The New Federal Reserve and America’s Financial Future

Speaker:Perry Mehrling

MR. MEHRLING: Two years ago, I addressed this group about the changing role of the Fed, pointing out that what the Fed was doing to combat the crisis was the most important thing that was happening; all the talk about TARP was much less important than people were making it. Since then, I have written a book to expand on the point. Today I’m going to say a few things about the book, and say something also about the political economy of the Fed – the current move to “end the Fed” — to put it in a larger historical context.

My book is a kind of biography of the Fed. The first four chapters skip through the first hundred years, and then the last two slow down to consider the last three years. It’s a story about the maturation of the Fed and also about its transformation in the crisis. As with a crisis in anyone’s life, it transforms you, it makes you different. The future Fed will be different from the past Fed. How so?

History of the Fed

Let me begin by taking you back in time and reminding you that the Fed arose in an era of political controversy.


Figure 1. Political Economy of the Fed, 1913

The Fed was founded on the heels of the financial crisis of 1907. The lender of last resort in that crisis was, basically, the private banker J.P. Morgan, and in the aftermath there was an attempt to regularize and legalize that private role—at least that’s how it looked when the bankers got together secretly on Jekyll Island to draft legislation for a central bank. That didn’t go down so well in Congress but later, under a new president, Woodrow Wilson, and with some new language and new politics, the Federal Reserve Act was passed in 1913.

I want to emphasize that a key piece of the new language and new politics was the doctrine known to monetary economists as the “Real Bills Doctrine.” “Real” bills are bills that finance goods on their way to final sale; this kind of financial instrument was the foundations of the British monetary system, the old Lombard Street. Monetary economists don’t think much of the Real Bills Doctrine as monetary theory, but as a political instrument it was very effective, because it articulated the idea that the central bank was going to channel credit preferentially to the productive sectors of the economy.

The Real Bills Doctrine that was embedded in the Federal Reserve Act of 1913 was very specific — Section 13.2 speaks of the Fed as engaging in the discount of commercial, agricultural, and industrial bills. We need to understand this as political language, and notice what is excluded. What this language really says is that the Fed will not be discounting finance bills, which means specifically that it will not be discounting Wall Street paper. It’s a political signal that the Federal Reserve Act is anti-speculation, anti-Wall Street. The same language is also saying that the Fed will not be discounting Treasury bills, that we’re not going to be using the Fed to finance the government. This is another political signal directed to deep cultural memories of the Greenback Era and the financing of the Civil War.

The American adaptation of the British Real Bills Doctrine was to expand from the finance of commerce (goods on their way to sale) to include manufacturing and farming. But the finance was still supposed to be limited to short-term bill finance, not long-term capital financing. That was the idea. The reality, once the Fed was created, was somewhat different.


Figure 2. Economists and the Fed, 1913

The matrix in Figure 2 shows the economists’ debate about the Fed in 1913. Everyone agreed that the national banking system (in the lower left-hand corner) that preceded the establishment of the Fed had a lot of problems: it was prone to crises, money wasn’t elastic, all kinds of problems. But there were two kinds of ideas about what to do about it.

One idea, associated with the Real Bills Doctrine, was to make money more elastic by discounting real bills on demand. This idea was put forth by Laurence Laughlin from Chicago and H. P. Willis from Columbia, among others.  By contrast, at Yale, Irving Fisher wanted to have a central bank that would manage the quantity of money to stabilize the price level. So there was a debate between self-regulation and active management, and between the banking principle and the currency principle, right from the beginning; the main voices in that debate were on the upper left and lower right of Figure 2. What we actually got, of course, was a central bank, and the person who was most active in pushing that was a foreigner, Paul Warburg. And the central bank we got managed to incorporate dimensions of both indigenous points of view. The Fed was born in controversy, and it’s been a controversial entity ever since.

Almost immediately after its establishment, the Fed was called upon to do things it was never intended to do. If that sounds familiar – shades of the recent crisis – it should. The Fed was called upon almost immediately to help fund World War I. As I said, real bills were supposed to exclude Treasury bills. It was not anticipated that the Fed would be discounting Treasury bills, and yet it wound up buying tons of them to finance World War I. Subsequently, all of monetary policy was based on buying and selling Treasury bills, so-called “open market operations” invented by Benjamin Strong in the 1920s. That’s not how the Fed was supposed to work so these innovations were controversial, but eventually they became orthodoxy. Over time, opinion evolved to say, “Well, I guess that’s okay, we can live with that, that seems appropriate for the actual conditions.”

