The US Federal Reserve is surely the most powerful and misunderstood institution in the world. It was designed just over 100 years ago for one discrete task — to ensure that the country has enough money to keep the economy growing to its full potential.
But over that time it has come to backstop the global market system, and in recent years it has created a bubble in everything that is now, slowly but surely, starting to burst. As a consequence, the Fed is trying to walk an impossible line between managing the inflation it helped to set off and the recession that may follow as it tries to stabilise prices.
How did we get to this strange and untenable place? Some would blame it on the massive quantitative easing programme launched in response to the 2008 financial crisis, followed by the propping up of any number of asset classes after the pandemic.
Others would say the problems began after the 1970s, when the end of the Bretton Woods system allowed central bankers more freedom to extend economic cycles. US politicians of both parties abused this freedom, avoiding tough “guns or butter” policy choices and passing the buck for economic policymaking to the Fed.
Lev Menand, a former senior adviser to the deputy secretary of the Treasury in 2015-2016 and an associate professor at Columbia Law School, would go back even further, all the way to the 1950s. In that era the Fed chair was William McChesney Martin.
He broke with the New Deal banking system of the 1930s and allowed the New York Fed to start lending to a select group of non-bank broker dealers, creating the “repo” market. As Menand points out in his new book, The Fed Unbound: Central Banking in a Time of Crisis, this was the beginning of a dangerous cycle of mission creep.
Even then, Congress complained that the Fed’s actions were illegal. Martin responded simply by asking them to amend the law. They never did, but shadow banking — in the form of everything from repos and eurodollars to commercial paper and money market funds — grew, and the Fed continued to support all these shadow entities. They in turn got bigger, and new types of shadow banking were created, contributing to a “financialisation” of the economy that has been linked to slower growth, higher inequality and more financial volatility.
Today’s Fed is struggling to get ahead of inflation. But as Menand points out, inflation fighting wasn’t even part of the central bank’s official mandate until 1977. While former Fed chair Paul Volcker had to take away the “punch bowl” (a term first coined by Martin) in 1981 with punishingly large interest rate increases, his strength in some ways allowed for more congressional weakness.
“There was a sense among inflation-exhausted politicians that ‘if he can fix it, let him’,” says Menand. Since then, both Congress and the executive branch have increasingly moved away from adopting a whole-of-government approach to financial stability, preferring to let the Fed take the heat for economic policymaking. And yet, all the central bank can do is bolster asset prices. It can’t create new business ideas, or retrain workers, or roll out a Green New Deal, or rethink trade.
Hoping that the Fed — an unelected, technocratic body with a limited toolbox — will somehow magically fix what’s broken in our economy is akin to “expecting the Supreme Court to address our social and political problems”, writes Menand. The court’s actions of late are having just the opposite effect. And it’s likely that the Fed’s current battle with inflation won’t end well either. A hard landing and the finger-pointing that will surely follow could trigger more of the extreme politics that we saw on both sides of the Atlantic after the great financial crisis.
So where do we go from here? Perhaps to another round of Fed reform, although it’s unlikely that this will happen before a major crisis. The original 1913 Federal Reserve Act was the result of two decades filled with financial crises. Indeed, half of the years between 1890 and 1913 were spent in recession.
We may be heading for a downturn now. When markets emerge from whatever chaos ensues over the next few years, we will need to find a way for the Fed to better fulfil its original mission of managing the money supply and supporting the banking system, without underwriting ever more bubbles in a massive, speculative financial sector that serves mainly itself.
It’s unlikely that politicians will stop passing the buck for policymaking, or that shadow banks will be put in check with formal charters, any time soon. Perhaps the simplest and most elegant solution in the short term would be to allow the Fed to focus less on financial institutions and more on real people.
One idea is for individuals to hold Fed accounts. Such digital wallets could provide a way for central banks to funnel money more precisely and directly to the places where it’s needed during a crisis. “Money could be doled out to people, not banks, on specific terms and conditions, at specific times,” Menand suggests.
It’s not a solution to the larger problems of our political economy. But it might help the central bank better meet its core mission: putting money where it’s really needed.
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