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BANKING
BUNKUM
Part 3b: More on the US
experience
By Henry C K Liu
Part
1: Monetary theology
Part
2: The European experience
Part
3a: The US experience
Most central banks,
led by the US Federal Reserve (Fed), see their prime
objective as the maintenance of "sound financial
conditions", not economic growth, on the belief that the
former must be a precondition for the latter, a belief
not always validated by events.
It is sometimes
said that war's legitimate child is revolution and war's
bastard child is inflation. World War I was no
exception. The US national debt multiplied 27 times to
finance the nation's participation in that war, from
US$1 billion to $27 billion. Far from ruining the United
States, the war catapulted the country into the front
ranks of the world's leading economic and financial
powers. The national debt turned out to be a blessing,
for government securities are indispensable for a
vibrant credit market.
Inflation was a different
story. By the end of World War I, in 1919, US prices
were rising at the rate of 15 percent annually, but the
economy roared ahead. In response, the Federal Reserve
Board raised the discount rate in quick succession, from
4 to 7 percent, and kept it there for 18 months to try
to rein in inflation. The result was that in 1921, 506
banks failed. Deflation descended on the economy like a
perfect storm, with commodity prices falling 50 percent
from their 1920 peak, throwing farmers into mass
bankruptcies. Business activity fell by one-third;
manufacturing output fell by 42 percent; unemployment
rose fivefold to 11.9 percent, adding 4 million to the
jobless count. The economy came to a screeching halt.
From the Fed's perspective, declining prices were the
goal, not the problem; unemployment was necessary to
restore US industry to a sound footing, freeing it from
wage-pushed inflation. Potent medicine always came with
a bitter taste, the central bankers explained.
At this point, a technical process inadvertently
gave the New York Federal Reserve Bank, which was
closely allied with internationalist banking interest,
preeminent influence over the Federal Reserve Board in
Washington, the composition of which represented a more
balanced national interest. The initial operation of the
Fed did not use the open-market operation of purchasing
or selling government securities as a method of managing
the money supply. Money in the banking system was
created entirely through the discount window at the
regional Federal Reserve Banks. Instead of buying or
selling government bonds, the regional Feds accepted
"real bills" of trade, which when paid off would
extinguish money in the banking system, making the money
supply self-regulating in accordance with the "real
bills" doctrine. The regional Feds bought government
securities not to adjust money supply, but to enhance
their separate operating profit by parking idle funds in
interest-bearing yet super-safe government securities.
Bank economists at that time did not understand
that when the regional Feds independently bought
government securities, the aggregate effect would result
in macro-economic implications of injecting "high power"
money into the banking system, with which commercial
banks could create more money in multiple by lending
recycles. When the government sold bonds, the reverse
would happen. When the Fed made open market
transactions, interest rates would rise or fall
accordingly in financial markets. And when regional Feds
did not act in unison, the credit market could become
confused or become disaggregated, as one regional Fed
might buy while another might sell government securities
in its open market operations.
Benjamin Strong,
first president of the New York Federal Reserve Bank,
saw the problem and persuaded the other 11 regional Feds
to let the New York Fed handle all their transactions in
a coordinated manner. The regional Feds formed their own
Open Market Investment Committee for the purpose of
maximizing overall profit for the whole system. This
committee was dominated by the New York Fed, which was
closely linked to big-money center bank interests which
in turn were closely tied to international financial
markets. The Federal Reserve Board approved the
arrangement without full understanding of its full
implication: that the Fed was falling under the undue
influence of the New York internationalist bankers. This
fatal flaw would reveal itself in the Fed's role in
causing and its impotence in dealing with the 1929
crash.
The deep 1920-21 depression eventually
recovered into the Roaring Twenties, which, like the New
Economy bubble of the 1990s, left some segments of
economy and the population in them lingering in a
depressed state. Farmers remained victimized by
depressed commodity prices and factory workers shared in
the prosperity only by working longer hours and assuming
debt with the easy money that the banks provided. Unions
lost 30 percent of their membership because of high
unemployment. The prosperity was entirely fueled by the
wealth effect of a speculative boom in the stock market
that by the end of the decade would face the 1929 crash
and land the nation and the world in the Great
Depression. Historical data showed that when New York
Fed president Strong leaned on the regional Feds to ease
the discount rate on an already overheated economy in
1927, the Fed lost its last window of opportunity to
prevent the 1929 crash. Some historians claimed that
Strong did so to fulfill his internationalist vision at
the risk of endangering the national interest.
When money is not backed by gold, its exchange
value must be managed by government, more specifically
by the monetary policies of the central bank. Yet
central bankers tend to be attracted to the gold
standard because it can relieve them of the unpleasant
and thankless responsibility of unpopular monetary
policies to sustain the value of money. Central bankers
have been caricatured as party spoilers who take away
the punch bowl just when the party gets going.
Yet even a gold standard is based on a fixed
value of money to gold, set to reflect the underlying
economical conditions at the time of its setting.
Therein lies the inescapable need for human judgment.
Instead of focusing on the appropriateness of the level
of money valuation under changing economic conditions,
central banks often become fixated on merely maintaining
a previously set exchange rate between money and gold,
doing serious damage in the process to any economy out
of sync with that fixed rate. It seldom occurs to
central bankers that the fixed rate was the problem, not
the economy. When the exchange value of a currency
falls, central bankers often feel a personal sense of
failure, while they merely shrug their shoulders to
refer to natural laws of finance when the economy
collapses from an overvalued currency.
The
return to the gold standard in war-torn Europe in the
1920s was engineered by a coalition of internationalist
central bankers on both sides of the Atlantic as a
prerequisite for postwar economic reconstruction.
President Strong of the New York Fed and his former
partners at the House of Morgan were closely associated
with the Bank of England, the Banque de France, the
Reichsbank, and the central banks of Austria, the
Netherlands, Italy, and Belgium, as well as with leading
internationalist private bankers in those countries.
Montagu Norman, governor of the Bank of England from
1920-44, enjoyed a long and close personal friendship
with Strong as well as ideological alliance. Their joint
commitment to restore the gold standard in Europe and so
to bring about a return to the "international financial
normalcy" of the prewar years was well documented.
Norman recognized that the impairment of Britain's
financial hegemony meant that, to accomplish postwar
economic reconstruction that would preserve British
privilege, Europe would "need the active cooperation of
our friends in the United States".
Like other
New York bankers, Strong perceived World War I as an
opportunity to expand US participation in international
finance, allowing New York to move toward coveted
international-finance-center status to rival London's
historical preeminence, through the development of a
commercial paper market, or bankers' acceptances,
breaking London's long monopoly. The Federal Reserve Act
of 1913 permitted the Federal Reserve Banks to buy, or
rediscount, such paper. This allowed US banks in New
York to play an increasingly central role in
international finance in competition with the London
market.
