On the Fed (from my book Wall Street

This is the section on the Federal Reserve from my book Wall Street: How It Works and for Whom (Verso, 1997). The complete text can be downloaded here. It’s a little out of datethe Fed is more open now than it was 15 years ago, at least superficially—but it’s still fundamentally right. Two quick updates: 1) The Fed now releases summaries of its policy decisions right after the FOMC meeting. They’re somewhat sanitized, but still informative. 2) The annual profit it turns over to the Treasury has more recently been around $25 billion. Last year, it was twice that—they made money on all the crappy securities they bought during the financial crisis.

The most important government agency in the realm of money is undoubtedly the Federal Reserve. If something as decentered as a financial system has a center, it’s the central bank, and since the dollar remains the world’s central currency, the Fed is the most important of all central banks. All eyes are on it, and the tone of both financial and real business is heavily dependent on its stance. When a central bank is in an expansive mood, finance bubbles; when it’s tight, things sag.

The Federal Reserve is a study in how money and the monied constitute themselves politically. Ironically, though it’s now an anathema to populists of the left and right, its creation perversely fulfilled one of the demands of 19th century populists: for an “elastic” currency — one administered by the government that could provide emergency credit when a financial implosion seemed imminent — as an alternative to the inflexibility of the gold standard. Instead of becoming the flexible, even indulgent institution the populists dreamed of, the Fed quickly evolved into Wall Street’s very own fourth branch of government (Greider 1987, chap. 8).

Despite a couple of attempts in the early and mid-19th century to create an American central bank, they were allowed to die because of Jeffersonian–Jacksonian objections to concentrated financial power. That left the anarchic, volatile U.S. financial system without any kind of lender of last resort, but in booms all kinds of funny money passed.

Canonically, it was the panic of 1907 that led to the Fed’s creation. In the frequent panics of the late 19th century, a cabal of New York bankers would typically band together to organize lifeboat operations in emergencies; in the panic of 1895, J.P. Morgan and his cronies bailed out the U.S. Treasury itself with an emergency loan of gold. The panic of 1907, however, proved too much for these private arrangements; that time, the Treasury had to be called in to bail out the cabal. After that brush with disaster, Wall Street and its friends in Washington came around to thinking that the U.S. could go no longer without a central bank (ibid., chap. 9; Carosso 1987, pp. 535–549).

Gabriel Kolko (1963) traced the loss of the Wall Street circle’s power to several things — the aging of personalities like Morgan and Stillman (the Rockefeller representative); the growth of the economy and financial markets, and the evolution of financial centers outside New York; and the shift of industry towards internal finance, which lessened Wall Street’s influence. The loss of raw financial power, however, was compensated for by the creation of the Fed, an institution that has been dominated by Wall Street since its birth in 1913. To Kolko, the Fed was an example of an interest group using the state to reverse its fading market fortunes. This line resonates in populist discourse today.

That canonical story, however, doesn’t comport with the convincing evidence massed by James Livingston (1986). To Livingston, the struggle for a U.S. central bank had a much longer history, and one central to the creation of the modern corporate–Wall Street ruling class beginning in the 1890s. Livingston showed that the campaign for a more rational system of money and credit was not a movement of Wall Street vs. industry or regional finance, but a broad movement of elite bankers and the managers of the new corporations as well as academics and business journalists. The emergence of the Fed was the culmination of attempts to define a standard of value that began in the 1890s with the emergence of the modern professionally managed corporation owned not by its managers but by dispersed public shareholders.

Though the U.S. had become a national market deeply involved in global trade and finance in the decades following the Civil War, in the early 1890s it was still dominated by small producers and banks. As any Marxian or Keynesian crisis theorist can tell you, the separation of purchase and sale is one of the great flashpoints of capitalism; an expected sale that goes unmade can drive a capitalist under, and unravel a chain of financial commitments. Multiply that by a thousand or two and you have great potential for mischief. This is one reason the last third of the 19th century was characterized by violent booms and busts, in nearly equal measure, since almost half the period was one of panic and depression. In panics, the thousands of decentralized banks would hoard reserves, thus starving the system for liquidity precisely at the moment it was most badly needed. But the up cycles were also extraordinary, powered by loose credit and kinky currencies (like privately issued banknotes). There was no central standard of value, unlike the way we think of assets of all kinds, from cash to inverse floaters, as denominated in the same fundamental unit, the dollar. “Progressive” corporate thought, which had mastered the rhetoric of modernization, wanted a central bank that would control inflationary finance on the upswing — which in the mind of larger interests, meant keeping small operators from “overinvesting” and laying the groundwork for a deflationary panic — and extend crucial support in a crunch.

