The Alchemists: Three Central Bankers and a World on Fire

by Neil Irwin

  The New York Fed, they thought, was particularly responsible. Stephen Friedman, a former Goldman Sachs chief executive, had been chairman of the New York Fed at the same time he was serving on Goldman’s board. He was allowed to remain in both roles after Goldman elected to put itself under the Fed’s regulatory umbrella in September 2008, and even received a waiver from New York Fed lawyers allowing him to buy more shares of Goldman at a time when the New York Fed’s lending programs were helping to prop up the investment bank. Friedman resigned his chairmanship in May 2009, after his conflicts of interest came to light in the Wall Street Journal. But in the view of many reserve bank presidents, the damage to the reputation of the entire Federal Reserve System had already been done.

  “That’s what really drives me crazy,” said Hoenig. “This exemption is made for a guy from Goldman Sachs, and suddenly the bankers in America all across the country are now villains. The bankers on our board from a little town in Nebraska and Denver, Colorado, are saying, ‘What the heck happened?’”

  As lobbying by the reserve bank presidents and Cam Fine’s Independent Community Bankers of America began to make inroads, Dodd’s staff was working toward a new compromise: The Fed would still regulate the more than five thousand “bank holding companies” nationwide, but it would no longer oversee the roughly nine hundred state-chartered banks.

  Hoenig and Fisher pushed Kay Bailey Hutchison, a Republican senator from Texas, to take the lead on amending Dodd’s legislation to make it more Fed-friendly. Fisher and Hutchison had run against each other for the Senate in 1994, an ill-fated venture into electoral politics for Fisher that predated his career as a central banker. In the incestuous world of Texas politics, they’d been friends before the race, and they remained friends after. But there was more than common history behind Hutchison’s decision to become the standard-bearer for small-bank regulation by the Fed, according to Fine.

  “We have a lot of community banks in Texas,” he said. “And she was running for governor.”

  Hutchison’s staff drafted an amendment that would undo the bill’s last major remnants of the Fuck the Fed strategy. Banks with less than $50 billion in assets, instead of being shunted over to the FDIC and state regulators, would remain under the umbrella of the reserve banks in Dallas and Kansas City and beyond. Hutchison had a reputation as one of the quieter members of the Senate, neither the creator of grand bargains nor a practitioner of overheated rhetoric. But on this issue, whatever mix of political ambition and personal loyalties drove Hutchison to take up the cause, she pursued it with abandon, making her case with language very similar to that of Fisher, Hoenig, and the IBCA: We must prevent the Fed from becoming a creature only of the biggest banks.

  On May 5, Hoenig, Jeffrey Lacker of the Richmond Fed, Charles Plosser of the Philadelphia Fed, and Narayana Kocherlakota of the Minneapolis Fed took seats in a hearing room in the Russell Senate Office Building. This would be a closed event, with only members of Congress and their staffs allowed in. With no cameras rolling, the usual bloviation was unnecessary; this session was meant for legislators to ask questions to which they actually wanted to know the answers. Around two dozen lawmakers from both parties and both houses of Congress came to the event, which was put on by the Joint Economic Committee and scheduled over the reservations of the Fed Board of Governors in Washington.

  Over nearly ninety minutes, with the Capitol Hill press corps huddled just outside the door, members of Congress asked one question after another, apparently genuinely curious about what the reserve banks do and why it matters. Their tone was warm and friendly, free of the vicious anger that had characterized discussions of the Fed over the past year.

  The message, the reserve bank presidents concluded, had finally gotten through.

  • • •

  Audit the Fed may have passed overwhelmingly in the House, but in the Senate finance reform bill that Chris Dodd put forward, it was nowhere to be found. Bernie Sanders wanted to change that, drafting an amendment that largely tracked with Ron Paul’s.

