by Nomi Prins
The Federal Reserve Board’s official mandate is to maintain stability in the economy while facilitating growth, by keeping the supply of money and the availability of credit balanced. The Fed operates to achieve maximum employment, stable prices, and moderate long term interest rates. Its principle tool is “printing” money, a process in which the Fed attempts to expand the economy by making cash for lending available by buying banks’ securities.
The Fed also regulates banks by setting and monitoring minimum reserve and capital levels (Title 12, part 208, of the Federal Reserve Act, if you want to check it out, something the Fed failed at miserably leading into the Second Great Bank Depression). In addition, during the past two decades, the Fed has been the main okay nod behind bank holding company mergers.59 During the end of 2008, the Fed ramped up this role with a vengeance.
According to the Fed’s Web site, “Congress created the Federal Reserve System in 1913 to serve as the central bank of the United States and to provide the nation with a safer, more flexible and more stable monetary and financial system.” Over the years, the Fed’s role in banking and the economy has expanded, but its focus has remained the same. Today, the Fed’s three official functions are to conduct the nation’s monetary policy, provide and maintain an effective and efficient payments system and to supervise and regulate banking operations.”60
That’s typically covered in the press and by mainstream economists as setting interest rate targets up or down a tiny percentage, which the Fed does to make sure we have enough unemployed people to keep inflation down. Really.
Thus, there are two tools with which the powers in Washington can calibrate the American economy. Congress and the president focus on fiscal policy, which relates to decisions on spending and taxes, while the Fed enacts monetary policy, influencing the flow or availability of money and credit. “Fine-tuning” the economy is how people typically refer to the Fed’s actions in raising or lowering interest rates, although it is equally widely acknowledged that “fine-tuning” is not really possible. The Fed’s tools include direct lending to banks, if necessary, and setting reserve requirements.61 The Fed stealthily and massively stretched its scope during the Second Great Bank Depression.
The Federal Reserve was spawned in secrecy, so it’s no wonder the notion stuck through the century. During a clandestine meeting at Jekyll Island, Georgia, in 1910, between the richest financiers in the country and their well connected government official friends, participants discussed the formation of the Federal Reserve, using only their first names as identifiers.62 With that kind of foundation, it’s apparent that the dangers inherent in the Federal Reserve Board were imbedded even before it was officially established.63
Woodrow Wilson was elected president in the fall of 1912 on a Democratic platform that promised to fight the powers of the money trusts. Technically, this platform opposed establishing a central bank that would have, by definition, created another kind of concentration of power. According to the 1912 Democratic Party platform statement:
We oppose . . . the establishment of a central bank; and we believe our country will be largely freed from panics and consequent unemployment and business depression by such a systematic revision of our banking laws as will render temporary relief in localities where such relief is needed, with protection from control of dominion by what is known as the money trust.
We condemn the present methods of depositing government funds in a few favored banks, largely situated in or controlled by Wall Street, in return for political favors, and we pledge our party to provide by law for their deposit by competitive bidding in the banking institutions of the country, national and State, without discrimination as to locality, upon approved securities and subject to call by the Government.64
You’d never sneak that into the Democratic Party platform now, that’s for sure. Public and political opinion against the consolidation of the country’s wealth provided the backdrop for both the Federal Reserve Act of 1913 and the Clayton Antitrust Act of 1914.65 Populist opposition extended even further against a central government bank that would establish a partnership between government and private entities, although the Democratic Party’s public statements opposing a federal bank would prove to be mere rhetoric.66
On December 23, 1913, Wilson signed the Federal Reserve Act, which had been formulated by Congressman Carter Glass (D VA) and Senator Robert L. Owen (D OK). Among other things, the act “provided for the establishment of Federal Reserve Banks . . . to establish a more effective supervision of banking in the United States.”67 Wilson regretted the act soon after he signed it, realizing that the nation’s wealth concentration would only increase under this central body of power. Despite some concurrent political opposition, the New York Federal Reserve Bank became and has remained the most influential bank in the Federal Reserve system, much to the joy of Wall Street—which could focus its attention more easily with the richest Fed bank in its hometown.68 Under Geithner’s leadership, it would become an equally chummy friend to that Wall Street community a century later.
Controlling the Punch Bowl
William McChesney Martin Jr., the Fed chairman for almost two decades from April 1951 to January 1970, once joked that the Fed’s job is “to take away the punch bowl just as the party gets going.”69 It was during his reign that the Bank Holding Company Act of 1956 was passed, a solid piece of regulatory legislation that Martin Jr. favored.70
While Martin Jr. was still chairman of the Board of Governors of the Fed, he made a statement on April 18, 1969, before the House Committee on Banking and Currency to advocate for further regulation of one bank holding companies “in the public interest.”
