How is the Federal Reserve expanding its powers?
The Federal Reserve System, the complicated and multilayered mechanism that serves as our country’s central bank, has been the subject of obsessive focus over the last year as the nation has watched inflation rise to levels not seen since the Carter administration, while at the same time many economists are projecting that we are inexorably sliding toward — may already be in — a recession of indefinite depth and duration. How did this happen? How will it end? And most important: How do we make sure it won’t happen again? These are all important questions, and based on my time as vice chairman of the Fed, I have answers — but those answers aren’t the subject of this essay. We are at a moment in time when questions about a looming recession are the least important questions to ask and answer about the Federal Reserve. I want to explain why that is, and what’s at stake.
But first, I think there is a federal rule of some sort — it’s not just a state thing — that recently rusticated vice chairmen of the Fed must take at least a few paragraphs to address the immediately topical. The most frequent question I am asked is “Can the Fed handle this inflation?” usually immediately followed by “Will the Fed handle it — does it have the guts to do what it takes as the economic body count rises?”
The answer to the first question — can the Fed do it — is a simple “Yes.” Inflation is driven fundamentally by an imbalance between supply and demand, which obviously can be the result of either too little supply or too much demand relative to trend. The Fed, by increasing the cost of money, which it effectively controls, can be quite successful at reducing demand — but the Fed cannot make computer chips, or unload containers on the docks, or distribute vaccines, so it is a weak vessel for increasing supply. Everything depends, then, on whether a particular inflationary episode is being driven by disruptions in supply or by spikes in demand.
In the spring of 2021, it was perfectly reasonable to believe — it must have been, since I believed it — that the inflation we were just beginning to see was driven by Covid-19-generated limits on supply. There’s not much the Fed can or should do about supply problems, if they are expected to resolve, so we held our fire. But by the fall of last year, it was evident that the principal driver of our current inflation was instead an overstimulated demand — many measures of supply had returned to their pre-Covid-19 levels, yet people wanted still more, driving prices higher and higher. So, the bad news is that the Fed’s initial misdiagnosis delayed the beginning of its response, and inflation has risen to levels not seen for 40 years. But the good news is that we now know this is precisely the type of inflation that the Fed can get on top of, and after a slow start it is now doing so with an athleticism that we also have not seen in decades.
As for the second question — does the Fed have the guts to stay the course — the answer is not just “Yes,” but “Yes, unquestionably.” Everyone connected with the Fed from Jay Powell, the current chairman, to the woman who waters the plants in the office every Friday, knows there is one “Great Satan”: Arthur Burns. Burns was Richard Nixon’s chairman of the Fed, and he famously wilted under pressure from Nixon and led the Fed to an anemic policy against overheating prices that ultimately resulted in spiraling inflation that took a decade of pain to uproot. If you ever have an appointment at the Fed, ask the guy X-raying your briefcase “Who is the one great villain,” and he will say, without hesitation, “Arthur Burns.” Most people at the Fed today don’t have any idea what the unemployment rate was in 1972, or what the exchange rate was in 1972, or what the Treasury market was doing in 1972, but they know that Burns let inflation get out of control, and he is thus a hiss and a byword in the building half a century later. Powell is definitely not going to allow himself to become Burns.
But I began this essay by declaring that questions of inflation and interest rates, though all over the news, are the least important questions about the Federal Reserve today. The big question is not what’s going to happen to inflation this year or in 2023. The big question is how dominant of a role will the Federal Reserve play, not just in our financial system, but in our entire economy — indeed, in our society — in a decade. The worrisome issue is that the answer is uncertain. What is certain is that it will be determined by two things. One, the continuing evolution of digital technology, and two, the degree to which politicians choose either to exploit or to constrain some hitherto dimly understood powers of the institution that they are only now beginning to grasp.
To understand what is at stake, you first have to understand that the Federal Reserve has been a constantly evolving organization. The Fed we have today is quite different from the entity created by the Federal Reserve Act of 1913. In fact, the Federal Reserve has had three main “constitutional moments” in its history, moments when its operation and its power underwent dramatic change.
