The Federal Reserve System operates as the central bank for the United States, managing the economy’s money supply and overseeing the banking system. Until recently, the Federal Reserve has not picked winners or losers when distributing money, nor has it brought credit risk onto its balance sheet.
It has slowed or stimulated the economy by raising or lowering interest rates.
Since March 2008, the Fed has resorted to using its emergency powers to pick win- ners and losers, and to take massive credit risk onto its books. Since September 2008, the Fed’s balance sheet has expanded from around $800 billion to over $2 trillion, not including off-balance-sheet liabilities it has guaranteed for Citigroup, AIG, and the Bank of America, among others. The bank is also monetizing the debt of the U.S. government by purchasing massive amounts of agency and Treasury bonds.
An audit is the first step in bringing this unaccountable system under the control of the public, whose money it prints and disseminates at will.
The Federal Reserve is an odd entity, a public-private chimera that controls the U.S. monetary system and supervises the banking system. The system is governed by a board of governors, with 12 regional Reserve Banks that serve a supporting role. While the governors are appointed by the president with confirmation by the Senate, the regional Reserve Banks have boards of directors chosen primarily by
private banking institutions. Jamie Dimon, the CEO of JPMorgan when this chapter was written, for example, served on the board of directors of the New York Federal Reserve Bank, as did Goldman Sachs director Stephen Friedman. Appointments such as these create striking conflicts of interest and unseemly appearances in the management of what is ultimately the public’s money.
Criticism of banker influence and control of the U.S. monetary system is not new. However, the urgency of the financial crisis and the actions of the Federal Reserve picking investment bank winners and losers have changed the nature of the criticism. The Senate passed a nonbinding resolution in its 2009 session requiring more transparency at the Federal Reserve in its budget resolution. The Federal Reserve has refused multiple inquiries from both the U.S. House of Representatives and the U.S. Senate to disclose who is receiving trillions of dollars from the central banking system. With discussions of allocating even more power to the Federal Reserve as the systemic risk regulator of the credit markets, more oversight over the Federal Reserve operations is clearly necessary.
The net effect of the recent Federal Reserve actions has been to isolate financial policy making entirely from democratic input, and allow the U.S. Treasury depart- ment to leverage the Federal Reserve’s balance sheet to spend money it cannot get appropriated from Congress. The public does not know where trillions of its dollars are going, and so has no meaningful control over the currency or the federal budget. That has become another negative legacy of the Greenspan and Bernanke Federal Reserve roles in the financial crisis.
NOTES
1. Tom Petruno, “Right Response to September 11th Remains Unclear,”Los Angeles Times, September 8, 2002.
2. David Eisenberg, “Greenspan’s Deficits,”Time,May 2, 2005, 44.
3. Anonymous. “A Tribute to an Unlikely Hero of 9/11,”Chicago Defender,April 18, 2002, 9.
4. Richard Stevenson, “Fed Chief Sees Decline Over; House Passes Recovery Bill,”New York Times,March 8, 2002.
5. Unsigned editorial, “Interest Rates and Deficits,”New York Times,December 18, 2004.
6. David Eisenberg, “Greenspan’s Deficits,”Time,May 2, 2005, 44.
7. Frederic Mishkin and Stanley Eakins,Financial Markets & Institutions,5th ed. (Upper Saddle River, NJ: Pearson, 2006), 189.
8. Alan Greenspan,The Age of Turbulence: Adventures in a New World(New York: Penguin, 2007).
9. Ibid.
10. Ethan S. Harris,Ben Bernanke’s Fed: The Federal Reserve after Greenspan(Boston: Harvard Business School Press, 2008).
11. Johan Van Overtveldt,Bernanke’s Test: Ben Bernanke, Alan Greenspan and the Drama of the Central Banker(Evanston, IL: Agate Publishing, 2009).
12. Ibid.
466 The Federal Reserve, Monetary Policy, and the Financial Crisis
13. Ethan S. Harris,Ben Bernanke’s Fed: The Federal Reserve after Greenspan(Boston: Harvard Business School Press, 2008).
14. Sewell Chan and David M. Herszenhorn,Bernanke’s Bid for a Second Term at the Fed Hits Resistance,New York Times, January 2010
ABOUT THE AUTHOR
Professor John Ryan is a fellow at the Center for Economic Policy Analysis, University of Venice, Italy. He formerly held senior teaching and administrative positions at the European Business School, New York University, the EDHEC School of Management, in Lille, France, the Cass Business School, the Hult Interna- tional Business School, and the German Graduate School of Management and Law, Germany. Professor Ryan was a visiting scholar at the Center for European Studies, Bonn, Sciences Po, CRG Ecole Polytechnique, and the Center for European Studies, Bonn. Professor Ryan was educated at Oxford University, Cambridge University, the London School of Economics, the Kiel Institute of World Economics, Germany, and University College, Dublin, Ireland.
CHAPTER 58
The Risk Management
Approach to Monetary Policy:
Lessons from the Financial Crisis of 2007–2009
MARC D. HAYFORD
Professor and Chair of the Department of Economics at Loyola University Chicago
A. G. MALLIARIS
Department of Economics, Loyola University Chicago
INTRODUCTION
The current financial crisis is the worst since the Great Depression. The U.S. crisis began in the summer of 2007, spread to global financial markets, causing severe declines in numerous national stock markets and has resulted a global recession, with declines in national real GDP averaging about 5 percent.
Capitalist economies are prone to such financial crisis and episodically ex- perience financial booms and busts. During booms, market participants are often euphoric and declare that financial busts are a thing of the past. For example, during the decade of the 1990s, many analysts believed that the United States had entered a new era of stable economic growth, low inflation, and consequently financial stability. This perceived new era, called “The Great Moderation” was thought to be the consequence in part of sound monetary policy. The Great Moderation may have contributed, along with innovations in information technology, to the mar- ket euphoria, Keynesian animal spirits or irrational exuberance that drove a stock market boom from the mid- to late 1990s. The boom turned to bust when the stock market crashed in 2000. A mild recession followed.
In this paper we review the monetary policies followed by Fed chairmen Greenspan and Bernanke after 2000 and claim that on several occasions the Fed deviated from what might be considered normal monetary policy by responding to a perceived low probability event, which if it occurred, would impose a high cost to the economy. We argue that this risk management approach to monetary policy had many successes, but it may also have contributed, inadvertently, to the current crisis. We also offer several lessons that may be learned from the current crisis.
467 Copyright © 2010 John Wiley & Sons, Inc.
468 The Federal Reserve, Monetary Policy, and the Financial Crisis