The nation likely will drift into a situation in which its central bank will be expanding its regulatory and safety-net coverage, vainly trying to protect everything in the interest of protecting ‘banks.’ The tremendous power it will come to wield not only will be harmful to the structure of the financial system but also will make the Fed an even more formidable foe to those inside and outside the government who believe that it is too powerful already.

 James L. Pierce, “The Federal Reserve as a Political Power,” 1990

How can the Federal Reserve help you today? A few years ago, such a question would have been rather odd. The Federal Reserve was created a little over a century ago as an independent government agency with a rather small mandate: manage the money supply. It was an important, but limited, role. In normal times, the Fed existed to ensure the money supply grew at a reasonable rate. In times of crisis, the Fed would become the Lender of Last Resort, lending funds to solvent banks to get them through a crisis. But, times have changed. The Fed, no longer tied to the mast, is here to take your order.

This new world is magnificently described in Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis. With impeccable brevity and precision, Menand details how the Fed has abandoned its historical mission, appropriating to itself a new mandate and powers of dubious legality. None of this has been done in secret. Its actions have been front page news, Congress has aided and abetted the unbinding, and as the quotation at the outset notes, it was all predictable in 1990. 

Monetary Policy before 2020

“The American Monetary Settlement” is Menand’s term for the world in which we used to live. Private commercial banks provided deposit accounts (both checking and savings) which constituted the bulk of what we used for money. The Federal Reserve System provides currency (also a form of money) and supervises the commercial banking system. The Fed also provides reserve accounts for commercial banks, which are used to transfer funds from one bank to another. By changing the volume of reserves in banks’ accounts, the Fed is able to exercise indirect control over the amount of money in the economy. The system has a remarkable simplicity, easily explained in any first-year economics class.

There have long been cracks in the money creation system. Over time, other types of accounts developed which also functioned as money, but were easily ignored when discussing the money supply. These other accounts were not provided by domestic commercial banks and thus existed in what became known as the Shadow Banking system. Menand points to three types of accounts (dealer repo accounts, Eurodollar accounts, and money market funds) which are all highly liquid and reasonably stable, and thus provide something that functions as money but pays a higher interest rate than a traditional deposit account at a commercial bank. Because none of these types of accounts are at commercial banks, the Fed has no regulatory authority over them and there are no precise measures of their size.

After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis.

The shadow banking system suddenly found itself in the sun in 2008. Once a small part of the financial infrastructure, the shadow banking accounts had grown to be about twice as large as the measured money supply. When an old-fashioned bank run hit the shadow banking industry, there was a grave danger of the entire system falling apart, which would have generated a collapse in the money supply equivalent to that which caused the Great Depression. The Bernanke Fed exercised an enormous array of powers designed to shore up the shadow banking system to prevent such a collapse. It was a moment of genuine monetary peril, and the resulting recession was much milder than it would have been had the Fed done nothing.

In the wake of previous financial crises, Congress inevitably passed a bill creating a new set of regulations to prevent the same thing from happening again. After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis. 

The 2020 Financial Crisis

The same crisis hit again in March 2020. With the arrival of Covid and the government lockdowns, the shadow banking system once again found itself reeling. This time, the Powell Fed acted promptly, using the same bag of tricks which the Bernanke Fed had stumbled into discovering. It wasn’t enough, so the Fed’s range of actions expanded. The panic ended and the shadow banking system stayed intact. But, as Menand describes in detail, the American Monetary Settlement was destroyed.

The result has been nothing short of a transformation in the Fed’s role in our society. Not only have its unprecedented actions helped once again to avert economic collapse, but they have also changed what members of Congress and members of the public expect of the country’s central bankers. Today, the Fed is no longer just managing the money supply by administering the banking system. It is fighting persistent economic and financial crises by using its balance sheet like an emergency government credit bureau or national investment authority…

In 2008, the Fed invoked an obscure provision in its charter which allowed it to become the lender of last resort to financial firms other than the commercial banking system. In 2020, when that proved to be insufficient to stem the panic, the Fed tried something new: it started directly buying massive volumes of assets in order to prop up their prices. The Chair of the Fed announced that the Fed would not “run out of ammunition”—that they had unlimited resources to buy as many assets as needed. The rhetoric suggesting financial crises are the equivalent of war is revealing; in wartime, even democratically elected governments appropriate seemingly limitless powers over the economy.

