Fed Hubris: Central Bank Ignores That It is on Thin Political Ice

A shot across the Fed’s bow from Simon Johnson, former IMF chief economist and bank critic, on the surface looks to be a good bit of news. Johnson, in a recent Project Syndicate article, warns that the notoriously cloistered central bank is overly confident about its political position.

Although Johnson is constrained by both space limits and Project Syndicate’s anodyne style, his warning is clear: the Fed is more powerful than ever despite having been wretchedly incompetent in the runup to the crisis. Many would say it has compounded its incompetence by going into “if the only tool I have is a hammer, ever problem looks like a nail” mode with ZIRP and QE. The Fed was not only silent when its input would have mattered a great deal, in the fiscal stimulus fight of 2009, but Bernanke called for deficit cutting in 2012, even as he had his foot firmly on the not-very-effective QE accelerator. The result is a flaccid economy, bubbles in many financial assets and destabilizing hot money flows sloshing through developing economies.

As a result of this misrule, Johnson contends the central bank is much closer than it recognizes to losing its vaunted independence. Johnson points out that the right wing is keen about restricting the Fed’s freedom of action, and that they are a much more serious threat than the Fed appears to understand. What happens if the Republicans gain a majority in the Senate in the midterms?

Even though Johnson is in some ways very critical of the central bank, he if anything overstated its base of support. The hostility towards the monetary authority among conservatives is perverse, given how much the Fed has done for the wealthy by showing such solicitude about asset prices. Nevertheless, it is not just the right that is unhappy with the Fed. It is pretty much anyone to the left of mainstream Democrats. Orthodox folks tend not to recognize its existence since its members are seldom welcome in polite DC company. Remember, it was Ron Paul and Alan Grayson who teamed up on Audit the Fed. And both conservative and liberal senators were responsible for putting an unheard of five holds on Bernanke’s reappointment as Fed chairman. Obama had to whip personally to get Bernanke approved.

Johnson regards the support of the central bank as reasonably secure on the left; that’s true only to the extent that you conflate, as he does, the left with the Democratic party. As we pointed out, the strained effort by Janet Yellen to rebrand herself in a New Yorker profile as a friend of the downtrodden says she’s aware of the central bank’s vulnerability on its left flank. As our correspondent Li pointed out at the time:

The piece is weirdly designed to prevent New Yorker-reader limo-liberals from joining forces with right-wingers who justifiably want to know WTF the Fed is doing.

Johnson’s bone of contention with the Fed is the way it refuses to make banks safe, boring, and smaller, as it is required to do under Dodd Frank. The critical sections of his discussion:

…senior Fed officials seem to have slipped back into their pre-2008 ways, ignoring concerns about dangerous financial-sector behavior – even when those concerns are expressed by members of the US Senate Banking Committee. This is not only unfortunate; it is also dangerous, because the Fed’s political position is much more precarious than its leadership seems to realize…

For example, the Dodd-Frank legislation specifies that all large financial institutions should draw up meaningful “living wills” – specifying how they could be allowed to fail, unencumbered by any kind of bailout, if they again became insolvent.

Creating such living wills is not an option; it is a requirement of the law. Yet, in a recent speech that reviewed the landscape of financial reform, Fed Vice Chairman Stanley Fischer skipped over the requirement almost completely….

Fischer appears to prefer to rely on the resolution powers of the Federal Deposit Insurance Corporation….Unfortunately, as currently constructed, these resolution powers are unlikely to work. They do not apply across borders, there is not enough loss-absorbing capital in large complex financial institutions, and the funding structure of big bank holding companies remains precarious.

Senior Fed officials emphasize that big banks fund themselves with more equity now than they did in the past. But the Global Capital Index constructed by Thomas Hoenig, the FDIC’s vice chairman, indicates that the largest US banks are still 95% debt-financed. With that much leverage, it does not take a lot to create fear of insolvency.

Yet, despite repeated and responsible expressions of concern – including from Senate Democrats – the Fed continues to ignore these profound problems…This is more than disappointing. It is profoundly dangerous to the economy.

Yves here. In other words, the Fed has become “independent” in the worst possible way. It shirked its oversight duties prior to the crisis (for instance, the Fed gave up supervision of primary dealers in 1992, and Greenspan announced his intention to let banks do as they wished with derivatives in 1996, despite a monster wipeout in 1994-1995 that destroyed more value than the 1987 crash) and now it thumbs its nose at performing tasks clearly and explicitly assigned to it under Dodd Frank.