The first, of course, was its founding in the early 20th century. The original Federal Reserve was a quite limited institution, fragmented in its power, decentralized in its governance and targeted in its objectives. It was created to address two main problems: First, it was meant to create an “elastic” currency, that would expand and contract with the volume of economic activity in the country at any time, and second, it created a system to support stable bank credit by quickly moving banking reserves from banks with a surplus to banks in need — a so-called “Federal Reserve,” which is where the institution got the name it still goes by today.
The big question is how dominant of a role will the Federal Reserve play, not just in our financial system, but in our entire economy — indeed, in our society — in a decade. The worrisome issue is that the answer is uncertain.
But given the historical suspicion in this country of all concentrations of economic power, the system created to meet these objectives was hobbled in a variety of ways. There would not be one central bank for the country, but at least 12 scattered across the continent, and while there was an overall system board in Washington to set general policy, it had limited authority and prestige — the clear weight of the system, by design, was in the Reserve Banks. So much so that in the early years of the Fed, one of the first heads of the board — the equivalent of our chairman of the Fed — resigned to take the position of president of the Reserve Bank of Atlanta.
This system was better than what went before, and lasted for roughly 20 years, but did not prove up to the task when it faced the existential challenge of the Great Depression.
The Roosevelt administration, looking both for ideas and for credibility in dealing with the country’s ongoing banking crisis, reached out to — of all things — a Republican banker and industrialist from Utah named Marriner Stoddard Eccles. Eccles is one of the unsung public servants of our history, consequential for many things, but for the purposes of this essay, he is important as the engineer of the Fed’s second constitutional moment. Roosevelt asked him to head the Federal Reserve System, and he agreed on the condition that the system be greatly modified. The board in Washington would be expanded, its powers increased, and although we would still have 12 Reserve Banks, the center of gravity of the system would move from the Reserve Banks to the board and its chairman. This structure was implemented in the Banking Act of 1935, and is the reason that Eccles is called the “Father of the Modern Fed” and that the Fed’s marble temple on Constitution Avenue is named after him (as it happens, Marriner Eccles is a common topic of conversation around our Sunday dinner table; my wife, Hope Eccles, is his great-niece).
This is formally the system we still have today, but the Fed had yet another constitutional moment of equal importance, though it did not change its formal legal structure. The third moment came in the early 1950s, and again featured Marriner Eccles. For almost a decade, interest rates had been “pegged” as a wartime necessity, keeping the cost of government financing low to help the war effort. After the war, Eccles — believing that continuing this practice in a peacetime economy would ignite inflation — wanted to “break the peg.”
President Harry Truman, and his Treasury Secretary John Snyder, did not.
Things came to a head when, in an unprecedented move, Truman summoned the entire Federal Open Market Committee — the body of the Federal Reserve that sets monetary policy, consisting of the full seven-person board plus five of the Reserve Bank presidents — to a meeting in the Oval Office where he would tell them how the cow ate the cabbage. The Federal Reserve listened politely to Truman’s demand that they maintain the peg and said, “Thank you, Mr. President, we will give that thought all due consideration,” and went back to their offices.
After the Oval Office meeting, however, Truman issued a statement saying the committee had agreed to keep interest rates fixed at the wartime peg. Eccles, in turn, released the minutes of the meeting to The New York Times, demonstrating the Fed had done no such thing. The Federal Reserve had called the president a liar in the country’s paper of record.
Headlines dominated the national press for weeks. Eventually, the Treasury and the Fed reached an agreement on March 4, now known as the Treasury Fed Accord of 1951. It is the source of the Fed’s current independence from political direction regarding monetary policy. The accord allowed the Fed to set interest rates and policy free from government intervention. The Fed was one of the first central banks in the world to enjoy this level of independence, and it is this combination of centralized power and effective independence — gradually developed over decades — that has caused many to say the Fed has essentially become a fourth branch of government.
