September 17, 2019

Hindsight: The Federal Reserve’s Framers Would Be Shocked

ONE hundred years ago today, President Woodrow Wilson went before Congress and demanded that it “act now” to create the Federal Reserve System. His proposal set off a fierce debate. One of the plan’s most strident critics, Representative Charles A. Lindbergh Sr., the father of the aviator, predicted that the Federal Reserve Act would establish “the most gigantic trust on earth,” and that the Fed would become an economic dictator or, as he put it, an “invisible government by the money power.”

Had the congressman witnessed Ben S. Bernanke’s news conference last week, he surely would have felt vindicated. Investors, traders and ordinary citizens listened with rapt attention as Mr. Bernanke, the Fed chairman, spoke of his timetable for scaling down stimulative bond purchases. “If things are worse, we will do more,” he said of the nation’s economy. “If things are better, we will do less.”

In 1913, few of the framers of the Fed anticipated that the institution would do anything of the sort. The preamble to the act specified three purposes: to furnish “an elastic currency,” to provide a market for commercial paper so that banks would have more liquidity, and to improve supervision of banks. Regulating the economy was not among them.

The framers saw that the banking system needed reform, but they were sorely divided about how to go about it. Wall Street wanted a strong central bank — preferably under private control. Populists like William Jennings Bryan, Wilson’s secretary of state, insisted that banks answer to the public. But many people from the farm belt, like Lindbergh, were opposed to any powerful financial agency.

The backdrop to the legislation was that the United States, in the late 19th century, suffered frequent financial panics. In 1907, banks ran out of cash and the panic snowballed into a depression. The nation had no central reserve — no agency that, in a crisis, could allocate credit where needed. All it had was J.P. Morgan Sr., who arranged for a private loan syndicate. That was not enough, and, anyway, in the spring of 1913 Morgan died. Leading financiers, like Paul Warburg, a German immigrant who wanted to replicate the Reichsbank in his adopted home, thought the United States needed some coordinating agency. They thought that the system was too decentralized.

Many ordinary Americans disagreed. They thought banking was too centralized already, and that credit shortages were the fault of uncompetitive practices on Wall Street. Over the winter of 1912-13, Congress staged sensational hearings to unmask the “money trust” — a supposed conspiracy among the biggest banks. The hearings did not uncover evidence tying credit shortages to collusive behavior. They did establish that Wall Street tycoons were overly clubby with one another — especially in the distribution of securities — and not exactly beacons of free competition.

The Democrats, who won control of Congress in 1912, promised in their platform to free the country “from control or domination by what is known as the money trust.” What’s more, they specifically opposed the creation of a “central bank,” which the delegates saw as a stalking horse for the money trust.

THUS, supporters of the Federal Reserve legislation faced a delicate problem: how to fashion a centralizing agency and not run afoul of the strong popular sentiment against centralization.

Representative Carter Glass of Virginia, the chief sponsor of the Federal Reserve Act, embodied this dichotomy. Before 1913, his claim to fame was helping to draft a state constitution that had disenfranchised African-Americans. He was an ardent champion of states’ rights. Like most Southern Democrats, he wanted to restrain federal authority — in banking as well as in race relations. Laissez-faire Democrats since Jefferson and Jackson had opposed central banks, and Glass embraced that tradition. But he recognized a need for banking reform, and wanted a more elastic currency to avert money panics and moderate depressions.

His solution was to propose privately owned regional reserve banks that would be new centers of banking strength, away from Wall Street. Wilson horrified him by insisting that a Reserve Board sit atop the individual banks. To Glass, this federalist design looked too much like a central bank.

Then Wilson horrified Wall Street by insisting that Reserve Board members be named by the president, rather than by banks. “History and experience unmistakably show that governments are not good bankers,” hissed The New York Times, which typically toed the Wall Street line. The Washington Post accused Wilson of engineering “a colossal political machine.”

Facing Congress on June 23, Wilson touched a popular chord when he said banks should be “the instruments, not the masters, of business.” But he also said that “our banking laws must mobilize reserves.” This had been Warburg’s main goal — to pool banking reserves so they could be tapped as needed.