Not that the Fed deserves to keep its independence, mind you. The Fed has engaged in a bad combination of political meddling and mission creep for so long that its wings should have been clipped years ago. It’s important to understand that the justification for Fed independence has become a dead letter. This is from former Fed economist Richard Alford, in a June 2008 post:

Since the first Latin American debt crisis, we have had a Fed that has been eager to lean against financial headwinds, but completely unwilling to take in sail when dealing with strong financial tail winds. The Fed did not the lean against either the NASDAQ or housing bubbles. Greenspan acknowledged that the NASDAQ might be a bubble, but decided it was appropriate to wait until the bubble popped and then mop up. Post 2000, the Fed denied the existence of a housing bubble. It ignored the declining credit standards, increased leverage, declining quality spreads and a Fed funds target below that implied by the Taylor Rule. The Fed then chose to characterize the bubble as localized froth even after it started to deflate. It then asserted that it was a contained sub-prime problem.

We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted.

Assuming for the moment that the Fed either made an error of commission (spiking the punch bowl) or omission (failure to exercise its regulatory and supervisory powers), is there any reason to believe it was the result of an erosion of the independence of the Fed? Unfortunately, the public record suggests that Fed independence has been compromised. There is reason to believe that Greenspan entered into deals with two of the three administrations during his tenure as Chairman. Some commentators believe that he entered into deals with all three. However, the number is unimportant. What is important is that the Fed’s independence was compromised and a very public precedent was set. Never again will an FOMC Chairman be able to say “The Fed does not make deals” to a President or a Secretary of the Treasury or a member of Congress.

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

So if we were to have Audit the Fed implemented in its original version (the central bank succeeded in getting the bill considerably watered down) or have other right-left initiatives to bring a central bank that can’t shoot straight to heel, that would be a welcome development. The disconcerting part, as Johnson indicates, is that the Fed appears to think that it is invulnerable. Whether the central bank is capable of being reformed remains to be seen

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  1. John

    The incompetent Fed have only themselves to blame for congresses wrath and encroachment. The Audit the Fed exposed how far the Fed had gone to prop up failed banks, globally. They picked winners and losers rather than put losing banks under receivership. They fixed Wall Street but failed utterly to do anything for Main Street, even though one of their mandates is for full employment.

    Only economists can fail miserably in their jobs and continue to enjoy great pay and perks and run the most powerful institution in the world, the Fed. Great work, guys!

  2. Worker-Owner

    With all due respects to John’s comment (above), the Fed has been spectacularly successful for its shareholders (the Commercial Banks that own shares in the Regional Federal Reserve Banks) and, apparently, has performed well enough that the Board of Governors acts pleased with the system’s performance.

    The Fed is a government-granted franchise to private bankers to run a Central Bank made up of Federated Private Banks. People get confused by the fact that the grant of the franchise was made by Congress (and signed into law by the President) and decide that, therefore, it is a part of the government. The Government has representatives on the Board of Governors and confirms the Chairman but the operations of the system are quite independent of detailed direction from the Board. True, Congress can rescind the franchise … but if you thought the hype was bad when Paulson went begging for the 2008 Bail-Out, movement in that direction would trigger a hype-storm and, probably, market behaviors that would scare the pants of Congressional Leadership.
    After all, The Federal Reserve Bank’s clients are leaders among the proud sponsors of both sides of the US political cartel.

    1. Ben Johannson

      The Federal Reserve Act expressly makes the central bank an agent of Treasury and the Chairman subordinate to the Secretary.

      1. susan the other

        Why would the government change the Fed? It is their perfect scapegoat. It’s oxymoronic mandate states that it will ensure price stability by two measures. One is controlling inflation. The other is full employment. Ha. What a joke. Our current Fed has the good fortune to have deflation for decades to come. So no problemo. Thanks to 50 years of insane and profligate capitalist protiteering.

      2. Worker-Owner

        I appreciate your clarification. Agency relationships are different than subordination relationships in my experience. Agency has its own interesting challenges. The question of the Chair-Person being subordinate to the Secretary is muddled here as the Federal Reserve System appears to act independently from Treasury in regards to ensuring liquidity and providing Reserves (currently loaned at near-zero interest rates). The Stimulus package and several of the other Federal Government funded programs were memorialized by Congress. I don’t remember the QE and friends ever being subjected to a similar democratic process. Maybe just my bad memory(?).

    2. John

      Lol. Please forgive my ignorance. It is comforting to know the Fed governance is safe and will continue feeding the bubble economy so the .01% will prosper at the expense of the 99.9%.

