Lenders at the last

Before the crisis of 2007-08, the general public rarely considered central banks and that was the way central bankers liked it. The less they were in the headlines, the better: if the global economy was working well enough to be considered boring, they were doing their job.

Then the banking system collapsed and the central banks had to come out of the shadows. Never were the words of central bankers such as Ben Bernanke and Mervyn King more eagerly scanned. They became financial physicians, applying quantitative easing here, cash injections there and radical surgery for the parts that couldn’t be saved.

Afterwards, reflection set in. The central banks had clearly played a major role in resolving the crisis — but had they also been responsible for causing it? Was their medicine effective or did it produce unforeseen side-effects? Are they really independent or have politicians and vested interests captured them? These are some of the questions addressed in three new books.

Their focus is the US Federal Reserve, the closest thing we have to a global central bank, and its older but smaller cousin, the Bank of England. President Woodrow Wilson signed the Fed into law in 1913, after the intervention of financier J Pierpont Morgan to restore confidence during the panic of 1907 highlighted the need for a more formal method of controlling the US banking system. The Bank of England was also formed out of adversity by a government in 1694 that needed urgently to raise funds to finance a war with France.

Their powers have waxed and waned but in the years since the crisis, sometimes in conjunction with other arms of government, they have had three core functions. They are the lenders of last resort to banks in trouble; they serve as banking regulators; and they act as their governments’ economic agents. The latter is achieved by controlling the money supply and setting interest rates, and the efficacy of this methodology is the common ground between the two trenchant critiques and one neutral account reviewed here.

The Fed’s global pre-eminence is based on the size of the US economy, which makes its presidential-appointed and congressional-vetted chair central banking’s global superstar. Excepting the incumbent Janet Yellen, the three dominant chairs of modern times are Paul Volcker (1979-87), Alan Greenspan (1987-2006) and Ben Bernanke (2006-2014).

Volcker took office at the time of “the Great Inflation”, after a period in which the Fed had unsuccessfully tried to tackle out-of-control price rises through interest rates. Influenced by the work of the monetarist economist Milton Friedman, Volcker switched tack by targeting the amount of money in the system and letting the market set interest rates in response. If money was scarce, the price that borrowers would have to pay would rise. It was brutal medicine, costing millions of jobs and causing interest rates to soar but it did bring inflation under control and perceptions of the Fed’s independence gave Ronald Reagan, president during many of these years, air cover from any collateral damage.

Volcker’s successor, Alan Greenspan, achieved iconic status as the central bank’s overlord. He was feted in the US and abroad, and in 2002 was given an honorary knighthood for his “contribution to global economic stability”. The basis for this was the low inflation and steady growth of the Greenspan years and the markets’ belief that, at times of disruption, the Fed would always come to the rescue with easy money or discrete pressure on private banks to help ailing institutions. This safety net became known as the “Greenspan Put”. Greenspan just had time to bring out a book explaining the secrets of his success before it all unravelled.

The task of resolving the crisis fell to his successor Ben Bernanke. The situation was desperate and Bernanke’s Fed used the authority granted it in Section 13(3) of the Federal Reserve Act to bail out banks “in unusual and exigent circumstances”. The subsequent exercise of economic power was virtually unprecedented in the US outside of wartime.

Peter Conti-Brown, an assistant professor of legal studies and business ethics at the Wharton School, writes the measured account from which the preceding historical analysis is partly drawn. The Power and Independence of the Federal Reserve describes the Fed’s journey from its early 20th-century role “as a banker’s bank and lender of last resort, to the god of the boom-time economy” in Greenspan’s time “and back again” after the crisis of 2007-08 to the “functions [that] defined the Federal Reserve System at its inception”, including regulation and supervision. He explains clearly how complex relationships shape the Fed’s independence in a meticulous study of its political, economic and constitutional history.

There are no villains in his account. “Central bankers at the Fed aren’t throwing darts at a decision tree, nor is there any evidence of venality and corruption,” he writes. Instead, the Fed adjudicates impartially between conflicting views, seeking to reconcile imperfect data and always shaped by the shifting blend of personalities and ideologies on its governing board. While that particular conclusion might be hard for the conspiracy theorists to swallow, it is hard to disagree with the author’s overarching premise that reforming the Fed’s “complicated, confused and opaque” governance would improve transparency, restore accountability and reduce the risk of groupthink.

