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How Crisis Empowered The Fed

June 19, 2022


Lev Menand is the author of The Fed Unbound: Central Banking in a Time of Crisis.

A professor at Columbia Law School, Lev served as senior adviser to the deputy secretary of the Treasury from 2015 to 2016 and as senior adviser to the assistant secretary for Financial Institutions from 2014 to 2015. Lev was previously an economist at the Federal Reserve Bank of New York. His research focuses on money and banking, central banking, financial regulation, administrative law, separation of powers, corporate governance, and the history of economic thought.

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GRAVITY EXISTS Hello, everyone. Today, we’re joined by Lev Menand, author of The Fed Unbound: Central Banking in a Time of Crisis. Lev is a professor at Columbia law school. He’s served as a senior advisor to the deputy secretary of the Treasury from 2015 to 2016 and as a senior advisor to the assistant secretary for financial institutions from 2014 to 2015. Prior to that, Lev was at the Federal Reserve Bank of New York. In his new book, professor Menand walks the reader through what has gone wrong with the financial system in the US and provides a critical analysis of the role that the Federal Reserve has played in that process. The book has won praise from noted economists and academics for providing a fresh perspective on a critical topic. Lev, thank you so much for joining us today.

LEV MENAND Thank you so much for having me and for those generous words of introduction.

GE Well, it’s a great time to be talking to you. Obviously, everybody’s focused on the Fed because of the recent 75 basis point rate increase. Obviously, the focus on inflation has caused a discussion of the role of the Fed to be a topic of great interest, particularly from a partisan political standpoint.

LM Absolutely. You know, for the past 15 years, I would say the Fed has been in headlines a lot.

GE Yes, and I do want to touch on that as we go along. But first and foremost, what I think is going to be of great interest to a lot of our readers is how you view the Fed’s role in the pandemic response. Obviously, that’s how you start the book. You do a very in-depth analysis, and in reading it, you really focus on the improvisational nature of that effort. Discussions of the murky mandate for the exchange stabilization fund, for instance. Can you walk us through how you see that having come together and walk us through where the limits were of an understanding of the frontiers of the Fed’s responsibilities and its ability to navigate?

LM Yeah, absolutely. So, the real impetus for the book was watching the Fed’s pandemic response and realizing that this was a very significant response that people needed to understand better. And that actually tells us a lot about underlying problems in our system that need to be addressed. So, the first half of the book is really trying to walk the reader through pretty recent history and shine a new light on it that you might not have gotten from just reading the papers in March and April of 2020.

So, the response as I see it had two components. One component was liquidity provision for the financial sector. In particular for the shadow banking sector. For the part of the financial system that is engaged in bank-like activities but isn’t subject to bank regulation and, therefore, isn’t covered by the Federal Deposit Insurance Fund. Doesn’t have access to the Fed’s ordinary discount window. And is subject to run-like dynamics…panics.

And we saw one of those panics in 2008, and we saw a second panic in 2020. And the Fed, as I argue in the book, isn’t really set up to deal with runs in panics in the shadow banking system because the whole Federal Reserve Act presumes that there really isn’t much of a shadow banking system at all. That banks do the banking business and that non-banks don’t. And so, you get a whole series of ad-hoc facilities that the Fed creates using its emergency tools in 2020 to basically set up ersatz discount windows, backstopping facilities for a different source of shadow banks. It’s trying to replicate its bank toolkit for the shadow banking system. And there’s a lot of complexities to how it does this. But it’s very ad hoc, and it leads to, in a variety of respects, suboptimal policy. The second set of tools have to do with credit provision to the real economy — what economists call “the real economy.” So, the non-financial sector, which is the business sector, the nonprofit sector, and the public sector — state and local governments.

