PT2 The Fed and the Crisis
Second part of Jane D’Arista commentary on the role of the US Federal Reserve in managing the crisis of global capitalism
JANE D’ARISTA, RESEARCH ASSOCIATE, PERI: So where are we now? In the absence of nationalization, we have ended up with a bloated, overly concentrated, more concentrated banking/financial system without having done anything to revive the economy of any real importance.
So we have to look now at the situation of can we move things around a little bit. The problem here is that nothing has changed. The way that we look at JPMorgan Chase’s loss and its effect on the credit markets, distorting them, both building a position and taking it apart, means that very little has changed at this point. We are in a situation in which velocity, money velocity, which means how many times in a given period of time money changes hands, is at a record low. This is an indication of how dysfunctional the financial system itself is and the central bank that is governing it.
So now we think about where to go forward, and we think of several things that have been proposed. The most reasonable proposals, it seem, have to do with accepting the sclerotic central bank that we have and continuing to focus on interest rates, to make the assumption that if we just plow ahead with more buying of bonds by the Fed (what we call quantitative easing), eventually we’ll get out of the morass. Others make other arguments in this regard.
But to go back to the Fed and the Fed situation is Bernanke, who was a student indeed of the Depression, picked up, in the case of quantitative easing, perhaps, from something that Eccles said back in 1935. Eccles was arguing then that the Federal Reserve needed the authority to buy any, quote, sound asset. When you get into a financial crisis, there are no sound assets except Treasury securities. And, quite frankly, in that particular crisis that we just went through, there were not enough. The flight to safety was such that the Treasury could not have issued enough securities to provide the liquidity that the central bank needed to create. There was no choice but to go into other kinds of assets, even toxic assets, which is, of course, exactly what they did.
Now, in the feasible proposal of more quantitative easing, for example, the Fed has said, well, even so we need help. We need Congress to help us. Some read that as we need more stimulus. Some read it as we need more tax cuts. But the Fed, not terribly specific about what it needs, is confronting a situation where the pressure is on it, and quantitative easing is what it has to go [sic]. Those who favor that, such as Christina Romer and president Evans of the Federal Reserve Bank Chicago, would like to see the Fed keep interest rates at zero until unemployment falls below 7Â percent or inflation rises above 3Â percent. Whether or not that will take us ten years or only five years is hard to say. Others would like to go in a different direction.
And there has been a good deal of talk about macroprudential issues that need to be under the purview of the central bank. Essentially, the kind of macroprudential issues that have been discussed in the past quite eloquently by the Bank for International Settlements involve reinventing ways to constrain or control or influence the supply of credit.
And one of the ways that we actually do have is, purportedly, capital requirements. On the other hand, capital requirements, which were brought in as a substitute for reserve requirements, have failed us totally, in this sense, that what we discovered is there’s not enough capital, and capital is procyclical. In other words, it’s available in a boom and not available when you really need it in a downturn.
And moreover, it’s a situation in which it disappears. The evaporation of capital during the financial crisis was absolutely stunning to watch. The entire financial system was in effect underwater at that time.
So what other macroprudential possibilities are there? Actually, there is one in Doddâ€“Frank, which will come into effect at the end of JulyÂ 2012, and that is sectionÂ 610, which goes back and corrects an enormous error made by a controller of the currency at the end of the Clinton administration, who acceded to the request of the banks to remove their requirement in the sense that loans to a single borrower had to be a given percentage of capital, if that affected financial institutions. In other words, the commonsense notion of don’t put your eggs all in one basket, which had been part of the National Bank Act since 1865, was to be waived if that basket was another financial or group of financial institutions. What sectionÂ 610 does is say, no, the law requires you to break it all up, to distribute your lending across the spectrum in relation to capital.
Moreover, it does something else extremely important. It recognizes, unlike the Federal Reserve, that the financial sector has changed. It now doesn’t speak of banks lending; it speaks in the statute of credit exposures. And the credit exposures include repurchase agreements, reverse repurchase agreements, derivatives, securities lending, etc.â€”in other words, all those exciting things that brought us into crisis.
If it is implemented, it will have incrediblyâ€”or when it is implemented, because it must be, it’s in the lawâ€”it will have very important consequences, one of which is that it will go at the issue of interconnectedness that has developed as a result of financial institutions borrowing and lending within the financial system rather than outside the financial institute system. It will also curtail speculation, because these instruments, repurchase agreements, etc., are the very things that were invented to find the funding for speculation. And then, of course, it will also curtail the amount of credit that is expanding out there and the ability of the financial sector itself to create excess liquidity in the system.
So what else is needed? How can the Federal Reserve help us get out of the problems we’re in? How can we solve the problems that the Federal Reserve’s inability to influence the supply and distribution of credit have created, both in terms of creating a crisis, a financial crisis, and in terms of their inability to move us past it?
Back in 1935, Marriner Eccles, again, the formerâ€”at that time former governor, I think his title was, of the Federal Reserve, made the point that the concentration of credit in Wall Street had caused a crisis and was impeding revival of the economy. We are replaying that tune. We have not got to the place where we have figured out (A) how does the central bank not only influence supply but how credit is distributed to make the economy function more effectively. Going forward, that, of course, is exactly what we need to do.
And among the things that need to be included in our thinking about that are making the central bank more aware of financial structure, of an important point that Hyman Minsky used to make, and how structure in the financial system influences not only the economy but the central bank itself. And the other is to rethink reserve requirements, ignore capital requirements, phase them out over time, except to the extent of a cushion base, but not expect capital requirements to do the work that only reserve requirements can do in terms of curtailing and expanding the credit supply. So those are the two things that need to be done.
In the case of reserve requirements, we need to rethink the instrument itself and how it functions in the current environment, and we also need to impose it, if you willâ€”extend it, perhaps, is a better wordâ€”across the entire financial sector, since what we know now is the banking sector, as difficult as it is for us in terms of the problems it is creating, is nevertheless not the main supplier of credit to the economy any longer.
So next year is the 100th anniversary of the Fed. We need a complete, thorough, and very thoughtful evaluation of this institution.
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