Leadership and Independence at the Federal Reserve

Legislative Resistance and Proposals for Reform (2009)

• Ron Paul’s Diagnosis (February 3, 2009): Representative Ron Paul (R-TX) introduced a bill to abolish the Federal Reserve, characterizing every economic downturn in the U.S. over the last century—from the Great Depression to the 1970s stagflation and the 2007–2009 housing crisis—as a result of Federal Reserve policy.

• Legislative History: Paul had consistently opposed the Fed, offering bills to dismantle it since $1983$. His $2009$ bill died in committee, as previous attempts had.

• Changing Political Environment: While few shared the desire to eliminate the institution, the $2007$–$2009$ crisis sparked curiosity regarding the Fed’s secrecy. Historically, supporters argued monetary policy must be separated from electoral politics to avoid short-term manipulation of the money supply and interest rates.

• Audit Proposal: By November $19, 2009$, Paul’s proposal for a full audit of the Fed had gained a record $313$ cosponsors. The House Financial Services Committee was scheduled to vote on appending this to a major financial reform bill.

Early American Banking and Distrust of Centralization

• Historical Precedents: Distrust of central banking traces back to the Federalist and Democratic-Republican rivalry.     * First Bank of the United States: Established by Federalists in $1791$; charter expired in $1811$.     * Second Bank of the United States: Established in $1816$ following fiscal challenges from the War of $1812$.

• Aims of the Second Bank: Beyond bolstering the treasury, proponents sought a national currency via banknotes and better utilization of specie (gold and silver coins).

• Institutional Conflict:     * William Jones (First President): Aggressive lending drew ire from state banks.     * Langdon Cheves (Successor): Contracted lending, causing financial distress.     * Nicholas Biddle (Third President): Considered a prototypical central banker, Biddle stabilized the currency and strengthened the institution, prioritizing "quasi-governmental responsibility" over private profit.

The Bank War and the Era of State Banking

• Andrew Jackson’s Opposition: Jackson, a populist skeptic of elites, vetoed the bank's charter renewal in July $1832$ (four years early). He declared the bank:     * "Unauthorized by the Constitution."     * "Subversive of the rights of the States."     * "Dangerous to the liberties of the people."

• The "Free Banking" Era: After the charter expired in $1836$, state-chartered banks issued unique notes. Without a national bank, notes were not disciplined for over-issue.

• Civil War Currency: State banks stopped exchanging notes for specie during the war.     * Greenbacks ($1862$): Congress issued official legal tender which depreciated significantly.

• National Banking Acts ($1863$, $1864$, $1865$):     * Authorized federally chartered banks to issue national banknotes backed by U.S. government debt.     * Taxed state banknotes out of existence.     * Created the Office of the Comptroller of the Currency.

• Persistent Instability: Major panics occurred in $1873$ and $1893$.

The Panic of 1907 and the Impetus for Reform

• The United Copper Crisis: F. Augustus Heinze, E. R. Thomas, and Charles W. Morse failed to corner the market on United Copper Company stock in October $1907$.

• Contagion: Rumors of instability hit the Mercantile National Bank (controlled by Heinze, Morse, and Thomas) on October $16$. The panic spread, leading the group led by J. P. Morgan to conclude that the Knickerbocker Trust Company ($62\text{ million dollar}$ in deposits) was too distressed to rescue.

• Private Intervention: J. P. Morgan assembled groups to support the New York Stock Exchange and the City of New York with approximately $40\text{ million dollar}$ and $30\text{ million dollar}$ respectively. The U.S. Treasury directed $35\text{ million dollar}$ into NY banks.

• Public Sentiment: While Morgan was thanked, some bankers argued such power should reside with men having "no private interests to promote."

Creating the Federal Reserve System

• Aldrich-Vreeland Act ($1908$): Created a mechanism for emergency currency and established the National Monetary Commission.

• National Monetary Commission: Led by Senator Nelson Aldrich (R-RI). Paul Warburg, a partner at Kuhn, Loeb & Co., influenced the commission by arguing for an "elastic" currency.

• Real Bills Doctrine: The theory that if banks only lent against "real bills" (short-term commercial debt tied to physical goods), the money supply would expand and contract naturally with commercial activity.

• Jekyll Island Meeting (November $1910$): Secret meeting between Senator Aldrich, A. Piatt Andrew, and elite bankers including Warburg. They drafted the "Aldrich Plan" for a privately owned "bank of banks."