Historians still debate what the Fed’s framers intended because many details were left vague, and the Fed evolved over time. When the act was signed, in December 1913, few anticipated that the Federal Reserve Board would become so central to the economy, though it did have authority over interest rates. And Glass pledged that the new agency would be restrained by the requirements of the gold standard — which the nation eventually abandoned.

The current Fed would dismay the framers. Glass would be shocked at the power of Mr. Bernanke. Warburg might applaud the Fed’s efforts to temper a recession, while frowning on its printing of “fiat money.”

For some of the same reasons, “end the Fed” is a rallying cry among Tea Partyers, and among critics with a fondness for the gold standard. Representative Kevin Brady, a Texas Republican who is chairman of the Joint Economic Committee, has marked the Fed’s centennial by calling for a commission “to examine the United States monetary policy” and “evaluate alternative monetary regimes.”

The trenchant question is whether nostalgia for “originalism” is a useful guide to policy. Wilson knew well that the Second Bank of the United States — a 19th-century precursor to the Fed — had been left to die, at the insistence of President Andrew Jackson. But Wilson was trying to govern for the present, not to placate his party’s ghosts. Congress today should receive reform proposals in the same spirit.

Roger Lowenstein is writing a history of the Federal Reserve.

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Economix Blog: Simon Johnson: The London Whale, Richard Fisher and Cyprus


Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

In the ordinary course of political events, months or even years pass between a definitive investigation and sensible policy remedies being proposed. There was a lag, for example, between the Pecora hearings in the 1933 and some of the modern securities legislation that followed. (Consider reading Michael Perino’s book, “The Hellhound of Wall Street,” or watch his 2009 conversation with Bill Moyers, in which I took part.)

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Perspectives from expert contributors.

We finally had a modern Pecora moment last Friday, when Senators Carl Levin of Michigan and John McCain of Arizona laid bare how JPMorgan Chase has been run since the financial crisis and since the passage of the Dodd-Frank Act, which supposedly “reformed” banks.

Within 24 hours, we had the clearest possible statement of how to think about the modern financial system – and make it less risky – in the form of a speech by Richard Fisher, president of the Federal Reserve Bank of Dallas. The timing was presumably coincidental, yet it also reflects the speed with which smart people are reassessing the risks posed by the mismanagement of financial institutions. With Mr. Fisher as a thought leader, some of the best new ideas are being developed within the Federal Reserve System.

The question now is how fast attitudes will change within the Board of Governors, the seven presidential appointees who sit atop the Federal Reserve System. Unfortunately, at least two powerful governors seem to resist sensible further reform.

At its heart, the Levin-McCain report reveals executives with a profound misunderstanding of risk in the world’s largest bank (I use the calculations of comparative bank size offered by Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation). Even worse, the report shows us in some detail that banks – even after Dodd-Frank – can and do readily manipulate complicated measures of risk in order to make their positions look safer than they really are.

As Jeremy Stein, a Fed governor, pointed out recently, there are strong incentives to do this repeatedly in banking organizations (read the opening few paragraphs of his speech carefully).

The banking regulators – in this case, the Office of the Comptroller of the Currency – are clearly unable to keep up with this form of “financial innovation” (which is really just clever ways to misreport risk).

Did JPMorgan Chase’s top management do this intentionally? Did they mislead investors, particularly in the fateful conference call on April 13, 2012? This is a fascinating question on which the courts will no doubt rule. (You should also review this report by Josh Rosner of Graham Fisher, with the link kindly provided by Better Markets.)

Jamie Dimon will survive because JPMorgan Chase remains profitable. But it is profitable precisely because it receives implicit subsidies from being too big to fail. JPMorgan Chase disputes the precise scale of these subsidies – as Idiscussed here last week. Let’s just call them humongous.

This is not about individuals, this is about policy. And Richard Fisher has exactly the right approach:

At the Dallas Fed, we believe that whatever the precise subsidy number is, it exists, it is significant, and it allows the biggest banking organizations, along with their many nonbank subsidiaries (investment firms, securities lenders, finance companies), to grow larger and riskier.

This is patently unfair. It makes for an uneven playing field, tilted to the advantage of Wall Street against Main Street, placing the financial system and the economy in constant jeopardy.

It also undermines citizens’ faith in the rule of law and representative democracy.