Herbert Hoover, after losing his
second-term US presidential election to Franklin D
Roosevelt as a result of the 1929 crash, criticized
Strong as "a mental annex to Europe", and blamed
Strong's internationalist commitment to facilitating
Europe's postwar economic recovery for the US
stock-market crash of 1929 and the subsequent Great
Depression that robbed Hoover of a second term. Europe's
return to the gold standard, with Britain's insistence
on what Hoover termed a "fictitious rate" of US$4.86 to
the pound sterling, required Strong to expand US credit
by keeping the discount rate unrealistically low and to
manipulate the Fed's open market operations to keep US
interest rate low to ease market pressures on the
overvalued pound sterling. Hoover, with justification,
ascribed Strong's internationalist policies to what he
viewed as the malign persuasions of Norman and other
European central bankers, especially Hjalmar Schacht of
the Reichsbank and Charles Rist of the Bank of France.
From the mid-1920s onward, the US experienced
credit-pushed inflation, which fueled the stock-market
bubble that finally collapsed in 1929.
Within
the Federal Reserve System, Strong's low-rate policies
of the mid-1920s also provoked substantial regional
opposition, particularly from Midwestern and
agricultural elements, who generally endorsed Hoover's
subsequent critical analysis. Throughout the 1920s, two
of the Federal Reserve Board's directors, Adolph C
Miller, a professional economist, and Charles S Hamlin,
perennially disapproved of the degree to which they
believed Strong subordinated domestic to international
considerations.
The fairness of Hoover's
allegation is subject to debate, but the fact that there
was a divergence of priority between the White House and
the Fed is beyond dispute, as is the fact that what is
good for the international financial system may not
always be good for a national economy. This is evidenced
today by the collapse of one economy after another under
the current international finance architecture that all
central banks support instinctively out of a sense of
institutional solidarity.
The issue of
government control over foreign loans also brought the
Fed, dominated by Strong, into direct conflict with
Hoover when the latter was secretary of commerce. Hoover
believed that the US government should have right of
approval on foreign loans based on national-interest
considerations and that the proceeds of US loans should
be spent on US goods and services. Strong opposed all
such restrictions as undesirable government intervention
in free trade and international finance.
In July
and August 1927, Strong, despite ominous data on
mounting market speculation and inflation, pushed the
Fed to lower the discount rate from 4 to 3 percent to
relieve market pressures again on the overvalued British
pound. In July 1927, the central bankers of Great
Britain, the United States, France, and Weimar Germany
met on Long Island in the US to discuss means of
increasing Britain's gold reserves and stabilizing the
European currency situation. Strong's reduction of the
discount rate and purchase of 12 million pound sterling,
for which he paid the Bank of England in gold, appeared
to come directly from that meeting. One of the French
bankers in attendance, Charles Rist, reported that
Strong said that US authorities would reduce the
discount rate as "un petit coup de whisky for the
stock exchange". Strong pushed this reduction through
the Fed despite strong opposition from Miller and fellow
board member James McDougal of the Chicago Fed, who
represented Midwestern bankers, who generally did not
share New York's internationalist preoccupation.
Frank Altschul, partner in the New York branch
of the transnational investment bank Lazard Freres, told
Emile Moreau, the governor of the Bank of France, that
"the reasons given by Mr Strong as justification for the
reduction in the discount rate are being taken seriously
by no one, and that everyone in the United States is
convinced that Mr Strong wanted to aid Mr Norman by
supporting the pound". Other correspondence in Strong's
own files suggests that he was giving priority to
international monetary conditions rather than to US
export needs, contrary to his public arguments. Writing
to Norman, who praised his handling of the affair as
"masterly", Strong described the US discount rate
reduction as "our year's contribution to
reconstruction". The Fed's ease in 1927 forced money to
flow not into the overheated real economy, which was
unable to absorb further investment, but into the
speculative financial market, which led to the crash of
1929. Strong died in October 1928, one year before the
crash, and was spared the pain of having to see the
devastating results of his internationalist policies.
Scholarly debate still continues as to whether
Strong's effort to facilitate European economic
reconstruction compromised the US domestic economy and,
in particular, led him to subordinate US monetary
policies to internationalist demands. There is, however,
little disagreement that the overall monetary strategy
of European central banks had been misguided in its
reliance on the restoration of the gold standard.
Critics suggest that the deep commitment of Strong,
Norman, and other international bankers to returning the
pound, the mark, and other major European currencies to
the gold standard at overly high parities, which they
were then forced to maintain at all costs, including
indifference to deflation, had the effect of
undercutting Europe's postwar economic recovery. Not
only did Strong and his fellow central bankers through
their monetary policies contribute to the Great
Depression, but their continuing fixation to gold also
acted as a straitjacket that in effect precluded
expansionist counter-cyclical measures.
The
inflexibility of the gold standard and the central
bankers' determination to defend their national
currencies' convertibility into gold at almost any cost
drastically limited the options available to them when
responding to the global crisis. This picture fits the
situation of the fixed-exchange-rates regime that
produced recurring financial crises in the 1990s and
that has yet to run its full course. In 1927, Strong's
unconditional support of the gold standard, which
emphasized the financial predominance of the United
States, with the largest holdings of gold in the world,
exacerbated nascent international economic problems. In
similar ways, dollar hegemony does the same damage to
the global economy today. Just as the international gold
standard itself was one of the major factors underlying
and exacerbating the Great Depression that followed the
1929 crash, since the conditions that had sustained it
before the war no longer existed, the
fixed-exchange-rates system set up by the Bretton Woods
regime after World War II will cause a total collapse of
the current international financial architecture with
equally tragic outcomes.
The nature of and
constraints on US internationalism after World War I had
parallels in US internationalism after World War II and
in US globalization after the Cold War. Hoover bitterly
charged Strong with reckless placement of the interests
of the international financial system ahead of US
national interest and domestic concerns. Strong
sincerely believed his support for European currency
stabilization also promoted the best interests of the
United States, as post-Cold War neo-liberal market
fundamentalists sincerely believe its promotion enhances
the US national interest. Unfortunately, sincerity is
not a vaccine against falsehood.
Strong argued
repeatedly that volatile exchange rates, especially when
the dollar was at a premium against other currencies,
made it difficult for US exporters to price their goods
competitively. As he had done during the war, on
numerous later occasions, Strong also stressed the need
to prevent an influx of gold into the United States and
consequent domestic inflation, by the US making loans to
Europe, pursuing lenient debt policies, and accepting
European imports on generous terms. Strong never
questioned the parities set for the mark and the pound
sterling. He merely accepted that returning the pound to
gold at prewar exchange rates required British deflation
and US efforts to use lower US interest rates to
alleviate market pressures on sterling. Like Fed
chairman Paul Volcker in the 1980s, but unlike Treasury
secretary Robert Rubin in the 1990s, Strong mistook a
cheap dollar as serving the national interest, while
Rubin understood correctly that a strong dollar is in
the national interest.