That promise opened the floodgates. With unlimited access to the printing press, there seemed to be no limit to what the Fed could do. The financial panic of March 2020 subsided, but the economic problems were only beginning. Those problems extended far beyond the financial sector, so Congress passed the CARES Act, one provision of which was to allow the Fed to lend directly to businesses, both for-profit and non-profit. Suddenly the Fed found itself with the power to lend funds to whatever firm or industry it deemed worthy.

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight.

The Fed did not stop there, however. Being the Lender of Last Resort by definition means the Fed is imposing an obligation to have the loans repaid at some point. That creates burdens on firms to whom the Fed has lent funds. To stimulate economic activity, and not incidentally to keep the interest rates low on government debt, the Fed began what commentators quickly dubbed QE Infinity. In effect, this was an open-ended commitment to keep buying as many financial assets as necessary to maintain low-interest rates.

What exactly now sets a limit on the Fed’s activity? With literally an unlimited amount of money at its disposal, and a mandate which has seemingly broadened to “do good things for the economy,” what should be its priorities? Now that the Fed has crossed the Rubicon by purchasing bonds from AT&T, Verizon, CVS, Comcast, GE, Apple, Microsoft, and so on, why not also your place of work or your favorite non-profit? Now that the Fed has lent to local municipalities, why not get free Fed money for your local school or community center? Is it any wonder that people are now seriously talking about what the Fed can do on the Climate Change agenda?

The world of the Unbound Fed is rife with peril. Menand barely scratches the surface of a world in which an unelected independent agency seemingly can create money to accomplish any goal it wants. We have entered a strange regulatory world in which it is no longer clear which rules the Fed must follow. Obviously, the Fed no longer is restrained to its traditional role of managing the money supply. What else is it now able to do, either legally or with Congress looking the other way?

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight. The now implied promise always to backstop the shadow banking system operating outside of the normal regulatory framework is a recipe for disaster. Using the money supply to finance whatever initiatives Congress wants to accomplish has already resulted in unprecedented growth in the money supply and the inevitable inflationary consequences.

Favoritism is inevitable. In the old days, the Fed avoided favoritism by lending to any commercial bank with good collateral. The only asset it purchased when it wanted to create more bank reserves was US government debt. In 2008, the Fed had to decide which parts of the shadow banking system it wanted to aid in order to prevent a collapse of the money supply (Lehman Brothers: no; AIG: yes). After 2020, the Fed no longer has to restrict itself to financial firms or concerns about the money supply. It will inevitably play favorites.

What Next?

Having laid out the reasons for, and the problem with, the Fed Unbound, Menand naturally enough turns to solutions. Alas, this is where the book founders. We should not fault Menand too much, though; it is not at all clear that there is an easy solution.

He offers two routes forward. First, he asserts the need for “a healthier macroeconomic policy mix.” It is hard to argue with that. After all, the most important reason to have an independent central bank is to prevent the legislature from having access to the printing press to fund every spending idea which comes along. Menand himself illustrates the problem. This discussion is one of the places for Menand’s periodic odd and inexplicable intrusion of his own vaguely leftist political agenda into the book. If the author of a book warning against the dangers of an unbound Fed cannot resist introducing his own legislative agenda into the argument, why should we expect members of Congress to keep their own legislative ambitions separate from a seemingly easy way to finance them?

Secondly, Menand suggests reining in the new financial world. Looking back to the world before 2008, it seems like we could return to those halcyon days gone by “enforcing the regulatory perimeter.” If the problem is types of accounts that function as money but are created outside the traditional commercial banking system, then why not either eliminate the possibility of such accounts or bring them under Fed supervision? Theoretically, that is possible. But, given that the shadow banking system is twice as large as the currently supervised banking system, this is not a small disruption to the monetary system. There is simply no way to predict the economic impact of trying to rewrite the rules on what types of accounts can be offered by what types of financial firms.

