The Federal Reserve System is an extremely controversial and largely misunderstood institution. Senators on both the right (Ron Paul) and the left (Bernie Sanders) are highly critical of The Fed. I’ve shied away from commenting on The Fed because it’s a pretty complex subject. Every time I think there’s a point to be made, I find it requires explaining some other point, which leads to yet another, and on and on. It’s always seemed too daunting. I could never figure out where to start. But a reader asked last week for my thoughts about The Fed audit, so I’ll make an effort:
What’s the meaning of the audit of the Federal Reserve Bank that has just been completed? I am hearing from friends that the revelation of loans made to banks by the Fed is evidence that they “are out of control” and doing something corrupt or dishonest. I find that hard to believe.
At the risk that I’ll have a few “I’ll explain this later” points in this post, let’s talk about The Fed and whether it’s corrupt. Let’s start with the results of the audit of The Fed which were released in July 2011 in response to a Congressional bill requiring a one-time public audit of The Fed.. The Raw Story summarizes the report for us and also has an embedded copy of the audit results for those interested:
The U.S. Federal Reserve gave out $16.1 trillion in emergency loans to U.S. and foreign financial institutions between Dec. 1, 2007 and July 21, 2010, according to figures produced by the government’s first-ever audit of the central bank.
Last year, the gross domestic product of the entire U.S. economy was $14.5 trillion.
Of the $16.1 trillion loaned out, $3.08 trillion went to financial institutions in the U.K., Germany, Switzerland, France and Belgium, the Government Accountability Office’s (GAO) analysis shows.
Additionally, asset swap arrangements were opened with banks in the U.K., Canada, Brazil, Japan, South Korea, Norway, Mexico, Singapore and Switzerland. Twelve of those arrangements are still ongoing, having been extended through August 2012.
Out of all borrowers, Citigroup received the most financial assistance from the Fed, at $2.5 trillion. Morgan Stanley came in second with $2.04 trillion, followed by Merrill Lynch at $1.9 trillion and Bank of America at $1.3 trillion.
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.
The Fed agreed to “strongly consider” the recommendations, but as it is not a government-run institution it cannot be forced to do so by lawmakers. The seven-member board of governors and the Fed chairman are, however, appointed by the President of the United States and confirmed by the Senate.
The audit was conducted on a one-time basis, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year. Fed officials had strongly discouraged lawmakers from ordering the audit, claiming it may serve to undermine confidence in the monetary system.
The big news, judging by both Ron Paul’s and Bernie Sanders’ reactions is the three-fold fact that The Fed provided loans (or their equivalent in asset swaps) to large banks and governments to the tune of $14.5 trillion “in secret”. The first concern is the size of the actions. The second concern seems to be that some of these banks and governments were foreign. And the third is that the loans were secret. I think the conflicts of interest and poor decision making processes are bigger issues uncovered by the audit. But I’ll get to that later in this post.
Before we can conclude The Fed is “out of control” or corrupt we need to look at what The Fed is supposed to do. The Fed, being the central bank for the U.S., is responsible for:
- maintaining the health of the U.S. banking and financial system and institutions. It does this by regulation of those institutions and by being lender of last resort in a crisis.
- conducting monetary policy. Legally, The Fed has a “dual mandate” on monetary policy. It is supposed to:
- maintain price stability (in other words, avoid inflation or deflation)
- maintain full employment
The critics from the right tend to be followers of Austrian economics (Ron Paul) or far-conservative and libertarian. These are the ones most likely to claim The Fed is “out of control”. What they generally mean (a typical example is here) is they think The Fed has created too much money and is debasing the currency. There’s very little The Fed can do that would satisfy most of these people other than to shut down and ask the government to return to a gold standard. Their concerns about the $14 trillion in loans being inflationary and “newly printed money” reveal deep misunderstandings about the nature of money (a post yet to be written), the functioning of the financial system, and even the nature of inflation. They make a big deal of the size of the loans by comparing them to real GDP. That’s apples to oranges. To figure out if the $14 trillion in loans was large, it should be compared to the total balance sheet of the banking system, not GDP. Yes, the loans The Fed made were of record amount, but so was the crisis. The Fed has a duty to act as lender of last resort in a financial crisis. It did that. And it largely avoided the scale of disaster that occurred in 1929-1933 when The Fed failed to act as lender of last resort and was complicit in creating The Great Depression, snuffing out thousands of banks in the U.S. and depositors’ savings with it. So if “out of control” means The Fed is wildly “printing money”, creating inflation, and debasing the currency, then, no, The Fed is not out of control.
A second charge that both the right and left have leveled is that The Fed shouldn’t have made loans to foreign banks and governments. In a pure-thought fantasy world of theoretical political economy, I suppose The Fed would be a nationalist institution. Certainly we expect the central bank of any other nation to be dominated by solely by protecting their own nation’s interests. (in the case of the Eurozone, it would be a great improvement if the ECB gave a hoot about even it’s own). But reality has to intrude. The U.S. dollar is the world’s reserve currency. We wanted it that way. More than half of all U.S. money is outside the U.S. The world’s trading and financial systems depend on the dollar. Given the scale and scope of the crisis in 2008, The Fed had little practical alternative to making loans to some large foreign banks and even some nations. Nobody else could do it. The alternatives were too nasty. Should it be regular practice? No. Should it be encouraged? No. Should we second guess the middle of the crisis when nobody else was stepping up? Probably not. Should we think about how to handle it better in the future so we don’t have to rely on The Fed? Yes. Have we thought about it and changed? No. So the second charge of being “out of control” as evidenced by making foreign loans doesn’t really hold up.
The third charge, the question of “secrecy” in the loans is more difficult. On the one side, 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. On the other hand, banking is a confidence game. Publicizing loans to banks, even when part of the normal course of affairs, can be misinterpreted by the public, fund managers, or other banks. It alone could spark a run on a bank. The run then creates the very crisis the loan was intended to avert, turning temporary liquidity crisis into permanent bank failure.
Some fear of the secrecy of these loans is driven by a misunderstanding of what The Fed loans and where it comes from. Again, this arises from common misunderstandings of what money really is or where it comes from. Many fear the “money” The Fed lends is money that had to come from somewhere (they suspect taxpayers) or diverted from some other useful purpose. Not so. The Fed doesn’t actually lend “money” in the sense that you and I have “money” to spend. The Fed creates new bank reserves out of thin air. It’s not spending money and it’s not scarce. The Fed can as easily remove these reserves later in the future.
So, is The Fed “out of control”? I don’t think so in the way that many critics make the accusation. Just because I don’t think The Fed is some “out of control money printing machine” doesn’t mean I think The Fed is innocent or doesn’t need to be changed. The audit revealed other issues regarding decision-making and transparency that I find much more troubling. They reveal that The Fed has fallen into a kind of “group think” that doesn’t serve the nation well. I think The Fed is both misguided and poorly structured. But I’ll deal with that in tomorrow’s post.
The Fed is a Rorschach test.