The current trajectory of Federal Reserve policy began in 2008. Since then, the Fed has moved into uncharted territory — beyond its statutory authority and without legislative direction from Congress.
The result, according to our guest on this week’s WhoWhatWhy podcast — former Treasury and Fed official Lev Menand, author of The Fed Unbound: Central Banking in a Time of Crisis, has been to deflect the US economy toward ever-greater inequity.
How serious is the problem? Menand argues that the Fed’s actions over the past 15 years are “risking the whole project of the United States… Without economic and monetary stability, democracy cannot survive.”
In his wide-ranging discussion, Menand draws our attention to the Fed’s original mission and how it differs from other central banks around the world.
He looks at how the Fed has shaped public policy with its “balance sheet tool”: a totally new intervention in our economic life, and one that has encouraged the stock market to outpace the productive economy and in so doing accentuate the wealth gap.
In Menand’s view, there are instructive parallels between the way both the courts and the Fed have been driven to fill public policy vacuums that inaction by Congress and the White House has created.
He concludes that, given the current fragility of our broader economy and the dramatic emergence of what he calls “shadow banks,” the Fed cannot fulfill its constitutionally mandated role of economic oversight without fundamental reforms.
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Jeff Schechtman: Welcome to the WhoWhatWhy Podcast, I’m your host, Jeff Schechtman. Willie Sutton said that he robbed banks because that’s where the money is. Deep Throat told Woodward and Bernstein to follow the money. And at Silicon Valley where we talk about technology and the future, tech bros, and charismatic founders, it’s the money in the hands of VCs that really shaped the future. For the country, it’s no different. The power to shape the future lies not fully in the White House or the halls of Congress, or even the Supreme Court, but at the end of constitution avenue in Washington, in the offices and boardrooms of the Federal Reserve.
Too often talk about the Fed and its power reverts to misconceptions about the institution and naivete about how money works in America, but for America and for democracy to survive, we truly best follow the money. To help us understand this I’m joined today by our guest, Lev Menand. Lev Menand is an Associate Professor of Law at Columbia Law School. He served as a senior advisor to the deputy secretary of the treasury from 2015 to 2016, and as a senior advisor to the assistant secretary for financial institutions from 2014 to 2015.
He has worked as an economist for the Federal Reserve Bank of New York, and for the bank’s supervision group. It is my pleasure to welcome Lev Menand here to the WhoWhatWhy Podcast to talk about the Fed Unbound: Central Banking in a Time of Crisis. Lev, thanks so much for joining us.
Lev Menand: Jeff, thank you so much for having me and for that wonderful introduction.
Jeff: Talk first about a little history of the Fed and what it was originally established to do, what the role of central banks were supposed to be.
Lev: So the Federal Reserve was established in 1913 and its statutory framework has been updated two major times, one in the wake of the great depression, in 1935, and again in 1977 during a period of stagflation and economic turmoil in the United States. And basically, throughout, it’s been given one mission which is to administer the banking system in this country. A system of government charter, but investor-owned banking institutions where the money is as you said, that actually create the money because in the United States, we live in an economy and most countries where there are two types of money.
Money that is provided directly by the government and today that’s physical cash which the Fed provides, and coins which the mint provides which is part of the treasury department, and then there are deposits which banks provide. And cash is a very, very small part of what drives the economy. It’s a small part of what we would call the money supply. Bank deposits are the big part, it’s where all the action is. Think direct deposits, that’s how you get paid your salary. It’s deposits that you use to pay your credit card bill, to pay your mortgage, banks issue deposits, and businesses use them for almost all the transactions that they engage in.
Fed’s job is to administer that system of banks which are investor-owned and to ensure that banks are creating the right amount of deposits to keep the economy, for all the resources in the economy fully employed, to avoid overheating the economy, and to avoid deep painful recessions caused by a shortage of money in the economy. And that’s still the Fed’s mission today. We’ve not fundamentally departed as a statutory matter, as an institutional matter from that original design in 1913.
Jeff: And when we look at the statutory responsibilities of the Fed, is it any different than other central banks around the world? If we look at the European central bank and other central banks, is the role of the Fed any different?
Lev: Well, I think there are some key differences. And so the practice of central banking in the United States and in other countries has converged over the past 40 years. And the frameworks for central banking have also converged, but in 1913, importantly, the Fed was really the first of its kind. And so a lot of other countries had what would be described as central banks like England had the Bank of England, and that was established in 1694. Bank of France was established during the Napoleonic period and so there were what were known as these national banks, just like the United States had the Bank of the United States in the early history of the republic.