Trusts were one attempt by leading industrialists and bankers to manage the system’s instabilities, but those were prohibited by the Sherman Act of 1890. The corporation, argued Livingston, was a response to the outlawing of trusts. By internalizing lots of the the competitive system’s gaps — by bringing more transactions within the same institutional walls — corporations greatly stabilized the economy.

With the emergence of the modern firm at the turn of the century came a broader rethink of the business system. Writing in 1905, Charles Conant, a celebrity banker–intellectual, explicitly cited Marx (and anticipated Keynes) in emphasizing that the presence of money as a store of value, the possibility of keeping wealth in financial form rather than spending it promptly on commodities, always introduces the possibility of crisis. In other words, the possibility asserted by Marx but denied by classical economics, the possibility of an excess of capital lacking a profitable investment outlet, and an excess of goods that couldn’t be sold profitably on the open market, had proved all too real in practice. A system for regulating credit was essential — one that while operating through the state would be taken out of politics; the regulation of money and credit would be turned over to “experts,” that is, creditors, industrialists, and technocrats who thought like them.

The struggle around the definition of money, Livingston showed, marked the emergence of corporate and Wall Street bigwigs as a true ruling class: energized, confident, highly conscious of its mission — capable of promoting its case to a broader public using PR and friendly expertise, and to Congress with deft lobbying. Universities became rich sources of expertise for the new class, and they endowed institutes and foundations to act as a marketing and distribution mechanism for the new ideas.

The fight for sound money was also consciously exapnsive, even imperial; the economic theory of the day held that chronic oversupplies of capital and goods could be alleviated by conquering foreign markets. Big business managers with global ambitions wanted their bankers to be international, and wanted the dollar to be firm against the British pound rather than a junk currency. They wanted their paper accepted in London money markets in dollars, not pounds, and to do that required a central bank to anchor the U.S. financial system. They were also tired of the federal state being weak and small.

The panic of 1907, rather than being the catalyst it’s sometimes presented as, was taken as the “evidence that validated conclusions [the corporate–financial establishment] had already reached” (Livingston 1986, p. 172). The elite had been agitating for sterner money for a decade. The PR campaign heated up, as did the political campaign; in 1908, Congress formed a monetary commission led by the blue-chip Senator Nelson Aldrich, and the next year, the Wall Stree Journal ran a 14-part editorial on its front page arguing the case for a central bank, written by Conant. This institution would regulate “the ebb and flow of capital,” and stabilize the economy. Among the elite there was a great loss of faith in the self-regulating powers of the free market; a central bank was just the sort of expert and dispassionate intervention required to brake its frequent tendency towards derailment.

This history helps explain the essential absence of a finance–industry split, minor family quarrels excepted, over central bank policy in the U.S. and elswhere. There was remarkable regional and sectoral agreement on the need to rationalize the banking system, both for reasons of stabilizing the economy and to promote overseas commercial and imperial interests.

This history also helps explain populist thinking in the U.S. today, with a similar analysis often shared by left and right, greens and libertarians. Their opposition to central banks, centralizing corporations, and global entaglements in favor of a decentered, small-scale system reflects the historical processes by which these modern institutions formed each other. They typically forget the volatile, panic-ridden history of the late 19th century in their dreams of simpler times.

From its founding, the Fed has consisted of twelve district banks scattered around the country — a concession to the decentralized traditions of American finance and politics — and a central governing board in Washington. The district Federal Reserve banks are technically owned by the private banks in their regions, which choose six of each district bank’s nine directors. Of the New York district’s nine serving in 1996, three were bankers (from the Bank of New York, and smallish banks on Long Island and in Buffalo); two were CEOs of giant companies (AT&T and Pfizer). The balance: conservative New York City teachers’ union leader, Sandra Feldman; private investor John Whitehead, formerly of Goldman, Sachs and the Carter cabinet; investment banker Pete Peterson of The Blackstone Group, formerly of the Nixon administration, and sworn enemy of Social Security; and the head of a giant pension fund, Thomas Jones of TIAA–CREF. Recent alums include the CEO of a large insurance company, a small business-owner, and the head of an elite foundation. Of all these, only two were outside the Big Business/Big Finance orbit — three if you’re generous, and want to count the foundation executive, but foundations have big financial holdings, and are politically and socially intimate with the corporate class. So while the Federal Reserve System is technically an agency of the federal government, an important part of the system is directly owned and controlled by private interests.

