Fed failures.

• Author: Michel, Norbert J.
• Position: Economics

"The Great Depression, the great stagflation, and the 2008 financial crisis (aka The Great Recession) all have occurred on the [Federal Reserve Bank's] watch."

WE NOW have a 100-year history by which to judge the Federal Reserve's performance. On balance, the Fed has not increased economic stability relative to the pre-Fed era. The Great Depression, the great stagflation, and the 2008 financial crisis (aka, The Great Recession) all have occurred on the Fed's watch. Even excluding the Great Depression, business cycles have not become appreciably milder, nor have recessions become less frequent or measurably shorter.

The Fed has strayed so far from the classic prescription for a lender of last resort--to provide short-term funds to solvent institutions at penalty rates--it strains all reason to suggest that it successfully has fulfilled that function. Its regulatory failures are numerous. It failed even to see the 2008 financial crisis coming. Perhaps the best that can be said about the Fed is that the variability in inflation has declined since 1984.

The Federal Reserve's centennial is the perfect time to assess the Fed's track record and to propose major reforms as needed. This article provides policymakers with direction to begin addressing these issues. Specifically, the article discusses several long-term policy reforms in the context of a monetary commission and also provides a list of reforms that more easily could be instituted outside of such a formal group.

One of the most glaring failures of the Fed, compared to its original purpose, has been its misuse as a lender of last resort. The essence of the classic prescription for a lender of last resort--well known at the founding of the Fed --is to avoid lending to financially troubled firms. The purpose is, instead, to ensure the system-wide flow of credit while avoiding the moral hazard issues that arise via government lending to private companies.

Within its first 25 years of operation, the Fed twice failed to provide any sort of liquidity to the banks it was supposed to serve, likely worsening the Great Depression. In 1929, the Federal Reserve Board prohibited the extension of credit to any member bank that it suspected of stock market lending, a decision that ultimately led to a 33% decline in the economy's stock of money. In 1937, the Federal Reserve Board of Governors doubled the reserve requirement for member banks, again preventing credit from expanding when and where it was needed.

Throughout its history, the Fed also has strayed consistently from the classic lender of last resort prescription by lending directly to specific institutions, especially those with questionable financial strength. The Fed's actions in the 2008 financial crisis merely were the latest in a long line of credit allocation activities that demonstrate this unfortunate proclivity. A classic lender of last resort would provide short-term loans to all solvent institutions, on good collateral, at a high rate of interest. Yet, during the most recent crisis, the Fed allocated more than 16 trillion dollars in credit to specific firms, at an estimated $13,000,000,000 below market rates.

The Fed's actions leading up to the 2008 crisis also highlight the Central Bank's failure as a financial market regulator. The U.S. Central Bank has been involved in banking regulation since its founding, and it became the regulator for all holding companies owning a member bank with the Banking Act of 1933. When bank holding companies, as well as their permissible activities, became more clearly defined under the Bank Holding Company Act of 1956, the Fed was named their primary regulator.

Although it would be unjust to place all of the blame on the Fed, the fact remains that the U.S. experienced major banking problems during the Depression era, again in the 1970s and 1980s, and also a severe financial crisis in 2008. All of these disruptions occurred on the Fed's watch. At best, the Fed did not predict the crises.

In 2008, for example, Fed chairman Ben Bernanke testified before the Senate that "among the largest banks, the capital ratios remain good and I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system." Simply being mistaken about banks' capital is one thing, but the Fed was the primary regulator for many of these institutions.

In fact, under the 1999 Gramm-Leach-Bliley Act, the Fed alone approved applications to become a financial holding company only after certifying that both the holding company and all of its subsidiary depository institutions were "well-managed and well-capitalized, and ... in compliance with the Community Reinvestment Act, among other requirements." The Fed has not always had sole discretion in determining which banks were well-capitalized but, in the 1950s, it developed a "risk-bucket" approach to capital requirements that formed the basis of the risk-weighted capital requirements still used today.

In particular, the Fed's original method was the foundation for the Basel I capital accords, which the Fed and the Federal Deposit Insurance Corporation (FDIC) adopted for U.S. commercial banks in 1988. Under these capital rules, commercial banks have been required to maintain several different...