The Price of Inequality: How Today's Divided Society Endangers Our Future (39 page)

In any democracy a public institution—and pretend as it might, a central bank is a public institution—must have some degree of accountability. There must be oversight to make sure that there is no malfeasance, and that the central bank functions in accordance with its mandate, and that the mandate in question is in accord with the public interest. In a modern democratic society, governance is a central concern. How are those responsible for making critical decisions chosen? How are the decisions made? Is there sufficient transparency that there can be meaningful public scrutiny?

Few matters are of greater concern to citizens than the performance of the economy, and monetary policy is a central determinant of that performance. Indeed, standard models in political science show that especially the level of unemployment and its rate of change is the most important determinant of presidential and congressional electoral outcomes. And yet, it seems that under current arrangements public officials are being held accountable for something over which they do not control one of the main levers.

In the United States our system of governance and accountability for our central bank should in fact be an embarrassment. Monetary policy is set by a committee (called the Open Market Committee) of the seven members of the Federal Reserve Board, plus the twelve regional Federal Reserve Bank presidents, of whom only the head of the New York Fed and four others have the right to vote. But the regional Federal Reserve Bank presidents are chosen in a nontransparent process that gives the public little say, and in which the banks (which they are supposed to be regulating) have too much influence.
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While the current Fed chairman, Ben Bernanke, has written forcefully about the virtue of transparency,
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he seems to have changed his mind once the task of providing hidden assistance to the banks moved more to the center of the Fed’s agenda. When the media requested information, of the kind that other government agencies are required to disclose under the Freedom of Information Act, the Fed claimed that the Fed was not subject to the act. The Federal District Court disagreed, but the Fed was unrepentant—it refused to disclose what the press wanted to know. The Fed appealed the decision, and the appellate court reaffirmed that the Fed was accountable. Reportedly, the Fed would have appealed to the Supreme Court, had the White House not told the Fed that it was in fact part of the government and had to obey the laws that applied to other government agencies. Congress, independently, demanded an audit of what the Fed was doing—including who was getting its money.

Eventually, the Fed succumbed to the pressure from courts and Congress, and when the information was disclosed, the American people understood better why the Federal Reserve had not wanted to disclose the information. The real reason for secrecy, it turned out, was to hide policies that would not meet with popular support—and to conceal inconsistencies between what the Fed was saying and what was going on.
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In the great bailout that marked the beginning of the Great Recession, the head of the New York Fed was one of the triumvirate (along with the head of the Federal Reserve and the secretary of Treasury) that shaped the bailout, determined who got saved and who got executed, and who got how much and on what terms. And he, in turn, had been nominated by a committee that consisted of bankers and CEOs from some of the same firms that were bailed out
on most favorable terms
.
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There is the appearance, if not the reality, of a conflict of interest. Americans never fully understood why AIG got a bailout of the magnitude that it did or why, when its derivatives were bought back, they were paid off at 100 cents on the dollar—far higher than was necessary. But when the ultimate beneficiaries of the AIG bailout were revealed, all became clearer: the biggest beneficiary was Goldman Sachs, and other recipients were large foreign banks, some of which were suspected of having complex financial dealings with Goldman Sachs. It seemed especially strange that the United States was bailing out foreign banks. If foreign banks were in trouble, it should have been the responsibility of the foreign governments to bail out their own banks.

As more information was given out, it became clear that the Fed had been lending massively to foreign banks long before the September 2008 crisis.
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Evidently, the U.S. Fed was the lender of last resort not only for U.S. banks but for foreign banks as well.
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Had American banks undertaken such complex and large-risk exposures with these other banks that if they sank, American banks would be at risk? If so, it was evident that the Fed had failed in its supervisory job as well as in its regulatory responsibilities. It also grew clear that in spite of statements from the Fed claiming that the problems of the subprime mortgage and the breaking of the bubble were well contained,
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global financial markets had been going through trauma for months.

