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Law professor Lev Menand has a new book out on that strange institution, the particular Federal Reserve, what it does and how the power and obligation have grown over time.
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Menand is an relate professor at Columbia Law School devoted to finance and legislation. Before he joined the law school, he or she held various functions at the Treasury Section during the Obama administration plus was an economist at the Federal Reserve Bank of New York, helping to oversee huge lenders.
Recently i sat down with him to discuss the particular Fed, the economic climate, the capital markets, regardless of whether we are facing one more financial crisis and the reason why he thinks the Fed is harmful to our economy plus our democracy.
This conversation continues to be edited for size and clarity.
Thanks very much for joining me. Are you able to summarize the thesis of your book, “The Fed Unbound: Central Banking in a Moments of Crisis”?
The particular Federal Reserve is definitely an organization created by Our elected representatives for a limited, essential purpose to do a difficult job, which is to handle the US money supply.
When you get on a Bank associated with America or Citigroup account and you view a balance there, that is the money that the Fed is managing. Those are not the same thing as green pieces of paper. And the Fed’s work is to ensure that you deal with them the same, that you simply think of them exactly the same. And that the amount of these Bank of America bucks is growing at a rate that is appropriate for the particular economy to put all of its resources to work, including all of its people.
The thesis from the book is that financial liberalization, deregulation from the banking system and a lot of choices made throughout the second half of the 20th century caused the Fed to get “unbound. ” Basically, what you have will be the rise of a “shadow banking” system.
All these monetary companies that are not under the Fed’s purview, they start developing money. The Given doesn’t have the tools to manage them, and then they will run into problems during economic downturns, and the Fed pulls out all the stops and tries to backstop all of them — bail all of them out.
That is the 2008 financial crisis. And that fundamental powerful is still with us.
Essentially what you’re saying is that this institution, which is regarding 100 years old, the Federal Reserve, was created to manage money so that when there was a financial crisis, the Fed would come in plus lend to them plus cushion that blow.
Yet over time, the Fed’s mandate had developed and its power got grown and we are trying to figure out why that will happened and regardless of whether that’s a good thing or a bad thing. Is that fair enough?
Fair enough.
Following the 1930s, the Fed had been very successful. We all didn’t have spotty banking panics. Each time there was a recession, people didn’t run on banks. We thought that we had solved monetary instability and financial crises until 08. And what was 2008? It was a run on shadow banks.
A whole group of financial institutions experienced come along and began to do what banking institutions do. They started to create deposits that belongs to them called different things. Plus they were exposed to the same run dynamics that you saw in the 19th century before the Fed was created.
And the Fed chose if we don’t are available in and backstop this technique, it will collapse. But it was never anticipated that this would be how the Fed [acted]. The Fed had not been designed to stabilize the particular shadow banking system.
Let’s simply back up. You’ve given a preliminary definition of shadow banking, but stroll us through this. These are not bank deposits that are backstopped by the federal government, by Federal Deposit Insurance plan Corp.
Give us a really simple example. The money market fund is part of the darkness banking system, right? So it’s not like it’s an obscure financial system for the top notch. Most middle-class Us citizens touch the shadow banking system.
Yeah. So you will find three major types of shadow banking which i talk about in the book. A person mentioned one, that is the one that ordinary Us citizens are most likely to have came across. The other types are usually primarily wholesalers regarding businesses, not ordinary individuals, but generally what they all have got in common is they may be non-bank firms that do not have bank charters that are trying to recreate the bank business model. The Fed doesn’t have the same set of tools to ensure that the cash market fund [and other shadow bank institutions aren’t] acquiring too many risks.
The shadow financial system is huge, right?
In 2007, which was the maximum of the shadow banking system, a top we will eventually go back to if further reforms are not made, it is estimated that there were about $15 trillion of shadow bank-issued money instruments against $7 or $8 trillion of bank deposits and lower than $1 trillion associated with government-issued cash.
In the aftermath, the particular shadow banking system got a lot smaller because we had lots of major shadow banks fail like Lehman Brothers. And then during the last 10 to 15 years, they have grown again.
