In a refreshingly quick read, Lev Menand takes a deep look at the history of the Federal Reserve, its recent actions in times of crisis, and its future possibilities.
The Fed Unbound: Central Banking in a Time of Crisis by Lev Menand, Columbia Global Reports
The Federal Reserve raised interest rates by half a percentage point this week, and such is the state of the world that this relatively arcane bit of news was not restricted to the financial news but was worked into the monologues of multiple late-night talk shows. You’d think that a brutal war of unprovoked aggression started by one of the world’s nuclear powers raging in Ukraine and the leak of a Supreme Court draft opinion suggesting that Roe v. Wade may be overturned in the coming months would bump any discussion of interest rates, but the Fed has so much power and influence that it has become an essential part of those pop culture conversations even amidst that other news.
Into this atmosphere comes the release, next week, of Lev Menand’s The Fed Unbound. If things like quantitative easing and interest rate hikes leave your head spinning, Menand will help clarify what they are, why they are so influential, and why they are important in both our personal and public lives. If you’re actually interested in such things, the book will deepen and clarify your knowledge. Even if you have followed the news closely and read many books on the topic, you will likely be surprised by how much this relatively slim volume adds to your understanding, and by what you didn’t know you don’t know (as the best books always do).
Menand begins the book by describing exactly what the Fed did during the pandemic, which was as substantial and productive as it was fraught with negative side effects and potential problems for our future:
By preventing another Great Recession, or possibly Great Depression, the Fed provided significant, broad-based benefits to society.
Yet, just as not everyone benefits equally from a tax cut, or a government program like Medicaid, not everyone benefitted equally from the Fed’s response to the pandemic. […] The inconvenient truth is that the Fed’s policy cocktail greatly assisted the already well-off, skewing benefits toward the richest Americans and driving wealth inequality to levels not seen since the New Deal.
Menard then backtracks to why the Fed was established in the first place (a fascinating history that Roger Lowenstein’s excellent book on the topic, America’s Bank, delves deeper into, if you’re interested in further reading), explaining the history and current realities of how money is created and works in America. Finally, he proceeds to explain how the nation’s banking laws have been undermined by an unregulated shadow banking system, how the Fed stepped in to save the economy from the ramifications of the potential collapse of that system when it was on the brink of collapse in 2007 and 2008, and how doing so propped up and perpetuated the problems it had created, including instability and inequality (a troubling history that Karen Petrou delves into further in Engine of Inequality, if you’re interested in further reading on that).
I came of age when the most trusted man in government was Alan Greenspan, who served as Fed Reserve chair for 20 years, and whose irrational exuberance about the wonders of deregulation ended up damaging his reputation, and more importantly the economy itself. (Menand makes clear he was not the first chair to loosen the rules, but more on that in a minute.) I don’t believe Menand actually mentions Greenspan by name, but an unregulated, more aggressive, and inherently unstable shadow banking system was allowed to take off—and take hold over much of the world’s economic activity—under his watch, ultimately leading to a financial crisis when it nearly collapsed in 2007 and 2008. During that crisis, and the Great Recession it caused, the Fed stepped in to backstop that shadow banking system, which it didn’t have any real regulatory power over, and it was forced to double down on doing so when the pandemic sparked an even deeper and more widespread crisis.
In March 2020, a second panic broke out, triggering an even larger Fed response. And despite appearances the possibility of another panic still looms. Meanwhile, the malfunctioning that began in 2007 spawned a series of further crises—economic and political—that are reducing economic security, widening wealth inequality, and damaging American democracy. As these crises worsen, the Fed continues to take on more responsibilities and further expand its purview.
So, while the interventions may have been necessary in the short term:
One of the side effects of the Fed’s efforts has been to facilitate more shadow banking by creating the expectation that the government stands behind shadow banks just as it stands behind banks.
An explanation of how and why the Fed came to stand behind those banks, first to act as a banker to the banks it charters and then to ensure shadow banks don’t fail, is necessary and provided in the book, but I won’t go into that here. What I will say is the section on how money works and how banking has evolved in America is not only informative, but an inspiration. If the work of Kafka shows how the law and bureaucracy can lead to absurd outcomes antithetical to human flourishing, there are moments in American history that prove that they can also lead to positive change that protects our ongoing experiment in self-governance against monied interests that could undermine it. “The government board-run Fed,” Menand notes, “was the world’s first monetary authority—a public organization and progressive reform.” The Fed was established to ensure money and power wasn’t concentrated in too few hands or specific regions, like the banking centers of New York City and Chicego. It was created to ensure that the creation of money, while remaining in the purview of private, for-profit institutions, would be diffused to smaller banks across the country that would not be able to oppress the businesses and individuals it lent to through sheer size. It ensured, until relatively recently, that those who provided banking services to a community resided in the community.
