The Price of Inequality: How Today's Divided Society Endangers Our Future (38 page)

Although the Fed’s low interest rate policy hadn’t led to the resurgence of investment as it had hoped, it did encourage those who were planning investments to substitute cheap capital for labor. Capital was, in effect, at a temporary artificially low price, and one might as well take advantage of this unusual situation. This reinforced distorted patterns of innovation that focused on saving labor at a time when it was increasingly in abundance. It is curious that at a time when unemployment among the unskilled is so high, grocery and drug stores are replacing checkout clerks with automatic machines. The Fed was making it more and more likely that, when a recovery set in, it would be a jobless one. Indeed, this turned out to be the hallmark of the recovery from the 2001 recession, during which the Fed had again put interest rates at low levels.
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Helping the top

We’ve already noted a number of ways that the Fed helped the banks and the bankers, especially in the crisis. The Federal Reserve lends to the banks
at very low interest rates
, rates that, especially in times of crisis, are far below the market rate. If a bank can borrow at close to zero, and buy a long-term government bond yielding, say, 3 percent, it makes a nifty 3 percent profit
for doing nothing
.
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Lend the banking system a trillion dollars a year, and that’s a $30 billion gift. But banks can often do better—they can lend to triple A–rated firms, prime customers, at much higher interest rates. If they can lend at just 10 percent, then the government’s willingness to lend them a trillion dollars at close to zero interest rate is a $100 billion a year gift.
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Banks can also deposit money into the Federal Reserve, and they now, for the first time, receive interest on those deposits—another hidden transfer from taxpayers to the banks.
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Curiously, this latest gift may have discouraged lending. Paying banks
not to lend
meant that the incremental returns banks got from lending were lowered.
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More broadly, the bailout strategy put the interests of the banks (and especially the large banks) and bankers ahead of the rest of our economy.
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Money was given to the banks
allegedly
so that the flow of credit would not be interrupted, but no conditions were imposed on the financial institutions receiving funds. No conditions to maintain the flow of lending, no conditions not to use the money to pay bonuses. Much of the money given to the banks went to bonuses, not to bank recapitalization. Money went disproportionately to the large banks, which were more interested in speculation and trading than in lending. To the extent that they lent money at all, it was disproportionately to large international firms. The government’s money, for the most part, didn’t go to the smaller regional and community banks that focus on lending to small and medium-size enterprises.
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Not surprisingly, hundreds of these smaller banks went bankrupt,
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and hundreds more were in such a precarious position that they had to curtail lending.
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For a strategy aimed at maintaining the flow of credit, the Fed’s decisions (together with Treasury) were deeply flawed.

Deregulation: key to the increasing financialization of the economy

This deference to the banks lies at the center of the Fed’s, and other central banks’, greatest contribution to inequality: their failure to impose adequate regulation and to adequately enforce regulations that existed—the culmination of two decades of financial deregulation that had begun under President Reagan. The Fed and its chairman Alan Greenspan were instrumental in stripping away the regulations that had been so important in ensuring that the financial system served the country well in the decades after the Great Depression. They were also instrumental in preventing new regulations to reflect changes in the financial sector, such as the development of derivatives, that posed threats to the stability of the financial and economic system.
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This deregulation had two related consequences, both of which we noted earlier. First, it led to the increasing financialization of the economy—with all the associated distortions and inequities. Second, it allowed the banks to exploit the rest of society—through predatory lending, abusive credit card fees, and other practices. The banks shifted risk toward the poor and toward the taxpayer: when things didn’t go as the lenders had predicted, others had to bear the consequences. The Fed not only didn’t discourage this; it encouraged it.
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It is clear that,
from a societal perspective
, the banks did not help people manage risk; they created it. But when it came to managing their own risk, the bankers were more successful. They didn’t bear the downside of their actions.

