Is The Fed Corrupt or Captured?

Yesterday I responded to a reader who asked if “The Fed is out of control”.  In short, I said no, not in the sense that critics have charged them with “out of control printing of money” that could produce inflation.  But I left the post with an acknowledgement that the secrecy of The Fed carries some risks.  I said:

…it is unseemly for The Fed to be able to make large loans on favorable terms to banks, loans that save those banks’ managers from failure, without any sunshine or transparency.  It makes fertile ground for corruption.

Today I want to look at the question of whether The Fed, as it is currently constituted, is corrupt.  The Fed has generated a lot of populist anger.  A quick Google search for “end the fed” turns up over 8 and 1/2 million results.  A lot of people seem to feel there’s something wrong here with The Fed, even if they can’t pinpoint what it is.  Typically the charge has been that The Fed has been guilty of creating (“printing”) money too fast and producing inflation.  We’ve seen that’s not true.  Inflation is not our problem and hasn’t been for 20-30 years. Nevertheless, many people feel there must be something wrong.

I tend to agree. First, let’s define corrupt.  From Webster’s online, we see two possible meanings for corrupt:

1…   b : characterized by improper conduct (as bribery or the selling of favors) <corrupt judges>…

3.  : adulterated or debased by change from an original or correct condition <a corrupt version of the text>

Going by this definition, The Fed is corrupt.  It’s characterized by improper conduct and it’s debased from a correct condition (although the original condition wasn’t much better).  Let’s take a closer look to understand problems better.

I’m not accusing The Fed or Fed officials of outright petty bribery.  I don’t think anybody has directly paid off Fed officials or promised personal gains in return for Fed decisions.  It’s more complex than that.  The Fed has become the subject of regulatory capture.  Regulatory capture occurs when an agency of the government is initially established to regulate or control the excessive behavior of some industry.  But then, over time, the industry captures the hearts, minds, and ideologies of the regulators.  The regulators come to function as the protectors and servants of the industry they were supposed to regulate.  Regulatory capture is common anytime the industry involved is complex and technical.  Experts have to be hired as regulators but the best source of experts on the industry is the industry itself.  The problem is made worse when the regulated industry is able to pay much higher salaries than the regulatory agency.  Wikipedia tells of a few examples from The Fed:

Federal Reserve Bank of New York (New York Fed)

The Federal Reserve Bank of New York is the most influential of the Federal Reserve Banking System. Part of the New York Fed’s responsibilities is the regulation of Wall Street, but its president is selected by and reports to a board dominated by the chief executives of some of the banks it oversees.[39] While the New York Fed has always had a closer relationship with Wall Street, during the years that Timothy Geithner was president, he became unusually close with the scions of Wall Street banks,[39] a time when banks and hedge funds were pursuing investment strategies that caused the 2008 financial crisis, which the Fed failed to stop.

In the wake of the financial meltdown, Geithner became the “bailout king” of a recovery plan that benefited Wall Street banks at the expense of U.S. taxpayers.[39] Geithner engineered the New York Fed’s purchase of $30 billion of credit default swaps from American International Group (AIG), which it had sold to Goldman SachsMerrill LynchDeutsche Bank and Société Générale. By purchasing these contracts, the banks received a “back-door bailout” of 100 cents on the dollar for the contracts.[40] Had the New York Fed allowed AIG to fail, the contracts would have been worth much less, resulting in much lower costs for any taxpayer-funded bailout.[40] Geithner defended his use[40] of unprecedented amounts of taxpayer funds to save the banks from their own mistakes,[39] saying the financial system would have been threatened. At the January 2010 congressional hearing into the AIG bailout, the New York Fed initially refused to identify the counterparties that benefited from AIG’s bailout, claiming the information would harm AIG.[40] When it became apparent this information would become public, a legal staffer at the New York Fed e-mailed colleagues to warn them, lamenting the difficulty of continuing to keep Congress in the dark.[40] Jim Rickards calls the bailout a crime and says “the regulatory system has become captive to the banks and the non-banks”.[41]

Regulatory capture isn’t limited to only the possibility that a regulators’ decisions might be influenced by their personal future employment prospects.  It also involves ideology and group think.  The regulators spend their time, both professional and personal, mixing with the regulated.  They come to think alike.  Professor Steven Davidoff writes at Deal Book:

Instead, we have ideological and social capture of the top regulators. This is an issue that trumps what can be a model regulator at the bottom where the line people are quite competent, able and uncaptured, but the message from the top skews their effectiveness….

