The Real Mission of the Fed

Enabling the government to borrow; and a go-live event tonight

Note: Tonight, November 11, at 8 PM New York time, I will attempt to “go live” on substack. This event will be for all subscribers, paid and unpaid. If I can figure out how to enable others to speak, it will last an hour. If I cannot, it will be shorter.

The Federal Reserve was created in 1913. Very shortly thereafter, the United States for the first time become involved in a European war, initially as a lender to the Allies, subsequently as a co-belligerent. Coincidence? Not entirely.

We are treated to such quaint myths about the purpose of a central bank. “It controls the money supply to steer the economy away from high inflation or high unemployment.” “It is the lender of last resort.”

The real purpose of a central bank is to enable the government to borrow money at a low interest rate. I learned this from Niall Ferguson’s The Cash Nexus. Reviewing this book years after I read it, I wrote,

I came away from the book thinking that all elements of financial policy are geared toward the goal of enabling the government to allocate credit to its preferred uses, especially its own spending.

Central banking originated in Britain. By achieving its mission, it enabled its government to prosecute wars, especially against France.

In its twentieth-century incarnation, an effective central bank enables the welfare-warfare state. Nowhere is it more effective than in the United States.

For much of our history, Americans resisted a central bank. The first Bank of the United States was created to help resolve debt that was created during the Revolutionary War. By 1811, with its mission largely accomplished, its charter was allowed to expire. A second Bank of the United States was chartered in 1816, but it was famously abolished by President Andrew Jackson twenty years later.

Populist anti-banking sentiment was very powerful up until late in the twentieth century. According to Charles Calomiris and Stephen Haber, this resulted in a fragile banking system. In my review of their book, I wrote,

They believe that the United States quickly succumbed to populism, with dire consequences for its banking system.

American populism fostered a tradition of “unit banking,” in which each town had its own quasi-monopoly bank. There were no national banks and states limited the number of branches any bank could have, with many states prohibiting branching altogether. These relatively lazy, non-diversified unit banks were naturally fragile, unable to withstand local economic shocks.

Before the creation of the Fed, America suffered from periodic financial crises. Since the creation of the Fed. . .America has suffered from periodic financial crises.

The populist era in American banking finally ended in the 1980s. Before then, a bank could not have a branch in more than one state. Many states allowed only a single branch within the state. Our contemporary banking system, dominated by a handful of large national institutions operating in every city, would have been unrecognizable as late as the early 1970s.

Prior to the deregulation of the 1980s, our financial system was so fragmented that savings in the East Coast, where there was a surplus, could not flow to the West Coast, where they were needed. The Federal Home Loan Mortgage Corporation, now known as Freddie Mac, was created in 1970 largely at the behest of California’s homebuilders and housing lenders, who were desperate to obtain capital from New York and other eastern states.

Deregulation eliminated many distortions that had raised the cost to the public. Savers could finally earn market interest rates, rather than have the earnings on their money capped by regulation. Stock market investors could take advantage of much lower commissions and a greater variety of investment vehicles.

But deregulation made it easier for the Fed to manipulate the flow of credit. For example, the Fed and other central banks came up with “risk-based capital” rules, under which banks could hold government debt without having to hold capital against it. Other assets were deemed “risky,” with various levels of capital required. This created an incentive for banks to hold more government debt and make fewer commercial loans.

In 2003, the Fed created the “recourse rule,” which put highly-rated mortgage securities in a low-risk capital bucket. This produced a boom in mortgages wrapped into such supposedly low-risk securities, ultimately ending in the financial crisis of 2008.¹

Since 2008, the Fed has employed a new tool to steer savings to the government: “Quantitative Easing.” This involves the Fed borrowing from private banks in order to hold tremendous volumes of government debt. Supposedly undertaken as a “temporary” measure to address the 2008 crisis, this vast expansion of Fed holdings never went away. It was enlarged again during the pandemic.

At the height of the crisis, government officials asked Congress for $800 billion for the so-called Troubled Asset Relief Program (TARP). Fed Chairman Ben Bernanke warned that without TARP he was worried that the ATMs (cash machines) that consumers rely on might be empty. This was a demagogic lie. The TARP funds were not used to support consumer banking at all. They were used to support the “primary dealers,” meaning the handful of Wall Street firms that are actively involved in purchasing government debt and marketing it to corporate money managers. If several of the primary dealers had gone under, the government’s ATM which might have malfunctioned.

More recently, banks came under stress when the Fed had to raise interest rates to try to reduce inflation. Long-term government debt, supposedly risk-free, generated losses at many banks, including Silicon Valley Bank, which had to be shuttered. Holding a long-term bond that pays 1 or 2 percent becomes anything but risk-free when the cost of borrowing to finance that bond goes up to 4 or 5 percent. In fact, the biggest loser from higher short-term interest rates is the Fed itself.²

The radical libertarian or populist cry used to be end the Fed. Maybe that is too extreme, but I would be happy to chant end quantitative easing. The supposed rationale for quantitative easing has long passed its expiration date.

Suppose that Congress required the Fed to reduce its holdings of government debt, returning to levels similar to what prevailed prior to the 2008 crisis and “quantitative easing.” I think that this would make it harder for the government to keep mounting up its deficit. For the long-term welfare of ordinary Americans, this would probably be a good thing.

1. See my post on Engineering the Financial Crisis, by Jeffrey Friedman and Wladimir Klaus. See also my monograph Not What They Had in Mind.

2. See Is the Fed boing bankrupt? If you don’t believe me, read Paul Kupiec and Alex Pollock.