending. Eventually a detailed program of about $800 billion was approved. Yet, the Fed has spent, lent, or promised untold trillions of dollars–far more dollars than Congress provided to the Treasury. Most of this was negotiated behind closed doors, often at the New York Fed. The Fed’s defence is that such secrecy is needed to prevent a run on troubled institutions, which would only increase the government’s costs of resolution. There is, of course, a legitimate reason to fear sparking a panic.
Yet, when relative calm returned to financial markets, the Fed still resisted requests to explain its actions even ex post. This finally led Congress to call for an audit of the Fed in a nearly unanimous vote. Some in Congress are now questioning the legitimacy of the Fed’s independence. In particular, given the importance of the NYFed some are worried that it is too close to the Wall Street banks it is supposed to oversee and that it has in many cases been forced to rescue. The President of the NYFed met frequently with top management of Wall Street institutions throughout the crisis, and reportedly pushed deals that favoured one institution over another. However, like the other presidents of district banks, the President of the NY Fed is selected by the regulated banks. This led critics to call for a change to allow appointment by the President of the nation. Critics note that while the Fed has become much more open since the early 1990s, the crisis has highlighted how little oversight the congressional and executive branches have over the Fed, and how little transparency there is even today.
There is an inherent conflict between the need for transparency and oversight when public spending is involved and the need for independence and secrecy in formulating monetary policy and in supervising regulated financial institutions. A democratic government cannot formulate its budget in secrecy. Except when it comes to national defence, budgetary policy must be openly debated and all spending must be subject to open audits. That is exactly what was done in the case of the fiscal stimulus package.
However, it is argued that monetary policy cannot be formulated in the open—a long and drawn out and open debate by the Federal Open Market Committee about when and by how much interest rates ought to be raised would generate chaos in financial markets. Similarly, an open discussion by regulators about which financial institutions might be insolvent would guarantee a run out of their liabilities and force a government take-over. Even if these arguments are overstated and even if a bit more transparency could be allowed in such deliberations by the Fed, it is clear that the normal operations of a central bank will involve more deliberation behind closed doors than is expected of the budgetary process for government spending. Further, even if the governance of the Fed were to be substantially reformed to allow for Presidential appointments of all top officials, this would not reduce the need for closed deliberations.
The question is whether the Fed should be able to commit the public purse in times of national crisis. Was it appropriate for the Fed to commit Uncle Sam to trillions of dollars of funds to bail out US financial institutions and nonfinancial firms, as well as foreign institutions and governments (through repo operations with foreign central banks that lent dollars to them, exposing the Fed to default risk)?
Some will object that there is a fundamental difference between spending by the Fed and spending by the Treasury. The Fed’s actions are limited to purchasing financial assets, lending against collateral, and guaranteeing private liabilities. While the Treasury also operates some lending programs and guarantees private liabilities (for example, through the FDIC and Sallie Mae programs), and while it has purchased private equities in recent bail-outs (of GM, for example), most of its spending takes the form of transfer payments and purchases of real output. Yet, when Treasury engages in lending or guarantees, its funds must be approved by Congress. The Fed does not face such a budgetary constraint—it can commit Uncle Sam to trillions of dollars of commitments without going to Congress.
Bail-outs necessarily result in winners and losers, and socialisation of losses. At the end of the 1980s when it became necessary to resolve the thrift industry, Congress created an authority (the Resolution Trust Corporation) and budgeted funds for the resolution. It was recognised that losses would be socialized—with a final accounting in the neighbourhood of $200 billion. Government officials involved in the resolution were held accountable for their actions, and more than one thousand top management officers of thrifts went to prison. While undoubtedly imperfect, the resolution was properly funded, implemented, and managed to completion.
By contrast, the bail-outs so far in this much more serious crisis have been uncoordinated, mostly off-budget, and done largely in secret—and mostly by the Fed. There were exceptions, of course. There was a spirited public debate about whether government ought to rescue the auto industry. In the end, funds were budgeted, government took an equity share and an active role in decision-making, and openly picked winners and losers. Again, the rescue was imperfect but today it seems to have been successful. Whether it will still look successful a decade from now we cannot know, but at least we do know that Congress decided the industry was worth saving as a matter of public policy.
No such public debate occurred in the case of, say, Goldman Sachs—which was apparently saved by a series of indirect measures (for example, providing funds to AIG that were immediately and secretly passed-through to Goldman). There was never any public discussion of the need to rescue Goldman through the back-door means of providing funds to AIG—indeed, those actions were only discovered after the fact. The main public justification for rescuing financial institutions has been the supposed need to “get credit flowing again”, but if so, the bail-outs have been largely unsuccessful (and given debt loads in the private sector, encouraging lending is probably unwise in any case). Alternative methods of stimulating credit, or—better—of stimulating private spending, have hardly been discussed.
Indeed, the massive sums already provided to Wall Street (again, mostly off-budget) prove to be a tremendous barrier to formulating another stimulus package for Main Street. Even as labour markets remain moribund, as homeowners continue to face foreclosures, and as retailers face bankruptcy, Congress fears voter backlash about additional government commitments. While economists make a fine distinction between commitments made by the Fed versus those made by Treasury, voters do not. Uncle Sam is on the hook, no matter who put him there. Voters want to know what good has been accomplished by expanding the Fed’s balance sheet liabilities to two trillion dollars, and by extension of Uncle Sam’s commitments by perhaps $20 trillion through loans, guarantees, and bail-outs.
In coming weeks and months I will revisit this topic—it is one of the most important issues facing this country as we try as we try to reform the financial system and policy-making so that we can recover from the crisis created by Wall Street.
L. Randall Wray is a Professor of Economics, University of Missouri—Kansas City. A student of Hyman Minsky, his research focuses on monetary and fiscal policy as well as unemployment and job creation. He writes a weekly column for Benzinga every Thursday.
He also blogs at New Economic Perspectives, and is a BrainTruster at New Deal 2.0. He is a senior scholar at the Levy Economics Institute, and has been a visiting professor at the University of Rome (La Sapienza), UNAM (Mexico City), University of Paris (South), and the University of Bologna (Italy).
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