The purpose of this brief history of the Fed is to show that the Federal Reserve has been a constantly evolving institution. As I see it, today we are in the middle of a fourth constitutional moment for the Federal Reserve, a moment in which the powers and operation of the institution could again expand dramatically and which has been the subject of too little public discussion or reflection. That moment is being driven by two central developments — and just as at the original founding of the Fed, the first of these deals with the nature of money, and the second with support for credit.
The first development is that we are witnessing a major revolution in digital technology, especially with regard to the nature of money. Cryptocurrency, stablecoins and decentralized finance are the mantras of the hour, and there are many who want the Federal Reserve to respond to them by taking the playing field itself and issuing its own digital currency to replace the greenbacks currently in our pockets. To many this can seem logical, incremental, even inevitable. It is instead quite radical, with potentially dramatic consequences for the expansion of the Fed’s footprint and the politicization of credit.
We can trace the eruption of activity in pursuit of central bank digital currencies (CBDC) to two concrete events in the summer of 2019. First, in June 2019, Facebook announced that it was developing a new stablecoin called Libra. A month later, the People’s Bank of China announced that it would rapidly develop and implement a state-sponsored digital currency. In response to these two revelations, the central banks and finance ministries of the world lost their minds. I spent that summer in international meetings of the G7 and the G20 in which more than one finance minister announced passionately that “only the state may issue money.” Bruno LeMaire, the French finance minister, was like Gandalf facing the Balrog, striking his staff against the ground and stating in majestic tones about Facebook, “You shall not pass.” In the U.S., there was a separate concern that a Chinese state-backed digital currency would be able to supplant the dollar as the global reserve currency. These two catalysts spurred a torrent of activity.
Not to put too fine a point on it, these are terrible reasons for the world’s central banks — and especially the Fed — to jump headlong into the highly complex world of digital currencies. To begin with, the notion that the issuance of money by a private company is a threat to national sovereignty is puzzling to the point of incoherence. Almost all retail money in the world’s advanced economies is already issued by private companies, namely by banks in the form of bank deposits. The only money you have that is issued by the Federal Reserve are the little pieces of paper in your pocket. All the other money you own is a claim on a private company, almost always a bank. So, the issuance of money by private companies through digital mechanisms like stablecoins is a new technology, but it is hardly a new concept. Governments of the world do have an interest in ensuring the stability of the structures through which such new private monies are issued, just as they have an interest in ensuring the stability of the institutions that issue bank deposits, but such regulation is perfectly possible to craft, and when properly regulated, stablecoins such as Facebook’s would pose no threat to national sovereignty or monetary policy.
Second, fears of China overtaking the United States as the provider of the principal global reserve currency simply because China has adopted a CBDC are, like many of the ideas that national security folks bring with them when they stray into the world of economics and finance, endearingly simple-minded. The strength of the U.S. dollar rests on many factors, including the strength and size of the U.S. economy, vast trade linkages throughout the world, deep financial markets, political stability, strong law and property rights, the ease of exchange and conversion, and the presence of a credible monetary policy. None of these factors is going to be threatened any time soon by a foreign currency, and certainly not because that foreign currency is in digital form. It would be like saying, “The Chinese have started printing the renminbi on purple paper and we’re still using green – we’ve got to catch up!”
Recently — recognizing that maybe these initial arguments were not so persuasive after 10 minutes thought — the proponents of a CBDC for the Fed have begun to settle on a new one: Over 90 different central banks around the world are currently evaluating or adopting digital currencies, and the U.S. will be required by circumstances to keep pace. Well, our oldest son is 23, and our youngest child, a daughter, is 18 and just started college. Doing the math, that means we are wrapping up just about a decade of raising teenagers — so I am familiar with the argument that “Everyone else is doing it, so I have to, too.” It’s just one I am used to hearing from children in inappropriate clothing, not from the world’s central banks.
OK, so maybe there are not good arguments for central bank digital currencies, but so what? It sounds kind of fun and future-y. They promised us jetpacks and flying cars and none of that happened — isn’t this the least they could do? What could it hurt?