    3. Banger

      If the financial community believes the Fed acts in their interests then the Fed is not, in my view, politically vulnerable. Wall Street is one of the four main pillars current State, the National Security State, News/Entertainment Media, and Carbon-Energy being the others. Those sectors are untouchable.

      Johnson, and apparently Yves believe that the democratic process works–it doesn’t. Say the GOP runs on an Audit the Fed platform in the midterms–what then? Like Obama and health-care they’ll just pass a bill that will re-arrange a few things but the end result will be the same only worse. Money talks and ……

      1. Doug Terpstra

        “… and bullshit walks.” Yes, indeed, the “Fed” lost its independence long ago to Wall Street, right along with Congress and the rest of the USG, media, and academia. All are now completely independent of and unaccountable to the American people … for now. The aftermath of the next crisis will force massive change, no thanks to Odious O.

        1. trinity river

          Maybe they never lost their influence. The fed was planned and set up at the urging of Wall Street according to Nomi Prins in “All the President’s Bankers.”

          1. Worker-Owner

            and According to St. Murry Rothbard and several others … the history is reasonably clear, if you go look for it. But it is rarely mentioned in polite company. Neither are the facts about ownership of the Regional Federal Reserve Banks.

      2. fresno dan

        I agree the whole political system is captured – and probably nothing substantive changes.
        And we live in strange times – republicans reflexively oppose anything Obama does (bring home a pow – he was a traitor. Why do I believe if Obama had not him home republicans would be screaming, “he left a brave serviceman in the clutches of Al Qaeda”)
        The FED appears to be the democratic version (or maybe more accurately “inversion”) of the republicans reflexive antipathy to Obama – the democrats appear to reflexively defend the FED, without thinking that the FED excuse is that something akin to a natural disaster, totally unforeseeable, (NOBODY at all predicted it) caused all our financial problems. To me, it really is quite amazing how an organization that has failed in so many ways so indisputably can still be genuflected to – – than again, Cheney still has an audience…

      3. Carolinian

        Surely if the GOP does capture the Senate any Fed bill would have to pass over Obama’s veto…or after that over Hillary’s veto (just kidding–I hope!)

        So maybe they are invulnerable at least until the financial house of cards collapses.

    4. F0ster

      So what you’re essentially saying is that the Federal Reserve has the Government and Congress cornered and thusly can commit and get away with doing what ever crimes to humanity it wishes in the interest of it’s shareholders. So the FED and it’s secret shareholders are essentially Too Big To Fail and in control of the US Government.

      1. Yves Smith Post author


        The Fed is more like a public-private partnership. It does not have banks as “shareholders” meaning owners of its common stock. Banks own PREFERRED stock. This preferred stock gets a dividend but does not carry voting rights.

        The regional Fed boards do not have any governance rights. They were created to give the regional Fed banks input on local economic conditions to help the Fed do its job in providing liquidity. Remember, the US didn’t start measuring GDP until the 1930s. The Fed boards do not do the things a board of directors of a private company does, like review policy and budgets and pending litigation. They could never, unlike a private company board, fire the president of a regional Fed. The members of these boards simply have tea and cookies with the Fed periodically. The Fed is cognitively captured, and clearly favors banks, but the advisory boards are not the reason. The Fed was set up and has always been a bankers’ bank. As a bank serving banks, it will tend to see the world through a bank’s point of view. It’s gotten much worse over time as neoliberal ideas have become dominant, in no small part due to Alan Greenspan.

        1. MaroonBulldog

          Shareholder’s don’t “own” corporations; all they “own” is the right to sue for performance of whatever obligations the corporate documents say the corporation statutes and corporate bylaws say the corporation owes to them. Doubly so for the bank shareholders of the “fed.”

          1. psychohistorian

            I think that both you and Yves are ignoring the elephant in the room, the global plutocrats, the private interests that rule the Western world.

            They are not shareholders of all the banks and corporations like the 99%. The global plutocrats have their people in place not just in control of governments but in control of all of finance and corporations. Next you are going to tell me that animal spirits gave us the car culture, killed mass transit, gave us consumerism, imprudent energy like Fukushima, etc…..and are giving Israel the right to commit genocide against the Palestinians.

            The longer we keep glossing over the fact that private interests run the world through their puppets in government, finance and multi-national corporations, the longer we will ignore the true levers of power and discussing how to wrest control into sovereign and not private hands.

          2. Yves Smith Post author

            Did you not read what I wrote? The banks own only preferred stock which has NO governance rights. None. Zero. Zip. Nada. The preferred stock owners have no right to information about Fed operations beyond what the greater public has, nor do they have any influence over governance in any way, shape or form.

            I don’t know why you refuse to believe this.

