From the White Horse to the Black Robe: The Fed as the Fifth Estate of Government

At the Fed’s humble beginning almost a century ago, its designated role was to dispatch a cash-bearing armored car to a member commercial bank whose depositors had lost confidence and were in line at the door to exchange their deposits for cash. This was the appointed role for the Fed as a lender of last resort to provide liquidity in a timely manner to a bank whose claimants were unwilling to roll over the bank’s short maturity deposits.

The stakes were a lot larger than merely providing the liquidity service to allow a bank to make good on its promise that demand deposits were truly paid in cash on demand. If the Fed’s instant liquidity service didn’t exist, the bank would be forced to meet the cash demand of its depositors by dumping its assets on the secondary financial markets hence cramming down the price of said assets for all holders. If banks were forced to dump assets and cram down their value, many that were solvent at the beginning of the day wouldn’t be by the end of the day.

This is how a liquidity crisis turns into a financial solvency crisis (as in the Lehman Brothers weekend) with grave implications for banking, lending, financial asset values, economic output, and unemployment that still persist in the wake of the Great Recession three years later. Hence on the wings of the Fed’s cash-bearing White Horse rested the stability of the financial “system”.

As was originally envisioned, the Fed’s role was passive in that its only discretion was whether the collateral for the cash loan to a U.S. bank experiencing a deposit run was sufficient to cover the Fed’s risk of making the loan. Moreover its actions were win-win for depositors, the bank’s stockholders, the bank’s borrowers, and the economy in general. The Fed was the modern day cavalry, rescuing all interests simultaneously.

From this passive-reactive role, a series of additional responsibilities were heaped upon the central bank over time, requiring judgment and ultimately leading to favoritism. In l946, the Full Employment Act mandated that the Fed provide liquidity — now generally called the money supply — to banks at just the right pace to finance an economic expansion that was sufficiently fast to prevent unemployment but not so fast as to generate inflation. The Fed’s role became that of providing monetary expansion at the right rate so as to promote a win-win situation even in the absence of bank deposit runs.

While there was room for minor quibbling regarding the right rate of money growth and some criticism that the Fed did not move fast enough to prevent this or that, the Fed was still basically the benign provider of money to meet the needs of the economy, and banks would allocate the funds as they saw fit.  And for this, the Fed and its governors were respected and often honored for their public service.

But from there, things became more complicated. In l956, the Fed was inserted into bank regulation for the first time as the regulator of Bank Holding Companies. Now that investment banks have been converted to bank holding companies in order to justify Fed lending to them, they too fall under its regulatory control. To further add to the Fed’s involvement, it also has responsibilities under the Consumer Credit Protection Act and is supposedly upholding consumers’ interests (not very well, from the consumers’ point of view) in ongoing wealth transfers known as the mortgage foreclosure issue.

From there, the Dodd-Frank Bill expanded Fed oversight as a key member of the Financial Stability Oversight Council, giving it the responsibility of determining whether the financial system is in a generalized price bubble. That means the Fed must now make a judgment as to whether financial prices are unsustainably high, and if they are, decide what to do about it.

If the Fed tightens money and moves off of its zero interest rate policy, the funding of the Shadow Banking system becomes more expensive. In that case, one could expect a deleveraging process to cause hedge fund asset prices to tumble and liquidity to evaporate, causing a repeat of the SOS for more Fed loans that occurred in 2008 and 2009. In that episode, Fed lending to save both U.S. and non-U.S. financial institutions of all kinds (including hedge funds, consumer finance companies, and insurance companies) amounted to $3 trillion in 21,000 transactions.

In the expanding role and scope of Fed activity in the Great Recession, the Fed, for the first time, financed private parties through its purchase of commercial paper and Residential Mortgage Backed Securities. Not only was the Fed financing private parties, but it did so by paying prices for these securities that amounted to a subsidy to the seller. Then, the Fed carried out additional clear and intended wealth transfers when it purchased the bad assets of Bear Stearns and Citibank at subsidized prices. Those assets were camouflaged on the Fed balance sheet in a vehicle called “Maiden Lane, LLC”.

What makes this all the more contentious is the Fed’s accounting cover-up so as to not reveal which private parties they loaned to or the size of the subsidies provided. It took the Dodd-Frank Bill and a Freedom of Information Act class-action suit to force the Fed to open the books and reveal the parties receiving the loans — but no one will ever know the size of the subsidies.

Given all these additional responsibilities, the Fed is no longer the hard-charging savior on the White Horse. Rather, it has inserted itself into the middle of most everything that is economic and financial. It gets to decide who gains and who loses, which amounts to wealth redistribution, and in this process, it has consistently favored the stockholders and management of big banks at the expense of small banks, consumers, the value of the U.S. dollar, the unemployed, savers with near-zero deposit rates, and real income with its inflation-generating Quantitative Easing policy.

Because of this wealth redistribution, the appointment of future Fed Chairmen will have the same politically charged theater as appointing a Chief Justice of the Supreme Court. From now on, it is no more White Horses but instead Black Robes for the Fed.

Indeed, the confirmation of Noble Prize winner Peter Diamond to the Fed’s Board of Governors has been rejected twice and is now on its third re-nomination over the last nine months. Instead of the Fed riding in on the White Horse providing liquidity on a timely basis, monetary policy will be constrained by income and wealth redistribution considerations for which political overtones are ascribed. Hence, the Fed has become the de facto Fifth Estate of Government, redistributing wealth using the printing press and other regulatory powers.

If this continues, the Fed will be put into political gridlock similar to the one Congress is in, as each constituency will come to have its own voting member. Indeed, the Fed’s decision regarding the extension of QE2 is less about monetary policy decision and more about providing benefits to constituencies. The U.S. Treasury derives the primary benefits of QE2, since the Fed is purchasing or monetizing 85 percent of new Treasury debt over the course of QE2, which will end in June.

The Fed in Black Robes rather than on a White Horse is not a change for the better, as shown by the public’s declining confidence. There is no doubt that Bernanke’s decision to hold the Fed’s first-ever press conference is an attempt to win back its compromised goodwill.

It would be in the Fed’s and the country’s best interest for the Fed to go back to the basics of creating monetary policy alone. It shouldn’t be a bank regulator or a consumer protector, and it shouldn’t be in the business of providing solvency support (either directly or under the guise of liquidity support) to selected institutions and the U.S. government.

Investors viewing this with dismay are increasingly shifting their wealth preferences to currencies other than the U.S. dollar and to precious metals. The speed of the dollar’s decline in the last year is a market vote of no confidence in the Fed and constitutes a constraint more binding than legislation.

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