  Bernanke and Geithner both saw dire consequences if it was enacted: There would be intense new political pressures on the Fed’s monetary policy, which would inevitably make policymakers more reluctant to make hard but necessary decisions. And provisions that would require disclosure of emergency lending to banks through the discount window would make banks reluctant to use those programs, making a financial crisis that much more likely. If the Sanders amendment passed the Senate as written, it would almost certainly become law, given that nearly identical provisions had been passed in the House bill earlier. There would be a committee to reconcile differences between the two versions of the legislation, but it couldn’t very well scrap something that was in both versions.

  Dodd and Senate majority leader Harry Reid were clear with Sanders: If he wouldn’t agree to changes to his amendment that would protect Fed independence, making it acceptable to them and the Obama administration, they would use the elaborate procedural hurdles of the Senate to try to block it, preventing it from ever coming up for a vote. If, however, Sanders could reach an agreement with Dodd that would achieve his main goal of transparency but compromise on areas that threatened Fed independence, they would put their full support behind his amendment and move quickly for a vote.

  On May 11, Sanders took to the floor of the Senate to formally introduce his amendment. His staff advised him to keep talking for as long as he could; they needed the time to hammer out a compromise on increasing oversight of the Fed. “The time is now that we have got to end secrecy at the Fed,” said the white-haired Vermonter. “This money does not belong to the Fed. It belongs to the American people, and the American people have a right to know where it’s going.”

  While he spoke, in the majority leader’s office a few steps from the Senate cloakroom, itself a few steps from the Senate floor, Sanders’s and Dodd’s staffs started going back and forth with Reid’s advisers looking on. Sanders’s people agreed that monetary policy wouldn’t become subject to oversight by congressional investigators. Dodd’s staff conceded to making the Fed’s emergency lending public, against the wishes of the big banks as well as the Fed—but only after a two-year delay that would help prevent banks from turning down the loans out of fear of stigmatization. Dodd’s aides also agreed to a Sanders demand that there be a top-to-bottom investigation and full public disclosure of the Fed’s lending during the crisis.

  The deal they struck had something for everyone—for Sanders the liberal populist and the anti-Fed crowd from the Tea Party right, it demanded that the Federal Reserve reveal more information than ever before about its operations. But it did so in ways that Bernanke, Geithner, and Dodd believed would leave the central bank with enough discretion to fight inflation or backstop the banking system when it needed to.

  “I had to make a political decision,” Sanders told reporters later that day. “What people were telling me—friends of mine were telling me, Democrats, some Republicans, were saying, you know, ‘We like the idea of transparency. We like the idea of an audit. But we are afraid that this is going to get into the day-to-day monetary policy of the Fed. We don’t want that.’”

  Whereas Sanders’s original amendment would have been a hard-fought vote, the compromise version passed the Senate 96–0.

  A day later, on May 12, it was the Hutchison amendment’s turn. After a full year of jockeying, lobbying, and arm-twisting, the debate on the Senate floor wasn’t a debate at all. Hutchison and her cosponsor, Democrat Amy Klobuchar of Minnesota, each spoke for about thirty seconds.

  “This amendment ensures that the nation’s monetary policy has a connection to Main Street and not just Wall Street,” said Klobuchar. Citing one of her constituents, the president of the Grand Rapids State Bank, she continued, “All senators should be reminded that the Federal Reserve System was created to serve all of America, not just Wall Street.”

  Making the case a
gainst—sort of—was Dodd, who’d become resigned to seeing his goal of cutting back the Fed’s authority go down in flames as one senator after another had heard from his or her local bankers. “I’m going to oppose the amendment, but I’m not going to speak against it,” he said. He looked at Hutchison and put his hands up, gesturing, “I surrender.”

  And that was it. The vote began. Hoenig and four of his colleagues watched it on a TV in the library just outside his office high above Kansas City. They started out writing down how each senator voted, but after a few minutes it became apparent that keeping a running tally was unnecessary. The final vote was 91–8, on legislation that reversed Dodd’s approach and left the Fed as regulator of almost all of the nation’s banks. Hoenig walked down to the ninth floor of the Kansas City Fed’s office tower, to where the bank examiners worked—the very department where he’d begun his career four decades earlier—and offered praise to a group that had been demoralized by becoming a pawn in the postcrisis negotiations.

