Inside the Fedby Ian Crouch
In Fed We Trust, By David Wessel, Crown Business
Until recently, what most of us knew of The Federal Reserve System came from the popular press’s breathless coverage of its interest rate announcements, especially during the celebrated reign of “rock-star” former chairman Alan Greenspan. The story was always the same: how will the markets react to a rate cut or hike? The Fed’s complex responsibilities—managing the country’s monetary policy, regulating banks, maintaining maximum employment—were simplified to whether Greenspan would make Apple or GE stock rise or fall.
That changed during the current financial crisis, what David Wessel ominously dubs “The Great Panic” in his brisk but information-saturated book, In Fed We Trust. As institutions like Bear Stearns and Lehman Brothers crumbled during the fall of 2008, it became clear that the Fed was time and again at the center of the story—lending substantial portions of its $900 billion in assets and seemingly making up the rules as it went along—exercising what Wessel calls “almost unchallenged power...over the U.S. economy.”
Wessel, economics editor at the Wall Street Journal, provides a succinct, clear explanation both of the Fed’s traditional duties and its expanding power as chairman Ben Bernanke vowed to do “whatever it takes” to prevent another Great Depression. He is a great explainer and re-explainer of key financial terms—he defines inflation, deflation, and others at each mention—dutifully reducing jargon and “Fedspeak” to plain language.
Yet generally the book suffers from a lack of focus. At times it seems more a pastiche of thoughtful, incisive articles rather than a coherent narrative. It’s a biography of Bernanke, a history of central banking in the United States, and a blow-by-blow account of the government’s response to the financial crisis. Along the way, Wessel manages to squeeze in a reappraisal of Alan Greenspan’s tenure as chair, reveal the total abdication of responsibility by the Bush White House, and even diagnose the fundamental causes of the housing collapse.
Wessel gets the most traction in his description of the Fed’s innovations during the current crisis. The crux of the Fed’s evolution is reflected in how, and to whom, it lent money. Along with managing interest rates, keeping prices stable, and ensuring widespread employment, Wessel explains that the Fed can lend money directly to the banks it regulates. In times of abundant credit, banks are unlikely to borrow from the Fed, since it implies that they can’t get the money elsewhere, and thus are weak or in trouble. For this reason, the Fed has long been known as the “lender of last resort.”
During the credit crisis, however, banks and other major financial institutions had nowhere else to turn for money. Soon, the Fed was becoming the lender of first resort, and critically, not just to the traditional banks it oversaw, but to any financial institution judged structurally integral to the economy as a whole.
The Fed’s full might emerged in September when it single-handedly lent AIG more than $85 billion to check its rush to bankruptcy. AIG wasn’t a bank, but a giant insurance conglomerate and de facto hedge fund, part of what Wessel incisively calls the “shadow banking system.” It had never been regulated by the Fed (nor, unfortunately, by anyone else). Wessel notes: “For many members of Congress, the Fed’s ability to come up with $85 billion overnight led to the realization that the Fed increasingly was acting like a fourth branch of the government.”
How could the Fed explain this revolutionary new practice, what one Fed staff member called “crossing the Rubicon or at least a very large tributary”? In its charter following the banking crisis of 1907, Congress granted the Fed power in “unusual and exigent circumstances” to make loans at its discretion. Throughout the crisis, the Fed came back to this clause, throwing money at shadow banks and securities firms—Bear Stearns, Fannie Mae, Freddie Mac—that hadn’t operated under the Fed’s stringent rules, but were nonetheless bailed out when their imprudent risk-taking came back to push the entire economy to the edge.
Along with massively increasing its lending scope, the Fed abandoned its long-valued political neutrality. Bernanke worked closely with Treasury Secretary (and Bush appointee) Henry Paulson, especially later in the crisis, when both men lobbied Congress to inject taxpayer money into the financial system. Wessel argues that Bernanke too often deferred to the formidable Paulson, leaving the Fed looking like a lapdog of the more politicized Treasury. Additionally, during the fast-moving crisis—when huge companies needed to be saved, often in the span of a single weekend—Bernanke often bypassed the Fed’s byzantine but time-honored leadership structure, leaving nearly all the decision-making to a small group nicknamed the “Four Musketeers.” This group—including Bernanke, Don Kohn, Kevin Warsh, and Timothy Geithner, then president of the New York Fed—may have prevented financial catastrophe, but Wessel poses an essential question: should such a small group of unelected officials wield so much power in a democracy?
Wessel’s answer is yes, at least in this case. Despite criticism from inside and outside the Fed—claims that Bernanke had committed “rogue actions” and made “the worst policy mistake in a generation” by randomly “picking winners and losers” among failing banks—Wessel puts it bluntly: “What the Bernanke Fed did was necessary.”
Despite his support of Bernanke, Wessel’s account raises fundamental concerns about the man’s leadership as he begins his second term as Fed chair. Wessel notes that Bernanke, arriving on the heels of the perhaps too influential Greenspan, wanted to reign in the Fed chair’s role as the nation’s banking Wizard of Oz. Greenspan’s cryptic remarks and subtle winks could move markets; Bernanke discussed making the Fed more transparent, its language more plain. Yet his decisions during the crisis, accompanied by precious little precedent or explanation, arguably made him more powerful and insular than Greenspan ever was. As the economy moves toward recovery, Bernanke’s open-door Fed seems a long way off. Bernanke needs an “exit strategy.”
Of larger concern is the way in which the Fed prevented what Wessel notes could easily have become Depression 2.0. By expanding its lending powers, buying distressed securities from ailing financial institutions, and packaging its own shoestring securities along the way, the Fed has undertaken many of the same risky “creative finance” solutions that got us into this mess to begin with. While the Fed’s unorthodox response has shown short-term success, its behavior has done little to dispel the public notion that the financial system in the United States is held together with Elmer’s glue and gimmickry.
Crouch is a frequent contributor to the New Yorker's Book Bench blog and lives in New York.