In the aftermath of the crisis, the Fed’s position in the regulatory debate showed where their allegiance was. Regulations should have been designed to encourage banks to go back to the boring business of lending. Recognizing that the too-big-to-fail banks had perverse incentives, they should have focused on how to limit the size and interconnectedness of the banks. Moreover, too-big-to-fail banks have a competitive advantage over other banks—those who provide them finance know that they can count, in effect, on a government guarantee, and thus they are willing to provide them funds at lower interest rates. The big banks can thus prosper not because they are more efficient or provide better service but because they are in effect subsidized by taxpayers. Our failure to impose a tax to offset this advantage is just giving the too-big-to-fail banks
another
large gift.
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The recognition that outsize bonuses gave financial professionals incentives to engage in excess risk taking and shortsighted behavior should also have led to tight regulations on the design of bonuses. And in acknowledgment of the risk of undercapitalized banks—where small changes in the value of assets can be enough to cause bankruptcy—there should have been tight regulation on the size of bonuses and dividends until the banking system was fully recovered. Recognizing the role that lack of transparency and derivatives had played in the banking crisis, the Fed should have insisted that something be done about both.

Little of the above was done, and what was done was often achieved over the opposition of the Federal Reserve. The new regulatory bill (Dodd-Frank) signed into law in July 2010 gave much of the responsibility for implementing regulations to the Fed, and at least in some areas it again showed where its loyalties were. To cite but a few examples: in the discussion preceding the passage of the Dodd-Frank bill, the Senate committee with responsibility for oversight of derivatives had recommended that government-insured banks not be allowed to write derivatives. While it wasn’t clear whether derivatives were insurance products or gambling instruments, it was clear that they weren’t loans. If they were insurance products, they should be regulated by state insurance authorities; if they were gambling products, they should be regulated by state gambling authorities; but in no circumstances should they be underwritten by the U.S. government, through the Federal Deposit Insurance Corporation, the government agency that insures
bank depositors.
But Ben Bernanke, the Fed chief, argued otherwise (over the opposition of two regional Fed presidents, who seemed to harbor the quaint notion that banks should focus on banking). Bernanke and the big banks that made billions a year from the credit default swaps, or CDSes, won.

Meanwhile, there emerged a broad consensus among economists and policy makers (including at least one Federal Reserve regional governor and the governor of the Bank of England, Mervyn King) that something ought to be done about the too-big-to-fail banks. King pointed out that if they were too big to fail, they were too big to exist. Even earlier, Paul Volcker, former chairman of the Federal Reserve, had observed that these banks were also too big to be managed. But the Federal Reserve Board’s current and past chairmen (Greenspan and Bernanke, responsible for bringing on the crisis) have never seemed even to recognize the problem, at least not enough to suggest that something be done. And there was much that could be done: from regulatory solutions limiting bank size and what they could do, to taxes to offset the advantages described earlier.

The Fed, of course, never set out to increase inequality—either by the benefits it proffered to those at the top or by what it did to those in the middle and at the bottom. Indeed, as we shall explain later, most of its board members probably truly believed that its policies—lax regulation, fighting inflation, helping banks that are so essential to the functioning of our economy—would promote growth from which
all
would benefit. But that’s just testimony to the extent to which the Fed was “captured” by the perspectives and worldview of the bankers.

T
OWARD A
M
ORE
D
EMOCRATIC
C
ENTRAL
B
ANK
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A central thesis of current conventional wisdom is that central banks should be independent. If they are subject to political forces, so the thinking goes, politicians will manipulate monetary policy for their short-run advantage at a long-run cost; they will stimulate the economy excessively before an election, with the price—higher inflation—to be paid after the election. Moreover, with an independent central bank committed to low inflation, markets will not build inflationary expectations into their behavior, so inflation will be contained, and there will be better overall economic performance.