  There were still a few more steps to go before what became known as the Dodd-Frank Act would become law, including a series of all-night conference committee votes at which the differences between the House and Senate bills were hammered out. In that process, one final provision that the Fed detested—for making the powerful president of the New York Fed a presidential appointee rather than a technocrat appointed by a private board of directors like at other Fed banks—was defeated. On every meaningful front—audits of its monetary policy, its role in regulating banks big and small, Bernanke’s confirmation—the battle for the Fed was over, and it was the mighty Federal Reserve System that had won.

  But why? What allowed this deeply unpopular agency to emerge from the crisis scratched and bruised but, if anything, more powerful than it had been before?

  However much Congress may have wanted to punish the Fed for its actions during the crisis, the task of regulating trillion-dollar banks is too complex to hand over to just anyone. The Federal Reserve, lawmakers began to realize as they studied the details, really did have the expertise and the means to do so.

  But there was some luck involved, too. Having a Fed man as treasury secretary and the president’s closest adviser on financial reform ensured that the administration would help fight for the central bank. A different treasury secretary and different president might have had different priorities. Bernanke would never be confused with a master legislative strategist, but his approach to dealing with lawmakers proved a good match for the moment: He was earnest and straightforward at a time when the great knock on the Fed was that it was excessively secretive and obfuscatory.

  The Fed also found a surprising source of strength in the very structure that made its governance a mess: those dozen reserve banks scattered around the country, with their private boards of directors and thousands of community banks under their regulatory umbrella. The community bankers lobbied not just on the issues of their own narrow concern—who would regulate them—but also on issues that mattered to the Fed as a whole, such as monetary policy independence and Bernanke’s confirmation.

  The series of compromises made to pass the Federal Reserve Act back in 1913 may have created something of a monster. But its tentacles turned out to be so tightly wrapped around American business and politics—large and small, national and local—that it was almost impossible to kill.

  THIRTEEN

  The New Greek Odyssey

  Are you sure?” asked the younger man.

  “Are you sure?” he repeated in disbelief.

  The older man, George Provopoulos, the governor of the Bank of Greece, was sure. The younger, George Papaconstantinou, Greece’s newly installed finance minister, was learning that the job he’d long coveted might be a lot more challenging than he’d imagined.

  Papaconstantinou and his colleagues in the Panhellenic Socialist Movement party had initially made their spending plans assuming that their nation’s budget deficit would be about 6 percent of its economic output. But in the months before the election, the previous government had ramped up spending while collecting taxes less aggressively. By the time voters went to the polls, on October 4, 2009, Papaconstantinou was looking at a deficit of 8 to 10 percent of gross domestic product.

  The Greek government may have its budgets and projections, but the Bank of Greece does the actual work of accepting tax payments and clearing outgoing checks. It knows better than any other entity what shape the country’s finances are really in. The startling message the central bank governor had for the new finance minister on the morning of October 7: You, sir, are looking at a deficit of 12.5 percent—or higher. (Years later, Greek politicians were still trading accusations about just how much the incoming government knew of the shortfall as it campaigned on a platform of maintaining social spending—an agenda that would prove impossible to enact.)

  The new government began working through its budget, setting a dozen or so analysts to work around a giant conference table. Every day, they found new expenses that hadn’t been properly accounted for—€600 million owed to hospitals, for example, with no accurate record of when the expenses had even been incurred. Every evening, Papaconstantinou would leave and say, “Okay, guys, is that it?” It never was. “Basically, we were discovering that the Greek government had no budget,” said Papaconstantinou later.

  When all the numbers were in, even Governor Provopoulos’s grim estimate would prove overly optimistic: The 2009 Greek budget deficit would end up amounting to 15.7 percent of its economy, the highest in the world.