Figure 3. The Fed and the Real World


The Fed and the Real World

This evolutionary adaptation to changing reality is what I mean to signal with the phrase “the Fed and the real world.” The Real Bills Doctrine had served very well as an ideology, as a political framework to make central banking possible, but when the Fed started actual operation, it couldn’t really abide by Real Bills. It was never going to work because it was not connected to the actual financing needs of our country, particularly to our need to finance a war.

It was also not connected to the financing needs of our country in two other dimensions. First, capital finance, meaning long-term finance, for farming and for industry — which was always much more important in the U.S. than it was in Britain. The banks continued to engage in this kind of lending even though it was not considered by the Real Bills Doctrine to be a safe bank asset. Specifically, banks invested in long-term bonds, and there was an active repo market using those bonds as collateral, long before the Fed was established, and continuing on after the Fed. The shadow banking system that everyone moans about today existed before the Fed; it’s always been with us.

The second real world factor that the Fed has been dealing with since its establishment is the international role of the dollar. When the Fed was founded it was never anticipated that the dollar was going to be the world reserve currency — that was the gold standard, and whatever happened in London we didn’t have to worry about. In fact, the Europeans were very happy about the Fed because the U.S. had been a perennial source of trouble for international monetary stability. Before we had a proper central bank, any trouble in the U.S. immediately went to the gold market in London and disrupted everything else.

So, Europe was happy that we created the Fed, but still no one imagined that the dollar would be become the world reserve currency. The Fed was called upon implicitly to serve some of these functions after World War I, but was completely not ready for it. And then it was called upon again, now quite explicitly, after World War II in the Bretton Woods agreement. Even so, the tie to gold continued until the early ’70s. After that we were in a dollar standard system, which saw the rise of a truly international dollar, a euro-dollar which existed parallel to the domestic dollar. I like to tell my students that there’s this international dollar, which is outside the U.S. and is traded between banks that don’t have accounts at the Federal Reserve, quite separate from the domestic dollar. And a lot of what this crisis was all about was strains in the par relations between those two dollars.

This is a strange language, I know, but I think it will illuminate some things for you. The point is that we got used to the fact that the Fed was going to be involved with government finance. World War I and World War II were popular wars, and that’s how we got used to the government finance angle. But we never really got used to the fact that the Fed is involved in capital finance, or the fact of the international role of the dollar. How did we handle those realities, so contrary to the language of the Federal Reserve Act?

Figure 4. Capital Finance, indirect

The language that you hear is that the Fed has a “rate target.” It sets the rate there in the top middle of Figure 4, and that affects the Fed Funds rate, which is the basic funding cost for banks. It also affects the repo rate, which is the basic funding cost for the capital market. Down the center column, there are arbitrage relationships that connect the rate target with longer-term rates on Treasury bills and Treasury bonds, so that’s the way the Fed influences longer term interest rates. And then there’s further arbitrage, credit spreads, that extend the riskless term structure to long-term bank lending and security prices in capital markets.

The important thing is that the Fed is supposed to be focusing its attention on the short-term interest rate, not the long-term interest rate, and on the risk-free interest rate, not the risky interest rates. The long rate, and the risky rate, are left to the private markets, and are no part of the operational responsibility of the Fed. In other words, we handled the reality of long-term capital finance by pretending that the Fed was not involved!

Figure 5. International Dollar, indirect

A similar intellectual strategy operated at the international level. Once again the language that you hear focuses on the short-term rate. When domestic dollar interest rates change, so do international dollar interest rates, and that moves the exchange rate against other countries. Again, the effect on the exchange rate, and hence on the international role of the dollar, is indirect, no particular concern of the Fed. Once again, we handled the reality of the international role of the dollar by pretending that the Fed was not involved!

