Is the Federal Reserve an almighty-like "creature" or rather extremely limited in its essential operations? In an interview with Lars Schall of MMNews, Randall Wray answers questions on the Fed and central banks in general.
LS: Mr. Wray: is it true that the Fed isn't the almighty-like "creature" as perceived in the view of the general public?
RW: Milton Friedman played the biggest role in promoting the Fed as the all-powerful Wizard of Oz, spinning dials and controlling the money supply which then determines output and employment. However, the Fed is not to be trusted, hence, should be constrained by a constant-rate-of-growth-of-money-supply rule. This was finally tried in the disastrous early 1980s great monetarist experiment run by Fed Chairman Paul Volcker (simultaneously attempted in Thatcher's UK). I say disastrous because it wiped out half of our thrifts (home mortgage lenders-but not before helping to set off a wave of fraud that was the subject of Bill Black's book). By the mid-1980s the Fed had given up money targets, and had also abandoned the Friedmanian myth that money and output are closely correlated-with money driving output.
In truth, central bank policy has always determined the overnight interbank lending rate (the fed funds rate in the US). Leaving to the side regulatory and supervisory power, that really is all the central bank does. There is no evidence that changing the overnight interest rate (within the usual range) has any significant or predictable impact on the economy. It truly is a Wizard of Oz-if one recalls that the Wizard behind the curtain actually had no power at all. What is unfortunate is that for a very long time policymakers believed that economic policy could be left to the "omnipotent" Fed-which means that the truly powerful fiscal policy has been neglected.
LS: What are the instruments of monetary policy? And do those instruments enable the Fed to create the "business cycle" of boom and bust essentially by itself?
RW: As I just discussed, really all the Fed does is set and manage the overnight interest rate-which has little impact on anything of importance. For example, the Fed responded to the crisis by lowering the interest rate essentially to zero. And just as this had no positive impact on the Japanese economy over the past two decades, it had no discernible impact on the US economy. Bernanke had long argued that what Japan needed was "quantitative easing" to supplement the zero rate policy. He was always vague about what that means, but he had this idea that the Fed can "push on a string"-encourage banks to lend and borrowers to borrow by "pumping liquidity" into the economy. This would take the form of increasing bank excess reserves-providing them with far more reserves than they wanted to hold-on the belief they would then lend.
Bernanke apparently believes in the discredited notion of a "money multiplier": when banks have excess reserves they expand loans and deposits by a multiple. But banks never have operated that way. The "multiplier" is just an ex post identity (we can always divide deposits by reserves and will find a number greater than one) with no causal implications. So what quantitative easing really amounts to is keeping excess reserves in the system and the overnight rate near zero. Nothing new about it--"quantitative easing" is a nice slogan with no economic implication. Banks will not lend and borrowers will not borrow because they know we are in a deep and long recession.
However, what is interesting and in some ways scary is that the Fed has expanded its balance sheet to $2 trillion. While there is a movement to force an audit of the Fed, until that is done we cannot know what Bernanke and company have done under cover of the quantitative easing slogan. I am not so much worried about the likely losses the Fed will suffer on the toxic waste it has bought and guaranteed. Rather, I would like to know what favors the Fed provided to Wall Street.
So to provide a more direct answer: the Fed can neither create nor cure recessions and crises. It can determine the overnight interest rate, and it can provide reserves on demand. It can also buy anything for sale simply by crediting reserves (a point Bernanke made in testimony before Congress). We used to think the Fed would never buy bad private assets-but Bernanke changed all that. However, only appropriate fiscal policy could have led to a quicker recovery. We did not get that.
LS: Of course, the inevitable next question has to be: who owns the Federal Reserve which issues the reserve currency of the world?
RW: The Fed is a creature of Congress, created in the 1913 Act, with subsequent legislation dictating functions and policies. In other words, it really is a branch of government, albeit an unusual one since there are private shareholders. Does the Fed cater to financial institutions? Yes, but so does the Treasury-and as we know, Goldman Sachs has been running the Treasury for the past three Presidencies-Clinton, Bush and Obama. I think that is of greater import than is Wall Street's control of the Fed. Capture of regulators is nothing new. But it's become more obvious and complete since Clinton, who essentially delivered Washington to Wall Street. Washington then deregulated finance, which responded by "Hoovering" up 40% of all US corporate profits. The triumvirate of Rubin, Greenspan and Summers led the charge, and then added Paulson, Geithner and Bernanke. Remarkably, only Greenspan's reputation has suffered in the collapse-and of this team he was the only one who actually raised some doubts during the speculative bubbles that followed.