When Norman sent him a
copy of John Maynard Keynes' Tract on Monetary
Reform, Strong commented "that some of his [Keynes']
conclusions are thoroughly unwarranted and show a great
lack of knowledge of American affairs and of the Federal
Reserve System". Within a decade, Keynes became the most
influential economist in modern history.
The
major flaw in the European effort for post-World War I
economic reconstruction was its attempt to reconstruct
the past through its attachment to the gold standard,
with little vision of a new future. The democratic
governments of the moneyed class that inherited power
from the fall of monarchies did not fully comprehend the
implication of the disappearance of the monarch as a
ruler, whose financial architecture they tried to
continue for the benefit of their bourgeois class. The
broadening of the political franchise in most European
countries after the war had made it far more difficult
for governments and central bankers to resist electoral
pressures for increased social spending and the demand
for ample liquidity with low interest rates, as well as
high tolerance for moderate inflation, regardless of
their impact on the international financial
architecture. The Fed, despite its claim of independence
from politics, has never been free of US
presidential-election politics since its founding.
Shortly before his untimely death, Strong took comfort
in his belief that the reconstruction of Europe was
virtually completed and his internationalist policies
had been successful in preserving world peace. Within a
decade of his death, the whole world was aflame with
World War II.
Central bankers around the world
nowadays may not know about Marriner S Eccles, the
president of tiny First National Bank of Ogden, Utah,
who became nationally famous through his successful
effort to save his bank from collapse in the late summer
of 1931. Eccles defused the panic of depositors outside
of his bank by announcing that his bank would stay open
until all depositors were paid. He also instructed his
tellers to count every small bill and check every
signature to slow the prospect of his bank running out
of cash. A mostly empty armored car carrying all First
National's puny reserves from the Federal Reserve Bank
in Salt Lake City arrived conspicuously while Eccles
announced that there was plenty of money left where it
came from, which was true except for the fact that none
of it belonged to First National. The crowd's confidence
in First National was re-established and Eccles' bank
survived on a misleading statement that would have been
considered criminally fraudulent in a vigorous
investigation.
Eccles was a quintessential
frontier entrepreneur of the US West and politically a
Western Republican. Beginning with timber and sawmill
operations, his family's initial capital came in the
form of labor and raw material. He learned from his
father, an illiterate who immigrated from Scotland in
1860, that the way to remain free was to avoid becoming
indebted to the Northeastern banks, which were in turn
much indebted to British capital. Among Eccles' assets
of railroads, mines, construction companies and farm
businesses was a chain of local banks in the West.
Immersed in an atmosphere of US populism that was
critical of unregulated capitalism and Northeastern
"money trusts", Eccles viewed himself as an ethical
capitalist who succeeded through his hard works and
wits, free of oppression from big business trusts and
government interference. A Mormon polygamist, the elder
Eccles had two wives and 21 children, which provided him
with considerable human capital in the labor-short West.
The young Eccles, at age 22 and with only a high-school
education, had to assume the responsibilities of his
father when the latter died suddenly. The Eccles
construction company built the gigantic Boulder Dam,
begun in 1931 and completed in 1936, renamed from Hoover
Dam in the midst of the Depression and re-renamed Hoover
Dam in 1941.
The market collapse of 1929 caught
the inner-directed Eccles in a state of bewilderment and
despair. Through eclectic reading based on common sense,
he came to a startling awareness: that despite his
father's conservative Scottish teachings on the
importance of saving, individuals and companies and even
banks, ever optimistic in their own future, tended to
contribute to aggregate supply expansion to end up with
overcapacity through excessive savings for investment.
It was obvious to Eccles that the problem of the 1930s
was that too much money had been channeled into savings
and too little into spending. This new awareness, like
Saint Paul's vision on the way to Damascus, led Eccles
to a radical conclusion that contradicted all that his
conservative father had taught him.
From direct
experience, Eccles realized that bankers like himself,
by doing what seemed sound on an individual basis, by
calling in loans and refusing new lending, only
contributed to the financial crisis. He saw from direct
experience the evidence of market failure. He concluded
that to get out of the depression, government
intervention, something he had been taught was evil, was
necessary to place purchasing power in the hands of the
public which, together with the economy and the
financial system, was in dire need of it. In the
industrial age, the maldistribution (excessively
unequal) of income and the excessive savings for capital
investment always lead to the masses exhausting their
purchasing power, unable to sustain the benefits of mass
production that such savings brought.
Mass
consumption is required by mass production. But mass
consumption requires a fair distribution of new wealth
as it is currently produced (not accumulated wealth) to
provide mass purchasing power. By denying the masses
necessary purchasing power, capital denies itself of the
very demand that would justify its investment in new
production. Credit can extend purchasing power but only
until the credit runs out, which would soon occur
without the support of adequate income.
Eccles'
epiphany was his realization that Calvinist thrifty
individualism does not work in a modern industrial
economy. Eccles rejected the view of his fellow bankers
that depressions are natural phenomena and that in the
long run the destruction they wreak are healthy and that
government intervention only postpones the needed
elimination of the weak and unfit, thereby in the long
run weakening the whole system through the support for
the survival of the unfit. Eccles pragmatically saw that
money is not neutral, and it has an economic function
independent of ownership. Money serves a social purpose
if it circulates through transactions and investments,
and is socially harmful if it is hoarded in idle
savings, no matter who owns it. Liquidity is the only
measure of the usefulness of money. The penchant for
capital preservation on the part of those who have
surplus money has a natural tendency to reduce liquidity
in times of deflation and economic slowdown.
The
solution is to start the money flowing again by
directing the money not toward those who already have a
surplus of it in relation to their consumptive needs,
but to those who have not enough. Giving more money to
those who already have too much would take more money
out of circulation into idle savings and prolong the
depression. The solution is to give money to the most
needy, who will spend it immediately. The only
institution that can do this transfer of money for the
good of the system is the federal government, which can
issue or borrow money backed by the full faith and
credit of the nation, and put it in the hands of the
masses, who would spend it immediately, thus creating
needed demand. Transfer of money through employment is
not the same of transfer of wealth. Deficit financing of
fiscal expenditure is the only way to inject money and
improve liquidity in a stalled economy. Thus Eccles
promoted a limited war on poverty and unemployment, not
on moral but on utilitarian grounds.
Now, the
interesting thing is that Eccles, who never attended
university nor studied economics formally, articulated
his pragmatic conclusions in speeches a good three years
before Keynes wrote his epoch-making The General
Theory of Employment, Interest, and Money (1936).
John Galbraith in his Money: Whence It Came, Where It
Went (1975) explained: "The effect of The General
Theory was to legitimize ideas that were in
circulation." With scientific logic and precision,
Keynes made crackpot ideas like those promoted by Eccles
respectable in learned circles, even though Keynes
himself was considered a crackpot by New York Fed
president Benjamin Strong as late as 1927.