The data that the Fed was forced to reveal also showed that in the months after Lehman Brothers collapsed, large banks, like Goldman Sachs, were borrowing large amounts from the Fed, while simultaneously claiming publicly that they were in excellent health.

None of this should be surprising: an independent central bank, captured by the financial sector, is going to make decisions that represent the beliefs and interests of the financial sector.

Even if it were desirable to have a central bank that was independent from the democratic political process, the board should at least be representative and not dominated by members of the financial sector. Several countries do not allow those from the financial sector to serve on their central bank board—they see it as an obvious conflict of interest. There exists a wealth of expertise outside the financial sector. Indeed, those in the financial sector are attuned to making deals and are not experts in the complexities of macroeconomic interdependencies. Today, fortunately, there are real experts in a variety of institutions other than the financial sector—including academia, NGOs, and unions.

Those who favor an independent central bank often assume that no trade-offs are involved in the decisions the bank takes. Technical experts can figure out the best way of managing the economy just as they can decide on the best design of a bridge. But trade-offs are the essence of economic policy making. There are, as we have argued, choices to be made; some will benefit from these choices while others lose. It is evident now that the Fed failed to maintain economic stability—and after the crisis, it failed to restore the economy to health; it is evident, too, that the economic doctrines on which its policies were based were badly flawed. No policy is without risk. But the policies chosen by the Fed forced the brunt of the risk to be borne by homeowners, workers, and taxpayers, while the upside was captured by the banks. There were other policies, with other risks, in which the rest of our society would have fared far better, and the banks worse. We need to recognize that a central bank’s decisions are essentially political; they should not be delegated to technocrats, and they certainly can’t be left to those who disproportionately represent one of the vested interests.
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The euro crisis—an example

The institutional flaws in the design of the central banking system for regulating banks and determining interest rates in the United States also arise in countries around the world. Before the crisis America was held up as a model of good institutional design, and countries elsewhere imitated it. In the aftermath of the crisis, the flaws in the system have become apparent, and the United States, and others that have adopted similar institutional arrangements, should be thinking of a redesign.

Critical as I am of the Fed, I find matters even worse in Europe. America’s central bank
officially
is supposed to look at inflation, growth, and employment. The European Central Bank (ECB), Europe’s equivalent of the Federal Reserve that rules over the seventeen-country eurozone, is supposed to focus only on inflation. It also reflects the mindset of the banks and financial community even more than the Fed does. The ECB response to the great debt crisis that began with Greece in January 2010 offers an example. First Greece, then Ireland and Portugal, later followed by Spain and Italy, faced interest rates on their debt that were unsustainable. The specter of a Greek default shifted from a remote possibility in January 2010 to an inevitability by July 2011, though somewhat gentler words like “a debt restructuring” were used. Greece owed more than it could possibly pay without inflicting politically unacceptable pain on the citizens of the country. When the only problem seemed to be that of Greece, a simple patch on the European system could have done the trick. But when large countries like Spain and Italy faced difficulties financing their debt at reasonable interest rates, it was clear that the problem would require more resolute action.

The ECB played, at best, an ambiguous role.
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For instance, in the case of Greece, it insisted that any restructuring of the debt (asking creditors to take a debt write-down and postpone repayment) be voluntary. They said whatever agreement was reached couldn’t be allowed to set off a “credit event,” meaning an event that would trigger a payment on credit default swaps, the risky securities that would pay off if Greece defaulted. In saying that, the ECB seemed to be placing the interests of the banks well above that of the Greek people. Greece needed a deep restructuring (another way of saying a large reduction in its debt burden), well beyond that which might emerge from a voluntary restructuring, but only a voluntary write-down would not be considered a credit event.

