Three Branches, Many Boughs

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The Federal Reserve Board celebrates in December the hundredth anniversary of its founding. That means Americans will be going to school on books about central banking for a while longer.  Thanks to the financial crisis of 2007-9, a larger niche is being carved in the civics curriculum for the government agency that oversees the intersection of the nation’s systems of money and finance.

It’s a good thing, too, for in the immediate aftermath of the financial crisis, Congress took the first steps toward creating a second, similarly elaborate regulatory system – this one intended to oversee the nation’s enormous system of medical care. Once again, a hundred years is not too soon to expect to get this one right. So the more you know about oversight of the banking system, the better you’ll understand the problems of taming the tendencies to overprovision of medical care.

The first book about the Fed’s role in the 2007-08 crisis remains, in many ways, the best. In Fed We Trust: Ben Bernanke’s War on the Great Panic (2009, Crown). by David Wessel, of The Wall Street Journal, got the story right, did it quickly, and placed it in the proper context, even if he overstated matters slightly. In establishing the Fed, in 1913, Wessel wrote,“Congress had created what would become a fourth branch of government, nearly equal in power in a crisis to the executive, legislative and judicial branches. Decades would be required for the Fed to grow into its skin, he noted, “but by the end of the twentieth century, it would have almost unchallenged power over its domain, the US economy.”  The key words there are “in a crisis.” Even then, the Fed remains, like the military, an agency of the federal government, not an autonomous branch.

Meanwhile, most new books about the Fed that come along add something worthwhile to our understanding. Take these three recently published ones, and a helpful fourth book whose relevance has been overlooked.

The Alchemists: Three Central Bankers and a World on Fire (Penguin, 2013), by Neil Irwin, of The Washington Post, continues the story of the crisis to the present day.  The WSJ’s Wessel was a veteran Washington economics columnist when the crisis began (and had the advantage of the paper’s superb staff behind him as well).  Irwin started covering the Federal Reserve beat for the Post in August 2007. So his book has the virtue of a fresh eye. You go along with him as he learns. The advent of central banking in seventeenth-century Sweden gets a chapter (a somewhat confusing one, in which Jimmy Stewart, from It’s a Wonderful Life, makes a guest appearance to explain fractional banking). A second chapter recalls the history of the Bank of England and Walter Bagehot’s classic work on money markets, Lombard Street. A third chapter describes the events leading up to the founding of the Fed in 1913; a fourth, the Weimar inflation of the 1920s and US and European central bankers’ failures in the early 1930s; a fifth, the post-World War II inflation and Paul Volcker’s role in ending it; a sixth, the birth of the European Monetary Union; and a seventh, the lost decade of Japan.  Then comes a brisk narration of the crisis itself.  At that point Irwin has become become comfortable with the story; and the second half of the book, which concerns the aftermath of the American crisis and the European second wave, adds a new and permanent angle to the story:  its international dimension.  Alchemy is a lousy metaphor for what central bankers do; but Irwin is a very capable reporter and the mostly successful collaboration among Fed chairman Ben Bernanke, Bank of England Governor Mervyn King and European Central Bank President Jean Claude Trichet is an important part of the  story.

When the Music Stopped:  The Finacial Crisis, the Response, and the Work Ahead (Penguin, 2013), by Alan Blinder, of Princeton University, seeks to provide “a truly comprehensive and coherent narrative” of how the crisis happened and a guide to what remains to be done. Blinder, a member of the Council of Economic Advisers and vice chairman of the Fed during Bill Clinton’s first term as president, isn’t exactly a disinterested observer. But his chapters on decision-making during the crisis are as lucid and fair-minded as anything I’ve yet read about what happened; after all, Blinder sat in those seats. But his list of the “malevolent seven” causes of the crisis doesn’t seem especially penetrating (housing and bond bubbles, excessive leverage, lax regulation, disgraceful mortgage-lending practices, crazy-quilt financial innovation, abysmal rating-agency performance, and perverse banking-compensation schemes). I would have thought the Mayday deregulation of Wall Street in 1975, the entry of China into the world trading system after 1980, and European integration after 1992 were much more fundamental factors. And on one point, Blinder is downright infuriating:  he thinks Obama should have “trumpeted a consistent… message from the get-go” as to “how we got into this mess.” But the fact is that Obama didn’t understand the nature of the panic at the time, nor did his chief economist Lawrence Summers, nor, for that matter, did Blinder himself. (If you doubt this, have a look at what Blinder was writing at the time – or have a look at his 1996 Robbins Lectures, Central Banking in Theory and Practice, which does mention central banks’ responsibilities as lenders of last resort.)  Instead, even now, the job of explaining the peculiar nature of the crisis has fallen to one of Blinder’s longtime fellow Princeton professors, Ben S. Bernanke by name.