  It would fall to three men named George to try to narrow this chasm—Papaconstantinou, Provopoulos, and Papandreou, the prime minister. The decisions they made in Athens—and the reactions to them by Jean-Claude Trichet and the leaders of Germany, France, and other Western powers—would remake Europe and the world.

  • • •

  Some countries experience financial crises because their banks face collapse. Others experience them because their public finances are out of control. But history teaches one consistent lesson: Regardless of how the crisis starts, it will soon spread. When a banking system fails, the economy inevitably collapses, straining public finances at the same time that the government takes on the extra expense of bailing out the banks. When a government faces a debt panic, that nation’s banks inevitably come under strain as well, as budget cutting leads to a weaker economy and banks suffer huge losses on the government bonds they own.

  Banking crises and public debt crises, in other words, are two sides of the same coin. But the wave of panic that began with that realization of the true state of Greek public finance in October 2009 had an added layer of interconnection. Greece’s decision to adopt the euro in 2001 had yoked the fortunes of all of Europe to that of this relatively small country—and left the three Georges and their eleven million fellow citizens without the usual tools needed to deal with a crisis.

  Greece was, at first glance, an unusual choice to join the seventeen-nation eurozone. Its economic output per person, about $13,000 in 1999, was only about half that of France and Germany. Its business environment was dysfunctional, with rampant bribery, onerous regulations, and unpredictable enforcement of them. Its political system was fragile, its democratic institutions not well entrenched—the nation had been governed by a military dictatorship as late as 1973. But Greece had something that neighbors such as Bulgaria and Turkey did not: It was where democracy was invented, the birthplace of the European idea, the original European empire. In geopolitical terms, it was the traditional border between Europe and the Arab world. Greece, for all its problems, was special.

  And the idea of joining the eurozone was particularly attractive to the Greeks themselves. Long after most industrialized Western nations had conquered inflation, prices in Greece rose at double-digit rates every single year from 1973 to 1994. That meant the drachma became steadily less valuable as the years passed, which was a boon to the nation’s tourism
sector but meant that ordinary Greeks’ savings blew away with the wind. Inflation was so high that lenders would give money to the Greek government or its citizens only on onerous terms. After all, they had to take into account the fact that the drachmas they were repaid would be worth less than those they had loaned.

  In 1992, when low-inflation Germany could borrow money for a decade at 8 percent, Greece had to pay 24 percent. Both the major Greek political parties, the center-left Panhellenic Socialist Movement and the center-right New Democracy, were enthusiasts for joining the eurozone, with only the communist left and neofascist right, together amounting to around 20 percent of the population, opposing. Greece’s problems during the 1980s and 1990s were anemic growth, double-digit inflation and interest rates, and large deficits. “With the adoption of the euro, Greece gained the credibility of the European Central Bank, which itself was modeled after Germany’s Bundesbank,” said George Provopoulos, the Bank of Greece governor, who was an academic at the time. “Gaining credibility meant low interest rates and inflation rates, which is what happened.”

  With decisions on monetary policy handed over to Jean-Claude Trichet and his colleagues in Frankfurt, Greek inflation hovered around 3 percent through the first decade of the 2000s. The cost of borrowing plummeted. Without the perceived risk of inflation, investors were willing to hand money over to the Greek government for pretty much the same interest rate they received for giving it to the German or French governments. In 2007, on the eve of the crisis, German ten-year borrowing costs averaged 4.02 percent. Greek rates were 4.29 percent. Investors had become complacent, viewing Greek debt as an essentially risk-free substitute for bonds issued by better-run countries like Germany, France, or the Netherlands. Indeed, under the bank regulations in effect in Europe, banks from those strong countries could buy Greek debt and treat it as a risk-free asset against which they needed to hold no capital, giving them every incentive to load up on the stuff. Unfortunately for Greece, and eventually all of Europe, the nation didn’t take advantage of that environment. “What Greece needed to do was take advantage of this low-inflation-rate and interest-rate environment to adjust its economy,” said Provopoulos.