            There are other regulators that are every bit as captured as the Fed. Let’s start with the OCC. You don’t need crazypants theories to explain the behavior.

            1. MRW

              Yves Smith wrote:

              I don’t know why you refuse to believe this.

              Because they all read Creature From Jekyll Island by G Edward Griffin and think he’s right.

              Researching the truth? Too much trouble. Too boring.

            2. MaroonBulldog

              In my experience, most crazy people don’t know they’re crazy. And they don’t believe it even when it’s pointed out.

        2. Clifford Johnson

          I think you are up against some important case law in being so dismissive as to the inherent governing powers of the Fed banks. I have in mind not only Lewis v. United States, 680 F.2d 1239, 1241 (9th Cir. 1982), which found the Fed banks to be privately owned corporations, but Fox News Network, LLC v. Bd. of Governors of the Fed. Reserve Sys, 601 F.3d 158, 160 (2nd cir. 2010), which held that the lending activities of the Fed banks were beyond the scope of the Fed Board’s authority, e.g.:
          “[S]ome records at the Federal Reserve Banks — those kept at the Federal Reserve Banks under certain conditions for ‘administrative reasons’ — are records of the Board; these [only] must be searched [in response to a FOIA request.]… In any event, it seems clear from the statutory scheme that enacted the Federal Reserve System that the lending activities of the Federal Reserve Banks do not take place ‘on behalf of’ or under the ‘delegated authority’ of the Board. The Board itself has no power to make a loan to any bank, and does not authorize each loan made by the Federal Reserve Banks. The power to make loans is explicitly granted by statute only to the Federal Reserve Banks themselves. 12 U.S.C. § 347b(a). In that way, ‘Congress divided the powers of the Federal Reserve System between the Board, which is a federal agency, and the [Federal Reserve Banks], which were established as regional banks.’ [Citation.]”

  3. cnchal

    Greenspan, after he found out the banksters were criminals instead of upstanding law abiding citizens, had a surprised look on his face. He thought he was the ring leader, only to find out he was the mark.

    1. MikeNY


      I think they actually believe their own bullshit, that’s the incredible thing. They can’t or won’t see that they’re simply plutocrat poodles.

          1. RUKidding

            Really! With the current nepotism we see in politics and the “media,” we mos def dodged a bullet with that bit of luck!

      1. RUKidding

        Greenspan, after all, was a fawning, slavering acolyte of Ayn Rand! Of course, dumbo Greenspan believes the hype and was shocked to learn that Banksters were crooks. Anyone who thought Rand had something to offer in terms of monetary policy was either terminally stupid, utterly credulous, or I don’t know what. Anyone who could read Rand’s turgid scribblings and take them seriously beyond the age of 15 needs their head examined. How Greenspan ended up as Chair of the Fed is one honking big Q. What a mistake. Not that any of his successors have been much better, sad to say…

    1. beene

      Tyler, the video does point out the Fed can function for the benefit of the people in at least one state of N.D..
      Maybe a solution is to end the Fed in NY.

  4. indio007

    When Federal Reserve notes become irredeemable, the organization became a criminal enterprise.

    If I write a note to get some good of service, and that note is not redeemable for anything of intrinsic value, I go to jail.

    Per 12 USC 411 , FRN’s are supposed to be redeemable in lawful money, on demand.
    Giid luck with that.
    The best you will do is to get coinage of dubious metallic content or identical paper.

    This is fraud, fraud and more fraud,

  5. Ed

    “Johnson regards the support of the central bank as reasonably secure on the left; that’s true only to the extent that you conflate, as he does, the left with the Democratic party.”

    This is a strange post on many levels, but one problem is that it conflates the right with the Republican Party.

    As Banger pointed out, the whole thing ignores the (by now pretty obvious) WWF/ Mexican wrestling nature of American politics. If Romney had been elected, the calls to restrain or audit the Fed would be coming from Democratic congresspeople. And nothing would happen, just like nothing will happen in this case.

    1. NotTimothyGeithner

      Democratic blogs would be calling for Fed audits, not elected Democrats, and Team Blue blogs would spend most of their time making excuses for Democratic elite silence. Democrats lined up to support Dubya except when it would be an obvious betrayal.

      1. susan the other

        It might be time to take a page from Argentina’s playbook. Let’s go domestic. Our Fed really operates like a foreign bank, and too often (nowadays always) it operates against us in order to preserve private, international banking. When the rationale for a private Fed has fallen apart and has only been glued together since 2007 by doling out US Treasury money, what reason do we have to keep supporting this “agency” of the Treasury. The out-of-control laissez faire private banking system of the US brought us all down and we have had to rely on the Fed to keep things from imploding completely into soup lines and tent cities. Which it has done, to its credit. But this is not a good economic practice (it is in fact disastrous) when we could actually have sovereign banking.

