How the Federal Reserve has Changed America

 Matt Taibbi recently interviewed journalist Christopher Leonard about his new book, The Lords of Easy Money, which tells the story of the Federal Reserve Bank's response to the Great Recession and its consequences. I decided to read it.  I am glad that I did.

Let me make one thing clear to potential readers at the outset: while the book tells a very important story makes very convincing arguments about its significance, its execution is a bit erratic. Leonard has to talk about a lot of complex financial instruments and transactions, and I often felt that he failed to explain them adequately to laymen, or even to convince me that he completely understood them himself. "Leveraged loans," which have become very important in corporate America, were an excellent example of this.  Yet he often makes up for this by emphasizing a few basic facts and figures, and his account of the impact of Fed policy in the last fifteen years and earlier opened my eyes to various key developments of which I was not aware.  I finished the book quite convinced that the foundations of our economy are now very unsound, that some kind of new collapse is almost inevitable, and that our economic powers that be remain in denial about these issues.

Most newspaper readers understand that when the big banks and our whole financial system nearly collapsed because of the subprime crisis of 2007-8, the Fed, led by Ben Bernake, embarked on a program called "quantitative easing."  Essentially, it created more than $1 trillion within a few months to purchase worthless assets from the big banks to save them from collapse. Leonard gives the impression that the Fed has the legal power to create as much new wealth as it wants, any time that it wants.  If that is true--and it seems to be--I couldn't help wondering when it became true.  I had the impression that when the Fed was founded in 1914 or so it was capitalized by existing financial institutions and that the size of its capital put some limit on its ability to make transactions.  If that was true, then the law must have changed at some point, and I am very curious as to when it was. There is, however, no dispute about the magnitude of what the Fed did beginning in the last quarter of 2008 when the crisis became dire. The Fed's balance sheet $910 billion at that moment increased to $2.1 trillion in one month.  It held fairly steady for about two years, but at that point, with unemployment still peaking, it began to increase fairly steadily and went from $2.31 trillion in November 2010 to $4.5 trillion in 2015, where it remained for about three more years. Meanwhile, the Fed's open-market operations kept interest rates at or near zero, in an attempt to force financial institutions to lend money to stimulate enterprise, instead of keeping it in treasury obligations that would not turn any profit.  It is here that I want to leave Leonard's argument behind for a minute and reflect on these developments from my own perspective.

In 1933, faced with an even more serious financial collapse and 25 percent unemployment, the New Deal had consciously attempted to increase the purchasing power of farmers and workers to get the economy moving again and stop the decline of GDP.  While those policies didn't cure the Depression until we began mobilizng for the Second World War, they did help, and they did increase economic equality within the United States.  This time, however, Bernanke, Tim Geithner, Larry Summers and the rest of the policy makers decided to increase the purchasing power and the lending power of our richest class.  Leonard does not make this analogy, but it occurred to me that quantitative easing was a new form of supply-side economics.  The Reagan tax cuts--the application of supply-side economics--were supposed to unleash a torrent of productive investment and set up a new round of dramatic economic growth.  Instead, they began increasing the wealth gap, and although the country slowly came out of the 1980-82 recession, the average American stopped making any serious economic gains.  In subsequent years much of corporate wealth and corporate borrowing went into new factories overseas, while high-paying jobs in the US became scarcer.  

Quantitative easing, Leonard shows, had a similar effect.  The loans it and zero-interest encouraged lenders to make did not create new factories or new infrastructure.  They simply increased the price of assets like stocks which rich people can buy.  That is why, as many have noticed, the movements of the stock market have become quite disconnected from the state of the economy, so that the Dow and other industries reached new highs during the recession that the pandemic triggered. I would go further and blame the same trends for the explosion of the housing market in major metropolitan areas, where those connected to the financial community and a few other growing sectors like health care have bid up the price of single-family homes until they are out of the reach of young couples.  

I strongly suspect that there is another dimension to all this as well, involving the ethos of our financial sector.  That sector, which the New Deal reforms like Glass-Steagall and the SEC put under significant control, regained much more freedom under the deregulation of the 1990s, which Bill Clinton, I had discovered, allowed without ever discussing it at any length with the American people.  These reforms and fed easy money policies allowed financial interests to accustom themselves to dramatic and continuing increases in their income.  That, I believe, is what led them into disastrous financial experiments such as the new derivatives market and subprime mortgages--bubbles that were bound to burst.  Quantitative easing ensured that they would not pay the price of having the bubbles burst, and encouraged them to create new ones, and that is what they have been doing ever since.  And over the last 30 years at least, Wall Street has become the leading destination of our brightest young men and women, trained in our elite educational institutions.  There they become committed to the new model and devote their tremendous ambition, energy, and intelligence to maintaining it and the wealth that it gives them. 

Leonard's book relies very heavily on interviews with Thomas Koenig, the one-time chief of the Federal Reserve Bank of Kansas City and a long-time member of the Fed's policy-making board.  Koenig, who was born in 1946 and thus grew up (as I did) in a very different time, opposed quantitative easing from the beginning because he thought it would create bubbles and, crucially, because he thought that it would be very hard to reverse when the economy became overheated or when financial interests became over-extended again.  Events have proven him right. Jerome Powell replaced Bernanke as Fed Chairman in 2018.  He too had been somewhat doubtful about  quantitative easing, and he initially decided that the time had come to raise interest rates, sell assets, and reduce the Fed's balance sheet.  It fell from $4.41 trillion in February 2018 to $3.82 trillion in July 2019.  That, however, as Leonard shows in detail, triggered a serious crisis in short-term money markets comparable to what had happened in 2008 and brought down Lehman Brothers. This time Powell reversed course, stepped in, and refunded the short-term money market that many hedge funds depended on on a massive scale.  The Fed's balance sheet was already rising again when the pandemic struck in the early spring of 2020.  It roes from $3.78 trillion in August 2019 to $7.17 trillion in June 2020--and it has continued to rise up to $8.96 trillion in late April of this year.  

Until the last two years, the Fed took comfort from low rates of inflation.  Now, a combination of factors including supply chain problems, the Ukraine war and its impact on energy prices, labor shortages in the US, and the huge deficits the federal government ran during the pandemic has returned inflation almost to the levels of the late 1970s, and Powell is rapidly raising interest rates to try to halt it.  Orthodox economic authorities seem to agree that we need a new round of unemployment to control inflation.  German authorities made a similar calculation in 1930-2, cutting government spending in the midst of a depression--and the result was the electoral advance of Nazis and Communists and the end of the Weimar Republic.  The United States stands at a similarly perilous political moment and our establishment really can't afford to alienate the working class, but they don't seem to understand this.

The rise in interest rates has already reversed the steady increase of the stock market.  If Leonard's argument is correct, it seems almost certain to trigger some kind of new financial crisis as well, since our whole system has come to depend on easy money.  That might lead the Fed to reverse course again as it did in 2019.  Thomas Koenig was right: it has become impossible not only to undo quantitative easing (now known under new names) but also to even halt it.  The Obama Administration in 2009 missed its chance to revive New Deal principles, and the bill for that decision may now be coming due.

Occasionally a lifelong newspaper reader like myself reads or hears a news item that is so unsettling that he immediately goes into denial.  One such moment occurred in the winter of 2008-9 when I read that Barack Obama had appointed Larry Summers as his chief economic adviser.  A second occurred a few days ago when I was nearing the end of Leonard's book, and read that Ben Bernanke had been awarded a share of the Nobel Prize.  When disastrous policies receive the highest imprimatur that our civilization offers, we are in real trouble.