For an example of social capture at the top, one need only look at the publicly available calendars of Treasury Secretary Timothy F. Geithner and his predecessor, Henry M. Paulson Jr. The people regulating the financial industry largely come from that industry or look to that industry for their social interactions. They play squash with them and dine with them, and these are the peers they look to when they have issues to discuss. Jo Becker and Gretchen Morgenson of The New York Times documented this ably in their April 2009article on Mr. Geithner’s social interactions during his time as head of the Federal Reserve Bank of New York.

Lawrence H. Summers may not be as social, but even he worked at a hedge fund in the year leading up to his current position in the White House.

Among these people, there is no evil or nefarious plot to regulate in favor of the banks. These men and women may believe they are doing their best, but their worldview is affected by the people they interact with. This is a problem that can be exacerbated by a revolving door between finance and regulators.

This social influence can be affected by an additional factor: ideological capture also at the top. This occurs when regulators are appointed who share the same beliefs and ideas as their industry. A prime example of this is Alan Greenspan, the former Federal Reserve chairman, who was a devotee of Ayn Rand and objectivism and a fierce devotee of free markets. He no doubt was acting in good faith and true belief; the financial industry benefited from the fact that he shared their ideology

James Kwak and Simon Johnson, the authors of the book 13 Bankers, have written extensively about the regulatory capture of The Fed and the resulting improper conduct and debased condition of the world’s largest central bank. The book is worth checking out, as is their blog The Baseline Scenario.  Bill Moyers interviewed them for PBS on these topics. You can watch the video or read the transcript here.

The evidence is extensive that The Fed has become captured by the very banks it is supposed to regulate.  The Fed now sees it’s mission as first and foremost as protecting Wall Street, the banks, and the financial system.  The audit of The Fed in July 2011 confirmed that problems existed with conflicts of interest:

The audit also found that the Fed mostly outsourced its lending operations to the very financial institutions which sparked the crisis to begin with, and that they delegated contracts largely on a no-bid basis. The GAO report recommends new policies that would eliminate such conflicts of interest, and suggests that in the future the Fed should keep better records of their emergency decision-making process.

It was evident before that.  I March 2010 I recounted how Nobel-prize winner Joseph Stiglitz accused The Fed of being corrupt and said if a developing nation had a central bank like The Fed, we’d pressure them to change.  So, yes, The Fed is corrupt because it has been captured.

 

Libya, Tunisia, Egypt – One of These Is Not Like The Other

Lately I’ve been puzzled about why NATO and the U.S. have intervened militarily in Libya, but stayed out of popular rebellions in Tunisia, Egypt, Yemen, Bahrain, and other middle east countries.  Human rights concerns doesn’t seem to fully explain it.  After all governments in Yemen and Bahrain in particular have violated human rights without so much as peep from the U.S.  Yes, there’s the oil explanation, but Libya doesn’t have that much oil (less than 2% of world exports) and besides Western firms (BP and Marathon) were involved in the production anyway.

Now comes a very interesting piece from Ellen Brown at Web Of Debt.  It’s the kind of thing that makes you go “hmmmm”:

If the Gaddafi government goes down, it will be interesting to watch whether the new central bank joins the BIS, whether the nationalized oil industry gets sold off to investors, and whether education and health care continue to be free.

Several writers have noted the odd fact that the Libyan rebels took time out from their rebellion in March to create their own central bank – this before they even had a government. Robert Wenzel wrote in the Economic Policy Journal:

I have never before heard of a central bank being created in just a matter of weeks out of a popular uprising. This suggests we have a bit more than a rag tag bunch of rebels running around and that there are some pretty sophisticated influences.

Alex Newman wrote in the New American:

In a statement released last week, the rebels reported on the results of a meeting held on March 19. Among other things, the supposed rag-tag revolutionaries announced the “[d]esignation of the Central Bank of Benghazi as a monetary authority competent in monetary policies in Libya and appointment of a Governor to the Central Bank of Libya, with a temporary headquarters in Benghazi.”

Newman quoted CNBC senior editor John Carney, who asked, “Is this the first time a revolutionary group has created a central bank while it is still in the midst of fighting the entrenched political power? It certainly seems to indicate how extraordinarily powerful central bankers have become in our era.”

Libya’s national central bank is not only not part of the BIS, the Bank of International Settlements in Switzerland, that regulates and coordinates international banking, but Gaddafi’s government has been actively promoting an alternative international currency and banking structure for African and Arab nations. The alternative currency and banking structure would greatly weaken the power of large, private international banks (largely U.S, British, and European) and facilitate popular policies in those countries.  Libya’s status as a non-member of the BIS is a status it shares with Iraq, Iran, Somalia, Sudan, and Syria.  Again, it just makes you go “hmmmm”.  I recommend following the link and reading the entire article here. 