In
one single testimony in 1933, Eccles in his
salt-of-the-earth manner convinced an eager US Congress
of his new economic principle and outlined a specific
agenda for how the federal government could save the
economy by spending more money on unemployment relief,
public works, agricultural allotment, farm-mortgage
refinancing, settlement of foreign war debts, etc.
Eccles also proposed structural systemic reform for
achieving long-term stability: federal insurance for
bank deposits, minimum wage standards, compulsory
retirement pension schemes, in fact, the core program
that came to be known as the New Deal. Eccles also
helped launched the era of liberal credits, through
government guarantee mortgages and interest subsidies,
making middle-class and low-income home ownership a
reality. It was not a plan to do away with capitalism as
much as it was to save capitalism from itself.
Eccles also rescued the Federal Reserve System
from institutional disgrace. For this, the Fed building
in Washington has since been named after him. The
evolution of political economy models in the early
1930s, a crucial period of change in the supervision and
regulation of the financial sector, can be clearly seen
in the opposing policies of the Hoover and Roosevelt
administrations. It resulted in a change of focus in the
Federal Reserve Board from orthodox sound money
initiatives to a heterodox Keynesian outlook, and the
push toward centralizing the monetary powers of the
Federal Reserve System at the Board, away from the
regional Federal Reserve Banks.
With support
from Roosevelt, despite bitter opposition from big money
center banks, Eccles personally designed the legislation
that reformed the Federal Reserve System, the central
bank of the United States founded by Congress in 1913
(Glass-Owen Federal Reserve Act), to provide the nation
with a safer, more flexible, and more stable monetary
and financial/banking system. An important founding
objective of the original Federal Reserve System had
been to fight inflation by controlling the money supply
through setting the short-term interest rate, known as
the Fed Funds Rate (FFR), and bank reserve ratios. By
1915, the Fed had regulatory control over half of the
nation's banking capital and by 1928 about 80 percent.
The Banking Act of 1935 designed by Eccles modified the
Federal Reserve Act by stripping the 12 district Federal
Reserve Banks of their autonomous privileges and veto
powers and concentrated monetary policy power in the
seven-member Board of Governors in Washington. Eccles
served as chairman for 14 years while he continued to
function as an inner-circle policy maker in the White
House. The Fed under Eccles had no pretension of
political independence. Galbraith described the Fed
under Eccles as "the center of Keynesian evangelism in
Washington".
The term "monetary policy" as used
by the Fed nowadays refers to the actions undertaken by
a central bank to influence the availability and cost of
money and credit to help promote national economic
goals. The Federal Reserve Act of 1913 gave the Federal
Reserve responsibility for setting monetary policy.
The Federal Reserve controls the three tools of
monetary policy: open market operations, the discount
rate, and bank reserve requirements. The Board of
Governors of the Federal Reserve System is responsible
for the discount rate and bank reserve requirements, and
the Federal Open Market Committee (FOMC) is responsible
for open market operations, with transactions handled by
the New York Fed.
Bank reserve requirements are
the amount of funds that a depository institution must
hold in reserve against specified deposit liabilities.
Within limits specified by law, the Board of Governors
has sole authority over changes in reserve requirements.
Depository institutions must hold reserves in the form
of vault cash or deposits with Federal Reserve Banks.
The dollar amount of a depository institution's reserve
requirement is determined by applying the reserve ratios
specified in the Federal Reserve Board's Regulation D to
an institution's reservable liabilities. Reservable
liabilities consist of net transaction accounts,
non-personal time deposits, and eurocurrency
liabilities. Since 1992, non-personal time deposits and
eurocurrency liabilities have had a reserve ratio of
zero. The reserve ratio on net transaction accounts
depends on the amount of net transaction accounts at the
depository institution. The Garn-St Germain Act of 1982
exempted the first $2 million of reservable liabilities
from reserve requirements. This "exemption amount" is
adjusted each year according to a formula specified by
the act. The amount of net transaction accounts subject
to a reserve requirement ratio of 3 percent was set
under the Monetary Control Act of 1980 at $25 million.
This "low reserve tranche" is also adjusted each year.
Net transaction accounts in excess of the low reserve
tranche are currently reservable at 10 percent.
Using these three tools, the Federal Reserve
influences the demand for, and supply of, balances that
depository institutions hold at Federal Reserve Banks
and in this way alters the FFR. The FFR is the interest
rate at which depository institutions lend balances at
the Federal Reserve to other depository institutions
overnight. Changes in the FFR trigger a chain of market
events that affect other short-term interest rates,
foreign-exchange rates, long-term interest rates, the
amount of money and credit, and, ultimately, a range of
economic variables, including employment, output, and
prices of goods and services.
The FOMC consists
of 12 members, comprising the seven members of the Board
of Governors of the Federal Reserve System; the
president of the Federal Reserve Bank of New York; and
four of the remaining 11 Reserve Bank presidents, who
serve one-year terms on a rotating basis. The rotating
seats are filled from the following four groups of
Banks, one Bank president from each group: Boston,
Philadelphia, and Richmond; Cleveland and Chicago;
Atlanta, St Louis, and Dallas; and Minneapolis, Kansas
City, and San Francisco. Non-voting Reserve Bank
presidents attend the meetings of the committee,
participate in the discussions, and contribute to the
committee's assessment of the economy and policy
options.
The FOMC holds eight regularly
scheduled meetings per year. At these meetings, the
committee reviews economic and financial conditions,
determines the appropriate stance of monetary policy,
and assesses the risks to the economic outlook, based on
forecasts prepared by the Fed staff that are kept secret
for five years. The committee's policy decisions are
undertaken to foster the long-run objectives of price
stability and sustainable economic growth, the
definitions of which are constantly affected by the
latest theories of monetary economics.
To this
day, using the tools of monetary policy, the Fed affects
the volume of money and credit and their price -
interest rates. In this way, it influences employment,
output, and the general level of prices. Commercial
banks, despite their initial opposition to the National
Banking Act of 1863, enacted during the Civil War, have
benefited from double-layer protection: the Federal
Deposit Insurance Corp (FDIC) and Fed discount lending.
Non-interest-bearing checking accounts were another
subsidy for the commercial banks prescribed by law at
the expense of depositors. The Glass-Steagall Act of
1933, which was finally repealed in 1999 after almost
seven decades, separated investment banking from
commercial banking and forbade banks from participating
in a whole range of other financial services. The repeal
of Glass-Steagall has been identified as a key factor
behind current bank scandals of conflicts of interest
and their unsavory role in widespread corporate fraud.
