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The Problems With the Federal Reserve -- and Its Alternatives

PH2009062504313.jpgWilliam Greider, author of "Secrets of the Temple: How the Federal Reserve Runs the Country", knows more about the Fed than just about anyone alive, with the possible exception of those who worked there. And that's only a possible exception. As such, his essay bemoaning the "antiquated" structure of the Fed and offering a proposal for reform should be taken pretty seriously. The key point, I'd say, comes near the top, when Greider takes aim at the Fed's vaunted independence.

Representative Wright Patman, the Texas populist who was a scourge of central bankers, once described the Federal Reserve as "a pretty queer duck." Congress created the Fed in 1913 with the presumption that it would be "independent" from the rest of government, aloof from regular politics and deliberately shielded from the hot breath of voters or the grasping appetites of private interests--with one powerful exception: the bankers.

The Fed was designed as a unique hybrid in which government would share its powers with the private banking industry. Bankers collaborate closely on Fed policy. Banks are the "shareholders" who ostensibly own the twelve regional Federal Reserve banks. Bankers sit on the boards of directors, proposing interest-rate changes for Fed governors in Washington to decide. Bankers also have a special advisory council that meets privately with governors to critique monetary policy and management of the economy. Sometimes, the Fed pretends to be a private organization. Other times, it admits to being part of the government.

The antiquated quality of this institution is reflected in the map of the Fed's twelve regional banks. Five of them are located in the Midwest (better known today as the industrial Rust Belt). Missouri has two Federal Reserve banks (St. Louis and Kansas City), while the entire West Coast has only one (located in San Francisco, not Los Angeles or Seattle). Virginia has one; Florida does not. Among its functions, the Federal Reserve directly regulates the largest banks, but it also looks out for their well-being--providing regular liquidity loans for those caught short and bailing out endangered banks it deems "too big to fail." Critics look askance at these peculiar arrangements and see "conspiracy." But it's not really secret. This duck was created by an act of Congress. The Fed's favoritism toward bankers is embedded in its DNA.

Greider's proposal goes a bit off the rails toward the bottom, when he suggests that Congress should recapture the mechanisms that the Federal Reserve employed in the bailout to and use them to produces hundreds of billions of new dollars for infrastructure investments. That's a dangerous game. I mean, look at our Congress.

But that doesn't obviate his analysis of the Fed's structure, or the recent swelling of its authority. One way of understanding the economic crisis is that a monetary dictatorship saved our democracy. The Federal Reserve did some things that the Congress could not have done, but it also did things that the Congress would not have done. Spending a trillion and change to buy up securities, for instance. But those were arguably the key interventions into the crisis. Comparatively, stimulus was small and slow and diffuse.

Which is to say that for a period of time, Ben Bernanke ran our economy under a monetarist's version of martial law. And the really problematic thing is that it probably worked. It may be all that saved us. You could argue that in the absence of the Federal Reserve, Congress would have been a whole lot more aggressive and responsible because Bernanke wouldn't have been there to backstop them. But would you really want to bet the U.S. economy on it?

Photo credit: Melina Mara -- The Washington Post Photo .

By Ezra Klein  |  July 23, 2009; 7:10 AM ET
Categories:  Federal Reserve , Solutions  
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Is it really "problematic" that it worked? Isn't that really the way honest stewards of government and the economy would like it? The Federal Reserve is a fast-moving organization and Congress is a slow one, so it makes sense that the direct power over economic power would belong to the Fed; we needed a response to the Bear Sterns and Lehman Brothers collapse within hours, and the only thing Congress can truly get its knickers in a twist over that quickly is Terry Schiavo.

Also, I'd submit that Congress isn't full of experts on the economy, to say the least. Most people with power in the Federal Reserve are. In this situation, the system worked exactly how we want it to: the Federal Reserve stepped in and held the economy at the ledge, and then helped to educate, along with others, Congress on the problem and potential solutions. Congress then decided among those solutions and implemented (or is in the process of implementing, as health care reform would be) the long-term fix that best fit their view of how economic policy should be shaped in the United States.

If the Fed decided to their "monetary dictatorship" at a time when it didn't call for it, Congress and the President would smack it around like a pinata. So they won't do that. But for now, the Federal Reserve is there to do exactly what it did, exactly what people wish it could have been around to do before the Great Depression.

Posted by: smhjr1 | July 23, 2009 8:08 AM | Report abuse

"Which is to say that for a period of time, Ben Bernanke ran our economy under a monetarist's version of martial law."

This is the best single sentence summation of what has gone on in this country since September 2008 at the Fed. Increasing the size of the Fed's balance sheet to its current levels truly was like the Fed going on a wartime footing.

Posted by: zeppelin003 | July 23, 2009 8:33 AM | Report abuse

I haven't read Greider's article yet, nor his previous book on the Fed, but after reading your post I think the question still seems open: Is there not some possible set of reforms--including, perhaps, something like what Greider is proposing for the Fed--that would result in two things simultaneously: 1) a more democratic institution for devising and enacting monetary policy, and 2) a stabilized financial sector consisting of small-enough-to-fail individual units that are together capable of performing counter-cyclical actions?