The problem with reining in the financial world is complicated by technological developments which have made it easier to create new types of accounts, using new types of assets (e.g. cryptocurrency), which may or may not end up functioning like money in limited sets of markets. No matter where you set the regulatory perimeter, there will be enormous financial incentives to set up shop right on the other side of that border.

These sorts of questions compound the longer you think about this new world of money. Unfortunately, the government does not have a good record when it comes to thinking through the monetary implications of the shadow banking industry. Will they sort this out before the next crisis, as they failed to do in 2008 and 2020? It’s hard to be optimistic, but, if you are not yet troubled by this new world, get a copy of The Fed Unbound.

*****

This article was published by Law & Liberty and is reproduced with permission.

Editors’ Note: It is estimated that 70% of the household worth of the Chinese people is invested in the property market. This market is largely run by the government, the Communist Party, and its state-owned banks. We have covered this ongoing story for some time but indications are the situation is getting worse and has spread well beyond the collapse of Evergrande. In part, this is because of the global economic slowdown, and it further has been aggravated by draconian Covid-related lockdown policies in China. The most recent Economist suggests the problem is now political, with widespread unrest. President Xi is up for”reelection” at what could be a very difficult time. Furthermore, the crisis has taken the form of banks freezing accounts, which has created riots, as well as property owners going on strike and refusing to make their payments. As the article below indicates, China is not only highly centralized, which creates concentrated economic error on a vast scale, it is incredibly over-leveraged. Falling asset prices endanger the loans used to support the particular asset in question, which runs the risk of a cascading scramble to get out and get liquid. This, in turn, runs the risk of a deflationary bust, and then particularly in authoritarian governments, a response by governments to try to stem deflationary pressures. Knowing the timing of such events is largely impossible, but history certainly provides ample examples of the general process. What is very clear is that you can’t have the world’s second-largest economy get into such trouble, Europe lurch into trouble because of energy mistakes, and Japan experience a currency crisis (Yen is down nearly 30%); without raising the risk of global economic trauma. Meanwhile here in the US, the FED is raising rates against our own asset bubble, increasing the risk of recession here as well.

Beijing’s centralized planning has created a massive bubble of obligations.

China’s ongoing debt crisis has experienced yet another twist of fortune. Some Chinese, fearful that their savings are in jeopardy, have protested so actively in front of banks that the Peoples’ Liberation Army has intervened. Others who had bought apartments before now-troubled developers could construct them—what the Chinese refer to as presales—have threatened to withhold payments on their mortgages. These latest aspects of China’s financial troubles have captured the media’s immediate attention, but they change nothing substantive in China’s underlying problem. Significant debt overhang points to fundamental, even systemic flaws in the Chinese Communist Party’s approach to economic organization.

China’s rolling debt crisis broke in 2021, when the huge property developer, Evergrande, announced that it could no longer support some $300 billion in liabilities. Evergrande, and other developers who have since made similar if less grand announcements have left bondholders and lending banks—both private and state-owned—with assets that are now worthless, causing some to try to lock down deposits, and bringing on protests from anxious savers. Would-be homeowners who paid for and floated mortgages for apartments that do not exist have been left holding the bag. In a pattern common to financial crises everywhere, these mortgagees and lenders may now fail on other obligations, imposing losses on others who had nothing to do with the initial failure.

The government in Beijing, as well as media outlets—both Chinese and western—have so far laid the blame for these debt problems on the profligacy of Chinese developers. There can be little doubt that many of these firms had flamboyant managements that borrowed too heavily and spent too freely. But if imprudent management can take some of the blame, the lion’s share belongs to policymakers in Beijing. It was, after all, they who gave property development pride of place in the nation’s growth model. Beijing used special bonds to encourage provincial governments to work with private developers to raise whole cities from what were previously farmers’ fields.