• Political Conflict: Democrats, gaining control in $1910$ and $1912$, rejected the bank-owned Aldrich model. Representative Carter Glass (D-VA) and Henry Parker Willis proposed many local reserve banks to ensure "home control."

• Wilson’s Compromise: Woodrow Wilson insisted on a central board to supervise the regional banks to ensure public control.

The Federal Reserve Act of 1913

• Legislation: Both houses passed the Glass-Owen bill, signed on December $23, 1913$.

• Organizational Structure:     * Maximum of $12$ Federal Reserve Banks.     * Reserve Requirements: Mandatory for national banks; approximately $12\%$–$18\%$ for demand deposits and $5\%$ for time deposits.     * Collateral: Reserve Banks issued "Federal Reserve Notes" backed by a gold reserve of at least $40\%$.     * Federal Reserve Board: Consisted of the Secretary of the Treasury, the Comptroller of the Currency, and five presidential appointees.

• Monetary Tools: The "discount window" allowed banks to borrow cash by selling qualifying assets to the Fed at a "discount rate."

Early Challenges: War and The Treasury Department

• Governors Conference: Led by Benjamin Strong (Governor of the New York Fed), this group rivaled the Federal Reserve Board until the Board restricted its meetings in $1916$.

• World War I Subordination: The Fed kept interest rates low ($3\%$–$4.5\%$) to facilitate Treasury bond sales. This caused high inflation (>15\%) after the war.

• Post-War Deflation: The Fed raised rates in November $1919$, leading to a sharp recession and deflation by $1921$. Outraged farmers sparked a congressional investigation.

• Open Market Operations ($1920s$): In $1922$ and $1923$, the Fed began buying/selling government bonds on the secondary market to manage the money supply. In $1923$, the Fed bought $500\text{ million dollar}$ in Treasury debt to expand the money supply during a downturn.

The Great Depression and Structural Overhaul

• Fed Inaction: Early on, Fed officials practiced a "policy of confirmed pessimism," believing liquidation of weak firms was necessary. They adhered to the Real Bills Doctrine and the gold standard even as bank failures rose.

• Monetary Tightening ($1931$): When Britain left the gold standard, the Fed raised rates to protect gold reserves, intensifying the domestic crisis.

• Legislative Respones:     * Emergency Banking Act ($1933$): Closed all banks temporarily; granted regulatory authority over member banks.     * Banking Act of 1933 (Glass-Steagall): Established federal deposit insurance (FDIC), separated commercial from investment banking, and created the Federal Open Market Committee (FOMC).

• Banking Act of 1935: Influenced by Board Chairman Marriner Eccles.     * Removed the Treasury Secretary and Comptroller from the Board.     * Renamed members "governors" and extended terms to $14$ years.     * Renamed bank governors "presidents."

World War II and the 1951 Accord

• The "Peg": From February $1942$, the Fed agreed to peg government bond interest rates at low levels to support war financing.

• Conflict with Truman: Fed Chairman Eccles opposed the peg due to inflation post-WWII. Truman replaced him with Thomas McCabe in $1948$.

• The 1951 Accord: On March $4, 1951$, the Fed and Treasury announced a joint "Accord," ending the peg and restoring the Fed's independence to set rates without prior Treasury approval.

• Milton Friedman’s Critique ($1952$): Friedman proposed abolishing the Fed, arguing it facilitated inflation and failed to prevent panics, and suggested a $100\%$ reserve-deposit system.

The Martin and Burns Eras

• William McChesney Martin ($1951$–$1970$): Famously described the Fed's job as "leaning against the wind" of inflation/deflation.     * Operation Nudge/Twist: Cooperation with the Kennedy administration to nudge down long-term rates while keeping short-term rates high.

• Arthur Burns ($1970$–$1978$): Faced "stagflation" (simultaneous rising inflation and unemployment).     * Gold Window Closure ($1971$): Nixon ended the convertibility of dollars to gold.     * Political Allegations: Burns was accused of loosening policy to help Nixon's $1972$ re-election.

Legislative Oversight and High Inflation ($1975$–$1978$)

• New Requirements: Laws in $1975$, $1977$, and $1978$ expanded oversight.     * Dual Mandate ($1977$): Established the goal of "maximum employment, stable prices and moderate long-term interest rates."     * Audit Expansion ($1978$): Instituted audits of some Fed expenses, but not monetary or financial activities.