Innovation in Monetary Policy in Sweden Works: Negative Interest Rates

The Sveriges  Riksbank (a.k.a.  Riksbanken), the Swedish central bank, tried an innovation in monetary policy two years ago in July 2009 when it set the official deposit rate at a negative interest rate of -.25%.  The objective was to stimulate and motivate banks to lend their “excess” reserves to businesses and households and to therefore stimulate the economy.  The Riksbanken was the first central bank to try a negative interest rate and as far as I know, it’s the only one that has tried it.

The results of the experiment look pretty good.  The Financial Times has reported that Sweden’s economy has come roaring back from the depths of the global recession.  It recorded a 7.3% growth in real GDP for 4th quarter 2010 (year-over-year). Fast enough growth that the bank has long since found it necessary to raise interest rates back into positive territory.

So what happened here? And how does a “negative interest rate” work?  Monetary policy is primarily handled by changes in interest rates. In particular, central banks change interest rates on their dealings with commercial banks in their country.  Remember a central bank is a “banker’s bank” – it’s where your average ordinary bank, be it JP Morgan Chase or Podunk Community Bank, has both deposit accounts and loan accounts.  The average commercial bank keeps a certain amount of money on deposit at the central bank. This is what are called “bank reserves” (technically currency in the vault also counts as “reserves” but it’s minor statistically).  Reserves are used to handle transactions with other banks (customer checks to be cleared) and, sometimes, as a cushion for safety. In normal times when the economy is growing and there are plenty of credit-worthy people to lend money to, a bank wants to hold only minimal reserves.  In fact they want to hold only enough to handle any withdrawals such as clearing checks to other banks.  Historically banks would be required to keep a certain % of their deposits as “reserves”.  However, in many nations that’s no longer true (Canada, Japan, Australia).  It’s partly true in the U.S. where demand deposits (checking accounts) have a minimum reserve requirement, but not true for savings deposits.  The reason banks don’t normally want to hold reserves is because they can make more profit by lending the money out.  But lending is only attractive (read highly profitable) in normal times.  In times of crisis, recession, and panic credit-worthy customers are harder to find.  Banks raise their lending standards and become more focused on security/safety instead of making more loans.  So the amount of reserves tends to rise as the banks are reluctant to lend the money.

So banks have deposit accounts called “reserves” at the central bank.  But banks also can borrow from the central bank when they want or need more reserves.  The central bank can arbitrarily set the interest rate for both of these, the deposit (reserve) accounts and the loan accounts (discount loans).  Historically, the Federal Reserve Bank in the U.S. has only set an interest rate on the loans to banks – this is the “discount rate” and it’s set by the Fed Board.  (it’s closely related to the “fed funds rate”, but that’s a whole other story).  Again, historically the Federal Reserve Bank never paid interest on the reserve accounts.  They required banks to keep them, but wouldn’t pay interest on the deposits.  That changed in October 2008 when The Fed finally did what others have long done and took the new step of paying interest to banks on the reserves they keep on deposit at The Fed.  I believe the current rate is 0.25%.  Not much, but when figured on hundreds of billions of dollars that are just sitting there securely at The Fed, it’s a nice source of profits to banks.

Therein lies a problem.  In the crisis banks accumulated very large reserves. Reserves are now much greater than what the need for transactions suggests.  In effect, banks are simply sitting on the money.  They have the funds to make loans but choose not to. Instead, they choose to let the reserves sit idle rather than loan them out.  It’s a nice deal for the banks.  Nice safe profits with no risk. But it’s a problem for the rest of us.  We need a growing economy. And a growing economy needs consumers and businesses to spend more.  Consumers need to buy more and businesses in particular need to spend more on investment and expansion if we are to create jobs and grow the economy.  Problem is, businesses and consumers aren’t getting the loans they need.  Why?  In part because banks want to sit on the reserves.

The solution?  Obviously we need to lower the interest rate paid on the reserves so that banks would choose to make loans (at least constructive loans, not just loans to buy derivatives) in larger volume again.  Well with an interest rate as low as 0.25%, one-quarter of one percent, it’s hard to go much lower.  Or at least that’s what economists and central bankers have long thought.  We thought there was a “zero lower bound” which fancy talk for “interest rates can’t be negative”.

