The Original Mandate of the Federal Reserve

Writing on his recently launched blog, my colleague Perry Mehrling traces the evolving mandate of the Federal Reserve from its founding to the present day:

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.

As it happens, one of the many responses of the Fed to the financial crisis was a return to its original mandate as an active participant in the commercial paper market: "funding purchases of commercial paper... to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households." But this was done in late October 2008, after a massive expansion of its balance sheet in support of failing financial intermediaries, and after TARP had been signed into law.

The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed's intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker's view that Ben Bernanke "deliberately misled" Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

It's a question that the most ardent defenders of the bailouts would do well to address. The impressive numerical estimates of the effects of these policies on output and employment rely on a comparison with a "scenario based on no financial policy responses." But this is obviously not the proper benchmark. If output and employment could have been stabilized by direct support of the non-financial sector, then we would currently be faced with a different distribution of claims to this output, as well as a different distribution of financial practices.

Among supporters of the government's financial market policies, Bill Dudley has been especially forthright in acknowledging their flaws:

[It] is deeply offensive to Americans, including me, and runs counter to basic notions of justice and fairness, that some of the very same individuals and financial firms that precipitated this crisis have also benefited so directly from the response to the crisis. This has occurred at the same time that many Americans have lost their jobs and hard-earned savings. The public outrage this situation has produced is understandable. In the context of actions taken to support the financial system, the Federal Reserve and other government agencies have provided considerable support to banking organizations and other large systemically important financial institutions. The employees and executives of those institutions have benefited from our intervention. In a perfect world we would be able to prevent those individuals and institutions from benefiting; we would have a better way to penalize those who acted recklessly. But once the crisis was underway, one goal took precedence: keeping the financial system from collapsing in order to protect the nation from an even deeper and more protracted downturn that would have been more damaging to everyone.

In a perfect world, according to Dudley, we could have done much better. But even in our very imperfect world, might we not have been able to stabilize output and employment by returning quickly and forcefully to the original mandate of the Federal Reserve, to channel credit preferentially to productive uses?