But, beginning in the 1950s, an alternative money supply began to emerge, implicitly encouraged by the Fed itself when Federal Reserve Chair William McChesney Martin, Jr. began opening access to overnight loans in the form of repurchase agreements (or repos). That was the beginning of increasingly complicated financial instruments that culminated in complex derivatives, especially mortgage-backed securities, at the heart of the system-wide failure in 2007. Which is to say that the increased role of the Fed in addressing crises was in large part prompted the expansion of alternative forms of money created in an unregulated shadow banking system that the Fed helped give rise to but had no control over:
The principal problem giving rise to the Fed Unbound is shadow banking. Over the past half century, wealthy individuals, businesses, and institutional investors have increasingly turned to alternative forms of money, issued neither by chartered banks nor by the government. These moneys are similar to deposits yet structured to evade the legal restrictions that forbid companies without bank charters from issuing deposits.
And, as already noted, these are inherently unstable, risky endeavors:
Perhaps the primary appeal of these alternative forms of money is that (in good times) they offer higher interest to their holders than deposits issued by banks. But in bad times people often lose confidence in them—because they are not backed by the government in the ways deposits are—leading to runs on the shadow banks that issue them.
When the system was on the brink of collapse in both 2007 and 2020, there was an immediate need to protect people from the fallout of the systemic failures that shadow banking created. But because of the way the Fed was set up, its actions favored financial institutions in a way that further skewed the gains of economic activity to the very institutions that created the crisis. While it provided a level of short-term stability and assistance to those who needed it, the “billionaire class saw its share of the national income skyrocket” and wealth inequality increased. Because of this, the gloomiest prognosis Menand offers is that the “Fed’s role risks short-circuiting the proper functioning of democratic politics.” That is one reason Menand rejects calls from the left to have the Fed use its increased power to take on issues like climate change. It would become, if I can paraphrase his argument using a pop-culture reference, the one ring to rule them all and end with an unelected, unaccountable group of super powerful bureaucrats that would end up being corrupted by such power. The process of who ended up in those positions would itself be corrupted:
The result would be a more polarized appointments process—as we have seen with the courts.
The final chapter is dedicated to “Finding a Way Forward” that avoids such a scenario. In Menand’s view, that starts by ensuring that the shadow banking system is subject to the same, relevant monetary regulations by requiring investment banks to obtain a bank charter. If the Fed is going to act as a backstop and lender of last resort to these shadow banks, they should at least exist within the Fed’s regulatory framework. It could also include Congress constructing a public option for money creation through FedAccounts and a central bank digital currency (or CBDC). Individual states could do the same. More ambitious, perhaps, would be enacting legislation that automatically increases government spending—in things like unemployment insurance, shovel-ready infrastructure projects, and support to state and local government—during economic downturns and that reduces them in good times. This would eliminate the need for the Fed to act as a lender of last resort or to engage in activities like quantitative easing. These “automatic stabilizers” have multiple advantages: allowing the Fed to get back to what it was chartered to do, placing the people’s elected (and therefore more accountable) representatives in Congress back in charge of ensuring a more level playing field, and not rewarding and further enriching the financial sector that created the problem in solving it. As Menand writes:
Unlike monetary policy, such programs would stimulate demand, counteract disinflationary tendencies, and drive up employment without directly enriching asset owners or aiding the financial sector.
I am always amazed by how deep the authors that write for Columbia Global Reports are able to go in the relatively slim volumes they produce. Lev Menand is able to expound much further (he wrote a literal textbook on Federal Corporate Law and the Business of Banking with Morgan Ricks), but this book is accessible and easy to absorb, which is important because these issues have a profound impact on how well our democracy functions. There are many indications that democracy around the world is under threat. The example Ukraine is providing in fighting for theirs is inspiring, and we should continue to support it however we can. But we also have an obligation to protect our democracy here at home. We have a great history of doing just that—expanding the rights of individuals, standing up to monopoly power, reigning in the influence of monied interests—and the creation of the Fed is one example. The design of our monetary system is and always has been a political choice. It needs rebalancing and the Fed has a role to play—the one it was originally intended to play in overseeing banks rather than bailing them out. Congress has a role to play, too—writing new laws and ensuring the ones on the book are followed rather than abdicating that responsibility to the Fed out of political cowardice and expediency.
In an ideal scenario, the pecuniary particulars of Fed policy would not hold so much weight because the economy itself would be weighted more fairly, the economy would be on a stronger foundation less exposed to continuous shocks and panics, and the benefits of economic interventions and growth would be more widely and fairly distributed. In an ideal scenario, Fed policy wouldn’t be fodder for late-night monologues. As it is now, hopefully in addition to the (albeit smart and funny) jokes about Fed policy, we can also construct a deeper and more robust conversation about it on the public airwaves. Inviting Lev Menand on to talk about it would be a good place to start.