He said, “The Congress took steps years ago, in the Banking Act of 1933, to separate banking from nonbanking businesses, a policy that was reinforced by the Bank Holding Company Act of 1956 as to companies that own two or more banks. Under section 4 of the 1956 Act, such companies are limited to banking and closely related activities. The Board unanimously agrees that there are sound reasons for separating banking and commerce, and that it is essential, if this policy is to continue, to bring one bank holding companies under the Holding Company Act.”71
Martin Jr., who died at the age of ninety-one, the year before the Glass-Steagall Act was repealed, was downright clairvoyant about the dangers of blurring the lines between various types of banking activity four decades before the Second Great Bank Depression surfaced. “To my mind, the greatest risk is in concentration of economic power. If a holding company combines a bank with a typical business firm, there is a strong possibility that the bank’s credit will be more readily available to the customers of the affiliated business than to customers of other businesses not so affiliated. Since credit has become increasingly essential to merchandising, the business firm that can offer an assured line of credit to finance its sales has a very real competitive advantage over one that cannot. In addition to favoring the business firm’s customers, the bank might deny credit to competing firms or grant credit to other borrowers only on condition that they agree to do business with the affiliated firm. This is why I feel so strongly that if we allow the line between banking and commerce to be erased, we run the risk of cartelizing our economy.”72
But Martin Jr. failed to tighten monetary policy quickly enough. During the mid 1960s, inflation had started to climb, and by the time Martin Jr. retired in 1970, inflation was 6 percent and quickly rising out of control.73 This pattern became more pronounced in the early 1970s and into the late 1970s, under the Fed chairmanship of Arthur F. Burns for most of the decade and under G. William Miller toward the end. The hyperinflation of the 1970s was exacerbated by the oil shocks of 1973 and 1978.74
The Last Banking Crisis
The early years of Alan Greenspan’s reign were marked by the Savings and Loan (S&L) Crisis, in which the Fed took an active role but did not dramatically open its discount windows to nonbank entities or change its collateral posting rules.75
The S&L Cr
isis began quietly in 1984 and escalated in 1988—the first year the FDIC suffered an operating loss—and 1989.76 So, on August 9, 1989, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) to dispose of the toxic—mostly real-estate—assets from these failed institutions.77 It was the 1990s version of a “bad bank.” (In 2009, a more bank-generous Washington was considering disposing of assets from existing institutions.) But the RTC couldn’t find buyers for its bad assets—shocking, considering they were bad because no one wanted to buy them in the first place, (just like during the Second Great Bank Depression). So, a year later, Congress got impatient and pressured the RTC to get rid of them anyway. The catch? When you sell stuff quickly, you don’t get top dollar for it.
No matter. The RTC had a fire sale, and investors squeezed the government (and the public money that funded the RTC). At the first RTC auction in Dallas in July 1991, assets worth $25 million sold for 20 cents on the dollar. In May 1992, another RTC auction sold assets for only 17 cents on the dollar. By December 1995—the last year of the RTC’s existence—prices barely reached 70 cents on the dollar.78 So eventually the assets did regain some value, but only after enough were sold at exceedingly low prices, which had the effect of rendering the remaining assets more valuable. Still, the assets never achieved the value at which they had been purchased.
During its six year existence, the RTC and the Federal Savings and Loan Insurance Corporation (FSLIC) sold off $519 billion worth of assets for 1,043 thrift closings.79 But the RTC never brought the profits to the American people that Washington had promised (sound familiar?). Instead, it left the public on the hook for $124 billion in losses, while the thrift industry lost another $29 billion.80 In 1997, the government was still paying $2.6 billion in annual interest on the bonds, with $2.3 billion coming from the Treasury, backed by those assets.81 Tell that to the next person who says a bad bank is a good idea.
The early 1990s brought a recession under President George H. W. Bush that became an insane boom time during the Bill Clinton deregulation years and through the late 1990s. That party was followed by a mini recession in 2001 and 2002, after which Greenspan’s rate cuts ultimately spurred a tremendous debt led boom and the Second Great Bank Depression.
Advocating the Wrong Policies
There are many causes for the current economic disaster that have nothing to do with the Fed. But one lethal cocktail did—the combination of lowering rates with promoting home ownership, particularly through the funky types of adjustable loans that then Fed chairman Alan Greenspan advocated as the subprime market blossomed from 2003 through 2005.
