The New Federal Reserve


GFC finance as war finance

The editors write:

Perhaps the most important development of the financial and economic crisis is that technocrats are losing control over policy debates to the populists….The Fed is perhaps the obvious target. The insurrectionists object to the notion of fiat (or government-made) money. On both left and right there is fundamental opposition to the coupling of private banking with the federal government that managed the entire response to the financial crisis

From a longer historical perspective, populist targeting of the Fed, both from the right and from the left, is nothing new. Big Finance and Big Government are perennial bogeymen in American political discourse. Coupling the two in the institution of a central bank is at the heart of current debate about the role of the Fed during the crisis.

In 1913, at the founding of the Fed, legislators directly confronted both bogeymen. The whole idea of the Federal Reserve System, so the language of the Act made clear, was to channel credit preferentially to productive uses. Section 13(2) makes clear who was supposed to get the credit: “Discount of Commercial, Agricultural and Industrial Paper”, not speculative financial paper and not Treasury paper. The new Fed was about reversing the upper hand enjoyed by Big Finance, and without replacing it with the hand of Big Government.

Exigencies of war finance soon shifted the focus of the newborn Fed, and the Act was accordingly amended. During both World War I and World War II, the Fed pegged the price of Treasury debt, and expanded its balance sheet as necessary to absorb any excess supply that was not taken up by private buyers.

Does that kind of emergency intervention sound familiar? It should.

So-called QE1, back in early 2009, involved the Fed pegging the price of mortgage-backed securities by taking $1.25 trillion worth onto its own balance sheet. This is war finance. Actually it started even earlier, back in September 2008, with the collapse of Lehman and AIG. The initial balance sheet expansion occurred as, in addition to its domestic lending, the Fed lent $600 billion to foreign central banks, as well as other billions directly to foreign private banks, financing the loans simply by expanding its own monetary liabilities. This again is war finance, but without the war.

What troubles critics of the Fed is the use of the powerful tools of war finance to support private capital markets, and to support foreign bankers. For some, a similar unease arises from the latest QE2 twist, which has the Fed buying $600 billion of Treasury debt. There is no doubt in my mind that the Fed’s actions were legal under the “unusual and exigent circumstances” provision of the Act. But what everyone wants to know is whether the Fed did the right thing, and what the transformation of the Fed over the last few years portends for the future.

The Fed has done a lot of things, but two new functions stand out. First, it has served as international lender of last resort to foreign banks and foreign central banks. Second, it has served as domestic dealer of last resort for mortgage backed securities.

These are both new functions unanticipated by the 1913 legislation, but that doesn’t mean they are necessarily inappropriate. Remember, in World War I, the exigencies of war finance were also new and unanticipated, but the system evolved to make room for this new function. I submit that we are living in a similar moment today.

The exigencies of global financial crisis have shifted the focus of the Fed, and there is no going back. Our problem today is not so much devising an early exit strategy from unwelcome new emergency functions, but rather designing institutions to accommodate these new unexpected functions in the future. The technical challenges are considerable, but the political economic challenges loom even larger.

The crisis of 2007-2009 is our 1907. Back then, the bogeymen were Big Finance and Big Government, and so they are today. What we need is a financial system that supports the capital financing needs of the nation, and a central bank that supports that financial system.

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