But these banks during this time, and they continued to exist in 1913, had a different structure and mission from the Federal Reserve because they were investor-owned banks just like all of the other banks in our economy today. JP Morgan Chase, they were a lot like JP Morgan Chase. The Fed was created to be a public board of control, and this was a radical step that President Wilson took. So the board of governors are a group of public officials appointed by the president confirmed by the Senate. That’s not how the Bank of England operated. And so the gap was closed after the Fed was invented, this public board of control for the banking system.
Other countries shifted in that direction. So Bank of England was nationalized following the great depression. Central banking practices have converged, but the Fed was sort of the first of its kind as a public board of control for a government-chartered banking system. And that design, that structural design in the US system is distinct in certain ways from the legal design of systems in other countries
Jeff: And the degree to which the Fed has played a larger and larger role in impacting the economy by controlling that money supply that you talked about before, what was the tipping point of making that almost de regur as it is today?
Lev: So the Fed’s role in our society and our economy I think has transformed in the last 15 years. And the 2008 financial crisis is an acute point of shift. And so during the pandemic, there was a financial and economic crisis and the Fed took all sorts of steps. Created $3 trillion of new Fed money that looked very different from the way the Fed ever operated prior to 2008 and are inconsistent with the statutory framework that there’s an institutional design of the Fed, how the Fed was conceptualized by the legislators who created it in the 20th century. And the question is what happened?
How come the Fed is getting bigger and bigger in terms of the role that it plays in the economy and the society and now there are demands for it to do even more, what happened? And the answer I think has to do with the breakdown of the banking system and the inadequacy of the rest of our government in its ability to deal with macroeconomic ups and downs, booms and busts in the business cycle. And so the Fed is overcompensating for the rise of what I call shadow banking. It goes by many names, which is basically the creation of money deposit alternatives by non-banks that don’t have the access to the Fed that banks have and the Fed can’t control in the way that it can control banks.
And also, the inability of the government to tackle problems like inflation or problems like recession without over-reliance on monetary policy. And this is what’s led to the Fed’s ballooning over the past 15 years and I think creates a lot of, second-best would be a nice way, glass half full way of putting it, but like second-worst we could be in a worse situation if the Fed weren’t there, but the Fed’s alternative isn’t that much better and we need to be thinking about how to improve our economic and monitoring infrastructure for the future.
Jeff: And in doing this, did the Fed specifically usurp the powers of other institutions or did it simply expand its responsibility to fill a void that existed?
Lev: The Fed is confronted by 2008 and it has a mission. The mission is to ensure there’s enough money in the economy for all the resources to be employed, for us not to be in a recession, for the economy to grow. And what we had was a monetary contraction in 2008, but that contraction was in money that was created by non-banks like Lehman Brothers.
Lehman brothers, non-charter banks, the shadow bank, and it created a lot of money that was used by businesses and institutional investors and now all that money started to disappear when there was a run on Lehman and Lehman failed and the Fed was confronted by this problem. Our job is to ensure there’s enough money in the economy. We were given tools and the expectation was that the money was all going to be created by banks, but now all the shadow banks are creating money, what are we going to do?
And so the Fed tried to repurpose its tool that stretch its authorities to deal with the reality of monetary system in which shadow banks were the major players. And that’s why you saw the various bailouts and government support efforts for various parts of financial sector that was not conceptualized in the framework, but that’s not supposed to happen. That’s not supposed to be necessary, but it became necessary because the activity of banking, so much of it migrated outside of the banking system. That was the beginning of this. And we still have that problem, in 2020, the same thing happened.
There was no tarp from Congress, but there was an enormous amount of said lending to shadow banks, that sort of that outside of the contemplation of the scheme were not supposed to have a system like that, but it was necessary to carry out the larger mission and prevent a severe depression. The process of doing this, of constantly having the Fed intervening in financial markets generally, on this large scale, in this system, they can’t control though in normal times the way they can control the banking system, has created all this pressure on the Fed to do more lending, to lend to businesses directly, to lend to state and local governments and to tackle other social and political problems that the political branches have failed to address.
Because the Fed has gone from being a limited purpose agency that engages in monetary fine-tuning with the banking system and doesn’t use its large balance sheet to put into place, to taking out this tool, that balancing sheet tool and deploying it, and this has led to a fundamental shift in the Fed’s role in our economy that I think is a troubling one that we should be concerned about, even though the Fed’s actions have been to preserve and avoid worse outcomes in the moment
Jeff: Worse outcomes in the moment, but that doesn’t mean worse outcomes down the road. There are plenty of people, for example, that would argue that in 2020, the actions that the Fed took, the amount of money that had pumped into the system was antithetical to the problem that the economy was stalled, people weren’t working, goods weren’t being produced, services weren’t being provided. The argument was made by many that we needed less money in the system, not more money. So there’s still a question mark and what the long-term outcome of all of that would be?