The Federal Reserve Act of 1913 defines the
goals of monetary policy. It specifies that, in
conducting monetary policy, the Fed and its FOMC should
seek "to promote effectively the goals of maximum
employment, stable prices, and moderate long-term
interest rates". In the past three decades, with the
ascendency of monetarism, the central bank has
increasingly focused primarily on achieving price
stability by an interest-rate policy that allows
unemployment to fluctuate. A sound money bias is now
justified by the claim that a stable level of prices is
the condition most conducive to maximum sustainable
output and employment and to moderate long-term interest
rates; in such circumstances, the prices of goods,
materials, and services are undistorted by inflation and
thus can serve as clearer signals and guides for the
efficient allocation of resources. This is despite the
fact that the boom-and-bust business cycle continues to
plaque the economy. Also, a background of stable prices
is thought to encourage saving and, indirectly, capital
formation because it prevents the erosion of asset
values by unanticipated inflation. This view of
neglect-on-demand management has led to the precarious
situation of overcapacity and speculative bubble we are
facing today.
The concept of a natural rate of
unemployment is a key contribution by monetarism to
modern macroeconomics. Its use originated with Milton
Friedman's 1968 Presidential Address to the American
Economic Association in which he argued that there is no
long-run tradeoff between inflation and unemployment: as
the economy adjusts to any average rate of inflation,
unemployment returns to its "natural" rate. Higher
inflation brings no benefit in terms of lower average
unemployment, nor does lower inflation involve any cost
in terms of higher average unemployment. Instead, the
microeconomic structure of labor markets and household
and firm decisions affecting labor supply and demand
determine the natural rate of unemployment. If monetary
policy cannot affect the natural rate, then its
appropriate role is to control inflation and, in the
short run, help stabilize the economy around the natural
rate. Doing so would be consistent with maintaining low
and stable inflation.
A second important
unemployment rate generally accepted by monetarist
economists is the "Non-Accelerating Inflation Rate of
Unemployment", or NAIRU. This is the unemployment rate
consistent with maintaining stable inflation. According
to standard neo-classical orthodox macroeconomic theory
enshrined in most undergraduate textbooks of economics,
inflation will tend to rise if the unemployment rate
falls below the natural rate. Conversely, when the
unemployment rate rises above the natural rate,
inflation tends to fall. Thus, the natural rate and the
NAIRU are often viewed as two names for the same
economic phenomenon, providing an important benchmark
for gauging the state of the business cycle, the outlook
for future inflation, and the appropriate stance of
monetary policy, identifying full employment and
inflation are partners in economic crime, based on the
assumption that the value of humans is inversely
proportional to the value of money. In other words,
money exists not to serve the welfare of people, but
rather, people must be sacrificed to serve the stability
of money. This explains why Paul Volcker, the US central
banker widely credited with ending inflation in the
early 1980s by administering wholesale financial
bloodletting on the US economy, quipped lightheartedly
that "central bankers are brought up pulling legs off of
ants".
While the two terms are often viewed as
synonymous, the natural rate is the unemployment rate
that would be observed once short-run cyclical factors
have played themselves out. Because wages and prices
adjust sluggishly for social or legal reasons, the
natural rate can be viewed as the unemployment rate when
wages have had time to adjust to balance labor demand
and supply. The NAIRU is the unemployment rate
consistent with steady inflation in the near term, say,
over the next 12 months.
The average long-run
unemployment rate measured in the United States since
1961 is 6.09 percent, and during the 1980s and early
1990s, most economists placed the natural rate quite
near that, in the 6-6.5 percent range. NAIRU has been
subject to much criticism, yet it continues to appear in
policy discussions. NAIRU or the natural rate of
unemployment would be less obscene if the unemployment
were not concentrated on the same group of people. But
structural unemployment tends to create a permanent
unemployed class, institutionalizing social injustice as
a structural aspect of the economy.
The central
bank, by adopting the natural rate of unemployment or
NAIRU as a component of monetary policy, is condemning 6
percent of the labor force to perpetual involuntary
unemployment. It seems self-evident that the population
has a natural right not to be forced to be part of this
6 percent of unfortunate souls in the workforce. A
natural rate of unemployment flies in the face of US
political culture. The "inalienable rights" of
all people (not some people) to life,
liberty and the pursuit of happiness is a concept not
compatible with chronic involuntary unemployment caused
by government policy, aimed at protecting the value of
money at the expense of a particular segment of the
working class. One is reminded of the Declaration of
Indepence: "... to secure these rights, governments [of
which the privately owned central bank claims to be
part] are instituted among men, deriving their just
powers from the consent of the governed, that whenever
any form of government becomes destructive of these
ends, it is the right of the people to alter or to
abolish it ..."
No worker has given any central
bank his or her consent to be involuntarily unemployed
so that the value of money can be preserved. The right
to gainful employment in an industrial society where
employment opportunities are systemically determined
comes from this simple and direct relationship between
the governed and the government. It is as sacrosanct as
the right to vote. Governments that cannot guarantee
full employment simply cannot legitimately claim the
right to govern.
Full employment being defined
as a level with 4 percent structural unemployment is an
official policy of the Fed, as defined by the Full
Employment and Balanced Growth Act of 1978, known as the
Humphrey-Hawkins Act. The act introduces the term "full
employment" as a policy goal, although the content of
the bill had been watered down before passage by
snake-oil economics to consider 4 percent unemployment
as structural; and now full employment is defined as at
or above that level, currently around 6 percent. Any
level near or below that is deemed economically
inconsistent, due to its impact on inflation (causing
wages to rise! - a big no-no), thus only increasing
unemployment down the road. Tragically, aside from being
morally offensive, this definition of full employment is
not even good economics. It distorts real deflation as
nominal low inflation and widens the gap between nominal
interest rate and real interest rate, allowing demand
constantly to fall behind supply.
Humphrey-Hawkins has been described as the last
legislative gasp of Keynesianism's doomed effort by
liberal senator Hubert Humphrey to refocus on an
official policy against unemployment. Alas, most of the
progressive content of the law had been thoroughly
vacated before passage. The one substantive reform
provision: requiring the Fed to make public its annual
target range for growth in the three monetary
aggregates: the three Ms, namely M1 = currency in
circulation, commercial bank demand deposits, NOW
(negotiable order of withdrawal) and ATS (auto transfer
from savings), credit-union share drafts,
mutual-savings-bank demand deposits, non-bank traveler's
checks; M2 = M1 plus overnight repurchase agreements
issued by commercial banks, overnight eurodollars,
savings accounts, time deposits under $100,000, money
market mutual shares; M3 = M2 plus time deposits over
$100,000, term repo agreements.
In 2000, when
the Humphrey-Hawkins legislation requiring the Fed to
set target ranges for money-supply growth expired, the
Fed announced that it was no longer setting such
targets, because money-supply growth does not provide a
useful benchmark for the conduct of monetary policy.
However, the Fed said too that "the FOMC believes that
the behavior of money and credit will continue to have
value for gauging economic and financial conditions.
Moreover, M2, adjusted for changes in the price level,
remains a component of the Index of Leading Indicators,
which some market analysts use to forecast economic
recessions and recoveries."
The Fed chairman is
required to testify before both the House and the Senate
to explain these goals and any deviant from the targets.