So right now we’re back where the banking system is a lot bigger. There’s $18 trillion of deposit. And the shadow banking system is probably across the same size, probably slightly smaller. It is very hard to estimate the size, well, because it’s in the shadows.
You say that this is in the shadows, which is another way of stating it’s not fully regulated. So we had an economic crisis in 2008. You write that they basically have two problems coming out of this. You are to not recognize the true nature of the turmoil. They think of it as the 100-year flood rather than a fundamental aspect of structural fragility.
And then the second thing is the fact that we pass the sweeping financial change, the Dodd-Frank take action, that touches every corner of the economic climate and yet is, I believe your view will be, woefully inadequate. What does the Fed do right? What does the Fed perform wrong?
Therefore a stable and, in fact , growing money supply is an absolutely important precondition for the sorts of economies that we live in today. If the cash supply shrinks rapidly, our entire financial structure falls aside. People owe each other money. And if the amount of money in circulation starts to shrink rapidly, since the entities that have released it are failing, then debtors can not pay back their debts and they start defaulting. That turns into a vicious cycle.
You can think of the failure of banks a little like the failure associated with power plants. When the Long Island Power Authority just shut down and stopped operating, it would be very hard for almost any business on Lengthy Island to continue to create goods and services. The Given and Congress eventually stepped in to bail out and prevent the particular further collapse of the grid. Now that was necessary, otherwise, we would have ended up in a great depression of the exact same scale or possibly a larger, worse depressive disorders than in the ’30s.
So the Fed’s hand in 2008 has been more or less forced. Whenever we wanted to continue to function this economy, i was held hostage from the players that were offering the infrastructure where the economy had been operating. Where stuff went wrong was a failure to grapple with the deep difficulties with continuing to have an economic climate in which the public and households and companies are at the mercy of unregulated strength plants that are able to fundamentally profit off financial activity during happy times, and then hold the entire society as it had been hostage for open public support during bad times. We wound up making some changes but not addressing that fundamental problem.
Today we always have a dynamic in which a very large financial sector is profiting away from implicit and explicit public backstops and it is fundamentally fragile in its design.
The particular pandemic was specifically such a shock. The particular lesson that the Given learned from 08 was to offer a lot more public support for the financial sector, also faster. And in a single respect that was productive. But the dynamics of the, the implications for everyone of the rest of us of having this federal government agency making $3 trillion available for a lot of financial firms that aren’t operating in the public interest, this is deeply troubling. It’s a dynamic that will eventually lead to possibly the failure of our democracy or the failing of our economy.
A dynamic leading to a failure of our democracy seems pretty dire and significant. We obviously want to explore that in a second and explore the particular implications of this, the quiet crash, the particular silent crash of March 2020. In some ways the Fed never ever stops bailing out there the economy all through that period from late 2008 through to March of 2020.
I do think in critical respects, we are still living in the 2008 financial crisis globe. The acute stage of that crisis ended in early 2009, but we have not retrieved from the damage.
The last 15 years are characterized by anemic growth, worsening inequality that is in part the byproduct of the Fed’s effort to fruit juice economic growth, which usually disproportionately enriches asset owners. [We have] a financial field that is not investing in growing the productivity of the American economy.
We didn’t in fact use this period to purchase expanding capacity. And we continue to have a financial system that is fragile.
By the time 2009 arrives, you have a financial system that is very weakened. Fed officials launch a course called quantitative easing. That’s initially targeted at the housing market. And they also go and buy countless billions of dollars of mortgage-backed securities.
“Quantitative easing” is wonky phrase, yet there are two reasons for it. One is the particular Fed is purchasing securities and it didn’t used to do that; it used to just proceed short-term interest rates up and down. And then the second thing is usually it’s buying property to help certain sectors of the economy. It’s a dramatic change that’s happening right here with the Fed, right?
Yeah. Look, the Fed is operationally a financial institution. It’s supposed to be the bank just for banks. And it’s usually the way that it operated from the Second World War up to the 08 crisis was to adjust the constraints upon bank balance bedsheets.