He says that his “book is for those readers who are eager not for single sentences, but for the quieter and necessarily lengthier discussion” and that he is “comfortable losing the fringe conspiracists”. He has achieved both objectives, though perhaps at the expense of enticing the general reader. If you are a serious student of central banking or heading for an interview at the Bank of England or the Fed, this is the book for you; if you are interested in the subject but prefer something more accessible, try the other books on this list.

These include Fed Power: How Finance Wins, a welcome demonstration that grounded academic work can be entertaining as well as informative. Lawrence Jacobs and Desmond King, political scientists from the universities of Minnesota and Oxford respectively, live up to their claim to “jettison the all-too-common hermetic language of academia in favor of candor and directness”.

Their interpretation of the Fed’s role goes beyond that of independent adjudicator into a more sinister form of regulatory capture, in which well-heeled lobbyists influence Fed officials for their own ends. Neither is the Fed a disinterested actor, for it has objectives of its own “to sustain its flow of resources to function and to reward the private banks in its system”. It achieved the latter by delivering “substantial advantages to one industry and a few privileged firms”.

Theirs is the more persuasive explanation but there is no smoking gun. The evidence of a deliberate attempt by the Fed to elevate the interests of big finance above the rest of the economy is circumstantial. Though the crisis was resolved in a way that favoured certain financial institutions, there are no revealing emails or memoranda that betray any kind of motive other than supporting the public interest as the Fed defined it.

The authors know the Fed inside out but they are on less sure ground when they contrast its performance with that of other central banks. The Bank of England is praised for requiring the banks it bailed out to support homeowners and small businesses, whereas the Fed rescued the US financial institutions unconditionally. But the US bounced out of recession more convincingly than the UK, raising questions about the effectiveness of the Bank of England’s intervention. Perhaps the Fed wasn’t so dumb after all.

The Bank of Canada’s tight grip on the Canadian banks ahead of the crisis is nicely contrasted with the Fed’s approach. It worked very well but a more detailed discussion of how that could have been applied to the larger US banking system would have been welcome. However, these peripheral criticisms should not detract from a book that is engaging throughout and generally persuasive in its principal thesis that the Fed is a politically loaded institution that drives rising inequality.

Finally, Anjum Hoda brings a practitioner’s insights and biases to the subject. She is a former portfolio manager, derivatives trader and strategist who is currently running a capital advisory business. She has an intricate knowledge of how money markets work and uses this to good effect in Bluff: The Game Central Banks Play and How It Leads to Crisis.

Her core belief is that the central banks’ use of interest rates to control the economy is ineffective and directly caused the crisis. The bluff is that by “lowering interest rates they can propel the public into economic activity that leads to greater prosperity characterized by more jobs and wages”. In fact, the updraught is felt primarily in capital asset prices: “Low interest rates, impending inflation and reasonable levels of current consumption stop people from realizing these apparent wealth gains and spending money proportionately on consumer goods and services.”

Thus the interest rate policy helped asset owners but did nothing for the have-nots and increased market volatility by mispricing risk. When, as occurred in the subprime mortgage crisis, interest payments were interrupted, the whole edifice cracked. This was the inevitable consequence of the misconceived Greenspan Put and, while she is not the first person to identify the flaw, it has rarely been more clearly explained. Even the most serious-minded readers will find the story enlivened by the likes of Mary Poppins, Kung Fu Panda and some amusing analogies.

Where the book falls down is in its overgenerous treatment of the industries with which the author is involved. According to Hoda it was the central banks, not the private banks, that bear primary responsibility for the crisis. She largely absolves commercial banks and investors, believing that they were mere infantrymen marching to the central banks’ low interest rate drumbeat. It is a very sympathetic interpretation. The front-line banks were volunteers rather than conscripts and could have exercised their own judgment to march out of time, as some indeed did.

Her analysis of the investment banks is benign to the point of absurdity. The long list of fines and restitutions they were later forced to pay show that they made their money in far more nefarious ways than she describes, and it is stretching credibility to regard them as innocent beneficiaries.

Nonetheless, if these particular judgments are suspect, understanding the central banks’ role in causing as well as resolving the crisis is still an important step in ensuring that in future they stay out of the headlines. For that we would all be grateful.

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