The failure of independent central banks

The independent central banks of the United States and Europe didn’t perform particularly well in the last crisis. They certainly performed far more poorly than less independent central banks like those of India, China, and Brazil. The reason was obvious: America’s and Europe’s central banks had, in effect, been captured by the financial sector. They might not have been democratically accountable, but they did respond to the interests and perspectives of the bankers. The bankers wanted low inflation, a deregulated financial sector, with lax supervision, and that’s what they got—even though the economic losses from inflation were minuscule compared with the losses that arose from the excessively deregulated financial market. The losses to ordinary consumers from predatory lending were given short shrift—indeed, the additional profits increased the financial strength of the banks. The soundness of the banking system was, after all, the central banks’ first charge.

Capture

We saw in chapter 2 that a regulatory agency is captured by those that it is supposed to regulate when the policies it pursues and regulations that it adopts reflect more the interests and perspectives of those that it is supposed to regulate rather than the public interest. Capture occurs partially as a result of revolving doors, where the regulators come from regulated sector and, after their brief stint in government, return to it. “Capture” is partly what is called cognitive capture—in which the regulator comes to adopt the mindset of the regulated. In the United States capture also occurred more directly, as when Wall Street weighed in strongly on potential appointees to the central bank. I saw that during the Clinton administration, where two excellent appointments were in effect vetoed by the financial markets, one because she had demonstrated a concern about discrimination in lending, the other because he seemed too concerned about encouraging economic growth and full employment. The most curious case was the one that occurred during the Obama administration, which nominated a brilliant Nobel Prize winner who had done pathbreaking work extending our understanding of unemployment and its determinants—something that should have been of central concern to the Fed. Perhaps some in the financial markets realized that having a critical thinker, who might cast doubt on certain conventional central bank doctrines that were not grounded in economic theory or evidence, would be
inconvenient.
His nomination never even got through the Senate Banking Committee.
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In spite of such pressures, there has been considerable diversity of perspectives among the Fed governors. There was even one Fed governor
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who warned about the bad lending to the housing sector, but he was effectively ignored by the others. In this recession, several of the Fed governors have been adamant that unemployment is the
key
issue, and there is a recognition that the underlying problem is a lack of demand. Some have even made the heretical (for central bankers) suggestion that until the economy’s unemployment rate is substantially lower, unemployment, not inflation, ought to be the “target” of monetary policy.

A lack of faith in democracy

The lack of faith in democratic accountability on the part of those who argue for independent central banks should be deeply troubling. Where does one draw the line in turning over the central responsibilities of government to independent authorities? The same arguments about politicization could be applied to tax and budgetary policies. I suspect some in the financial market would be content to turn those responsibilities over to “technical experts.” But here’s the hidden agenda: the financial markets would not be content with just any set of technical experts. They prefer, as we have seen, “experts” who shared their views—views that support their interests and ideology. The Federal Reserve and its chairmen like to pretend that they are above politics. It is convenient not to be accountable, to be independent. They see themselves as simply wise men and women, public servants, helping to steer the complex ship of the economy.

But if there was any doubt of the political nature of the Fed and its chairmen, it should have been resolved by observing the seemingly shifting positions of the central bank over the past twenty years. In 1993, when the United States had a large fiscal deficit and high unemployment, the chairman of the Fed, Alan Greenspan, urged the government to take strong actions to reduce the deficit, with the understanding that interest rates would then be reduced to restore the economy to full employment. But the economy was facing unemployment; it was not overheated. There was no reason to make the lowering of interest rates conditional on a reduction of the deficit; indeed, lowering interest rates and increasing the availability of credit could have worked hand in hand to help get the economy growing, and that would have done wonders for the deficit. But interest rates were lowered only to a little below 3 percent—presumably if they had been lowered further, the economy would have had a more robust recovery. Then, in 2001, Greenspan urged Congress to cut taxes,
creating a massive deficit
, and responded to the recession by lowering interest rates to a much lower level—eventually to under 1 percent. One interpretation of these seemingly inconsistent positions was that the real objective was to downsize government and reduce tax progressivity.
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