The Federal Reserve Act, passed at the close of 1913, created the current U.S. central bank in order to “establish a more effective supervision of banking in the United States.” However, in response to monetary-policy errors committed by the central bank, Congress has, from time to time, amended the act. For example, during the 1970’s, when Americans faced double-digit inflation and unemployment—for which, according to some critics, Fed policy was responsible—Congress passed the Humphrey-Hawkins Act of 1978, sponsored by Sen. Hubert Humphrey (D-MN) and Rep. Augustus Hawkins (D-CA), which required the Fed to establish a monetary policy for the country that would “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Of course, supporters of the central bank reject this sort of meddling and argue instead for a laissez-faire approach toward the Fed.
The Fed includes, according to its own literature, “a central governmental agency—the Board of Governors—in Washington, D.C., and twelve Regional Federal Banks.” The Federal Open Market Committee (FOMC) is a major component of the system. It includes members of the board of governors, the New York Fed president, and presidents of four other Fed member banks who serve on a rotating basis. Meeting eight times annually, the FOMC oversees the bank’s open-market operations, the main tool used by the Fed to influence monetary and credit conditions. The Fed chairman can also call the FOMC into teleconference whenever he deems it necessary. As an independent government agency, the board of governors must comply with federal transparency provisions, including the Freedom of Information Act.
Proponents like to describe the Fed as a neutral umpire. Yet FOMC transcripts, released (after a five-year time lag) for an entire year’s worth of meetings, raise serious doubts about the impartiality of this powerful government agency.
The FOMC faced a crisis in the fall of 1998. Heavily leveraged trades by Long-Term Capital Management (LTCM), a private hedge fund, declined precipitously. LTCM’s money managers, including Nobel laureates reputed to be among the best in finance, had underestimated the impact of a Russian fiscal crisis on worldwide financial markets. LTCM imploded when investors fled en masse into the U.S. Treasury market (a safe haven) after the Russian government defaulted on its bond obligations and the ruble collapsed. Market liquidity declined dramatically, leading Treasury spreads to widen beyond historic norms, which caused LTCM’s leveraged portfolio to collapse. House Banking and Financial Services Committee Chairman Jim Leach (R-IA) later observed that LTCM had underestimated “the role of corruption in Russia.” This miscalculation threatened huge losses for large money-center institutions and European central banks who found themselves on the wrong side of the deal.
FOMC transcripts reveal that Greenspan was clearly worried as he addressed the October 15, 1998, FOMC teleconference. “At this stage, after 50 years of looking at the economy on almost a daily basis, I would say that I have never seen anything like the current situation,” he said. “Certainly, based on all the historic annals I have read, and I have done a good deal of reading in economic history, it would be an extremely rare event for this type of financial environment to emerge and eventually recede without having an impact on the economy.” His remarks, and the teleconference itself, are revealing on several levels.
First, Greenspan spent his 19-year tenure as a government economist preaching about the free-market order. “A free market capitalist system,” he said in a commencement address at Harvard in 1999, “cannot operate fully effectively unless all participants in the economy are given opportunities to achieve their best.” In a truly free market, there are failures as well as successes. There would be no bailout mechanism for LTCM in the market order described by Greenspan, who was once a disciple of Ayn Rand. LTCM and the banks that extended credit tried their best, delivered the worst, and failed. The financial institutions that extended LTCM credit would have taken their losses like men if Greenspan’s order really existed.
Instead, these large financial interests were allowed to hide behind the Fed’s skirt. New York Fed President William McDonough organized a deleveraging of the hedge fund’s book. Then Greenspan led the FOMC to cut the Intended Fed Funds rate three times to alleviate the crisis. The transcripts reveal that only one FOMC member, St. Louis Fed President William Poole, was courageous enough to express any concerns. “[I]s there any chance that action today could be viewed, by some anyway, as an effort to help bail out the hedge funds?” he asked.
Second, imagine the FOMC meeting to discuss altering monetary policy in response to a crisis faced by a major U.S. manufacturer. Vast industrial enterprises such as U.S. Steel, General Motors, and Chrysler are among America’s largest manufacturers operating in the real economy. They all faced their own economic crises during the 50 years Greenspan spent “looking at the economy on almost a daily basis.” In the late 1970’s, double-digit inflation and interest rates forced numerous manufacturers out of business. The Fed, under chairman Arthur Burns, had erred in letting the inflation genie out of the bottle earlier in the decade, and manufacturers and their employees were left to pay the tab. Still, the FOMC did not alter its monetary policy, because a “market order,” to the Fed, means that (to paraphrase Orwell) some economic animals are more equal than others.