There was something even more curious about the ECB position. Credit default swaps are supposed to provide insurance. If you have an insurance policy, you want the insurance company to be generous and declare that an “insurable event” has occurred: it is the only way that you can collect on your policy. In fact, sometimes people do something to create such an event (that’s how the term “moral hazard” arose). In the Greek case the ECB said that it didn’t want these insurance policies to be triggered. If the derivatives had been purchased as insurance products, then the banks would have wanted to collect on the insurance, and the ECB, as protector of the banks, would have wanted that as well. One explanation was that the ECB had failed in its regulatory role, and some banks, rather than buying insurance, were engaged in gambling and stood to lose if the CDSes had to pay off. The ECB seemed to be putting the interests of these banks ahead not only of the citizens of Greece but also of those banks that had been more prudent and purchased insurance.
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Of course, the responsibility of the ECB and the European financial authorities was to make sure that the banks were adequately capitalized and were not excessively exposed to risk. That they had failed miserably was evident: weeks after European financial institutions were given a clean bill of health (from the passage of a stress test, supposedly designed to ensure that the banks could survive a major economic stress), the Irish banks collapsed. A few weeks after they were given a second seal of approval, having supposedly tightened their standards, another major European bank (Dexia) failed.
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M
ONETARY
P
OLICY AND THE
B
ATTLE OF
I
DEAS

A central theme of this book is that there has been a battle of ideas—over what kinds of society, what kinds of policies, are best for
most citizens—
and that this battle has seen an attempt to persuade everyone that what’s good for the 1 percent, what the top cares about and wants, is good for everyone: lower tax rates at the top, reduce the deficit, downsize the government.

It is not a coincidence that currently fashionable monetary/macroeconomics finds its origins in the work of the influential Chicago school economist Milton Friedman, the strong advocate of so-called free-market economics, which downplayed the importance of externalities and ignored information imperfections and other “agency” issues.
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While his pioneering work on the determinants of consumption rightly earned him a Nobel Prize, his free-market beliefs were based more on ideological conviction than on economic analysis. I remember long discussions with him on the consequences of imperfect information or incomplete risk markets; my own work and that of numerous colleagues had shown that in these conditions, markets typically didn’t work well. Friedman simply couldn’t or wouldn’t grasp these results. He couldn’t refute them. He simply
knew
that they had to be wrong. He, and other free-market economists, had two other replies: even if the theoretical results were true, they were “curiosities,” exceptions that proved the rule; and even if the problems were pervasive, one couldn’t rely on government to fix them.

Friedman’s monetary theory and policy reflected his commitment to making sure that government was small and its discretion limited. The doctrine that he pushed, called monetarism, held that government should simply increase the money supply at a fixed rate (the rate of growth of output, equal to the rate of growth of the labor force plus the rate of growth of productivity). That monetary policy could not be used to stabilize the
real
economy—that is, to ensure full employment—was not of much concern. Friedman believed that on its own the economy would remain at or near full employment. Any deviation would be quickly corrected as long as the government didn’t muck things up.

In Friedman’s eyes, the Great Depression was not a market failure, but a government failure: the Fed had failed to do what it should have done. It let the monetary supply decrease. In economics we don’t have the opportunity to do experiments. We can’t relive the Great Depression again, changing monetary policy to see the consequences. But in some ways, the Great Recession has provided a wonderful, if costly, opportunity to test some of the ideas. Ben Bernanke, a student of the Great Depression, knew the criticisms of the Federal Reserve, and he didn’t want to be accused of ignoring lessons learned. He flooded the economy with liquidity. A standard measure of monetary policy action is the size of the Fed’s balance sheet—how much it has lent out to the banking system and bought in government and other bonds. The balance sheet nearly tripled, from $870 billion (June 28, 2007) before the crisis to $2.93 trillion as this book goes to press (February 29, 2012).
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This liquidity increase—together with the massive Treasury bailout—may have saved the banks, but it failed to prevent the recession. The Fed may have caused the crisis through its loose monetary policy and lax regulations, but there was little it could do to prevent or reverse the downturn. Finally, its chairman admitted as much.
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