Then you can find subsequent rounds of QE where the Given buys Treasury securities, the federal government’s debt, in an effort to reduce longer-term interest rates throughout the economy and further juice financial activity. So there are not sufficient fiscal stimulus and the economic climate is coming back really slowly. And the Fed has moved its interest rates down to absolutely no so that the banks may expand their balance sheets, but they are not expanding their balance sheets for a price sufficient to allow the economy to come back.
The system by which QE functions is to increase asset prices. So you have a booming stock market, the booming government debt market, a flourishing housing market, even though you come with an economy, an underlying economic climate that is still weaker than it was prior to the 2008 crisis.
It’s a worrying way in my see to do economic plan. It might be the ninth-best approach. It’s making one group of people that are already very well off even more well off. It is a very harmful place for community to be.
My friend, Chris Leonard, has written a book known as “The Lords associated with Easy Money” about how the Federal Book “broke the economy. ” Here in this interregnum between downturn, what you’re saying is that the Fed had been flooding the markets along with purchasing power that was stimulating the asset markets and it has been flowing to the wealthiest people, asset cases already.
And we got something that looked like bubbles too, right? We get the crypto markets, we get NFTs, we get SPACs. The particular Fed in some ways is usually trapped into this particular because governments around the world are not spending wisely. They’re not helping the Fed away. They’re not assisting the economy. Actually they’re counterproductive. They are embracing austerity.
Yeah. The failure of the fiscal specialists of legislatures in the usa and also in Europe to address economic weakness is a source of the particular pressure and the inspiration on the Fed to experiment with massive asset purchases as an alternative approach to staying away from an even weaker economic climate.
We need to identify this was a very bad policy mix that individuals ended up in, to inject huge amounts associated with liquidity into the financial system as opposed to, say, creating people checks or helping keep individuals in their homes or even investing in infrastructure the way that Chinese authorities does.
There are numerous other ways to manage financial weakness. But if your approach is not to do any one of those things and actually limit the amount of money available to governments and state plus local governments to invest, and to cause layoffs of public-sector employment, if you’re not going to go of those things and you simply want to flush the particular financial system full of liquidity, one of the problems you are going to have is the fact that you’re going to get bubbles in financial marketplaces.
So let us go back to March of 2020. It’s poorly understood. Because in some ways the government and the Fed have learned from this review that you’re leveling. The Fed does a bunch of things it had never done before, even in the financial crisis of 2008.
Yeah. Simply the lesson they took from 08 was never allow things get therefore bad that we have a failure of a major company like Lehman Siblings, because that’s a disaster. And so when stuff started to deteriorate within March of 2020, when there was simply a run on the shadow banking system, the same as there was in 2008, the Fed walked in quickly.
It expanded its very own balance sheet enormously, very rapidly. This didn’t do anything like this in 08. This was a shock-and-awe approach to suggest in order to anybody running on the shadow bank there was no need to operate, that the Fed could take all the assets onto its own balance sheet, that there wasn’t going to be a repeat of Lehman Siblings.
With some support from Congress, it also set up facilities in order to lend to ordinary companies and to state and local governments. However the actual dynamic, if you look at it carefully, is they’re getting breadcrumbs and these additional programs are helping to legitimize the much, much larger and fundamentally difficult lending programs for your financial sector.
Our politics are calcified. Our political system is subject to numerous veto points. The particular Fed in contrast is a committee run simply by one guy, Jerome Powell. A defense of the Fed would certainly say:
“Look, they can behave very quickly. Yes, this goes through the financial system, which helps bankers and asset cases and the wealthy disproportionately, but eventually it trickles down and saves the economy. Your criticism really is with the political system, not the Federal Reserve. ”
There is this dynamic in which the more the particular Federal Reserve tries to use its economic system-based tools to respond to economic complications, the more pressure it will take off the political program to produce legislative solutions that are more egalitarian and more effective at resolving these same problems.
A key predicate of this is our own democracy doesn’t work, that our politics don’t work, that essentially legislators can’t make good policy, that we need to rely on a few unelected technocratic experts to make policy that most Americans don’t understand that benefits the economic sector disproportionately, and that’s the best we are able to do as a community and a polity.
