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 Sachs, Merrill Lynch, Deutsche 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.