Figure 6. The Shadow Banking System


The Shadow Banking System

Figure 6 shows the shadow banking system that developed in the last couple of decades. Traditional banks are down at the bottom of the figure, taking in deposits and making loans, loans being mortgage loans. And the shadow banking system is up at the top, funding mortgage loans with money market mutual fund shares, but with the money flowing through the shadow banking system in between. Like traditional banks, shadow banks fund long-term assets with short-term liabilities. But unlike traditional banks they have no explicit backstop from the FDIC or the Federal Reserve Bank (FRB). Instead, they had backstop from the traditional banking system, and so indirect access to government backstops. Again, we handled the reality of the burgeoning shadow banking system by pretending that the Fed was not involved.

I want to emphasize two things about Figure 6, the capital financing dimension and the international role of the dollar. The latter comes in because a lot of the shadow banks were offshore. They were in Europe. Further, the MMMF deposits were owned by foreign entities. This was the reality, but a reality that was out of sight, out of mind. The Fed knew all this was happening but kept focused on the short rate and other instruments under their direct control. Meanwhile, most people had no idea, and continued on with a Jimmy Stewart idea about how the banking system works, even as such an idea became increasingly divorced from actual reality.  Then came the crisis and all these realities could no longer be ignored.

Figure 7. MM Funding Stress (Swagel 2009)

Figure 7 is the famous Swagel diagram from his wonderful paper for the Treasury [Phillip Swagel, March 2009]. This is the spread of one-month LIBOR over the OIS (overnight indexed swaps) — you can think of this as the euro dollar rate minus the Fed funds rate at a one-month term. It’s very clear in this diagram that the crisis began in summer of ’07. Certainly for those of us teaching money and banking in the fall of ’07, it was very clear that something very unusual was happening. These spreads are usually a couple of basis points, and they were blowing out to 100. It was unbelievable.

These different one-month instruments are usually thought of as close substitutes, but in the crisis it turned out that they were not. The international dollar and the domestic dollar were supposed to trade at par, and everyone had always assumed they always would, but in the crisis this par relationship came under stress. In order to keep investors holding international dollars rather than fleeing to the safety of domestic dollars, issuers of international dollars had to pay an extra 100 basis points. And the stress did not go away, but rather got worse. You can see the collapse of Bear Stearns in March of ’08. You can see the collapse of Lehman Brothers in September ’08 when the spread went even more crazy.

Figure 8. Collapse and Fed Response

Figure 8 shows how the Fed responded to the crisis. You can see the different stages of its involvement. The first vertical line is Bear Stearns. The second vertical line is Lehman. The chart shows how the Fed’s balance sheet expanded during the crisis, and the different colors show the different liquidity facilities that were responsible for the expansion.

These balance sheet numbers were all that I knew when I was writing the book. They’re all from H.4.1 release, where the Fed reports its balance sheet numbers every week. (Today, as a consequence of Dodd-Frank, we have detailed information on every single loan that the Fed made.) You can see from the chart that before Bear Stearns, the Fed was not doing very much; in the first stage, its response was mainly to lower interest rates, from 5 percent to 2 percent. That seemed like a pretty dramatic response at the time, but in retrospect it was small potatoes. After Bear Stearns, the Fed was the huge lender of last resort; that’s what I call this period, when the Fed sold off 500 billion worth of Treasury bills, or lent them out as collateral, and replaced them with private loans to private banks and dealers.

That kind of intervention stabilized spreads for a while. It seemed to be working, but then it came unglued in September 2008. After the TARP bill failed to pass (on the first attempt) there was no remaining alternative, and we moved the entire problem onto the Fed’s balance sheet in September 2008. That’s when the balance sheet doubled.

The particular thing I’d like to emphasize is central bank liquidity swaps, which rose to a maximum of about $600 billion. That caused, and is causing, a lot of controversy in Congress. You may remember that Ben Bernanke was called on the carpet about this when he was testifying to Congress. He was asked, “Is it really true that you lent $600 billion to foreign central banks, and who gave you the permission to do that?” Well, it is true actually, and it was necessary.

And the reason it was necessary was because of the fact that the shadow banking system was abroad. They were funding themselves in the short-term international dollar money markets. So when the Fed stepped in a lender of last resort, it could not stop with the domestic dollar; it had to serve also as lender of last resort to the international money market. I think now we can admit it, and face up to the reality.