Lev: Absolutely, I think that we began a crisis in 2007, it reached an acute phase in 2008. We saw another acute phase in 2020. But we’re still fundamentally in that same crisis that began in the summer of 2007. And we don’t know how this long-term is going to end. We see already that the amount of support that the Fed had to provide to the financial system, to the shadow banking system, to the unregulated monetary system in 2020, and 2021, has contributed to a lot of speculation and asset markets, and potentially contributed to inflationary pressures in the economy more generally.
And now there’s the question about whether the Fed can actually reverse inflationary pressures without precipitating another financial crisis, an acute crisis like we saw in 2008. Whether the underlying financial structure is, in fact, so fragile, what Fed officials aren’t really talking about, that they will even be able to do what they’re saying they want to do now, which is raising interest rates substantially and tighten the financial conditions.
Jeff: Well, right. And to that point, because what the Fed has done is not institutionalized or not set in policy, there is this question of whether or not it can be reversed because there isn’t necessarily the mechanism to do that other than going back to what Volcker did in the ’70s.
Lev: Yes, when Volcker, did the Volcker shock, which was a rapid hiking of interest rates, overnight interest rates, which is a tool for the creation of bank money, is trying to tighten the amount of deposits in the system. That was in an environment where banks created most of the money and the banking system is subject to regulation, and structurally is supported by deposit insurance and various other Fed programs. And so the Fed was able to do that and it trigger a recession. So this is why I think this is not the ideal tool for dealing with inflation, but he was able to address inflation this way, without also having a financial crisis.
The question is today in a world of shadow banking when the Fed had to provide easy money to support non-bank financial firms that are in fragile condition, whether the Fed could even pull off something like the Volcker shock without also precipitating a financial crisis, whether such a policy would even work anymore is, I think, an open question.
Jeff: Talk about the broader effects that this Fed policy has had on the economy in general, up and down the scale of the economy in ways that were never intended or anticipated?
Lev: Yes, I think this is a really important point. So in 2008, the Fed is responding to prevent a monetary contraction like the great depression by from the collapse of shadow banks like Lehman Brothers, and they’re responding again in 2020 for the same purpose, and they achieved that. But the collateral damage in terms of the shape of the rest of the economy is significant. It comes at a real price that isn’t appreciated in many debates about what’s going with the Fed. And that price is that asset owners in the economy get a lot wealthier, that the Fed policy here is operating through the financial sector and through asset prices.
It’s achieving its goals by doing things that make financial firms much more profitable, so you’ve seen record profits for financial firms over the last couple of years. Even over the last decade, there have been huge profits in the financial industry, notwithstanding attempts to increase regulation. And you’ve had a huge run-up in asset prices, which is an obvious side effect of what the Fed is doing to stabilize the shadow banking system, but is really problematic for ordinary Americans. If you’re trying to buy a home for the first time, real estate prices in city centers across the country are at record highs and had been rising rapidly at rates that resemble the housing bubble in the 2005 period.
And this is a byproduct of a central bank policy that is trying to juice asset prices. Now, the purpose of it isn’t to reduce asset prices so that people can’t afford homes, that’s a side effect byproduct of it, that’s really problematic. It also means that stock prices and bond prices and there’s other financial assets have been at record-high levels over the past couple of years, even though the economy has been a weak place. And so a remarkable thing is that the markets have far outstripped the economy for many years because of that policy, which is disruptive to people who don’t own financial assets, and it is also disruptive to investment and business activity.
And the Fed has not figured out how to get out of this box. And it’s time for Congress and for public policymakers more generally, to rethink the whole framework that we’ve been operating in for the past 15 years
Jeff: Isn’t the fundamental problem that the Fed has responded to changes in the economy, changes in financial markets, changes in technology, has tried to deal with all of the shifts that have taken place but has done it on the fly without any statutory authority to do so?
Lev: Yes, the Fed has responded to changes and underlying conditions without any assistance from Congress to reframe either its own statute, to update it for the current environment, or to address the underlying problems themselves. Because fundamentally, the Fed is trying to address problems that it just does not have the tools to properly resolve. And this is why we just need to have Congress step in and do a rethink of the structure of the banking and financial system and the way this country manages the business cycle so that we’re not looking to the Fed to control the booms and prevent them from becoming inflationary.
