After The Recession: What Next For the Fed?
By Simon Johnson
The Federal Reserve was created in 1913 to help limit the impact of financial panics. It took a while for the Fed to achieve that goal, but after World War II – with a great deal of help from other parts of the federal government – the Fed hit its stride. Today the Fed has not only lost that touch but, given the way our political and financial system currently operates, its own policies exacerbate the cycle of overexuberance and incautious lending that will bring on the next major crisis (and presumably another severe recession).
Sudden loss of confidence in the financial system was not uncommon toward the end of the 19th century, and while the private sector was able to stave off complete disaster largely by itself, the tide turned in 1907. In that instance J.P. Morgan could stand firm only because, behind the scenes, his team received a large loan from the United States Treasury (on this formative episode, see The Panic of 1907: Lessons Learned From the Market’s Perfect Storm by Robert F. Bruner and Sean D. Carr). Leaders of the banking system realized they needed help moving forward, and there was general agreement that the widespread collapse of financial intermediaries was not in the broader social interest. The question of the day naturally became: How much government oversight would bankers have to accept in return for the creation of a modern central bank?
The skeptics from the left – but also from the nonfinancial private sector (including those speaking on behalf of small business people) – pointed out that the presence of a “lender of last resort” (of the kind already operational in Western Europe), would be likely encourage less care on the part of major financial institutions and the people who lent to them. The issue we now call “moral hazard” was front and center in the political discourse at the very founding of the Federal Reserve (although with different terminology).
Nevertheless, the original deal turned out to involve only a very light supervisory touch. In part this was about the individuals involved – the New York Fed was run by Benjamin Strong, a close associate of Morgan, until 1928. In part it was about the choice of organizational structure and internal rules – so the Federal Reserve Board in Washington had little de facto power relative to the New York Fed. But mostly the structural weakness was that the central bank was not designed to keep up with the pace of financial innovation.
This innovation had an important feature then, just as it does now. While some new products were sensible, many seemingly good ideas turned out to be ways to disguise the true nature of risks being taken. (In the early 1930s, “what did they know?” and “when did they know it?” were big questions for leaders of the financial sector regarding the true risks involved; see Michael Perino’s The Hellhound of Wall Street: How Ferdinand Pecora’s Investigation of the Great Crash Forever Changed American Finance, to be published in October.)
If banks had remained as they were in 1913, the Fed might have had a fighting chance. But banks changed dramatically after the tight World War I controls were removed and entered rapidly into the business of selling and trading securities. The result was the financial shenanigans of the 1920s – with big banks front and center. The victims in that instance were middle-class investors lured with the promise of easy money – the parallels with the subprime craze are all too apparent. But the banks also damaged themselves thoroughly – as with subprime lending, because much of the ultimate risk ended up on banks’ balance sheets, presumably much more than the top bankers intended.
As a result of that experience and the ensuing financial disaster, during the 1930s the Fed received more regulatory powers, became a tougher-minded supervisor and was supplemented by a range of powerful agencies – including the Securities and Exchange Commission. The tougher rules included the Glass-Steagall Act of 1933, which separated commercial banking from the world of investment (and speculation). Yet none of this was anti-business: the Federal Reserve plus tough regulation oversaw the post-World War II boom in which the United States managed to combine the kind of investing and risk-taking that supports nonfinancial innovation – pushing forward the technological frontier while maintaining high real-wage growth – all the while avoiding significant financial crises.
But effective oversight and constraint on financial-sector innovation was dismantled, starting in the 1980s and culminating when Congress in 1999 tore down (what little was left of) the Glass-Steagall wall with the Gramm-Leach-Bliley Act. And it was not reimposed or updated by the Dodd-Frank financial regulations of 2010. The Federal Reserve is again set to support a financial system within which “innovation” is not effectively constrained (at least this is my reading of Perry Mehrling’s The New Lombard Street: How the Fed Became the Dealer of Last Resort, forthcoming in January). As a result we face again the prospect of a 1920s-type roller-coaster.
Regulation remains largely ineffective (in fact, the industry has managed to demonize the word), the big banks are too important to fail, and interest rates are low across the yield curve. The Fed provides downside protection and there is no effective limit on the amount or nature of risks that the private financial sector can take. This is a recipe not for stagnation but rather for a metaboom in which we will receive warnings, including painful recessions – but consistently ignore them.
The 1920s opened with an 18-month recession, an eerie parallel to the 2007-9 experience. It ended with the Great Crash of 1929.
An edited version of this post appears this morning on the NYT.com Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.