The Volcker and Greenspan Years

• Paul Volcker ($1979$–$1987$): Employed "practical monetarism." He raised the discount rate and reserve requirements to kill inflation (>10\% down to $3\%$ by $1983$), though it caused a severe recession.

• Alan Greenspan ($1987$–$2006$):     * 1987 Stock Market Crash: The Dow fell $22.6\%$ on October $19$. Greenspan provided massive liquidity.     * Political Conflict: George H. W. Bush blamed Greenspan for his $1992$ loss due to slow rate cuts.     * Deficit Reduction: Greenspan cooperated with Bill Clinton, but angered him by raising rates in $1994$.     * Post-9/11: Target federal funds rate cut from $6.5\%$ to $1.75\%$ and eventually $1\%$.

Bernanke and the Subprime Crisis

• Magnitude of Subprime Market: By early $2007$, lenders held over $7\text{ million}$ subprime mortgages worth approximately $1.3\text{ trillion dollar}$.

• Emerging Distress: By spring $2007$, $3.5\text{ million}$ mortgages were "under water."

• Crisis Liquidity Initiatives:     * Term Auction Facility (TAF): Auctioned funds to depository institutions.     * Currency Swaps: Provided dollars to foreign central banks.     * Term Securities Lending Facility (TSLF): Exchanged Treasury debt for Mortgage-Backed Securities (MBSs).

Rescue Operations of 2008

• Bear Stearns: In March $2008$, the Fed loaned Bear Stearns $12.9\text{ billion dollar}$ under the "unusual and exigent circumstances" clause of a $1932$ law. It later assumed risk for $29\text{ billion dollar}$ of Bear's assets to facilitate a sale to JPMorgan Chase.

• Fannie Mae and Freddie Mac: These firms backed $30\text{ million}$ mortgages worth $5.5\text{ trillion dollar}$. Federal regulators seized them on September $7, 2008$, with the Treasury committing up to $100\text{ billion dollar}$ each.

• Lehman Brothers: Bankrupted on September $15, 2008$. Officials claimed Lehman lacked collateral for a lawful rescue.

• AIG: The Fed provided an $85\text{ billion dollar}$ loan on September $16, 2008$, taking a controlling stake in the company.

TARP and Quantitative Easing

• TARP Establishment: Secretary Paulson requested $700\text{ billion dollar}$ to stabilize the system. Despite initial House rejection, it passed on October $3, 2008$.     * Equity Purchases: $125\text{ billion dollar}$ was used to buy nonvoting equity in major banks.

• Monetary Expansion ($2009$):     * Quantitative Easing (QE): Cutting federal funds rates to near zero and purchasing long-term assets.     * Asset Purchases: The Fed announced $1.75\text{ trillion dollar}$ in purchases ($1.25\text{ trillion dollar}$ in MBSs).     * TALF: Lent $47\text{ billion dollar}$ by year-end to support consumer and small-business loans.

Questions & Discussion

• Power and Accountability Hearing (February $10, 2009$):     * Member Barney Frank (D-MA) expressed discomfort with the lodge of power in the Fed with few restrictions.     * Spencer Bachus (R-AL) noted that Fed loans dwarfed TARP expenditures.     * Chairman Bernanke testified that while the Fed acted out of necessity, it would be "delighted" if Congress created an alternative program for such emergencies.

• Administrative Reform Debate (July $2009$):     * Ron Paul and Michael Castle (R-DE) pushed for audits.     * Donald Kohn (Fed Vice Chairman) argued that audits would undermine monetary independence and provoke interest rate instability.     * Melvin Watt (D-NC) and Brad Sherman (D-CA) debated the Fed's role in consumer protection and the selection of bank presidents.

• Transparency Act Debate (November $19, 2009$):     * Paul-Grayson Amendment: Proposed a complete GAO audit of all Fed activities, excluding only unreleased FOMC transcripts and delaying market action findings for $180$ days.     * Melvin Watt’s Alternative: A milder amendment restricting audits to "unusual and exigent" loans and regulatory functions, protecting monetary policy from audit.     * Alan Grayson (D-FL) Response: Grayson mocked Watt’s plan, saying it would only allow auditors to "count the pencils on the desks."