The answer is, it could hurt a lot — and it would certainly result in a fundamental change in how our system operates. The most significant problem in my view would be the inevitable politicization of credit in our economy.
The creation of a CBDC will necessarily reduce at least some of the funds currently in the private banking sector. Many people are likely to hold at least some funds in the form of CBDC in an internet wallet that otherwise would have been in the form of bank deposits. Economists from the European Central Bank have estimated that this drainage could be between 12 percent and 20 percent of banking system deposits. Even with only a mild deposit drain, the credit market would be constrained unless those funds are put back into the system somehow: Either the central bank itself must make those loans directly that banks would otherwise have made supported by those deposits — and the politicians will certainly want a large say in how that allocation is done — or the central bank must find a way to return those funds to the private banks, and no political system known to man would allow those funds to go back without strings. People may be of different views as to whether greater government involvement in the allocation of credit is a good thing or a bad thing — I think it would be a nightmare — but my point is that it is not a thing that should happen without a broad national discussion of the implications, and instead it is proceeding almost in stealth, disguised as a discussion about whether we should have a cool new gadget.
But just as the original Federal Reserve was created to respond to two problems — the nature of money and the stability of credit — the Fed’s current constitutional moment similarly has two prongs. We have dealt with the nature of money. The second has to do with the Fed’s potential but hitherto very limited role in the provision of credit — a potential that was revealed during the Fed’s response to the financial pressures of the Covid-19 event in the spring of 2020.
The Covid-19 event caused an unprecedented — indeed, previously unimagined — administrative shutdown of economic activity in the United States and much of the world. The Federal Reserve responded by creating lending facilities to provide direct credit support to households, businesses and state and local governments under once obscure powers that had been granted to the Fed in the Great Depression, but almost never used. I supported these actions, and still do, as the right response when faced with the specific challenges we faced in the spring of 2020.
But I did at the time, and still do, have deep concerns about the possible precedents that have been created by the novel facilities that we designed. The Fed has always provided liquidity to the financial system in times of stress — that was the reason for its original creation. But providing credit directly to households and businesses and governments had been a red line that the Fed had long viewed as inviolable.
The danger is that support provided by the Fed does not require budget appropriation from the Congress, even though it is a real financial cost to the Treasury because the Fed reduces its remittances to the Treasury by the cost of providing such support. Now, the absence of Congressional appropriation is not a defect in a response to a true emergency — the ability to act quickly is one of the prime reasons Congress gave the Fed this power. But extended provision of credit to broad sections of the economy without either a required appropriation or effective limit could easily prove an impossible lure for future Congresses to resist, under the guise of one “emergency” or another. Having established the precedent that the Fed can lend to businesses and municipalities for the Covid-19 event, there will inevitably be those whose plans are grand and whose patience with democratic process low who will begin to ask why the Fed can’t fund repairs of the country’s aging infrastructure — surely Jackson, Mississippi, is an emergency — or finance the building of a border wall — surely our immigration crisis is an emergency — or purchase trillions of dollars of green energy bonds — surely the death of the planet is an emergency — or underwrite the colonization of Mars. An entity that can do that without any need for Congressional appropriations would be the financial equivalent of an “attractive nuisance,” which, as the lawyers among you know, is a dangerous instrumentality that a property owner allows to remain on his property, knowing that it will have an irresistible attraction to persons of impulsive and immature judgment, such as children and congressmen. It would encourage dangerous fiscal irresponsibility, and the annals of history are littered — from Sargon of Akaad forward — with the husks of empires that mistook vast wealth for limitless wealth, and vast power for the power to do anything they could conceive. People of goodwill may differ on what the answer to this question should be, but my concern is that the answer is being written already in the practices and precedents of the Fed, without the necessary public focus and debate.
Inflation and interest rates will continue to dominate the headlines for months to come, but the bigger questions about the Fed are yet to be addressed, and that has great, and possibly grave, implications for all of us.