Continuing with the theme of the 100th anniversary of the Federal Reserve and the five years since the 2008 episode of the ongoing financial crisis, the House Financial Services Committee's Subcommittee on Monetary Policy and Trade, chaired by John Campbell, R-Calif., held a hearing on Sept. 11 titled "The Fed turns 100: Lessons Learned over a Century of Central Banking."
The panel of witnesses consisted of four conservative critics of the Fed and two defenders of Fed policy appointed to the panel by the Democratic minority.
This article will outline the major points of the testimony and add some of my observations.
The star of the panel, as he is on any panel, was Allan Meltzer, a public policy professor at Carnegie Mellon University and former member of the Council of Economic Advisors under Presidents Kennedy and Reagan. He is author of the second generation of "The Monetary History of the United States," a project begun by the legendary Milton Freidman and his colleague Anna Schwartz.
Meltzer sketched the circumstance at the time the Fed was born: "The United States was on the gold standard, limiting Federal Reserve actions to the requirements of that rule. In addition, the new system authorized Reserve banks to discount commercial paper, banker's acceptances and the like. The discounting operation was always at the initiative of the borrower. Also, the act prohibited any direct purchases of Treasury debt. All of these restrictions ended long ago."
He concluded that the Fed "evolved under pressure of events and political responses to crises from an independent agency with constrained powers to become the world's major central bank with nearly unrestricted ability to expand."
Meltzer faulted Congress for failing to oversee the Fed, and he urged legislators to reassert their constitutional authority by requiring the Fed to follow a monetary rule such as the one proposed by John Taylor of Stanford. Meltzer found that during two periods in its 100-year history, when the Fed followed a monetary rule, 1923 to 1928 and 1985 to 2003, the economy experienced "stable growth, moderate recessions and low inflation."
Another criticism of the Fed is that it has never adopted a rule to govern the exercise of its role as lender of last resort. Now he suggests that all of the rules of the Dodd-Frank Act could be obviated if Congress adopted three rules:
1. A clearly stated rule governing the exercise of the lender-of-last-resort function, as set forth for the Bank of England by Walter Bagehot in 1973 — to "lend freely against good collateral at a penalty interest rate."
2. Protect the payments system, not banks or bankers.
3. Require large banks to hold at least 15 percent and as much as 20 percent equity capital against all assets.
If readers were to pick one statement from the panel to read in its entirety, Meltzer's should be the one, and it's only 18 pages long.
Meltzer's colleague at Carnegie-Mellon, Friends of Allan Meltzer Professor of Economics Marvin Goodfriend, added a warning that as practiced by the Fed, the lender-of-last-resort authority is overly expansive and has led markets to take undue short-term risk under the assumption that the Fed is standing by. He calls for this power to be "carefully circumscribed."
Next, Alex Pollock of the American Enterprise Institute cautioned that despite all of the research power housed at the Fed, history shows it is no better at predicting the course of the economy than anyone else is. Taking off on Robert Solow's assertion that "central banking is not rocket science," Pollock argued that it is harder, because it is not a science and is not governed by scientific laws.
Pollock performed a useful service by recognizing that the Fed's mandate has grown beyond the prosaic "dual mandate" of stable prices and full employment. He listed three additional mandates, and whether one agrees or not, this testimony should help to foster discussion.
Pollock's additional mandates are: "to furnish an elastic currency, to act as the manager of the risks and profits of the banking club and to provide ready financing for the deficits of the government of which it is a part, as needed."
Lawrence H. White, an economics professor at George Mason University, not to be confused with Lawrence J. White, an economics professor at New York University, offered specific criticisms of the extraordinary actions the Fed took in response to the 2008 episode in creating "unprecedented special purpose vehicles" to protect the bondholders of the failed Bear Stearns, refusing to do the same for Lehman Brothers and then creating two more special purpose vehicles for the assets of failed insurance company AIG. He argued these actions were unauthorized, as well as unprecedented, and he lamented the damage these actions have done to the principle of the "rule of law" that supposedly undergirds the financial system.
White warned that the putative restrictions of the Fed's bailout authority contained in the Dodd-Frank Act are not enough to restore the rule of law. Essentially, what Dodd-Frank takes away with one hand, it gives back through other provisions that expand the authority of the Fed to allocate credit arbitrarily and override the functions of Congress and financial markets. He called for restoration of limits on the Fed's authority so that "lenders will not let financial firms leverage up cheaply in the belief that they will be protected."
Finally, Joseph Gagnon, a senior fellow of the Peterson Institute for International Economics, and Josh Bivens, research and policy director of the Economic Policy Institute, both endorsed the Fed's interventions in support of failing and flailing financial institutions since 2008.
Gagnon holds that the Fed "has performed at least as well over its first 100 years as could be expected" and he called for the Fed to be given more tools and "free rein" to use them as it sees fit, while holding the Fed accountable "for any failure to achieve its objectives that could reasonably have been prevented."
Bivens is more concerned that the Fed will withdraw support too soon and that it has gone too far.
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