In FED We Trust (7 page)

Bronze bas-relief sculptures of Wilson (identified only as “founder of the Federal Reserve System”) and Glass (“defender of the Federal Reserve System”) occupy niches on either side of the Constitution Avenue entrance to the Fed’s headquarters. Under Wilson’s bust is a wonderfully pragmatic, though not particularly eloquent, excerpt from his first inaugural: “We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step by step we shall make it what it should be.”

Carter Glass’s words are taken from an angry book he wrote to dispel suggestions that one of Wilson’s White House aides was the true father of the Fed: “In the Federal Reserve Act,” the gold letters say, “we instituted a great and vital banking system, not merely to correct and cure periodical financial debauches, not simply indeed to aid the banking community alone, but to give vision and scope and security to commerce and amplify the opportunities as well as to increase the capabilities of our industrial life at home, and among foreign nations.”

In the end, Alexander Hamilton prevailed. As Bray Hammond, the Fed staffer turned historian, wrote, “Americans still maintain a pharisaical reverence for Thomas Jefferson, but they have in reality little use for what he said and believed — save when, on occasion and out of context, it appears to be a political expediency. What they really admire is what Alexander Hamilton stood for and his are the hopes they have fulfilled.”

Although neither the legislation nor the gilt lettering that adorns the Fed’s building makes mention of the fact, Congress had created what would become a fourth branch of government, nearly equal in power in a crisis to the executive, legislative, and judicial branches. It would take the Fed decades to grow into that role, but by the end of the twentieth century, it would have almost unchallenged power over its domain, the U.S. economy.

The host of politically expedient compromises created a flawed institution. The law provided for a weak Federal Reserve Board in Washington, chaired
by the secretary of the Treasury and including the comptroller of the currency and five others to be appointed by the president. It also mandated up to twelve regional or “district” (as the Fed refers to them) Fed banks, each to be owned by the private banks in their districts, each to be run by a “governor.” It was a classic American balancing between centralization and decentralization, but the legislation provided no clear division of responsibilities between the board in Washington and the regional Fed banks, a feature that would prove troublesome before and during the Great Depression.

Three Wilson appointees — the secretaries of the Treasury and agriculture and the comptroller of the currency — spent months drawing boundaries and designating headquarters of twelve regional Federal Reserve banks, a politically delicate exercise that, among other things, gave Missouri two Fed banks, one in Kansas City and the other in St. Louis. The memory of the regional fights was so lasting that the boundaries have never been adjusted to reflect the westward movement of the population, leaving only two banks, in Dallas and San Francisco, west of Kansas City.

Benjamin Strong, the Morgan lieutenant, had campaigned against the compromise legislation as too decentralized and too fragmented. With some reluctance, he became president of the Federal Reserve Bank of New York and the most powerful player in the system. “He regarded the twelve reserve banks as eleven too many,” Carnegie Mellon economist Allan Meltzer wrote in his voluminous history of the Fed, a sentiment that Strong’s successors at the New York Fed shared, Geithner especially.

The institution was still in its adolescence when it confronted and failed its biggest test: misstep after misstep on the Fed’s part turned a bad late-1920s recession into the Great Depression, an indictment made by Nobel laureate Milton Friedman and collaborator Anna Schwartz, and later expanded by Ben Bernanke in his years as an academic.

In the preface to a collection of his essays on the Depression, Bernanke described those years as “an incredibly dramatic episode — an era of stock market crashes, bread lines, bank runs, and wild currency speculation, with the storm clouds of war gathering ominously in the background all the while. Fascinating, and often tragic, characters abound during this period, from hapless policy makers trying to make sense of events for which their experience
had not prepared them to ordinary people coping heroically with the effects of the economic catastrophe.” The words might have applied accurately to the early twenty-first century.

“[M]uch of the worldwide monetary contraction of the early 1930s,” he wrote, “was … the largely unintended result of an interaction of poorly designed institutions, short-sighted policy-making, and unfavorable political and economic preconditions.” The Depression occurred because the government stood by as the financial system imploded. “That went on for three and a half years without any significant action,” Bernanke said. “The banks failed. The stock market crashed, other credit markets stopped functioning, foreign exchange markets stopped functioning and that collapse of the financial system, together with the deflation and monetary policy, was the basic reason why the Depression was as severe as it was.”

The bottom line — that the Depression was largely the Fed’s fault — dominated Bernanke’s thinking throughout the Great Panic. He was determined that no future scholar would convict
him
of similar timidity or complacency in the face of a financial crisis. As Bernanke put it in his book of essays, “To understand the Great Depression is the Holy Grail of macroeconomics.” That Holy Grail has been the driving force of his entire professional life.

Critics of the Fed’s ineptitude in the late 1920s and early 1930s point to an absence of enlightened, strong leadership at the top. Friedman and Schwartz argued that the Depression would have been avoided had Benjamin Strong, who had chronic tuberculosis, not died in October 1928, a year before the crash. Shortly before his death, Strong had written a prescription for the Fed: “Not only have we the power to deal with … an emergency instantly by flooding the street with money, but I think the country is well aware of this and probably places reliance upon the common sense and power of the System.”

The Fed didn’t take his advice. Its mistakes were many. The original sin was to tighten credit and lift interest rates in 1928 and 1929, in what now appears to have been a misguided attack on speculation in the stock market
when the deeper problem was a weakening of the overall economy and an absence of inflation.