Posted by: JonathanTE | July 23, 2009 9:18 AM | Report abuse

'Would you bet American Economy on Congress?' Surely not when it comes taking quick decisions. Quick economic decisions to protect American Economy cannot be modeled on electoral democracy because stake holders in 'economy / money' are not uniform (unlike one person one vote). A millionaire or a small business owner has far more to loose by the collapse of the economy than many others.

Regional structure of Fed is something which ought to be revamped. Moreover, Fed & Congress needs to tweak it from time to time. For example, if in a decade Alternative Energy based economy sprouts up in Midwest (wind and gas); then we may need more representation of that section of the economy on Fed. But meanwhile, it is the West Cost economy which is a big share of the economy and hence needs larger representation than what is the case today. To keep the dynamism of the economy, you would need relatively nimble structure of Fed.

Posted by: umesh409 | July 23, 2009 10:04 AM | Report abuse

"Ben Bernanke ran our economy under a monetarist's version of martial law. And the really problematic thing is that it probably worked. It may be all that saved us."


But Greenspan drove it into the weeds in the first place.

The power to create is also the power to destroy.

Posted by: pj_camp | July 23, 2009 10:22 AM | Report abuse

I think you're misrepresenting Greider's article here: he wasn't recommending that the Fed be dismantled, but rather that its regulatory role be divorced from its role in stabilization. That way the person who gets to implement monetary martial law isn't also the person who has been in charge of whether a bunch of juvenile delinquents gets free access to monetary crowbars and gasoline.

Posted by: paul314 | July 23, 2009 10:47 AM | Report abuse

JonathanTE I recommend Greider's book, Secrets of the Temple. I just re-read it this year, and it's plain to see that nothng has changed since his initial explanation in the Eighties of how the Fed works.

This business of slow versus fast, Congress versus some agency or commission, non-expert versus expert, is a bit of a straw man.

It's commonly posited that the Fed CAUSED the Great Depression by not loosening the money supply.

Congress only has fiscal policy, because monetary policy is given to the Fed. Money creation is a part of how our economy works, and from old history the banks remain a party to this creation, which gives them lovely free profits.

The point is that it's government money, a sovereign thing. We the people through our representative government could actually share in this largesse of the system, rather than the banks, who actually do nothing for it other than expand credit - except when we really need it of course.

The Fed over the decades has caused immense suffering and hardship. The governors have shown in analysis after analysis that they really haven't known what happens in the economy - they operate by incremental trial and error. The trials generally err in favor of the banks, and the erors are weighted against us.

They consistently sacrifice the productive economy to bolster the banking industry - their mandated and acculturated constituency.

So when Greider is saying reform the Fed he's talking about switching the constituency of the money-creation power back to the productive economy of us, the people.

Posted by: wapomadness | July 23, 2009 10:47 AM | Report abuse

My body starts itching when the "it worked" argument is brought to center stage. There IS value in pragmatic choices leading to pragmatic outcomes.

BUT. Stalin mobilized the entire work of the Soviet Union to outproduce and outfight the Germans in WWII - slave camps, loyalty through terror on their own population, and defense/offense without regard to the cost in human life.

Doesn't anyone else get worried about what the 'it works' argument logically becomes when untempered by democratic rule, accountability, and moral/ethical values?

We just had eight years of "I'm the President and I can do what I think is needed" authoritarianism. Being above the law can't be reconciled with a democratic republic - ultimately a choice must be made.

There is little question that the Fed acted in some cases without legal backing in this crisis. Its charter requires both concern for a stable financial system but also for maintenance of employment. There is little or no evidence that the Fed acted based on the needs of preventing unemployment and destruction of assets. They certainly haven't exercised the powers they have a regulator to prevent the chaos the 'too big to fail' banks. The Fed has made them bigger through consolidation, and also made them less risk adverse through moral hazard of government bailouts.

It isn't just the banks that are too big to exist, the Fed itself cannot balance financial market stability, regulation in the public interest, and overall concern for citizen welfare via jobs, and therefore the Fed is too conflicted (too large a charter) to be awarded Stalinesque authority.

Posted by: JimPortlandOR | July 23, 2009 11:34 AM | Report abuse

Admittedly it's odd to have a critical institution be so insulated from popular pressures, but in the last 12 months, on more than one occasion, I've thought "thank god that these decisions aren't being made by congress."

I mean really, for all Bernake's flaws, and Greenspan's before him, would anyone want monetary policy to go through the sausage grinder that is congress?

Posted by: TWAndrews | July 24, 2009 12:59 PM | Report abuse

Having the FED is like having a mechanic whose sole job is to lubricate a really expensive machine when it needs it , because the cost of the machine freezing up far outweighs the cost of the mechanic.

Posted by: avraamjack | July 24, 2009 4:25 PM | Report abuse

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