Thus monetarism has now gained center stage, through the
televised hearing on current chairman Alan Greenspan's
testimony, riding on the legislative carcass of fading
Keynesianism. Twice a year, the nation, and indeed the
world, holds its breath waiting for the cryptic
deliberations of Greenspan on his views on where the
economy had been going and why and where he wants it to
go. This ritual of esoteric transparence is neutralized
by the cat-and-mouse game that the FOMC does with the
market with its closely guarded secret on its FFR target
until 2:12 pm on the day of its meeting. And its staff
forecast on the economy on which the FFR target is
derived is kept secret for a period of five years. It is
a strange way to shoot for market stability, by
institutionalizing policy surprises and keeping forecast
analysis secret.
The US economy now sits on top
of the pyramid of a globalized economy wielding the
fearsome sword of dollar hegemony, sucking wealth from
the rest of the world. Economic policy in the United
States exerts a major influence on production,
employment, and prices worldwide in what Greenspan calls
US finance hegemony. The dollar, a fiat currency of the
world's most heavily indebted nation that is most used
in international transactions, constitutes more than
half of other countries' official foreign-exchange
reserves. A handful of US banks abroad and foreign banks
in the United States monopolize a globalized
international financial market. The policies and
activities of the Fed control the globalized
international economy. Thus, in deciding on the
appropriate monetary policy for achieving basic economic
goals, the Fed Board of Governors and the FOMC consider
the record of US international transactions, movements
in foreign-exchange rates, and other international
economic developments, including war and economic
sanctions, which are really economic warfare. And in the
area of bank supervision and regulation, innovations in
international banking require continual assessments of
and modifications in the Fed's orientation, procedures,
and regulations. The development of structured finance
and the Fed's reluctance to regulate needed disclosure
and management of risk associated with derivatives
trading, particularly over-the-counter (OTC)
derivatives, which are traded off exchanges directly
between counterparties, has made transparency an
illusion. Not only is the economy distorted by a debt
bubble, it is also distorted by an invisible bubble.
Not only do Fed policies shape and get shaped by
international developments, the US central bank also
participates directly in international markets, being
both market regulator and market participant, with
inevitable conflict of interest. The Fed undertakes
foreign-exchange transactions in cooperation with the US
Treasury, compromising its "independence" in deference
to national-security concerns. These transactions, and
similar ones by foreign central banks involving dollars,
may be facilitated by reciprocal currency (swap)
arrangements that have been established between the Fed
and the central banks of other countries.
US
monetary policy actions influence exchange rates
directly. Thus, the dollar's foreign-exchange value is
one of the channels through which US monetary policy
affects the US economy. In theory, when Fed actions
raise US interest rates, the foreign-exchange value of
the dollar should rise. An increase in the
foreign-exchange value of the dollar, in turn, would
raise the foreign price of US export goods traded on
world markets and lower the price of goods imported into
the US. These developments could lower output and price
levels in the US economy. This may lead to a US trade
deficit. But low-price imports would help reduce US
inflation, allowing the Fed to lower interest rates. If
the low-cost import is used as part of a US product, it
may lower the export price of that US-made product,
neutralizing the adverse impact of a strong dollar.
An increase in interest rates in a foreign
country, in contrast, could raise worldwide demand for
assets denominated in that country's currency and
thereby reduce the dollar's value in terms of that
currency. US output and price levels would tend to
increase in directions just opposite of when US interest
rates rise. But high US interest rates attract
investment into US financial assets, producing a capital
account surplus.
Therefore, in formulating
monetary policy, the Board of Governors and the FOMC
draw upon information about and analysis of
international as well as US domestic influences. Changes
in public policies or in economic conditions abroad and
movements in international variables that affect the US
economy, such as exchange rates, must be evaluated in
assessing the stance of US monetary policy. The Fed also
works with other agencies of the US government to
conduct international financial policy, participates in
various international organizations and forums, and is
in almost continuous contact with other central banks on
subjects of mutual concern, all to maintain what
Greenspan proudly calls US financial hegemony. In other
words, the free market is a mere figment of the
conservatives' imagination and a propaganda slogan of
neo-liberals. Central banking is the biggest private
financial monopoly with governmental power in the world
economy.
In the 1980s, recognizing their growing
economic interdependence, the United States and the
other major industrial countries intensified their
efforts to consult and cooperate on macroeconomic
policies. The Plaza Accord in 1985 forced Japan to raise
the value the yen to reduce its trade surplus with the
US. At the 1986 Tokyo Economic Summit, formal procedures
to improve the coordination of policies and multilateral
surveillance of economic performance were agreed upon
among the Group of Seven (G7) industrialized nations.
The Fed works with the US Treasury in coordinating
international policy, particularly when, as has been the
norm since the late 1970s, they intervene together in
currency markets to influence the external value of the
dollar.
Using the forum provided by the Bank for
International Settlements (BIS) in Basel, Switzerland,
the Fed works with representatives of the central banks
of other countries on mutual concerns regarding monetary
policy, international financial markets, banking
supervision and regulation, and payments systems. (The
chairman of the Board of Governors also represents the
US central bank on the Board of Directors of the BIS.)
Representatives of the Federal Reserve participate in
the activities of the International Monetary Fund (IMF),
on which the US has a controlling vote, discuss
macroeconomic, financial-market, and structural issues
with representatives of other industrial countries at
the Organization for Economic Cooperation and
Development (OECD) in Paris, and work with central-bank
officials of Western Hemisphere countries at meetings
such as that of the Governors of Central Banks of the
American Continent. The dubious policies of the IMF
around the world as an international lender of last
resort to the world's troubled central banks in deep
financial crisis have been essentially dictated by the
United States.
The Fed has conducted
foreign-currency operations, the buying and selling of
dollars in exchange for foreign currency, for customers
since the 1950s and for its own account since 1962.
These operations are directed by the FOMC, acting in
close cooperation with the US Treasury, which has
overall responsibility for US international financial
policy. The manager of the System Open Market Account at
the Federal Reserve Bank of New York acts as the agent
for both the FOMC and the Treasury in carrying out
foreign-currency operations.
The purpose of
Federal Reserve foreign-currency operations has evolved
in response to changes in the international monetary
system. The most important of these changes was the
transition in the 1970s from the Bretton Woods system of
fixed exchange rates to a system of flexible exchange
rates for the dollar in terms of other countries'
currencies. Under the latter system, while the main aim
of Fed foreign-currency operations has been to counter
disorderly conditions in exchange markets through the
purchase or sale of foreign currencies (called
intervention operations), primarily in the New York
market, the net effect has often been high market
volatility. During some episodes of downward pressure on
the foreign-exchange value of the dollar, the Fed has
purchased dollars (sold foreign currency) and has
thereby absorbed some of the selling pressure on the
dollar. Similarly, the Fed may sell dollars (purchase
foreign currency) to counter upward pressure on the
dollar's foreign-exchange value. The Federal Reserve
Bank of New York also carries out transactions in the US
foreign-exchange market as an agent for foreign monetary
authorities.