Mr. Fisher’s speech is entitled “Ending ‘Too Big To Fail,’” the same title as a recent speech by Jerome Powell, a governor of the Fed board (which I wrote about here recently).

The difference between Mr. Fisher’s approach and what Mr. Powell proposes is significant, particularly regarding the timing for needed action.

Mr. Fisher wants to make the largest banks smaller – and particularly force investors to confront the reality that they will face losses when high-risk investment banking arms fail. In Mr. Fisher’s words:

The downsized, formerly too-big-to-fail banks would then be just like the other 99.8 percent, failing with finality when necessary – closed on Friday and reopened on Monday under new ownership and management in the customary process administered by the F.D.I.C.

Mr. Powell, by contrast, is not willing to take any additional actions at this time. As far as we can see, the Fed’s chairman, Ben Bernanke, is on the same side as Mr. Powell in this argument. But the Bernanke-Powell team is losing ground almost every day, at least on the merits of the argument. On Wednesday, Mr. Bernanke seemed to move a little closer to Mr. Fisher’s position but did not go as far as he should.

As Jesse Eisinger sums up the JPMorgan Chase mess with its multibillion-dollar trading loss last year, “Regulators remain their duped and docile selves.” The view that “smart regulation” can rein in excessive risk-taking is completely implausible.

Cyprus now demonstrates that the case for limiting the size of individual banks relative to the size of the economy is beyond debate. The awful financial debacle in that country, including the fumbled bailout unfolding this week, is a further reminder of the dangerous ledge on which we live.

If you let a few banks become very large relative to the economy, then their missteps can cause enormous damage – and big costs that will fall on someone. The losses incurred by Cypriot banks – around 6 billion euros (almost $8 billion) – are roughly on the same scale as the losses suffered by JPMorgan Chase as a result of its failed “London Whale” trades.

As the Nobel laureate Christopher Pissarides points out, nothing about this situation is fair or good for economic prosperity. A few Cypriot banks bet big on Greek bonds, very big, and their losses are about one-third of Cypriot G.D.P. Why would anyone want bank executives and traders to be in a position to do this much damage to a country?

The question is only what the size cap should be – surely in the United States we should seek to be below the risk levels that built up in Cyprus (or Iceland or Switzerland or Britain). In fact, why should any single financial institution be big enough to damage the United States with its miscalculations or misrepresentations? Yet the existence of too-big-to-fail subsidies means that a financial company like JPMorgan Chase has motive and opportunity to become even larger.

The British have figured out that finance needs to become safer; the authorities there are pushing for higher capital levels (above what seems likely to happen in the United States). And Martin Wolf, an influential senior columnist at The Financial Times, has a ringing endorsement of Anat Admati and Martin Hellwig’s new book, “The Bankers’ New Clothes,” on what is wrong with banking. Expect more British thinking to follow in this direction.

Why, in the United States, are we standing by?

As with so much in our economy today, much depends on the Federal Reserve. The Fed could do a great deal by itself to make the largest banks smaller and safer; the F.D.I.C. is ready to move in this direction.

The Fed likes to look to Congress for action. But Congress will not act unless so advised by the Fed.

It’s time for Mr. Bernanke and Mr. Powell to listen more carefully to Mr. Fisher – as they watch the awful events in Cyprus.

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Deal Professor: Federal Reserve as a Hedge Fund: Higher Profits, Lower Pay

Harry Campbell

The year 2011 is over, and soon we’ll be hearing again about billion-dollar paydays for select hedge fund wizards.

If it makes you feel any better, not everyone is sharing in these riches. The people who operate the most successful hedge fund around are receiving a relative pittance.

That hedge fund is the Federal Reserve. Last year, the central bank turned over $76.9 billion in profit to the federal government, slightly down from $79.3 billion it provided in 2010.

The Fed made this money in interest on a nearly $3 trillion portfolio of securities. This enormous holding was built up largely in the wake of the financial crisis as the Fed bought these securities through two rounds of quantitative easing.

