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Fri. November 16, 2018
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Not Your Mother’s Central Bank
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By George A. Pieler & Jens F. Laurson What is a central bank? The term conveys a state-controlled, usually or at least nominally independent of partisan politics, supplier of money and credit: The lubricator and back-stop for a nation’s financial system, the “lender of last resort”. The honorable tradition of central banking in the 20th century posited central banks as a stabilizing force, managing economic conditions with disinterested objectivity while warding off avoid inflation and currency debasement. Not an easy job, and met only with limited success by the Federal Reserve in the US. Low points were stagflation in the 1970’s after floating the dollar and the 2000’s tech-bubble bust-boom. The European Central Bank (ECB) and its national predecessors have a more consistent reputation for sticking to business despite varying economic fortunes of the European Union and despite considerable political pressure in the 2007-2008 crisis to ‘do something’. Through ups and downs, the central banking template has retained its reputation as a defender of confidence in a nation’s currency and thus economic stability. In recent years the Fed and the ECB have evolved into more political entities, indeed into major economic players in the political process. At the heart of this is the very explicit addition of a new goal for central banks: the facilitation of economic growth. This underlies a process that may have been under way for a long time, but the 2008-2009 meltdown-and-recovery of western economies has changed the nature of central banking. Forever? Hopefully not. United States Federal Reserve This transformation is particularly notable in the United States. Never entirely free of a political function, the Fed has been commanded to report to Congress its goals and projections on inflation, growth, and unemployment. It has been one of the principal regulators of the financial system (including banks with state-granted, rather than federal, charters, and holding companies of banks which may also offer diversified financial services). In 1977 it was additionally tasked with monitoring ‘redlining’, the (alleged) denial of or allocation of credit away from low-income areas, often with a suggestion of racial bias, and various other miscellaneous consumer protection laws. These regulatory functions are very much at odds with its monetary policy responsibilities and, at a minimum, should be separated by a ‘Chinese wall’. Better yet, they should be relocated to a separate consumer protection agency or divided among existing financial regulators not tasked with monetary duties. Unfortunately, the newly ramped-up Consumer Financial Protection Bureau has made matters worse, being housed in the Fed itself, funded by the Fed, and thoroughly insulated from political accountability. Somehow this regulatory baggage hasn’t yet undermined the Fed’s traditional central banking mission of maintaining financial stability through regulating the money supply—at least in most public and political minds. Three striking developments might change this yet, and may make the Fed a ripe (or rather: riper) target for criticism: • The Fed’s role in TARP and the bailouts of US companies since 2008 • Its decision to explicitly and directly purchase US public debt to hold down costs of government financing • The enactment of the Dodd-Frank legislation overhauling financial regulation In 2008, when financial companies, and eventually manufacturers (like the automakers), faced their own financial meltdown, no one questioned that the Fed would and should stand ready to provide credit as the lender-of-last-resort. But instead of limiting itself to that role, the Fed, in cooperation (or collusion) with the US Treasury, bailed out individual firms and participated in political decisions as to who would fail and who would be rescued. The Fed made loans to support the sale of Bear Stearn’s assets when that investment bank failed, for example, and it bailed out AIG (“too big to fail”), while letting Lehman Brothers go to the dogs. The Fed’s role in TARP was (and remains) less explicit and more subtle: the Fed provided emergency cash and credit to many financial institutions, several of which also got TARP funds, and helped facilitate the AIG bailout. The Fed has also regulated payback of TARP funds, for example by bank holding companies, deciding when and whether they could pay back their TARP debts. Of course, many of those debts were pushed at financial institutions at the peak of the financial crisis, when investment banks and other nonbank financial firms converted to holding companies, even at institutions that wanted nothing to do with TARP. Ironic, then, that the Fed now sets financial standards for certifying institutions to be ‘sound enough’ to get off the TARP welfare rolls. It would be foolish to think that TARP would have happened if the Fed had not backed the Treasury at every juncture; in consultations as well as by using its lending powers to support marginal firms (not all of which survived). Most important of all, the Fed has supplied and continues to supply money to the faltering US economy by buying Treasury bills, keeping Fed funds rate low and real interest rates as close to zero as possible, setting aside any concern about inflation and commodity price surges—not to mention the value of the dollar—in favor of heading off, at all costs, a theoretical threat of deflation. In all of this, the White Houses (first George W. Bush’s, now Barack Obama’s) and their respective Treasury officials were intimately involved, even calling the shots. None of which seems very ‘independent’ for an independent central bank. This brings us to “Quantitative Easing”, “QE” and “QE2”, as they’re abbreviated, with “QE3” already rearing its head. They constitute the Fed’s determination to buy enough US government debt and other securities to keep pressure off interest rates and restrain the cost of unprecedented levels of US borrowing. The Fed essentially compensates for the failures of US fiscal policy and its actions increasingly blur the line between its steady-as-you-go responsibilities and the assumption of an inappropriately political role. There is more—and likely worse—to come: The Dodd-Frank financial regulation law institutionalizes the Fed as a direct actor in the political arena. Under Dodd-Frank, the Fed—in conjunction with the Federal Deposit Insurance Corporation (FDIC)—is responsible for interpreting that law’s “too-big-to-fail” rules and definitions. In short, the financial regulators, including the Fed, are to identify in advance which financial firms (very broadly defined, by the way) are so large that their failure would damage the US economy. They are then supposed to manage and structure reforms of those firms (including the option of liquidation) to prevent a potentially catastrophic failure. The problem, of course, is that once you list such firms, they become magnets for investors seeking low risk (since we know the government will guarantee them, one way or the other), to the detriment of equally or more important firms that don’t make the cut. The result will be a sea of moral hazard that will make the Fannie Mae/Freddie Mac cases—pushing subprime lending with implicit taxpayer guarantees, one of the main ingredients of the last crisis—look like child’s play. The European Central Bank The case of the ECB is less dramatic and (so far) less severe than the politicization of the Fed, but it is headed in the same direction. The ECB has held a more consistent line on monetary policy and can’t be accused of buying up EU member states’ debt as the Fed does with the US. But it has been successfully pressured to purchase Irish, Greek, and Portuguese debt as part of the ‘save the euro’ campaign. Given that Europe has also agreed on a permanent bailout facility for European states at risk of sovereign debt default, an agenda heavily promoted by Nicolas Sarkozy and Angela Merkel, the ECB’s bailout role may be difficult to unwind. The reluctant participant in these debt purchases is the outgoing ECB head Jean-Claude Trichet, and no obvious successor has the reputation of being nearly so firm in defense of pure central banking. With the office being a political appointment (ensuing heavy EU political horse-trading), it is reasonable to assume the ECB will take on a more explicitly political role henceforth, similar in kind, if not degree, to that of the Fed. While TARP and the Fed’s bailouts of financial firms were taking shape in the States, the ECB did not object to these policies but chose not to follow the Fed’s lead. Where the principled difference lies, though, between bailing out firms directly, as in the US, and bailing out nations that can’t service their debts (partly because so many non-bailout firms themselves fail), is hard to see. Consequences There have been and will be consequences for this evolution (ECB) and incipient revolution (Fed) of the central banking function. The Fed’s commitment to monetizing debt has already lead to calls for supplements to the dollar as a world-reserve currency, if not its wholesale replacement. As part of Dodd-Frank, the Fed now houses and funds, independent of any direct control by Congress, a consumer financial protection bureau with a near-unlimited mandate to probe the actions of financial firms. Congressional calls for direct and constant oversight of the Fed are reaching record levels as it becomes increasingly apparent that the Fed is the most critical player in the American political economy without direct accountability to either the legislative or executive branch— ultimately to the voters. Whether the subsequent politicization of the Fed would be desirable is another matter altogether. ‘Democratic control’ of central banking is in many ways a fiscal nightmare. But the fault lies with the Fed for moving so far away from pure central banking in the first place: To be a political player demands – sooner or later – playing by political rules, however ugly they be. At this increasing rate of political-economic activism without accountability, it’s not just the likes of Ron Paul demanding an end to the Fed. In Europe, meanwhile, the ECB is constantly being brought into the public debate over a Euro-stabilization regime, including a permanent revolving fund to ‘resolve’ the fiscal problems of Eurozone nations on the brink of insolvency. It is hard to see how the ECB will stay out of Euro-politics in circumstances where the next bailout (Portugal, most imminently) seems always just around the corner. Some of this damage could possibly be avoided by reverting to original central bank principles. One such principle is that central banks should not have the power to regulate the very entities they bail out, no matter what regulatory powers they hold. If the US wants the Fed to be the premier financial regulator, it cannot also have it function as Bailout Central. If Europe wants the ECB to provide liquidity to at-risk states to bolster the Euro, it must understand that the credibility of the ECB as defender of fiscal soundness will be put at risk which could ultimately result in more at-risk states across Europe. Crises like the 2007-2009 financial meltdown can certainly produce necessary innovations in policy. They can also produce quick-and-dirty solutions with disturbing long term consequences. The recent history of the Fed and ECB shows more of the latter than the former. George A. Pieler is a former attorney for the Federal Reserve. Jens F. Laurson is Editor-at-Large of the International Affairs Forum.

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