And just looking to the Fed solely to do that, or look into the Fed primarily or solely to get us out of a recessionary dynamic, because it doesn’t have the tools for that. And it also doesn’t have the tools to manage the shadow banking system, and so Congress has to do something about that or else it’s risking a hard landing, and further financial crises, and a return to the sort of economy this country had in the 19th century before the Fed was created.
Jeff: In so many respects it has become so pervasive, I think a good example of where the Fed has stepped out into uncharted territory, we saw recently with the nomination of Sarah Bloom Raskin to the Fed board, the failed nomination because of the entire debate with respect to the Fed’s role regarding climate change.
Lev: Yes. So I see this dynamic as being also a side effect of the Fed’s transformation over the past 15 years. And so this is the nomination of Sarah Bloom Raskin, a former Fed governor and highly qualified government official who was nominated to this position on the Fed board. And a big question in the hearings, and a question that has been looming over central bankers, not just in the US, but also in Europe for the past couple of years is, what is the role of a central bank in addressing climate change? There’s some obvious role that has to do with preventing financial crisis. You don’t want the banking system to experience huge losses.
But there are questions given how the Fed has used its balance sheet over the past 15 years, about whether it shouldn’t have additional roles that go beyond that sort of traditional function to actively promote green finance and to shift capital from polluting sectors of the economy to less polluting sectors of the economy. And in Europe you actually have central banks pursuing that in various ways. This is not what the Fed was set up to do in the US, but because the Fed has transformed over the past 15 years, largely to address the shadow banking problem, we have this question.
Now that the Fed is deploying its balance sheet in this way, should it take into account all of these other questions like climate change? So I see the whole climate change debate as a signal that there needs to be a congressional rethink of this whole monetary financial framework because it is going to lead to all these sorts of questions for which the current statutory framework doesn’t provide the answers.
Jeff: What happens if congress doesn’t address any of this, what are your concerns for the Fed?
Lev: My concern is that we have a worse crisis than 2008, and I think that we could have that crisis in the next 12 months, unfortunately. There are many ways in which the system is safer than in 2008 because of reforms made in Dodd-Frank Act in 2010, but there are other ways in which the system is more unstable, and there’s a lot of opacity. And we’re already starting to see some run-like dynamics on the fringes of the system in the stablecoin cryptocurrency space, which is a new teched-up version of shadow banking that’s developed in the past decade. And those runs could lead to more widespread runs in the more well-known parts of the shadow banking system, the Wall Street parts, as the Fed continues to tighten.
If we avoid a financial crisis this cycle, I would be worried in the coming cycle that all we’ve achieved is to kick the can down the road, and we’re going to have another crisis that the Fed can’t control like it was able to control 2020 and that ultimately is worse than 2008. And at that point, I think you do probably get some reform, but you might have so much political and economic dislocation in the country that you could have even worse outcomes, and maybe not the right reforms. And so it’s really a question of preserving our democracy for the long term, we need to have economic and monetary stability. And if congress doesn’t give it to us now, it’s risking the sort of instability that could wreck the whole project of the United States.
Jeff: Part of what’s happening, we talked earlier about the changes to the financial system and technology, and you mentioned crypto, is that events are moving faster even than when the Fed was trying to handle these things back in 2008, 2009.
Lev: It’s true there is a sense that things are moving faster now. The shadow banking system that hit the rocks in 2008 was at least 20 years in the making, and in some deeper sense 50 to 60 years in the making. In just five or six years, we’ve had the emergence of stablecoins, a pretty significant size. They weren’t able to grow large enough or significant enough to create a 2008 crisis-type situation on their own before they’ve already hit the skids now. But that whole dynamic does suggest that we don’t have time on our side. And if we want to avoid a 2008 crisis we need to start thinking and working to make reforms now. We don’t have 20 years to figure this out.
Jeff: Isn’t the problem worse than 2008, but even worse than the Volcker period, when we look at the amount of money that the Fed has printed into the system. When we look at $31 trillion of deficit out there, and the degree to which that limits the Fed’s ability to do a Volcker, to do a shock, it’s hard to imagine 14%, 15% interest rates with $31 trillion in debt, and what that costs the government, and where that leaves us in terms of the potential for default.
Lev: I tend to be less concerned about the government’s ability to continue financing itself among other things because when economic downturn comes around, private market investors tend to flood into government security. And so there will be huge demand for treasury if in fact the Fed brings inflation down, even in a hard landing, and creates a recession because that’s the safest place to turn in a difficult economic climate. And so in some ways, the US government is nicely hedged, where it is a safe harbor in a storm and so is in an estimable position in its ability to continue servicing its debt during a period of economic instability.