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I call the Fed a hedge fund because it is operating like one, leveraging its balance sheet to earn huge profits. The main difference between a hedge fund and the Fed is that the Fed effectively creates its own money, so it doesn’t have any borrowing costs, meaning yet more profits. Remarkably, the Fed’s profits are also an afterthought. The Fed is trying to stabilize and increase the United States economy in the wake of the financial crisis, and its profits are a nice byproduct.

Still, these earnings blow away any other hedge fund profits.

The Fed employees who manage this operation receive a federal salary for their efforts. The money is well above the pay of the average American but still relatively modest compared with those in the financial industry. The top salary class at the Federal Reserve has a maximum of $205,570 a year. Ben S. Bernanke, the chairman of the Federal Reserve, earns $199,700 a year, while the other members of the Federal Reserve board earn $179,700.

Officers of the branch banks of the Federal Reserve system earn more. The president of the Federal Reserve Bank of New York, Treasury Secretary Timothy F. Geithner’s old position, receives $410,780. By my calculation, the 17,015 employees of the Federal Reserve received an average compensation of $87,579 in 2010.

Figures for 2011 hedge fund compensation are yet to be known, but compare the Fed’s salaries with the highest paid hedge fund managers in 2010. According to AR: Absolute Return + Alpha magazine’s annual list, the top 25 hedge fund managers made $22 billion, or an average of $880 million. The highest paid hedge fund manager in 2010 was John Paulson, who made $4.9 billion running a hedge fund that had about $33 billion in assets. (He is likely to make much less in 2011, with his funds falling as much as 52.5 percent last year.)

Hedge fund managers make their money from the “2 and 20.” Hedge funds generally charge a fee of roughly 1 to 2 percent on all assets under administration and take 20 percent of the profits. The idea is that this large cut will incentivize the hedge fund manager to earn outsize profits.

But federal employees who were paid astoundingly less made fantastically higher profits than any single hedge fund manager. The entire Fed payroll for 2010 was still less than Mr. Paulson’s 2010 salary. One man made four times more than the Fed’s 17,000 plus employees combined, and earned much less money.

The point is not that the federal government should go into the hedge fund business or that making money is relatively easy for the Fed. Rather, it is that these government employees did this service without demanding to be paid billions in compensation.

They are not alone. Treasury Department employees take on the similarly complicated, hedge fund-type task of supervising the economy for even lower pay than the Fed’s employees.

Even outside the federal government, there are those who are not paid enormous sums to perform the most complicated financial tasks.

David F. Swensen, the chief of the Yale endowment, for example, is one of the most successful asset managers in recent history, consistently earning outsize returns and often beating the best hedge fund performers. His salary too is much less than that of the hedge fund barons. In the last few years, his salary has ranged from $3 million to $5 million a year for managing Yale’s endowment, which is valued at about $20 billion.

Even so, people in private industry argue that you have to pay top dollar to get the best people and that the market demands it.

We even see this argument being made by the federal government. The regulator who oversees Fannie Mae and Freddie Mac, Edward J. DeMarco, has asserted that he had to pay the top six executives at Fannie and Freddie more than $35 million in combined pay over 2009 and 2010. He said that to do otherwise would be “irresponsible” because it would fail to retain and attract the appropriate people. Yet, the Fannie and Freddie executives are arguably doing even less sophisticated work than the Federal Reserve employees do.

Why these executives should be paid more than Mr. Bernanke and his colleagues defies reason. This is government work now.

These disparities show that compensation, like people, is a complicated issue. People are willing to forgo earnings for prestige and other benefits like job security. And perhaps top dollar simply does not need to be as high as those in the finance industry would want you to believe.

Perhaps more interesting, the Fed pay structure may show that the work that these hedge fund barons and other titans of finance and industry perform doesn’t require multimillion-dollar salaries — even when some claim that the market demands them. Perhaps they would be willing to accept lower amounts when push comes to shove.

This will happen only when the pension funds and other institutional investors recognize that a 20 percent cut of the profits paid to hedge fund managers is too much, and they push hard to lower these fees. In the private equity realm, the Institutional Limited Partners Association is leading a similar crusade, but no such movement has yet penetrated the hedge fund universe.

The Fed has unwillingly made billions, to the benefit of the United States taxpayer. The Fed and its employees have done it in a way that would make even the most ardent opponent of the Fed proud — at a low cost.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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