And while the sort of the liquidity provision, the first set of facilities, that’s really just the Fed repeating everything it sort of figured out in the 2008 crisis. The second set of facilities are very novel. And so, the Fed sets up lending programs for businesses and nonprofits called the Main Street Lending Program. It sets up the municipal liquidity facility for state and local governments. It sets up something called the Secondary Market Corporate Credit Facility that goes out into the open market and buys corporate bonds, including index funds of high-yield corporate bonds. And this has the Fed doing something pretty unprecedented. Something it didn’t do in 2008. Intervening, really, in credit allocation in the economy more broadly in an effort to correct some of the dislocations caused by the pandemic, and also to respond to a political demand from Congress and from the public more generally that it not just be, you know, when things go wrong, that it not just be offering support for Wall Street, but that it sort of somehow extends its embrace to Main Street.

So, you have the Fed taking on a huge range — there’s over a dozen facilities it sets up — a huge range of activities in 2020 to respond to the pandemic. And part of what I try to do in the book is look at how well it does these various things. And what you see is that it’s much better at supporting the financial system than supporting the non-financial part of the economy.

GE That ties in with another aspect of the book. I think that in your analysis of how the Fed has risen to a nearly all-powerful status that’s central to the economy, you seem to take pains to point out how the Fed is taking the lead in the absence of Congress doing so. We’ve had discussions with other folks here, both elected officials and policy experts, who’ve talked about the legislative branches sort of passing the buck onto different groups, whether it’s the judiciary or the Fed. And that’s something that you seem to touch on in your book as well. That the Fed is doing jobs that perhaps are better suited to Congress.

LM Yeah, that’s right. So, it’s a bit of a vicious cycle. There are reasons why Congress has not been more effective in recent years — in recent decades — that have to do with our politics; money in politics; a variety of deeper issues in American society. But among the reasons why Congress has had sort of a trend towards less and less effectiveness, especially in economic policy, is it’s come to rely more and more on Fed officials. And so, the Fed was there to, at the worst moments in 2008, step in and alleviate some of the panic that was threatening to bring about a second Great Depression. And then, when Congress sort of failed to sufficiently respond to the economic downturn that resulted, the Fed was there again with quantitative easing, and you get a dynamic that develops where Congress becomes more passive and leans on the Fed more.

And that’s a bad dynamic because Congress has the ability to craft policy that is more distributionally fair and more efficacious than the Fed, which has really been stretching and using its toolkit in ways that it wasn’t designed, to try to get a little extra juice out here and there. That’s how you can think about QE two, QE three. But you know, there’s a lot of collateral consequences for trying to do that in that way.

And so, the book argues that we need to recognize that this is suboptimal. It’s not an ideal arrangement. It’s not an ideal way to do macroeconomic stabilization and try to work towards other administrative or legislative solutions for dealing with things like recessions and things like an overheated economy and inflationary periods, rather than just expecting that this one organization can, with this pretty limited toolkit, be the one-stop-shop for these sorts of problems. And of course, there have been efforts by Congress throughout this period that have been very significant. And I think if you look at the steps that Congress has taken when Congress does act, it’s able to do things that the Fed can’t do. And, uh, it’s evidence for why we need, I think, more Congressional action and less reliance on central bankers.

GE But we also live in a polarizing partisan political environment in the US, and the Federal Reserve has become an incredibly convenient scapegoat for partisan posturing. How does that play into how you envision the future for the Fed? Do you see the situation as it stands improving to address these practical concerns, or do you see more of the same for the foreseeable future?

LM So, the more the Fed takes on, the more powerful the Fed becomes. The bigger the role it has in a variety of non-banking, system-related issues, the more politicized Fed appointments [are] going to be; the more polarized the Fed is going to become as an agency. That’s certainly the path we’re on right now. To get onto a different path depends upon a whole number of factors that are hard to forecast. One thing that could lead to significant reforms of the monitoring and financial system, for example, is another financial crisis, which I think is a risk that’s out there all the time, given the inherent instability of the financial system today. And a financial crisis. That’s what we experienced, really, in 2020. It was just a financial crisis the Fed was very effective in quelling.

But another financial crisis like the 2020 crisis that the Fed wasn’t able to quell might lead to legislative reforms. And ultimately, organizing public opinion around addressing certain issues is how you get legislative change. And sometimes, it can take decades of organizing before major changes are made. And that includes the creation of the Federal Reserve in the first place in 1913. That was the culmination of more than 20 years of agitation for changes to the banking system. The creation of deposit insurance in the 1930s. That’s 30 or 40 years of effort to bring about that healthcare reform in 2010 was also a 20-year policy process. And so, you have to take a long view in terms of fixing some of these problems.