Now we return to Sweden.  The Swedes at the Riksbanken thought “outside the box”, or at least outside the “lower bound”.   They lowered the interest paid on bank reserves deposited at the Riksbanken to a negative number: -0.25%.  In effect, Swedish banks now had to pay the Riksbanken for the privilege of keeping the reserves at the central bank.  As their chair explained, it was, in effect, like having a penalty tax on holding extra reserves.  The idea was to motivate banks to reduce the level of reserves to what they really needed for transactions and take the rest and lend it.  By lending it, it would lower interest rates charged to business and consumers (‘banks compete, you win!’). Businesses and consumers take their new loans and spend the proceeds.  Spending makes sales at businesses. GDP grows. People get hired.  The economy recovers.

It worked. Dramatically.

And it worked.  Sweden’s growing now at over 7%.  They’re now concerned about how to keep the economy from overheating.  We in the U.S. should be so lucky.  Instead we’re still stuck with anemic growth of around 3% despite unemployment of near 9% or more.  Both the government and Federal Reserve continue to be concerned with the health of the banks – whether they are profitable enough and have enough reserves.  We’re worried about helping banks, but nobody is willing to make the banks help the economy through the right incentives.

The challenge getting an economy to recover and grow again after

Inflation vs. The Cost of Living

We are now seeing a disconnect between how the public and policymakers/central banks perceive what each calls “inflation”.  The public at large, encouraged by talk from the hard-money gold crowd, are encouraged to see “inflation” whenever certain key prices go up.  Recently we’ve seen gasoline and food prices go up, and along with these price increases more people are worrying about “inflation”.   In reality, they are worried that the “cost of living” is going up.  Rises in the cost of living is not inflation.

Dennis Lockhart of the Atlanta Federal Reserve Bank gave an excellent explanation of the differences between “inflation” and “a rise in the cost of living” in a recent speech.  It is well worth reading in it’s entireity, particularly for any student of macro. Here’s an excerpt (emphasis is mine) of his key points – he explains each in greater detail:

the term “inflation” is misused in describing rising prices in narrow expenditure categories (for example, food inflation). Nonetheless, recent price news has encroached on the public consciousness with the effect that any price rise of an important consumption item is often taken as signaling inflation.

I think it would be helpful, therefore, to remind ourselves of three basic points about inflation and a central bank’s obligation to deliver price stability. They are

First: The rate of inflation encompasses all prices. It is the practical equivalent of the weakening of the domestic purchasing power of our money.

Second: Inflation is to be distinguished from the cost of living. While central banks, and only central banks, can control the domestic purchasing power of our money, central banks are largely powerless to prevent fluctuations in the cost of living.

Third: The primary economic cost of inflation is that it increases the risk associated with long term planning and decision making.

Let me elaborate on these points….

Lockhart goes on to explain some of the difficulties in monitoring (not really measuring) inflation prospects:

To achieve price stability, policymakers must detect inflation in its early stages before it is firmly established, especially in the psychology of consumers and businesses. This early detection is a challenge because inflation is not easily measured in the short term with any precision. No single price statistic enjoys a sufficient vantage point from which to assess inflation in the short term. With imperfect tools, inflation is more easily monitored than precisely measured.

Almost exactly 100 years ago, the economist Irving Fisher, who laid out many of the foundational ideas about money and inflation, likened measuring inflation or the purchasing power of money to tracking a swarm of bees. The swarm is going in a certain direction, while the bees have their own individual movements within the swarm…

Lockhart summarizes with (again emphasis is mine):

Notwithstanding the energy-driven jump in prices in December, underlying inflation is currently below the level that I would define as price stability. My current projection shows underlying inflation gradually rising over the next few years, putting us back into a range consistent with the 2 percent target by 2013. Key to the realization of this inflation forecast is that inflation expectations of the public remain well anchored. And for this to happen, the public has to have a good appreciation of what the central bank is trying to achieve and have adequate faith that we will achieve it.

In these remarks I have made a distinction between rising prices and a rising cost of living versus inflation. It’s a fair question—is this a distinction without a practical difference? Not at all. The distinction is real and important for all of us to grasp. The distinction ought not to be lost on the general public because to understand the intent of current policy, to form reasonable expectations, and to make sound decisions for the long term, the attention should be mostly on the full picture of inflation and the long-term purchasing power of our money. As a policymaker, I watch prices—that is, the behavior of highly evident and prominent prices we all take note of. I am also interested in movements in the cost of living that the great majority of households experience. But I am focused most intently on broad inflation because I believe long-term stable prices to be fundamental to a healthy and growing economy. For the moment, inflation, properly defined, is tame, in my view. And the rise of individual prices does not signal incipient inflation.

Excellent points.