“American homeowners clearly like the certainty of fixed mortgage payments,” Greenspan said in a speech to the Credit Union National Association in Washington on February 23, 2004. “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage”; particularly if they are “willing to manage their own interest-rate risks, the traditional fixed rate mortgage may be an expensive method of financing a home.”82
With that kind of cover from the Fed boss, subprime lenders got into high gear. Stan Kurland, president of Countrywide Financial Corporation, didn’t hide the firm’s intentions in 2004. “Countrywide has a long history of working to meet the needs of borrowers. Our determination to dominate the ARM market builds on that history,” he said. “As of March 2004, more than 40 percent of our retail and wholesale nonconforming fundings were for adjustable rate products. The ARM product menu is strong and deep, enabling consumers and business partners to meet their financial goals in ways that are affordable and beneficial, despite the recent rise in interest rates.”83
Greenspan was a major and vocal proponent of deregulation of basically everything and said that “free markets” were not to be tampered with. He believed, by definition, that orchestrated tampering with the functionality of the markets will always be too late to be effective,84 or “in essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities.”85
In May 5, 2005, ever the free market advocate—why constrict the poor markets with rules, when they’d have so much more fun without them?—Greenspan sounded like the head of marketing for any Wall Street credit derivatives department. He actually talked down critics of more regulation for the growing credit derivatives market, stating that the entities with less regulation had more incentives to monitor and control risk. He staunchly believed that “private regulation generally has proved far better at constraining excessive risk taking than has government regulation.”86
Five months later, he said in a speech to the National Italian American Foundation in Washington, D.C., “Being able to rely on markets to do the heavy lifting of adjustment is an exceptionally valuable policy asset. The impressive performance of the U.S. economy over the past couple of decades, despite shocks that in the past would have surely produced marked economic contraction, offers the clearest evidence of the benefits of increased market flexibility. In contrast, administrative or policy actions that await clear evidence of imbalance are of necessity late.”87
So the market would take care of everything, and those unregulated entities, well, they’d exercise self-discipline. Yeah, right. Except that four years later, the costs incurred by that realm of thinking hovered at more than a cool $13 trillion, including a $182 billion bailout for AIG, an insurance-company turned-unregulated-credit-hedge-fund classified as an S&L for a whole bunch of counterparties, none of which were that prudent.88 But in the end, the Fed under Greenspan’s successor, Ben Bernanke, bailed out AIG and Greenspan’s ideology.89
“Had the Models Been Fitted More Appropriately”
Things finally caught up with Greenspan in late 2008, as the markets crumbled, and the mainstream press caught up with the progressive press in blaming many of his policies.
On October 23, 2008, Greenspan was called before Representative Henry Waxman (D CA) and the House Committee on Oversight and Government Reform, alongside other powerful men who held posts during the subprime and credit buildup, such as John Snow, the former secretary of the treasury, and Christopher Cox, the chairman of the SEC.90 The testimony went like this:
REP. WAXMAN: . . . you had a belief that free, competitive—and this is your statement—“I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We’ve tried regulation. None meaningfully worked.” That was your quote. . . . And now our whole economy is paying its price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?
MR. GREENSPAN: Well, remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to—to exist, you need an ideology.
The question is whether it is accurate or not. And what I’m saying to you is, yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. But if I may, may I just answer the question—
REP. WAXMAN: You found a flaw in the reality—
MR. GREENSPAN: Flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak.
REP. WAXMAN: In other words, you found that your view of the world, your ideology was not right. It was not working.
MR. GREENSPAN: Precisely. That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well. But just let me, if I may—
REP. WAXMAN: Well, the problem is that the time has already expired.91
After epic turmoil in world markets led by announcements of bank insolvency and mounting criticisms about the cause of their meltdown, which Greenspan described as “a once-in-a century credit tsunami,” he found “a” flaw. Greenspan claimed, “Those of us who have looked to the self interest of len
ding institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.”92
Now, really, it is we who should be in shocked disbelief at Greenspan’s philosophical bantering about the need for an ideology—whether dangerous or not, apparently—and at his blaming the economic crisis on the models, not on the plethora of deregulation that allowed the banking industry to pile on such excessive and risky debt with no regard to the possible downside. Why didn’t he blame the exceptionally bad judgment of the biggest bank regulator and regulating body in the world? Even if the models were wrong, it was the Fed’s responsibility—no, its mandate, in fact—to monitor the capital on hand in the banking industry to back mounting losses.
Greenspan went on to say that the sophisticated asset pricing models the Fed had effectively relied on collapsed because the data being put “into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today.”93
