Guest Post: “The Fed has never believed in sunshine as a disinfectant”

By DoctoRx, who writes at EconBlog Review:

In The Fed, the veteran journalist Martin Mayer has written a real-time prequel of the Great Financial Crisis (“GFC”) of the past two years. People may find it a good read or reread because historians have a point of view. If Mayer were a cheerleader for Alan Greenspan’s New Era, this book that was completed when Bush II was merely President-elect and that has precisely zero mention of the name ‘Bernanke’ would likely not be worth the trouble. Here, however, is how the book ends, referring initially to the Gramm-Leach-Bliley Act of 1999 that effectively repealed the 1933 Glass-Steagall Act:

Having won supervisory control of the entire financial services industry, the Fed must bring into the light where the markets can see them continuously the now hidden maneuverings of the private banking empires, the derivatives dealing, the over-leveraging that accompanies overreliance on diversification and probability. And the Fed has never believed in sunshine as a disinfectant. The tragedy for all of us would be if the Fed’s and the Treasury’s and the Congress’s reverence for people who make a lot of money left us unprotected against some sudden revelation of the truth that becomes obvious only in hindsight, that a lot of them don’t know what they’re doing.

There is a great deal in that short passage that relates to the GFC. Mayer foretells the Fed’s recent secret dealings and presages its current fight with Bloomberg’s FOI request to name names, dates and dollars. He suggests here and more clearly elsewhere in the book that the Fed has historically been a lackadaiscal monitor of the state-chartered banks over which it has regulatory authority. He mentions derivatives; in another chapter he writes presciently about the President’s Working Group on financial markets that its “most important function in the late 1990s was as a device to crush the intelligent proposal of Brooksley Born of the Commodity Futures Trading Commission that over-the-counter derivatives be subject to greater disclosure and perhaps regulation, a word with which the Clinton Treasury did not wish to be associated.” (P. 279)

He gets to the heart of the late Greenspan and Bernanke years, stating unequivocally that a central bank’s main function in the new millenium was to affect asset prices (p. 314). From the vantage point of 2009, it would appear that these Chairmen have only wanted them to move in one direction, and now they are increasingly locked in as well to the desire to have the price of government debt stay stable or go up along with those of stocks, houses, and consumer interest rates. How long this feat can be accomplished should be interesting to watch.

By the end of the book, I was therefore inclined to accept the Mayer version of the history of the Fed given how true his insights appear in light of the current GFC.

The book starts with a touch that appears as dated today as a history of the Fed one might read after the next GFC might be; it starts dramatically with a focus on Alan Greenspan “saving the world” during the 1998 Long Term Credit Management debacle that followed the Russian debt crisis. That aside, the book moves crisply from the history of the formation of the Fed to the present as of late 2000. On p. 68, he states:

Nothing would have more greatly surprised the authors of the Federal Reserve Act of 1913 than a later time’s opinon that the Fed represented the ideal of the central bank. They wanted it understood that the Federal Reserve System was not and never would be a “central bank”. “We intended”, Carter Glass (Ed.: of Glass-Steagall) said nineteen years later (Ed.: in 1932), “to preclude all idea of central banking.” The Democratic Party’s platform for the 1912 election had proclaimed, “We oppose the so-called Aldrich bill or the establishment of a central bank. . . . Banks exist for the accommodation of the public. . . . All legislation on the subject of banking and currency should have for its purpose the securing of these accommodations on terms of absolute security to the public and of complete protection from the misuse of the power that wealth gives those who possess it.”

Glass’s chief-of-staff stated that the Federal Reserve Act was intended to diffuse rather than centralize authority.

It would seem that times have changed.

One wonders what the Progressives who at least said that they intended to protect the public from the wealthy’s “misuse of power” would have thought of the Fed’s serial bailouts of mere stockholders and somewhat less mere bondholders of an insurance and financial services holding company and its bank holding company purchasers of strange beasts called credit default swaps whilst world trade was imploding and real human beings were receiving no help except unemployment insurance checks, some being forced to take refuge in tents in view of California’s Capitol in Sacramento. Not to mention the war on savers imposed by the Fed in its to date successful effort to enrich lending margins at bank holding companies. It would appear that “absolute security” was provided to the legal fictions called corporations rather than simply providing absolute security to insured depositors at the subsidiaries of bank holding companies that are actually banks rather than businesses engaged in financial activities.