I reject the idea that’s the best we can do.
We are dooming ourselves in order to very bad mechanics over time, a decreasing economy really, plus potentially a decreasing society. To reinvigorate our economy plus our society, we have to move beyond the reliance on central bank medicine and to revive a meaningful economic, legislative plan and politics. And another thing that’s encouraging in this regard is that the final couple of years you’ve seen some of that. You have seen the legislature act in ways it did not act in between 2008 and 2020, reflecting some feeling that mistakes had been made during that period.
Now we have a very interesting and unpleasant period because we have the Fed dealing with something much more conventional. We have an overheated economy.
What do you think about the particular Fed’s job at the moment? Is the Fed doing it right thing? Is a product of the darkness banking systems flaw or is this completely separate?
I believe it’s important to notice that the current inflationary dynamic is primarily the supply-side shock. The pandemic just scrambled the normal patterns associated with demand for goods and services, and we ended up with shortages in certain important goods and services, which caused prices to rise.
After that we have spiking item and energy costs due to geopolitical discord and also due to the pandemic in various ways. The particular driving factors of this inflationary dynamic are not loose financial circumstances.
Here again, we stand the chance of over-relying on the Fed to solve a set of problems that require action by the government through a variety of other tools. Therefore it’s certainly the case that some interest rate hiking is essential. Interest rates were too low and should be hiked. But the big question is whenever they continue to be hiked to the stage where they choke off the whole general economy, to shrink the overall economy in order that it can match up in dimensions with the amount of essential oil and natural gas that’s currently being produced as well as the amount of key services and goods that are coming by means of our supply chains?
We do not need the Fed to tighten in order to such an extent that it induces a recession. Instead, we need various other government policies directed at supplying more of the services and goods that are experiencing this particular shock. It would be really unfortunate if, because of the high price of coal and oil, we cause individuals to lose jobs all across the economy.
I am cautiously optimistic that policymakers understand this now better than they have. We will be better off tolerating some amount of inflation for some period of time as the economy adjusts to an enormous shock rather than overreacting and aiming to eliminate that pumpiing by creating an assurance of high unemployment as well as a bad investment view and climate for that economy going forward.
It’s so annoying. The Fed functions through the financial system disproportionately helping the wealthy. It creates asset bubbles all throughout the economic climate. It then starts to tighten.
And doing so, it disincentivizes companies from investing and growing while courting a recession that will throw numerous average people unemployed after those countless average people have only barely begun in order to benefit from a decade of loose financial problems by having their wages grow.
Let me just add another piece that will actually make your head increase. There’s a very good opportunity that to the level the Fed comes after through on aggressive tightening in the arriving months, that it results in financial instability. Therefore at the same time, as you have the Fed pursuing policies that push up unemployment, weaken the labor market and reduce business investment, the Fed may well find itself standing up all its emergency amenities again to support the particular shadow banking program.
Essentially simply because they created bubbles plus now…
The particular shock of getting rid of them, yes, will cause a run dynamic in the shadow financial system. It could take place at any point really.
Well, that was exactly where I was going to end this conversation, which is: Do you think we’re headed for another financial crisis? Since the fundamental fragility of the economy — the particular shadow banking program — has not been addressed, and you have a Fed that is using these extremely blunt tools.
I think it’s entirely possible. Part of the problem we now have is it’s very hard for officials or academic observers and even market participants to possess a handle on the stability sheet strength associated with financial institutions that finance themselves in the [shadow banking system]. And so it’s difficult to anticipate each time a run might take place.
The Given needs to be very careful. It’s not actually dealing with a financial system that may necessarily go to that speed and soak up that shock. We are in a very uncertain and risky time through an economic and monetary perspective right now.
Everybody ought to be on high notify and people should need that their Congress try to tackle problems and think about these problems, because it’ll be much better to begin moderating now in order to wait for another big crash, to put in location safeguards and constructions that are necessary for a healthy economy and thriving society going forward.