LS: How do you judge on the performance of the Fed in the build-up and the handling of this crisis? And do you agree or disagree with William Greider, the author of "The Secrets of the Temple", who concluded in an article for The Nation that "the Fed is the problem, not the solution"?
RW: I have a lot of respect for Greider. I do think Greenspan and Bernanke have almost always got things wrong -- they always misread the economy. They try to fight inflation exactly when the economy heads into a recession. They usually fail to see speculative booms. They promote deregulation and risky new financial practices. They cause a lot of asset price instability by continually monkeying around with interest rate targets. That is not good, but impacts are usually short-lived. So while I think most people overestimate the Fed's power, I do agree that we ought to tie the hands of the Wizard.
I propose that Congress mandate the Fed set the overnight rate at 25 basis points (0.25%) and leave it there. Forever. That would be the extent of monetary policy in the US. A very simple robot would replace the FOMC, programmed to pay 25 basis points on reserves, and charge 50 basis points on loans of reserves to chartered banks.
There are two other issues. First, should the Fed lend to "shadow banks"? Our current crisis began in the shadow bank sector, when Lehman, Bear, Goldman, and others could not raise funds-essentially facing a "bank run", not on deposits but rather on commercial paper and other short-term instruments. The Fed has typically dealt with such problems by calling in chartered banks and telling them it would open up its discount window to any bank that would lend to non-bank financial institutions. In this way, commercial banks service their investment bank customers.
Alternatively, the Fed could lend directly to shadow banks, but require they open their books to the Fed. The Fed would then lend against good assets to stop the run, and would use the opportunity to conduct a thorough examination. Of course, insolvent institutions do not like this-but it's the cost imposed in order to get the benefit of Fed lending. No one should lend to a customer without assessing credit worthiness. If the Fed finds the institution insolvent, a resolution (including bankruptcy proceedings) would begin. If the Fed had dealt with the shadow institutions in this manner in 2007, there is little doubt that many of them would have been resolved and closed. That is why the commercial banks would not lend to them-it was widely believed that all large institutions were massively insolvent due to toxic waste. We have rescued them and encouraged them to go on with the same practices that created their insolvency. The situation is now much worse than it was in 2007.
Second, we have issues of regulation and supervision of financial institutions, including protection of consumers. There is a movement to consolidate regulation and supervision, possibly in the hands of the Fed. It is ironic that the Fed has long displayed no interest in regulating or supervising wayward institutions, but it now is fighting hard to become the super-duper regulator. I do not think the Fed is reformable. It is probably far better to consolidate regulation and supervision at the Treasury-with the caveat noted above that since Clinton it has been run by Goldman. Still, I think it is easier to reform the Treasury. I would, however, retain the Fed as lender of last resort-and it would then have the power as a lender to examine the books of any institution to which it lends.
LS: Two last questions, Mr. Wray. Why do we need central banks at all? Aren't they, as James Turk puts it, "the barbarous relic"?
I do not think they are relics -- or at least, I think the functions that central banks perform are still important. Let me put it another way: central banks were originally founded to provide government finance and to act as lenders of last resort. Both functions are still needed. To be sure, we could consolidate the central bank and treasury and have that consolidated power provide both of these functions. Indeed, I would strongly support that-not because it is necessary but because it would simplify procedures and make the processes much easier for the population and politicians to understand. Most importantly, we could end all the nonsense about fiscal sustainability. We would just have the treasury directly credit bank accounts when it spends and debit them when it taxes; we would stop issuing treasury bonds and everyone could stop worrying about government debt-because we would not issue any (the only government IOUs issued would be cash and reserves, neither of which are included in the debt numbers).
Thank you very much for taking your time, Mr. Wray!
Roosevelt Institute Briantruster L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri-Kansas City (UMKC).