Figure 9. The New Fed and the Real World

The Fed as Dealer of Last Resort

And there was another reality revealed by the crisis. Starting in March 2009, the Fed bought mortgage-backed securities amounting eventually to $1.25 trillion. Now, instead of indirect influence over capital market prices and quantities, the Fed exercised direct influence.

I call that “dealer of last resort” to contrast it with “lender of last resort” because the Fed took the securities onto its own balance sheet, not just lending against them as collateral. During that period after March 2009, if you refinanced your mortgage, it was the Fed who lent you the money in effect.

So, those two dimensions that the Fed used to engage indirectly—capital finance and the international role of the dollar—it had to confront directly during the crisis. In the crisis, the Fed had a direct role that you can see right on its balance sheet. These are facts about the world.

Now, exit strategy. Maybe these are just temporary facts, and it’s an aberration; maybe we can go back to business as usual? I think not. History tells that these have long been aspects of the real world; all the crisis did was to force us to pay attention to them. No one was minding the store in these dimensions, everyone was hoping it didn’t need minding, but it did need minding and so the Fed stepped in. I’m a defender of the Fed in this regard. I think the Fed did the right thing. It did what was necessary during this period.

Was it legal? Well, there’s this huge Section 13.3 loophole in the Federal Reserve Act. These were certainly unusual and exigent circumstances, so I think it was legal, but a legalistic defense is not going to work for the Fed. You also have to be able to say it was the right thing to do, and that’s exactly what I’m saying. It was the right thing to do, whether or not it was legal. In retrospect, the Fed did the right thing, even though they were making it up as they went along.

Figure 10. America’s Financial Future


America’s Financial Future

But now we’re faced with the problem of absorbing all this new stuff into our political consciousness, into our economic consciousness, and understanding how the world works. All of these debates that we’re having about policy (those are in parentheses in Figure 10), I see all of them as sort of proxy debates.

For example, we’re debating Dodd-Frank or Basel III. This is really a debate about what kind of prudential regulation makes sense for the shadow banking system, for the way credit is actually allocated today — which is certainly not through the traditional banking system. This is about capital finance and stabilization policy. Similarly, the debate about QE2 is really about, in this modern world, the right way to do monetary policy. But those are technical challenges.

I think the bigger challenges, the ones I want to draw your attention to, are the political economy challenges, the relationship between the Fed and Wall Street since 1913, the relationship between the Fed and its international role. You could call it protectionism or xenophobia. Historically, the US does tend to withdraw into itself in times of economic troubles.

So these debates about China, these debates about the role of the euro, they are really about our discomfort with globalization. These debates about too big to fail (TBTF), they are really about our discomfort about the role of the banking system in capital financing of the nation. I think we have to confront that politically because people are calling to end the Fed. Underlying that call is a real concern. The political economy challenges do not have easy answers. You can’t answer that kind of concern by saying, “Oh, we’re the experts. We understand.” I don’t think that’s going to work.

We need to learn the lessons of the last three years and of the last 100 years. We are living in a teachable moment, and so that’s what I’m trying to teach.

Do we have time for a question or two? Okay.



SPEAKER: I think one of the things I see in the debate that’s going on is frustration and difficulty with the challenges of dealing with globalization — globalization of finance, globalization of manufacturing, et cetera, et cetera.

And the Fed is taking what might be said to be baby steps in the direction of J.P. Morgan as backer of the system, of the global system. There is also the G-20 that has been trying to take some steps.

What do you see coming institutionally; what do you see the development process looking like over the next few years when it comes to prudential regulation of the international system?

MEHRLING: What I’m trying to say to the people who want to end the Fed is, if you end the Fed, you’re going to get J.P. Morgan. You think the Fed is anti-democratic, okay, what about J.P. Morgan?

We’ve got to understand that the Fed is a move in the direction of political responsibility, and it’s better. Now we need to be moving and extending that, not contracting, but extending that in a way that we’re comfortable with as a people. I don’t think we can do that without engaging this debate in a public way. Doing this behind the scenes, saying the technocrats have it in hand, I think it’s going to be like the Aldrich Bill at Jekyll Island. Jekyll Island didn’t work.