  6. Ed

    Worker-Owner’s point about the Fed being a consortium of private banks, to which the federal government contracted out the responsbility of running a federal bank, is excellent. And this isn’t really so strange. The Bank of England was technically a private bank for most of its history.

    The current situation arose because the banking industry consolidated into a few large banks which are joined at the hip with the US Treasury. So you have the Fed, the Treasury, and a few big banks forming a sort of cartel. Return to the pre-1998 banking system and the Fed starts looking alot different.

    If someone tasked me with setting up a central bank from scratch, I would probably come up with a government chartered and owned entity where the government parked its cash. A measure of independence could be provided through long, fixed, non-renewable terms for the chairman and the board. Five of the board members could be appointed by the governors of the states that provide the five greatest amounts in taxes to the Treasury. But I’m not sure if the post- New Deal system, with all its flaws, wasn’t a good enough way of managing things.

  7. Jim Haygood

    ‘Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner?’

    What’s this ‘expected’ stuff? Bernanke was groomed for a year on Bush’s Council of Economic Advisors, before being appointed Fed chair. So was Yellen, in the waning days of the Clinton administration. (She had to wait awhile for her reward.)

    Framing the Fed’s political environment in terms of ‘left’ and ‘right’ is so old-school antique. Speaking for the Whig party, I, too, oppose the Federal Reserve.

  8. ifthethunderdontgetya™³²®©

    The hostility towards the monetary authority among conservatives is perverse, given how much the Fed has done for the wealthy by showing such solicitude about asset prices.

    You could say the exact same about their attitude towards Obama.

    1. Vatch

      Yes, it’s perverse, but it’s also effective. The criticism of the Fed and Obama prompts Obama and the Fed to try placating their critics by doing more of what the critics want. If the criticism ever ends, then the conservatives will risk losing some of their special treatment.

  9. impermanence

    Throughout history, there must have been slaves who felt that their masters were really not so bad, going to bed each night hoping that somehow the next day, these sociopaths would put away their whips, and call for freedom throughout the land.

    The organization of society always leads to the same sorry state of affairs. If you do not believe this to be the case, then you are among those who have sold-out the vast majority who continue to suffer under the rule of these maniacs.

  10. Bob

    Many of these legislators on the left and the right may not like the Fed, but that doesn’t mean they would do anything to cross them. This would be similar to a kidnap victim obeying his kidnapper. The most powerful people in the world own the Federal Reserve. Cross them and you won’t be in any position of power for long.

  11. Min

    I think that the recent misrule of the Fed, such as Bernanke’s calling for deficit reduction, are a result of its awareness of its political vulnerability. Bernanke certainly did not follow the advice he had for Japan, and as a result we seem to be heading for our own Lost Decade or two. Nor are the Fed’s right-wing critics basing their criticism on its recent history. They want to return to those thrilling days before 1933.

  12. Oregoncharles

    We can hope. I actually think it should be shut down and replaced with a government agency, along with the involuntary, punitive breakup of the largest banks.

    But I wonder how all this actually fits into the political situation. I agree whole-heartedly with the statement that the Dems are NOT the Left, and write it almost every day in other places. But none of the left is presently in power. Even Sanders is pretty compromised. How is left-wing opposition to the Fed going to be expressed?

    At the moment, it mostly means running 3rd-party candidates against Democratic incumbents – like, in my case, Merkley, because of his vote to support the Israeli genocide. That may or may not have any effect; it isn’t November yet. It would be nice if it meant a few Greens in Congress, but so far that seems very unlikely. I wish.

    Anyway, how do you see a Fed overthrow actually happening?

  13. MRW

    Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration.

    Sure he did. As Robert Rubin recounted in one of Adam Curtis’s documentaries, they both told Clinton two weeks before he was President that the US was broke. If Greenspan as head of the Fed had told that to Clinton after the inauguration, Greenspan would have been guilty of sedition. So. Either Greenspan was lying to the President-to-be before the inauguration, or he had no business being a Fed head because he didn’t understand federal accounting after fie+ years on the job. Either way, Greenspan was not working for the US people.

    In 100 years, history will view Greenspan as an enemy within diddling with badly-educated Presidents elected by even more poorly informed voters.

  14. Fiver

    The Fed succumbing to reform is about as likely as the whole political/economic process subject to serious reform in a number of core areas. But I do think their last performance will be an absolute shocker.

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