Chapter 7, “The Age of Invention”, includes a review of the Fed’s actions before, during and after the 1929-32 period. Mayer identifies those who got it right or wrong, deftly skewers the gold standard’s role in inducing the Fed to raise its discount rate from 1.5% to 3.5% in 1931, and quotes the banker and businessman Marriner Eccles as, despite never having read Keynes, pointing out that only government spending could revive a depression when vast amounts of productive capacity lay unused. In view of today’s political flap about reading legislation before voting on it, it is resonant that Mayer notes that the Emergency Banking Act of 1933, which reopened the banks after the bank holiday, “was rushed through both houses of Congress in a single day before the bill was printed, and almost nobody who voted for it knew what was in it.”

It was Eccles, by then Fed Chairman, who engineered the power grab that in 1935 centralized the Federal Reserve System’s power in the Board in Washington. Mayer interestingly ends the Eccles section by pointing out that post-bubble in the 1990s, the Bank of Japan did not find success in the Eccles prescription for reviving the economy via government spending and could not save a “bloated banking system” that had helped drive “land prices and stock prices far beyond rational valuations.”

Mayer does not quote FDR’s Treasury Secretary Morgenthau’s diary entry of 1939:

“We have tried spending money,” Morgenthau wrote in his diary. “We are spending more than we have ever spent before and it does not work. . . . After eight years of this Administration we have just as much unemployment as when we started. . . . And an enormous debt to boot!”

The experience of Japan before its bank clean-up and the U. S. in the last two years is similar, which has been to appease the financial interests. Why that general approach, which did not succeed in Japan, became the chosen path here, is at best unclear and possibly explained by the instant classic essay from Simon Johnson. Not only is it unclear that this strategy will work, but many believe that it is unfair. In that vein, one may note the electoral news from Japan, which is that the opposition party has won a huge victory. Amongst its plans is to slash spending on roads and “bridges to nowhere” and instead focus on more humanistic-oriented spending. One wonders whether instead of spending tons of money on its own roads program and aid for bankers and auto-makers, the new Obama administration had instead put its stimulus spending directly into healthcare spending, it could have simultaneously stimulated the only ongoing growth sector of the economy and gotten healthcare reform passed.

Focusing on key individuals, most centrally William McChesney Martin (Chairman from 1951-69) except for Greenspan, Mayer describes the Fed’s accord with the Treasury of 1951 that provided relative independence for the Fed, the political interference with it in the 1970s, and the ascending series of bailouts, “too-big-to-fail” policies, and the like, culminating in the LTCM and Russian crisis of late 1998. For those readers who would like to learn more, the book generally reads well.

The book is full of other historical and operational information on all aspects of the Fed, including its centrality in the inter-bank payments system. It was news to me that an academic study estimated that the costs of the checking system in 1996 were $1050 per adult, more than 2% of the gross domestic product.

In a 1999 interview with Derivatives Strategy, Mayer refers to Nassim Taleb in the context of explaining how hedging can increase rather than decrease risk. “The Fed” is dismissive of excessive reliance on value-at-risk “measurements”, suggesting that perhaps only its origin at a direct descendant of the House of Morgan got it widely accepted.

A theme of the book is that Mayer likes things simple, because he shows the Fed’s failure as a regulator. There are few jokes in the book, two exemplify the point. He recounts Preston Martin commenting in a 1999 conference that when he was Fed vice chairman in the mid-1980s, the Fed’s staff economists prepared large macroeconomic models into which different variables could be plugged to predict the future if the Fed did ‘A’ rather than ‘B’. (p. 180) Martin then asks Edward Gramlich, a sitting governor…

…..whether those models were still on tap. Gramlich, a dignified former business school dean, made a face. “I prefer little models, myself,” he said.

Greenspan himself said as much in a talk during the annual meetings of the World Bank and the International Monetary Fund in fall 1999. “The fact that our econometric models at the Fed, the best in the world, have been wrong for fourteen straight quarters,” he told his audience with a straight face, “does not mean that they will not be right in the fifteenth quarter.”

Perhaps that’s why Martin Zweig said, “Don’t fight the Fed.” They just might get it right, someday.