The actual legislation that passed in 1913 was almost the same as the Aldrich Bill. Why did it pass? Because we got the politics right. So that’s going to be the main obstacle.

Now maybe we’ll just do it in stages. We’ll get the technical stuff worked out right, and it will then be defeated in Congress; and then we’ll get the politics right, and we’ll adopt it. Maybe that’s what will happen.

I think you avoid the politics at your peril, knowing how Americans feel about big finance and big government, both of which they hate, and a central bank is both at the same time. That’s the problem.

Yes, Alice?

MS. RIVLIN: I just wanted to get you to talk a little bit more explicitly about what would happen if in Ron Paul’s words, “You end the Fed.” Because what Ron Paul wants you to think is we don’t need a central bank because we could go back to the gold standard, and we’d have this wonderful automatic thing that controlled everything without the intervention of these suspect people.

So what do you say to that?

MR. MEHRLING: Well, historians will tell you that the gold standard never was an automatic thing. That’s not actually how it worked. The Bank of England ran the system, and when they were not able to run it anymore, it broke apart. It was a sterling system — in fact, my next book is about international finance for exactly that reason.

So I don’t think we’re going to do that. That’s not the road forward. It may be that the role of the dollar will be much diminished as an international reserve currency, and maybe that’s a good thing for us as well as for the world. These discussions are ongoing. Sarkozy was just recently making these kinds of proposals.

I think there are going to be big changes afoot in the international monetary regime, but it’s early days.

Ron Paul is just a non-starter, and I think we need to —

MS. RIVLIN: But does he know that?

MR. MEHRLING: It doesn’t matter if he knows that. What’s important is that the people who are listening to him know that. Why are people listening to Ron Paul? It’s because he’s expressing their dismay at the Fed using the instruments of war finance: We used the Fed to finance World War I by expanding its balance sheet just like this. We used the Fed to finance World War II by expanding its balance sheet just like this. Those were popular wars. They were fights for survival of civilization. But what was the last three years about?  We used the very same mechanism to do what? To bail out a bunch of bankers. This is trouble. This is trouble.

Again, I think we did the right thing. We used the instruments of war finance to fight a different kind of war, but we now have to convince the people who pay the bills — ultimately, the taxpayers — that this was a war that we needed to fight. And they’re not convinced, as you can see. That’s why Ron Paul is getting a hearing. They’re not convinced.


MR. BOSWORTH: It’s not just Ron Paul. At a Greenwich roundtable session about a month ago that I moderated, James Grant and Amity Shlaes both waxed away nostalgically for this supposedly automatic gold standard in front of a room of fairly sophisticated investors and had no pushback at all.

And so if it were only politicians, that could be managed, but people who actually have apparently fairly responsible podiums are saying this irresponsible thing. And so I do think that there needs to be a more organized and articulate response, particularly so that common people can understand what’s at stake here.

MR. MEHRLING: That’s a very interesting comment. You know, what you’re saying is J.P. Morgan doesn’t mind ending the Fed. Why would he? Why would he? I’m translating what you said, pushing it farther.

I think it’s true that a lot of the support for that populist thing is actually some conservative finance interest —

MR. BOSWORTH: Something else in disguise, exactly.

SPEAKER: Yes. Something else in disguise.

Maybe one last comment because we do have to move on. Yes.

SPEAKER: Kind of a short-focus comment and then a long-focus comment. The short-focus comment is as a bond market participant and issuer. The level of engagement from the Fed during the crisis, reaching out to sector experts and issuers was unprecedented, and it’s gone away. And I don’t know whether that’s because they feel they need no more information, but there was a real engagement there for about six months that, unfortunately, has gone away — with the world not back to where it needs to be. That’s really unfortunate. That’s the narrow comment.

The wider comment is that I think that sometimes it’s very easy for people to support the crazy positions out there in the world or to remain silent because they don’t have any expectation that it’s going to carry the day. So why fight a fight that you don’t think you’re going to lose?

When you have a crisis like this, you know, the Fed has to act. It has no other choice, and it did its job. And it did it well, and if that’s unpopular with the world, there are a lot of things that are unpopular in the world.

MR. MEHRLING: Maybe I’ll just leave it there.

MR. BOSWORTH: Thank you, Perry.