Intervention operations involving
dollars could affect the supply of reserves in the US
depository system. A purchase of foreign currency by the
Fed with newly created dollars, for instance, would
increase the supply of reserves. In practice, however,
such operations are not allowed to alter the supply of
monetary reserves available to US depository
institutions. That is, interventions are "sterilized"
through open market operations so that they do not lead
to a change in the market for domestic monetary reserves
different from that which would have occurred in the
absence of intervention.
The New Deal did not
become fully Keynesian until after the 1937 recession,
which most economists have since laid blame on Eccles'
Fed policy of doubling the reserve requirement for
commercial banks from 12.5 percent to 25 percent at the
same time as the executive branch was tightening its
fiscal policy. Gaining confidence from the recovery of
1935, Eccles permitted the Fed's institutional penchant
to be activist in monetary policy. It was an error late
in his career that would tarnish his earlier reputation
as a New Dealer. The 1937 recession would re-establish
monetary-policy passivity for the Fed for decades to
come, until the chairmanship of Paul Volcker and now of
Alan Greenspan. The focus on interest rates instead of
stable money supply to stimulate aggregate demand became
the Fed's operational mode for decades after.
The liberal economists of the Kennedy "New
Economics" of the 1960s were in tune with the political
wind of their time, that fiscal-policy-engineered
government deficits were considered therapeutic to a
slowing economy. Expansionist budgetary shortfalls can
be compensated by increased economic activities that
enlarge the revenue base. The pie gets bigger faster
than the shrinking slice of tax take. At its peak, the
New Economics managed to bring unemployment down to 3.5
percent, from 7 percent when president John F Kennedy
took office, and sustained an uninterrupted economic
expansion for 106 consecutive months.
However,
this focus by the Fed on interest rates and credit
conditions to accommodate the fiscal policies of the New
Economics of Kennedy, instead of a focus on stable value
of money and gradually expanding money supply, was
attacked by Milton Friedman and his monetarist
colleagues of the Chicago School. Besides attacking
Keynesian fiscal policies as producing only ephemeral
results, Friedman asserted that the only effective
government influence over the private sector of the
economy was its control of money. The Fed's short-term
manipulation of the money supply was criticized as
consistently destabilizing and damaging. Yet not until
mid-1960s was Friedman taken seriously, when president
Lyndon Johnson's Vietnam War spending was sinking the
New Economics. The unraveling of the New Economics that
began in 1968 was caused by the political system's
unwillingness to follow Keynesian rules in good times.
Galbraith concluded that "Keynesian policy is
unavailable for dampening demand if taxes cannot be
increased except under the force majeur of war
and public expenditure cannot be decreased for any
reason". The failure of fiscal policy to slow an
overheated economy left it to monetary policy to do its
nasty chore.
Friedman emerged as the
intellectual leader to challenge three decades of
Keynesian supremacy. Wall Street analysts, following
Friedman's theory, find the weekly fluctuation of M1 a
more reliable indicator of economic swings than the
slow-changing federal budget. Friedman's 1976 Nobel
Price firmly enthroned the rise of monetarism as a
mainstream concept, validated temporarily by recent
events.
In 1966, the consumer price index (CPI)
increased by more than 3 percent, the steepest in 15
years. By 1969, the annual price increase was above 6
percent. Even president Richard Nixon's brief wage-price
controls failed to bring inflation below 3 percent,
despite price-induced shortages in many industries,
including toilet seats for restrooms in new office
buildings. The Cold War was still going strong and there
was no globalized trade to supply low-price imports and
the Vietnam War was feeding inflation at home as well as
exporting it to the non-communist world. By 1973, the
CPI rose 8.8 percent and the Organization of Petroleum
Exporting Countries (OPEC) embargo and price hikes
pushed the 1974 CPI increase to 12.2 percent. The Fed
tightened money and promptly produced a recession that
lasted five months, with unemployment jumping to 9.1
percent and gross domestic product (GDP) shrinking by 15
percent. But inflation kept roaring toward double digits
throughout the recession. A fundamental disconnect now
confronted Keynesian theory - inflation and unemployment
were moving in the same direction, which was not
supposed to happen. There was plenty of blame to go
around for the inflation, but none of it explained the
high unemployment.
Friedman offered a simple and
plausible alternative: he blamed the Fed for the
inflation when it eased monetary policy over time and
for the unemployment when the Fed tightened abruptly. A
new term, "stagflation", came into common use.
Friedman's slogans "money matters" and "inflation is
everywhere and anywhere a monetary phenomenon" became
headlines in the financial and even popular press.
Friedman advocated a fixed expansion of M1 at 3 percent
long-term to moderate the runaway business cycle
overstimulated by Keynesian measures.
At its
base, Friedman is against government intervention not
merely because it may be ineffective, but because it is
immoral. To him, the Fed has forgotten its institutional
role as a stabilizer of the value of money, in a quest
for power and influence. A strict-money rule, such as
the later Taylor rule, would restore sanity to the Fed.
The rule proposed by John Taylor, now Treasury
undersecretary, is that if inflation is 1 percentage
point above the Fed's goal, rates should rise by 1.5
percentage points, and if an economy's total output is 1
percentage point below its full capacity, rates should
fall by half a percentage point.
Friedman's
criticism of the Fed as protector of its constituent -
the commercial banks - is populist but his willingness
to allow the market to impose high interest rates and to
allocate credit only to the creditworthy is biased
toward the rich. It is the syndrome of the banker who
offers umbrellas only when it is not raining. To carry
Friedman's theory to its logical conclusion, there would
be no need for a central bank in truly free financial
markets, while the need for a national bank might be
argued on nationalist political grounds.
As
engineered by Eccles, the independence of the Fed is a
peculiar, uniquely American institution. The
institutional conflict between the Treasury and an
"independent" Fed has yet to be resolved. Nixon accused
Fed chairman William McChesney Martin of costing him the
election loss to Kennedy, not without reason. As
president finally in 1968, Nixon was to consider himself
a Keynesian by proclaiming: "We are all Keynesians now."
The Fed's political base is the commercial
banks. As more banks resigned from the Federal Reserve
System, the system ran the risk of being exposed to
political attack. The Fed's control of monetary policy
technically requires membership of no more than the 400
largest banks. Universal membership brought in thousands
of small regional and local banks that were crucial for
the Fed's political protection, not for monetary policy
requirement. Since its beginning in 1913, the Fed has
been subjected to criticism that it is a captive
institution of the big banks.
Arthur Burns, the
Fed chairman appointed by Nixon, in trying to ensure the
president's re-election, laid the seed of hyperinflation
that left post-Watergate president Gerald Ford with
having to fight inflation with his ludicrous WIN (Whip
Inflation Now) lapel buttons. In hoping to get
reappointed by Jimmy Carter, who defeated Ford as
president in 1976, Burns continued to pursue an
easy-money monetary policy in the first two years of the
Carter administration. To Burns' disappointment, G
William Miller became chairman of the Fed in 1978 when
Burns' term expired.