Despite the original decentralizing intent of the district structure, power quickly gravitated toward two centers — Washington, where the Fed is headquartered, and New York, the site of the most important of the regional banks because of its location just blocks from Wall Street. Day-to-day monetary policy is carried out, based on broad instructions from Washington, at the New York Fed’s trading desk. The system’s executive body is a Board of Governors, consisting of seven members nominated by the President and confirmed by the Senate, who serve for a term of fourteen years. That long term is supposed to insulate the governors from political pressures; in reality, it insulates them almost completely from anything like democratic accountability. From the seven board members, the President nominates, subject to Senate confirmation, a chair and a vice chair, who serve four-year terms. The board has in practice been pretty well dominated by the chair; after leaving the vice-chairship in 1996, Alan Blinder complained publicly about his difficulty in even getting information out of the staff economists. From the chair down to the vice presidents and directors of the district banks, the Fed’s senior staff is overwhelmingly male, white and privileged (Mfume 1993).

Unlike ordinary government agencies, the Fed is entirely self-financing; it need never go to Congress, hat in hand. Almost all its income comes from its portfolio of nearly $400 billion in U.S. Treasury securities. It’s not a difficult trick to build up a huge piggy bank when you can buy bonds with money you create out of thin air, as the Fed does. In fact, at the end of every year, the Fed returns a profit of $15–20 billion to the Treasury — after deducting, of course, what it considers to be reasonable expenses. Salaries are far more generous, and working conditions far more comfortable, than in more mundane branches of government — and there’s not much that mere civilians can do to challenge its definition of reasonableness.

Monetary policy is set by a Federal Open Market Committee (FOMC), which consists of the seven governors plus five of the district bank presidents, who serve in rotation —five of the twelve votes are cast by the heads of institutions owned by commercial banks, a very strange feature in a nominally democratic government. Imagine the outcry if almost half the seats on the National Labor Relations Board were reserved for staunch unionists.

The FOMC meets in secret every five to eight weeks to set the tone of monetary policy — restrictive, accommodative or neutral, in Fed jargon. Until very recently, the committee didn’t announce policy decisions until six to eight weeks after they’d been made. In a departure from almost eighty years of history, the sequence of tightenings started in February 1994 were announced immediately, a frank attempt to steal some of the populist reformers’ thunder. Until early 1995, those reformers were led by Texas Rep. Henry Gonzalez, who spent his few years as chair of the House Banking Committee deliciously torturing the Fed in every way possible. The threat of subpoenas from Gonzalez caused a sudden bout of recovered memory syndrome at the Fed; for 17 years, it had denied that it even took detailed minutes at FOMC meetings; in fact, it had been taping and transcribing them all along. The Republican takeover of Congress in 1994, however, ended Gonzalez’ reign of terror.

Still, despite this whiff of glasnost, the Fed remains an intensely secretive institution. This opaqueness has spawned an entire Fed-watching industry, a trade reminiscent of Kremlinology, in which every institutional twitch is scrutinized for clues to policy changes. One of the sacred moments in Wall Street life is “Fed time,” just before noon every day, when the central bank intervenes or doesn’t intervene in the market (by buying Treasury securities in the open market to inject liquidity into the banking system, or selling them to drain liquidity). In the days before the Fed announced policy changes immediately, these interventions or their lack — whether they were more or less generous than Fed watchers had been expecting — were read as signs of a possible change in policy. Fed watchers, many of them recent alumni of the central bank, “earn” salaries well into the six figures for such work; greater openness at the Fed would reduce their importance, if not put them out of business, a rare form of unemployment that would be entirely welcome. The Fed also manipulates the media ably; reporters, eager for a leak from a central bank insider, will print anything whispered in their ears, whether or not it’s true — leaks sometimes designed to mislead or enlighten the markets, and other times the product of some internal struggle.

Even though FOMC members would no doubt invent all sorts of clever euphemisms to express the dangers of excessively low unemployment, televising the FOMC’s proceedings on C-SPAN would still provide an enlightening glimpse into the mentality of power.

One Comment on “On the Fed (from my book Wall Street

  1. Pingback: Sunday Reading « zunguzungu

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