If the financial institutions in the LTCM episode had been private U.S. manufacturing enterprises, they would have been told to liquidate their losses, lay off workers, reduce wages, eliminate benefits, and flagellate themselves as a reminder that they—not monetary forces in the United States and Asia—were responsible for their problems. Yet it was Fed-induced inflation that distorted manufacturers’ price structures in the 1970’s, and deflation imported from Asia has devastated producers since the mid-1990’s. But the Fed is not in the business of bailing out manufacturers—only financial services. For many, that is a particularly bitter pill to swallow, considering that LTCM employed a tiny fraction of the millions of workers employed by these great industrial enterprises. Yet it was big enough to manipulate the supposedly neutral Fed.
The LTCM debacle was not the first time the Fed displayed its benevolence toward money-center banks on the wrong side of big losing trades. In 1994, these banks were exposed to huge losses in the Mexican bond market after the peso was devalued. The FOMC met on December 30, 1994, in another teleconference in which it approved a $1.5 billion “supplementary facility” to help stabilize Mexican financial markets. Once again, private money managers had misread political and economic developments in foreign countries. The Fed rewarded this incompetence by organizing a bailout.
During the Mexican crisis, some of Wall Street’s biggest investment banks were caught holding large books of declining Mexican bonds. According to the FOMC’s December 30, 1994, transcript, Greenspan expressed surprise at the outstanding amount of tesobonos (peso-denominated Mexican bonds that are dollar-indexed). The transcript, which remains heavily redacted 12 years later, leaves little doubt that the FOMC was not meeting to organize a lifeboat for widows and orphans. Greenspan minced no words. He began by telling the panel, “The purpose of this conference call is to discuss the Mexican situation in which we and the Treasury have been fairly heavily involved during the last few days.” The panel met on the eve of a speech by Mexican Finance Minister Guillermo Ortiz, which was meant to calm restive financial markets. Page five of the transcript is especially instructive regarding how financial bailouts emerge with the Fed’s assistance. In the lone paragraph that has not been redacted, Greenspan states, “There is a case to be made for a significant amount of Congressionally appropriated funds to buy down a very large part of these tesobonos, which is effectively foreign aid. But it’s a type of foreign aid that probably would be rather wise for us to engage in.” He describes “a commercial banking package that is being initiated by [redacted] specifically, and it looks to be several billion dollars in size or at least that is what they are talking about.”
When the FOMC voted on the supplementary facility meant to ease the Mexican crisis, there was only one dissenting voice. According to the transcript, Richmond Fed President Al Broaddus told Greenspan,
Specifically, I’m worried because even if we get this package—we get the speech, and we have the enlarged facility—it is not at all clear to me, and I’m sure it is not at all clear to anyone, that it is going to do the job. If that were our only choice, that would be something we could swallow, but what worries me is we are a party to it. We are now adding to our Federal reserve commitment and I am worried about that from the standpoint of our credibility.
Greenspan replied, “Okay. Are there any other questions or comments?”
Congress, unlike the Fed, is made up of elected citizens rather than unelected economists drawing government paychecks. Throughout the Fed’s history, some members of Congress have proved tenacious in uncovering the truth. In the LTCM episode, congressional pressure led the President’s Working Group on Financial Markets to issue a report stating that the New York Fed had encouraged 14 financial institutions involved with LTCM “to seek the least disruptive solution that they believed was in their own collective self-interest.” The panel concluded,
The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets.
In sum, the Fed came to the rescue of financial institutions that had been foolish or incompetent enough to do business with a highly leveraged hedge fund. Greenspan was among the report’s coauthors.
How neutral is a public institution that admits it encourages private financial enterprises to craft public policy to their benefit?
During a congressional grilling, Greenspan insisted that the Fed had acted to prevent a financial meltdown. Rep. Ron Paul (R-TX), one of the few members of Congress who understands enough about monetary policy to question Fed claims, was having none of it. Representative Paul observed,
[O]ne place where I want to challenge you is the fact that in the type of system that we have, not everybody benefits equally . . . There are some who suffer where others benefit more. So, for instance, I see that we have today where the lower- or middle-income person who does not go on the dole has the toughest time.