But I am worried about the financial system’s ability to continue functioning with 15% interest rates. And I think that’s the more proximate problem because the financial system is foundational for the way our whole economy is organized. And when the financial system stops functioning properly, even if the government is able to continue to operate, the business climate breaks down, and this causes huge increases in unemployment. And that is the story of the great depression, and we really don’t want to repeat that experience in the 21st century.
Jeff: To your initial point though, which assumes the hedge nature of the government to play both sides of the transaction, that assumes a certain degree of global stability, which is an open question at the moment as well, particularly with respect to China.
Lev: Every country that deficits finances and depends on investors to finance their deficit has to consider international dynamics, except the United States traditionally, in recent decades because the dollar has served as a global reserve currency. There’s huge demand for treasury, then nobody wants to be in anybody else’s debt quite as badly as they want to be in treasury debt. If that changes in the coming decade, if the global reserve currency and international financial system shifts away from the dollar, that could be very destabilizing for the US and add a whole additional layer to our current monetary and financial difficulties.
I tend to be pretty optimistic that in the great power competition between the US and China, at least economically, which is the part of the competition that I think about, the US Dollar is a much more appealing and established currency and financial system for global trade and other countries to use than the Chinese Yuan. And I don’t see that changing in the near term, but it’s always something to keep an eye on. Obviously, the British thought that the Sterling would stay at the center of the world economy forever at one point only to find eventually that the dollar displaced them. But I don’t think something like that, like the switch from Sterling to Dollar is right up at the horizon for the US right at the moment.
Jeff: Talk about the leadership of the Fed. Jerome Powell, most of the current governors, and what you see in that leadership that gives you either cause for concern or optimism at this point.
Lev: So I think that the Fed leaders have done an excellent job avoiding a second 2008, which we came much, much closer to than people commonly imagine. So there was a whole pandemic and economic crisis in 2020, which drew a lot of attention and a lot of focus, rightfully so, but there was also a big financial crisis and the Fed’s leaders fought that crisis very effectively in that acute moment. And they deserve a lot of credit for that.
Where I would be more critical of them is on sounding the alarm about the sustainability of the whole set of arrangements that caused them to have to do all of that crisis-fighting. And so while the leadership has proven adept at getting out of sort of acute crises, it’s left us as a frog in boiling water. It hasn’t gotten us out of the crisis dynamic and, as a result, the underlying problems have worsened. And now we’re starting to see that as 15 years of stretching by the Fed has put its policymakers in a very difficult position today. And I think that this sort of situation that we’re now in could have been avoided if policymakers had raised the alarm earlier about the need to make fundamental reforms to the system.
Jeff: Part of it is that, as you’ve talked about, that in some ways, this feels like nothing but a continuation of where we started in 2008. That we’ve been living in this zero interest rate world, this quantitative easing world for 15 years.
Lev: That’s right. We are basically in the period that began in 2007 summer, that really had an acute period in 2008. We have never gotten back to normal as it were, and we’ve muddled along. And the fact that we’ve been able to muddle along and we didn’t have a depression like in 1933, that is to the Fed’s credit. The fact that we’re muddling along and weren’t able to return to a period of broad-based economic prosperity like in the 1950s and ’60s, that’s to the Fed’s discredit and to the discredit of many policymakers who have been unable to correct the fundamental structural problems that brought 2008 about and that have left our economy in a stagnant place for 15 years.
Jeff: And, of course, the pandemic hasn’t held global stability as we talked about is one of the fragile things out there and potential bubbles down the road. People are talking about the danger of a credit bubble as we see amount of credit used rising everywhere right now.
Lev: That’s right. The pandemic hasn’t helped, and neither has the war in Ukraine, but these sorts of exogenous shocks to economy happen from time to time. The test for your economic structure and your monetary system is how well they can weather those shocks. And our system is particularly fragile and has been since 2008, and it means that our ability to weather this shock isn’t what it should be. And it should be a cause of concern to everybody that the coming year could be extremely turbulent. Much more turbulent than it ought to be.
Jeff: Lev Menand, his most recent book is The Fed unbound: Central Banking in a Time of Crisis. Lev, I thank you so much for spending time with us here on The Who, What, Why Podcast.
Lev: Thank you for having me.
Jeff: Thank you.
Lev: It’s been a pleasure.
Jeff: Thank you. And thank you for listening and joining us here on The WhoWhatWhy Podcast. I hope you’ll join us next week for another radio WhoWhatWhy Podcast. I’m Jeff Schechtman. If you liked this podcast please feel free to share and help others find it by rating and reviewing it on iTunes. You can also support this podcast and all the work we do by going to whowhatwhy.org/donate.