The Federal Reserve and the Financial Crisis (Princeton, 2013), by Bernanke, is a slightly cleaned-up version of four unusual lectures the chairman of the Fed gave at George Washington University, in March 2012, with the aim of giving an overall account of what happened, and why, and what he thought was likely to happen next. As coauthor of a best-selling introductory economics text (with Robert Frank, of Cornell University), Bernanke is a well-qualified expositor. He is also one of the leading economic historians of his generation. Mostly, though, he is the man who, with the help of his many counselors, led the way out of the fog. It figures that he would produce the clearest version of the story, and so he has.  Like Irwin and Blinder, he makes use of It’s a Wonderful Life to illustrate what a bank run is like.  Unlike them, he elaborates:

The crisis of 2008-2009 was a classic financial panic but in a different institutional setting: not in a bank setting but in a broader financial market setting. As house prices fell in 2006 and 2007… it was increasingly evident that more and more [subprime borrowers] were going to be delinquent or default, and that was going to impose losses in the financial firms, the investment vehicles they had created, and also on credit insurers like AIG.  Unfortunately the securities were extremely complex, and financial firms’ monitoring of their own risks was not sufficiently strong.  The problem was not just the losses. If you put together all the subprime mortgages in the United States and assumed they were all worthless, the total losses to the financial system would be about equivalent to one bad day in the stock market. The problem was that they were distributed through different securities and [to] different place and nobody really knew where they were and who was going to bear the losses. So that created a lot of uncertainty in the financial markets.

As a result, wherever you had short-term funding, whether commercial paper or other types of short-term funding, the lenders refused to lend. We had all kinds of funding that was not deposit-insured; it was so-called wholesale funding, which came from investors and other financial firms. Whenever there was doubt about a firm, as in a standard bank run, the investors, the lenders, and the counterparties would pull back their money quickly for the same reason that depositors would pull their money out of a bank that was thought to be having trouble.  So there was a whole series of runs, which generated huge pressures on key financial firms as they lost their funding and were forced to sell their assets quickly, and many important financial markets were badly disrupted. During the Depression, thousands of banks failed, but almost all of them, at least in the United States, were small banks (some larger banks failed in Europe).  The difference in 2008 was, in addition to the many small banks that failed, there were also intense pressures on quite a few of the largest financial institutions in the United States.

You won’t find a better description of the 2008 panic than that. And the rest of the book is equally clear.  Bernanke explains how the principle associated with Walter Bagehot – that the best way to quell a panic is by lending freely, at a penalty rate, against good collateral, to firms suffering from a loss of funding – enabled the Fed and its European counterparts to halt the potential meltdown, and in the end at little ultimate cost to taxpayers, or to the central banks themselves. But the lesson of the 1930s, he says, is that much work remains to be done, in terms of providing accommodative monetary policy.  So if you are still interested in working through the details of what happened and why, then Bernanke’s lectures are definitely the right place to start. Neither Irwin nor Blinder cites them.

But if you’re mainly interested in the long arc of the story of the Fed – in the way its machinations affected your family, from your great-grandparents to the outlook for the lives of your children – and if you like a good political thriller, then you might consider When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of America’s Monetary Supremacy (Princeton, 2007), by William Silber, of New York University. Silber relates how William Gibbs McAdoo, Treasury Secretary to President Woodrow Wilson (and chairman of the Fed while the agency was opening its doors), managed to shut down trading on the New York Stock Exchange for four months following the outbreak of World War I in Europe to prevent a panic among European investors who were eager to sell US securities in order to demand gold with which to fight the war. The panic subsided, the bond-trading resumed in November (stocks a month later) and in November 1914, the discount at which the dollar had previously traded in global currency markets disappeared. Within months, says Silber, the US would replace the United Kingdom as the world’s preeminent financial power, thanks to McAdoo’s determination to maintain the integrity of the nation’s banking system.  It was the first decisive victory of the Fed; and while that may have set the institution up to fail in the 1930s, the story demonstrates how long the shadows cast by events can be.

Thus When Washington Shut Down Wall Street is not a bad meditation for those interested mainly in the future of health care legislation. The Affordable Care Act of 2012 was just the beginning.  Legislators hoping to rein in soaring health costs and provide decent health care to all American citizens should take a leaf from the 62nd Congress that created the Fed. Those highly practical reformers recognized that central bankers would have to be insulated to some degree from political pressure, so they created a seven-member Board of Governors.  They understood, too, that in order to command widespread support, the system would have to be highly decentralized, so they created a dozen regional federal reserve banks, each with strong links to local banking establishments.  Decades were required to work out relationships within the system, between New York and Washington in particular; still longer to develop the will to exercise the power to achieve what until recently was described, without irony, as the Great Moderation. (That adventure is the subject of Silber’s newly-published biography of Paul Volcker.) But the moral of the story is that, in the Panic of 2008, the Fed succeeded in maintaining the stability of the global financial system. A workable solution for one thorny problem suggests a blueprint for dealing with another.

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Last week I sowed a certain amount of confusion in describing some thirty granite inscriptions that decorate the walls of the US Courthouse in Boston as tending to support the extension of equal protection under the law to matters of sexual preference and gender orientation.

Better to say, as did the late Anthony Lewis, in his introduction to a pamphlet describing the installation, that the quotations symbolize “a democratic conversation in which all those encountering these inscriptions are invited to participate… about what the law can and should do in a free society.”  See for yourself here,