Early on, these rapid developments formed the basis of glowing western media reports. Property development became a huge part of China’s gross domestic product (GDP). But Beijing’s planners, insensitive to facts on the ground, as central planners frequently are, went far beyond the nation’s needs. Today, Beijing estimates that some 20 percent of China’s housing stock is unoccupied and paying no return on the huge debt load incurred to produce these units. It should be no mystery, then, that the developers cannot service those obligations.

If the real estate problem were the whole story, it would be dangerous enough, but the problem is more fundamental. Beijing’s top-down, centrally planned approach to economics has multiplied these kinds of mistakes across the economy. True, this centrally planned system once worked well, but China has changed since those halcyon days, making the centralized approach increasingly wasteful and debt-prone.

When China began its decades-long growth surge, its underdeveloped state made central planning easy. All Beijing needed to do was look at the developed world and see that China lacked roads, ports, rail links, housing, and other such obvious essentials. That emphasis paid off handsomely as the nation filled in its blanks. But as China’s economy has developed and, in many ways, caught up to the developed west and Japan, future avenues for sustained growth have become harder and harder to identify. China’s planners have accordingly begun to make more and more mistakes, setting priorities that, like residential development, have increasingly missed the economy’s needs—bridges, rail links, roads to nowhere, and impressive transit systems in cities with relatively few residents. Even as such fundamentally wasteful projects are abandoned or razed, the debt incurred to build them remains.

Of course, unplanned, market-based systems also make mistakes about future needs.  No one can see the future. But the mistakes of market systems are seldom as massive or pharaonic as in China’s centrally planned system. Market-based participants, typically more sensitive than are central planners to signals from buyers, adjust more quickly before going too far down the wrong road. Because the decentralization in market-based approaches implicitly creates a great diversity of efforts to capture the future, each mistake happens on a smaller scale than when central planners marshal national economic and financial resources toward relatively few priorities. The same diversity of market-based systems means that one of the many efforts to capture the uncertain future will likely be right, thereby generating great returns for the firms and individuals involved, but also crucially for the economy at large. Central planners, on the other hand, place relatively few but very large bets, and suffer commensurately when they fail to pay off. It is noteworthy that America’s market-based system has suffered its worst collapses when government intervenes, as for instance when Washington pressured banks to lend mortgage money to lesser credits, fostered dubious financial practices, and encouraged the overbuilding that culminated in the 2008 and 2009 financial crisis.

A comparison of relative debt loads in China and the United States can quantify this crucial difference and assay China’s essential problem. To be sure, Beijing has kept a lid on government debt issuance—certainly much better than Washington has. But central government debt is an inadequate measure of this effect. The financial legacy of failed projects lies with China’s provincial and local governments and the state-owned enterprises (SOEs) that control the bulk of the nation’s industry. To see the errors wrought by China’s system and make a valid comparison to the United States, the debt to track is a combination of central government obligations, provincial (or state) and local obligations, and the debt of the corporate sector.

During the ten years from 2009 to 2019, aggregate debt in China grew at a 23 percent annual rate, far in excess of the nominal economy’s otherwise impressive 8 percent growth rate. This difference offers a rough (admittedly very rough) estimate of the burden of waste left by the mistakes of the top-down planners. The equivalent debt aggregate for the United States shows a legacy of error, but on a much less grand scale. In America, this measure of debt has grown at about 5.6 percent a year over the ten years ended in 2019, faster to be sure than the 4 percent average growth of the nominal economy, but a much narrower gap than in China. The relative burden of these legacies is apparent in debt levels relative to the overall economy. In the United States, this composite of debt outstanding amounts to just over 190 percent of GDP. In China, aggregate debt verges on 270 percent.

None of this is to forecast a collapse in China or eventual American triumph. To paraphrase Adam Smith, counties can withstand a lot of ruin. What it does say is that China’s underlying economic system will for the foreseeable future create an ever-larger debt overhang. The planners may still get lucky from time to time, but the odds point in the direction of more mistakes, raise questions about easy and popular forecasts of eternal Chinese dominance and should take the edge off equally popular fear-mongering over China.

*****

This article was published by The American Mind and is reproduced with permission.