Miller, chief executive
officer of Textron, a high-tech defense contractor, true
to the empire-building tendency of a CEO, decided to
halt the membership decline in the Federal Reserve
System. Commercial banks had been electing to withdraw
from the Federal Reserve System in protest of the Fed
not paying interest on reserve balances. Banks that
withdrew could place their lower reserves, required by
state banking regulations, in corresponding banks to
earn income from securities.
During the '70s, as
hyperinflation pushed up interest rates, the no-interest
hidden "tax" on Federal Reserve member banks became
proportionately more burdensome. Miller decided to pay
interest to member banks for their reserves, over the
opposition of Congress, which considered it another
giveaway to the big banks. Not only were the big banks
getting free safety-net protection through emergency
borrowing at the Fed's discount window, they also
enjoyed a free check clearing and payment system from
the Fed. Congress thought the banks were pigs for
complaining about the no-interest "tax" since the tax
was lower than user fees for services the banks
received. The effective tax rate in the 1980s for
financial institutions was only 5.8 percent, compared
with 34.1 percent for retail, 24.5 percent for
electronics, 16.4 percent for aerospace, and 10.9
percent for utilities.
Senator William Proxmire,
a Democrat from Wisconsin who chaired the Senate Banking
Committee, and Representative Henry Reuss, his
counterpart in the House, answered Fed interest payments
with the Monetary Control Act of 1980 (a misnomer, since
its real effect was to decontrol, just as the Full
Employment and Balanced Growth Act of 1978 actually
legitimized structural unemployment), enacted just when
the Fed pushed interest rates to historical peaks,
requiring all depository institutions, members and
non-members alike, to maintain reserves with the Fed.
Ostentatiously, since the Fed now paid interest on
deposited reserves, the small banks ought at least to
get the benefits of Fed services and protection and
bypass the fee-paying correspondence relations with big
banks.
It was amazing that the Fed was able to
get a Congress increasingly hostile to government
regulation to consolidate the Fed's institutional base
at a time when the Fed was imposing intrusive conditions
in the private economy. The rationale was based only
marginally on economics and heavily on politics. Fed
membership was a non-issue as far as monetary control
was concerned, and governor Henry Wallich, the Fed's
most scholarly economist, said as much publicly. The
legislation favored the Fed's main constituent in the
private sector, the large money center banks, forcing
all other regional and local financial institutions to
fall in line and accept the terms that are most
operative for the big internationalist banks.
The Fed's legislative victory was delivered on
the back of a larger issue - the deregulation of
finance. In companion legislation, Congress repealed
virtually all of the remaining government limits on
interest rates and regulation on lending that had
existed since the New Deal, much as the enactment of the
Gramm-Leach-Bliley Act (GLBA) in November 1999 in effect
repealed the Glass-Steagall Act, the long-standing
prohibitions on the mixing of banking with securities or
insurance businesses, and thus permitting "broad
banking". The price of money was free at last to seek
its "natural" equilibrium in the market place.
The prime rate rose above 15 percent in early
1980 when the deregulation legislation reached its final
stage. The Democratic Congress voted overwhelmingly for
a package that condemned borrowers to high cost and
favored lenders with high returns, by arguing that the
benefit of high interest on pension accounts justified
the high cost of mortgage payments. In other words, as
Pogo the cartoon character said: "The enemies, they are
us." The populist Regulation Q, which regulated for
several decades limits and ceilings on bank and
savings-and-loan (S&L) interest, was phased out.
Banks were allowed to pay interest on checking account -
the NOW accounts, to lure depositors back from the money
markets. S&Ls' traditional interest-rate advantage
was removed, to provide a "level playing field", forcing
them to take the same risk as commercial banks to
survive. Congress also lifted restrictions on S&Ls'
commercial lending, instead of the traditional home
mortgages, which promptly got the whole industry into
trouble that would soon required an unprecedented
government bailout of depositors with tax money. But the
developers who made billions were allowed to keep their
profits. State usury laws were unilaterally suspended by
an act of Congress in a flagrant intrusion on state
rights.
The political coalition of converging
powerful interests was evident. Virulent high inflation
had damaged the holders of financial wealth, including
small savers, created by a period of benign low
inflation earlier, so that even progressives felt
something has to be done to protect the middle class.
The solution was to export inflation to low-labor-cost
areas around the world, taming domestic inflation with
the export of jobs and the domestic inflation devil - US
wages. Neo-liberalism was born with the twin midwives of
sound money and free financial markets, disguising
economic neo-imperialism as market fundamentalism.
There was even a devious argument that universal
Fed membership serves to dilute the institutional bias
of the Fed toward big banks. Commercial banks of course
argued for free market competition when they knew very
well that predatory acquisition rather than fair
competition was what unregulated markets sustain. Labor,
small business and small local banks and S&Ls
complained, to no avail. US labor, unlike its European
counterparts, focused union contracts on wages and
benefits on a shrinking unionized workforce while
management shifted jobs overseas wholesale with the
support of the internationalist banks as a painless way
to control domestic inflation, in the name of free
trade. Many Fed economists, Volcker included, actually
knew that financial deregulation with the elimination of
interest-rate ceilings would weaken the Fed's control
over expansion of credit.
To gain support for
the Monetary Control Act of 1980, the Fed offered member
and non-member banks that, under universal membership,
the existing levels of reserve would be lowered for
every bank. Reserves required for demand deposits, the
checking accounts that represented the core of bank
funds, were reduced from 16.25 to 12 percent. This would
mean a substantial loss of revenue for the Fed. The Fed
had been paying a handsome dividend to the Treasury from
surplus income from reserve holdings invested in
government securities over operating expenses, $9.3
billion in 1979. According to the Board's 1999 Annual
Report, the Federal Reserve System had net income
totaling $26.2 billion, which would qualify it as one of
the most profitable companies in the world if the system
were a typical corporation. These profits were
distributed as follows: $342 million, or 1.4 percent of
the profits, was paid to member banks as dividends.
Another $479 million, or 1.8 percent, was retained by
the 12 Reserve Banks. The balance of $25.4 billion, or
96.9 percent of the profits, was paid to the Treasury.
The Fed started to charge banks for its services
when the new reserve rules were fully phased in. The
larger money center banks welcomed this development
since they intended to provide their own service system
for banks in competition with the Fed, and with the Fed
charging a fee, it would make it easier for the big
banks to lure away customers. To get the endorsement of
the American Bankers Association, the Fed agreed to drop
reserve requirements on time and saving deposits. This
concession meant a vast benefit for the big banks whose
balance sheet depends on large-denomination CDs
(certificates of deposit).
Next: Still more on the US
experience
Henry C K
Liu is chairman of the New York-based Liu
Investment Group.
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