GE Now, for our audience, one aspect of the book that I think is particularly fascinating — and you touched on this earlier when we were talking about the pandemic response — is the rise of the role of shadow banking in our financial system and how the risk is spread across global financial markets in a different way than it has been in decades past. You touch heavily on discussions at the repo market and how different financial intermediaries and asset managers have taken a central role in capital flows. Could you walk us through what risks you see as being new to the financial system over the past two or three decades? And what reforms, if any, you think might be positive as far as making the financial system more secure in the US?

LM So the big change has been the emergence of banking activities outside of the banking system. And by banking activities. I mean, something very specific. I don’t mean financial intermediation. You know, borrowing from some people and then lending to others. The whole financial sector is engaged in that. Banks are engaged in a very particular type of financial intermediation. They’re engaged in money, finance, credit allocation. So, they issue something called a deposit, and a deposit is a cash substitute. That is the primary form of money in the economy. We use deposits to pay for most of our big-ticket items, and businesses almost exclusively use deposits to pay for things. Cash is just not part of the equation. And banks are supposed to be the entities with a monopoly on the ability to issue this cash equivalent — the deposit. And the whole regulation of thinking is about ensuring that this form of money that’s not issued directly by the government, but it’s sort of issued by franchisees of the government. Investor-owned franchisees of the government that it trades at par at all times with cash. That’s what monetary stability looks like. It’s what you take for granted every day.

When you log into your Bank of America bank account, and you see your balance, and you think that’s the same thing as having physical government cash. There isn’t actually government cash back there, but you treat it the same way. And we’ve set up a whole system to ensure that. The repo market is an alternative to deposits for corporate treasurers and other businesses and whole side players. And so, an overnight repo is really a deposit. It’s functionally a deposit. It’s formally structured as a sale and an agreement to repurchase a financial asset, but the economic interest in the financial asset doesn’t shift. And so, what it really is is a collateralized deposit. And this market is cannibalizing the banking business. It’s also extremely unstable because there’s no deposit insurance for overnight repo.

And so, the corporate treasurer, who’s doing an overnight repo with a dealer firm that’s not a bank. They’re there for the extra yield that they can earn over having their excess cash, managing their cash, with bank deposits. But if there’s any economic uncertainty, they really just want cash, and they’re not interested. They’ll run. And so this leads to panic. And the failure of Lehman brothers in 2008 is just a run on its repo and its Euro dollar and commercial paper funding sources; it’s deposit alternatives. And so, you know, they go from having 150 repo counterparties to like 50 in a week or two. And that’s just a classic bank run. It doesn’t, doesn’t manifest the way a 19th-century bank run does, where individuals line up outside the bank and try to withdraw their cash. It’s just a bunch of businesses electronically trying to not renew their repos, and, you know, even if Lehman was completely solvent, it could be subject to this sort of run and collapse. And that’s why we set up banking regulation.

But once you have the emergence of things like the repo market and the Euro/dollar market that aren’t subject to banking regulation. You’ve introduced this inherent instability into your whole monetary framework and as a result to your economy because your economy depends upon a stable and, in fact, growing supply of money over time in order to grow. And so, what’s the solution? It’s pretty simple. It’s, you know, in insurance, we regulate insurance activity, wherever it is if it’s functioning like an insurance arrangement. If you’re issuing something that functions like a security or an investment contract, you’re subject to the securities laws. And we just haven’t had that in banking for several decades now, and we have to restore that.

And so, any entity that is engaged in a banking activity needs to be part of the same framework that banks are part of. And there are a lot of details that have to be worked out about what you do with the various different types of shadow banks that are out there right now. But ultimately, a system that involves banks and shadow banks that are subject to different regulatory schemes is an unstable system.

GE The book again is called The Fed Unbound: Central Banking in a Time of Crisis. Lev, thank you so much for joining us. This has been a fascinating discussion, and I hope we have the chance to talk to you again.

LM Thank you so much for having me.