As Bernanke retold the story, the post-Strong Fed “passed into the control of a coterie of aggressive bubble-poppers,” the most determined of whom was Adolph Miller, an economist who was among the first members of the Fed board and served for twenty-two years into F
DR’S
presidency. Herbert Hoover — a neighbor and friend of Miller — was a fervent foe of “speculation” and encouraged him. Under Miller’s influence, the debate inside the Fed shifted from whether to try to stop stock market speculation to how to stop it. The Washington faction threatened to cut off loans to New York City banks as a way to stop them from lending to stockbrokers. It also favored rhetoric, the sort of jawboning that Alan Greenspan tried with his warnings about “irrational exuberance” in 1996.

Strong’s successor at the New York Fed, George Harrison, a Harvard-trained lawyer who had been the Washington board’s general counsel, argued that the brokers would get money elsewhere and that rhetoric would do nothing. His solution was to raise interest rates in an economy that had hardly recovered from a recession that began in November 1927, and was experiencing no inflation. He prevailed, and the Fed’s discount rate on loans it made to banks went from 3.5 percent in January 1928 to 6 percent by August 1929, higher than at any time since 1921.

The Fed tightened credit again in 1931 at just the wrong moment, responding with then-conventional tactics when gold flowed out of the United States. By 1932, with Congress shouting for relief, the Fed reluctantly opened its spigot for a few months, and the economy responded. But when Congress went home in July, the Fed reversed course with Harrison’s support, and the economy collapsed. “The monetary policy of the ’30s led to a deflation of about 10 percent a year, so it was extraordinarily tight monetary policy, which created, among other things, the greatly increased value of debts, which therefore led to more defaults and bankruptcies,” Bernanke said.

Friedman and Schwartz argued the key to the Depression was that the Fed had been too stingy with credit. Bank failures were “important not primarily in their own right” but because they were the vehicle for the “drastic declines in the stock of money,” they wrote. Bernanke contended that that wasn’t
the whole story. In seminal research done while he was still in his twenties, Bernanke emphasized the devastating impact that the collapse of the banking system had even beyond its depressing effect on the money supply. Bank failures and the weakness of surviving banks, he wrote, meant households, farms, and small firms found credit “expensive and difficult to obtain.” In turn, the “credit squeeze … helped convert the severe but not unprecedented downturn of 1929-30 into a protracted depression.”

As happened in 2008, confidence in financial institutions evaporated. A toxic combination of depression and deflation made borrowers insolvent. Nearly half the banks that existed in 1929 had collapsed or been merged into other banks by the end of 1933. Those that survived suffered massive losses and often could not or would not lend. When they did, they often charged outrageous rates.

As with lesser panics, worries about the safety of banks prompted runs in which depositors pulled out their money. Runs, or even the anticipation of them, forced banks to sell securities or call in loans to raise cash. Dumping assets at the same time other banks were doing so pushed down the market price of virtually all assets, generating losses that actually caused banks to fail. “Thus, expectation of failure, by the mechanism of the run, tends to become self-confirming,” Bernanke wrote. The words could have been used to describe Bear Stearns or Lehman Brothers.

In seeking to understand why the economy had a disturbing tendency toward growth spurts followed by recessions, panics, and depressions, many economists discounted the financial markets as a sideshow. They believed that financial markets reflected and predicted what was going on in the underlying economy but weren’t an independent driver of the business cycle. It was a reflection of much of the profession’s amazing proclivity for assuming away reality at times and understating the importance of institutions. Ben Bernanke didn’t see the world as they did. The health of banks and other financial institutions and their attitude toward lending was a major driver of the
business cycle — and could amplify the impact of Fed policies on the economy, he said. He called it “the financial accelerator,” and the Great Depression became his leading case study. His research on this subject provided the lens through which he would later view the Great Panic.

Beginning with an article published in 1983 in the prestigious
American Economic Review
and in subsequent research, Bernanke emphasized banks’ role in the economy, employing concepts that later brought Nobel Prizes to Joseph Stiglitz and George Akerlof for their insights into the functioning of markets when one side has more information than the others.

Bernanke, among others, contended that banks and other financial intermediaries were “special” because they did more than funnel money from savers to borrowers; they developed expertise in gathering information about industries and borrowers and maintained ongoing relationships with customers. “The widespread banking panics of the 1930s caused many banks to shut their doors,” Bernanke told a 2007 audience. “Facing the risk of runs by depositors, even those that remained open were forced to constrain lending to keep their balance sheets as liquid as possible.” The economy, thus, was denied the benefits of banks’ unique knowledge and ability to discern the creditworthy borrower from the less desirable. Stingier banks inhibited consumer spending and capital investment and made the Depression worse. His determination to avoid repeating that mistake drove Bernanke during the Great Panic to do
whatever it takes
to resuscitate the financial system.

The other way that financial disturbances exacerbated the rest of the economy in the 1930s, Bernanke said, was through the creditworthiness of borrowers — and, particularly, through the value of the collateral that they could offer as a way to assure lenders that a loan would be repaid. Bernanke viewed the collapse of home prices during the Great Panic primarily through this lens: a decline in the value of American families’ best collateral would inevitably make it harder for them to borrow. This reading of economic history also led him to press earlier and harder than Paulson did for the government to take steps to avoid “preventable foreclosures” and reduce the size of mortgages that exceeded the value of the homes on which they were written.

In his dissection of the Fed’s mistakes in the 1930s, Bernanke also cited the Fed’s misreading of interest rates as a gauge to the availability of credit.

At times of panic and uncertainty, bankers and others rush to the security of the safest securities, especially the debt of the U.S. Treasury. This pushes down the interest rate that the Treasury has to pay to borrow money, a measure that ordinarily is a useful gauge for the Fed. More important, though, are the rates that consumers and businesses have to pay to borrow, if they can borrow at all. If the gap — known as the “spread” — between the rates the Treasury pays on supersafe borrowing and the rates that ordinary borrowers pay widens (if they can borrow at all), then that becomes a much more important gauge of financial distress.