Paul’s point is valid, in light of the FOMC transcripts.
Americans have been conditioned to believe that monetary policy is too complex for them to understand. The conventional view is that fiscal policy, which deals with budgets and taxes, is easier to comprehend than monetary policy, which is concerned with control of the money supply and the credit necessary to achieve macroeconomic goals. But monetary policy was publicly debated in the 18th and 19th centuries—and well into the 20th. Thomas Jefferson and others adhering to a strict construction of the U.S. Constitution opposed the establishment of a central bank. Tennessean Andrew Jackson spoke about monetary policy more than any other president. He vetoed the Second Bank of the United States and repeatedly attacked central banking, terming it “the scourge of the people.” Jackson argued against currency debasement and supported hard money, signing the Specie Circular Act, which required payment in gold of all federal debt obligations. Grover Cleveland successfully defended the gold standard against populist attacks. In the 20th century, the actions taken by Franklin D. Roosevelt and Richard Nixon to reduce gold’s role in the monetary order were hotly debated.
Citizens have good reason to be acutely interested in monetary policy, because it does not operate in a vacuum: It influences macroeconomic goals, including employment. American manufacturers and other private-industry sectors that produce real goods are affected by Fed policies that have caused or contributed to economic contractions.
Serious academics have been far less gullible than the popular media in analyzing Fed monetary errors. Allan H. Meltzer, in his 800-page History of the Federal Reserve, Vol. I: 1913-51 (2003), argues that Fed errors contributed to the worst economic contractions of the period (1920-21, 1937-38), including the Great Depression (1929-33). This view is so widely accepted that the Fed even cooperated with Meltzer, and Greenspan wrote the book’s Introduction.
The Fed tolerates some dissent, but only within narrow parameters. Poole and Broaddus have dissented privately at FOMC meetings. Other Fed officials have publicly questioned or criticized monetary policy. In 1969, during a vigorous debate between the New York and St. Louis banks, St. Louis Fed President Darryl R. Francis suggested that excessive growth of the money supply contributed to inflation. This idea, popularized by monetarist Milton Friedman, was once considered heresy among most economists. In 1979, Minneapolis Fed President Mark Willes admitted that “Nobody is very happy with the conduct of monetary policy.” Willes observed that “virtually every policy maker admits that, in hindsight, we have made some mistakes that have added to our economic woes.” Today, the Fed acknowledges on its website that “[T]he FOMC did not have great success in combating the increase in inflationary pressures that resulted from oil-price shocks and excessive money growth over the decade.”
American manufacturers and their workers have paid a steep price for the Fed’s errors. Following World War II, employment in durable- and nondurable-goods manufacturing peaked in 1979, according to the U.S. Bureau of Labor Statistics. It has declined in four subsequent business cycles. Meanwhile, employment in the financial-services and government sectors has grown since 1979. Greenspan has tried to define this industrial decline as a normal long-term process, telling Harvard’s 1999 commencement audience that
The quintessential manifestations of America’s industrial might earlier this century—large steel mills, auto assembly plants, petrochemical complexes, and skyscrapers—have been replaced by a gross domestic product that has been downsized as ideas have replaced physical bulk and effort as creators of value.
The Fed’s role in this Schumpeterian process of “creative destruction” is absent from this explanation. The problem is not one man—Alan Greenspan or Benjamin Bernanke or any government economist to follow. The central bank itself, through its manipulation of interest rates, has contributed to this large-scale replacement of “physical bulk and effort” with “ideas.”
Since the central bank wields such considerable power and influence over the jobs and well-being of U.S. citizens, the Federal Reserve should be more transparent. “Openness is more than just useful in shaping better economic performance. Openness is an obligation of a central bank in a free and democratic society,” said Greenspan on October 21, 2001. “U.S. elected leaders chose to vest the responsibility for setting monetary policy in an independent entity, the Federal Reserve. Transparency of our activities is the means by which we make ourselves accountable to our fellow citizens to aid them in judging whether we are worthy of that task.”
The Fed could start by declassifying redacted FOMC transcripts, as other agencies do with the passage of time. It should also publish a more diverse range of views in its member-bank reviews, not only those of economists who agree with its decisions. Where, for example, are the articles by economists who argue that Fed policies have harmed the U.S. manufacturing sector? To publish such views would demonstrate humility and reassure the rest of us that the Fed and its chairman are aware they are not omniscient.