Why the Federal Reserve Needs an Overhaul

This 100-year-old antique is undemocratic, too close to elite banking interests and often blind to the economic conditions that affect most Americans.

The Federal Reserve is celebrating its 100th birthday with due modesty, given the Fed's complicity in generating the recent financial crisis and its inability to adequately resuscitate the still-troubled economy. Woodrow Wilson signed the original Federal Reserve Act on December 23, 1913. Eleven months later, the Federal Reserve System's twelve regional banks opened for business. But in a sense the central bank was born in the autumn of 1907, when another devastating financial crisis swept the nation, destroying banks, businesses and farmers on a frightening scale.

J.P. Morgan and his fraternity of New York bankers intervened with brutal decisiveness in the efforts to halt the Panic of 1907, choosing which banks would fail and which would survive. Afterward, Morgan was hailed in elite circles as a heroic figure who had saved the country and free-market capitalism. The nostalgia for Morgan was misplaced, however: as insiders knew, the real story of 1907 was that Washington intervened to save Wall Street--the twentieth century's own inaugural bailout.

When Morgan's manipulations failed to heal the hemorrhaging banking system, the Morgan men turned to Treasury Secretary George Cortelyou and implored him to send money--lots of it. The next day, some $25 million in emergency federal deposits were sent to New York, and the Morgan team spread the money around among the desperate banks. About the same time, Morgan dispatched two industrialists from US Steel to meet with President Teddy Roosevelt and get his assurance that the government would look the other way as they executed a corporate merger likely to violate anti-trust laws.

The government saved the day, but it was a close call. Wall Street's wiser heads recognized that the country's banking system had become dangerously unstable, prone to reckless excess and recurring panics and depressions. Banking needed a safety net. Leading financiers designed one: a central bank empowered to stabilize the financial system and rescue it in times of crisis.

The bankers not only wanted access to the Federal Reserve's money but insisted on controlling this new institution themselves. They pretty much got what they wanted. The Federal Reserve Banks in twelve major cities would literally be owned by local banks, which would function as private shareholders (they still do). The Federal Reserve Board in Washington, with governors appointed by the president, was a modest concession to democratic sensibilities.

This hybrid institution, in which private economic interests share power alongside the elected government, was founded on an absurd pretense. Decisions at the Federal Reserve, it was said, should be made by disinterested technocrats, not officeholders, and deliberately shielded from the hot-blooded opinions of voters as well as politicians. Representative Carter Glass of Virginia, a leading sponsor, promised "an altruistic institution...a distinctly non-partisan organization whose functions are to be wholly divorced from politics."

Of course, the claim was ridiculous on its face. Given the enormous size of the Fed's power to affect economic outcomes and people's lives, the central bank's decisions inescapably favor some interests and injure others. By controlling interest rates and the availability of credit, Fed governors necessarily referee the conflicts between lenders and debtors. Whatever you call it, that's the realm of politics.

The remnant Populists still in Congress in 1913 were not fooled by the talk of political neutrality. Representative Robert Henry of Texas described the new central bank as "wholly in the interest of the creditor classes, the banking fraternity, and the commercial world without proper provision for the debtor classes and those who toil, produce and sustain the country."

A hundred years later, the country seems to have circled back to the very same arguments. We are confronted again by the financial destructiveness the Fed was supposed to eliminate. Despite some worthy reforms that centralized power in Washington, bankers still run wild on occasion, ignoring restraints and spreading misery in their wake. The Fed still rushes to their rescue with lots of money--public money. And people at large still pay a terrible price for official indulgence of this very privileged sector.

So this is my brief for fundamental reform: dismantle the peculiar arrangement and democratize it. The Federal Reserve has always been a glaring contradiction of democratic values. After a century of experience, we should be able to conclude from events that the system simply doesn't work. Or rather, it does very well for bankers, but not for ordinary citizens. The economy does require a governing authority--Fed advocates are right about that--but it suffers from the Fed's incestuous relationship with Wall Street bankers. My solution: throw open the doors, let the people into the conversation and the decision-making. The untutored ranks of citizens are as fallible as any economist, but they often know things about economic reality well before the experts.

I know reforming the Fed sounds improbable, especially given our dysfunctional political system. But I have a hunch the case for reform will grow stronger, because the pain continues for most Americans. Despite frequent assurances by the authorities, the broken economic system has not been fixed--not by the Federal Reserve, not by the Obama administration and certainly not by Congress.

Treasury Secretary Jack Lew recently claimed that the Obama administration has eliminated the specter of "too big to fail" banks. Reform-minded critics responded with catcalls. "I'd tell him he's living on another planet," said Senator David Vitter, while his colleague Sherrod Brown noted that the four largest banks, after receiving bailout money in 2008, have grown by $2 trillion. They also enjoy below-market interest rates when they borrow from credit markets and other banks because the investors figure Washington won't let them fail.

An even harsher critic is Sheila Bair, former chair of the Federal Deposit Insurance Corporation, who had to liquidate hundreds of smaller banks during the crisis. "What system were we trying to save, anyway?" she asked in her under-appreciated 2012 book, Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself. "A system in which well-connected big financial institutions get government handouts while smaller institutions and homeowners are left to fend for themselves?...

"Because we propped up mismanaged institutions, our financial sector remains bloated. The well-managed institutions have to compete with the boneheads," Bair wrote. "A culture of greed and shortsightedness" permeates even the best-managed banks, one that "goes undetected by their executives and boards as well as their regulators." Bair is a conservative Republican, an insider disgusted with the failure of her fellow regulators.

Part of that failure is because the Fed governors have not been isolated from political influence. Bankers, and their representatives at the twelve Reserve Banks, are very much insiders too. After the recent collapse, they were represented by some 20,000 lobbyists, who swamped federal regulators with formal comments and complaints on the Dodd-Frank reform law, weakening it considerably. But the heavy-handed influence of the banking industry is only part of the problem. Since citizens and their elected representatives have no voice in Federal Reserve decisions, the central bank excludes the issues, and downplays the economic consequences, that matter most to ordinary people. Instead, the monetary debate proceeds in the sanitized language of economic abstractions and is limited to a small group of elites. Self-interested financial-market participants constantly critique monetary policy, a debate reported in the business pages as though Wall Street traders are speaking for the broad public.

This reliance on a narrow frame of reference produces institutional blind spots and gross errors. I don't doubt the integrity of Fed professionals; they sincerely believe their political isolation is a virtue. I say it is the source of their great failing. The telling evidence lies in what the Fed does not talk about. If you scan the public record over the last generation, you might conclude that the policy-makers were unaware of the grave disorders that were steadily accumulating. Or that they believed the economic pressures assaulting citizens were not relevant to monetary policy. Whatever the explanation, the Fed missed the big story--the steady economic deterioration stalking the middle class--just as it did not see the reckless behavior in banking that would lead to collapse.

After the fall, the extreme inequalities of income and wealth could no longer be ignored and belatedly hit the front pages. How could the Fed--staffed by professional economists who are trained to examine broad trends--have missed the importance of this? Or that industrial wages for hourly workers had been declining in real terms for three decades? Did the governors recognize that global trade and the migration of US jobs overseas destroyed the once reliable link between rising productivity and rising wages? How did the Fed explain the mountainous debt growing inexorably across the economy--not just government debt, but household and business debt too?

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