POLITICAL ECONOMY OF THE FED'S UNCONVENTIONAL MONETARY AND CREDIT POLICIES.

• Author: Burns, Scott A.

Most textbooks and professional literature on monetary policy assume that the Federal Reserve seeks only to promote the public interest. Many of the Fed's actions over the past decade, particularly those actions that show signs of favoritism to particular firms, however, are difficult to square with that assumption.

After the housing price bubble burst, the Fed expanded its total asset portfolio five-fold, reaching $4.5 trillion in October 2016 (and remaining there until September 2017) from a starting point of $900 billion in August 2008. With some small asset runoffs since October 2017, the assets currently stand at about $4 trillion. Ordinarily, monetary expansion is intended to increase the growth rate of the broader monetary aggregates to satiate the excess demand for money that arises during a liquidity crisis. But by paying interest on excess reserves (IOER) for the first time, the Fed deliberately prevented the expansion of its liabilities (mostly banks' excess reserves), which financed the Fed's asset purchases, from increasing the broader monetary aggregates like M2.

This dramatic change in the size of the Fed's asset portfolio was accompanied by an equally dramatic change in its composition. Between October 2007 and November 2018, the Fed's holdings of Treasury securities declined from 88 percent of its asset portfolio to 56 percent, while its holdings of mortgage-backed securities (MBSs) went from zero to 40 percent. During the crisis, the Fed created lending facilities for nonbanks and began accepting riskier assets as collateral for loans. It also stood ready to lend to insolvent banks (e.g., standby credit lines for Citibank and Bank of America) and to purchase dodgy assets from nonbanks (e.g., Bear Stearns and AIG). The Fed discarded its longstanding practice of purchasing almost exclusively short-term Treasury securities: it switched into longer-term Treasuries ("Operation Twist 2") and purchased $1.7 trillion worth of MBSs.

In all of its midcrisis and postcrisis improvisation, the Fed departed from a focus on overall market liquidity and stability of aggregate demand. It allocated credit to specific firms and sectors at the expense of the general market. It also greatly expanded its exercise of powers under Article 13 (3) of the Federal Reserve Act (Meltzer 2011). By lending on highly questionable collateral at subsidized rates, it departed dramatically from Walter Bagehot's classical lender-of-last-resort doctrine (Bagehot 1873; Hogan, Le, and Salter 2015). The Fed's actions can be described as "preferential credit allocation" (White 2015), that is, as a move toward greater top-down financial flows (Hummel 2011).

The Fed's choices of unconventional monetary and credit allocation policies during and after the Great Recession have reopened a discussion of the political economy of Fed policymaking that had gone largely dormant during the Great Moderation. In this article, we offer a public-choice account of the Fed's unprecedented response to the Great Recession. We consider the Fed's reluctance to pursue monetary policy "normalization" in this light. In theory, the Fed could readily shrink its bloated balance sheet and return it to normalcy. In practice, the Fed has dragged its feet under pressure from political, bureaucratic, and private interests. We conclude that the case for strict rules designed to limit the range of central bank actions, and the need to consider institutional arrangements that offer an alternative to central banking, are stronger than ever.

Our inquiry is rooted in a long-standing literature that takes a "cynical" public-choice approach to explaining Fed policymaking (see, e.g., Kane 1980 and Havrilesky 1990), in contrast to the "utopian" view that the Fed aims only at advancing the public interest. The renowned monetary historian Allan Meltzer concluded: "History does not offer evidence of [the Fed] seeking to optimize policy in the interests of consumer welfare" (Meltzer 2011: 47). Given how politics and powerful private interest groups shaped the legislation that created the Federal Reserve System (see Selgin 2016), it should not be surprising that elected officials, financial-market actors, and its own bureaucratic imperatives have continued to shape Fed policies to the present day. Like any individual or firm or other agency, the Fed's decisions can be explained as responses to the incentives and constraints it faces (Wagner 1986: 519).

Preferential Credit for Primary Dealers

In its initial response to the subprime mortgage crisis, the Fed redistributed liquidity from the general market toward financially suspect but "systemically important" financial institutions. It lent on highly questionable collateral and often at subsidized rates. It later made outright asset purchases designed to raise asset prices, specifically in the housing sector (Thornton 2015; Hummel 2011; Goodfriend 2014; White 2015).

With rising mortgage defaults, especially on adjustable-rate mortgages, the prices of MBSs began to decline in late 2007 and early 2008. Many investment banks were exposed to substantial losses on their MBS holdings (Gorton 2010) and had difficulty rolling over short-term funding in the form of overnight repos and commercial paper (Hummel 2011). Bear Stearns experienced a sudden stop in its funding in March 2008 when its short-term funders suspected (rightly) that it was insolvent.

Had the Fed followed the modern prescription for a lender of last resort, it would have let Bear Stearns fail while providing sufficient liquidity to the banking system as a whole. Instead, the New York Fed created "Maiden Lane LLC" to purchase nearly $30 billion of dubious mortgage-related assets from Bear Stearns to sweeten JP Morgan Chase's acquisition of the firm, thereby shielding Bear's bondholders and other lenders from losses.

In the same month, the Fed also created a special emergency lending program for "primary dealers," a group of broker-dealers and investment houses (including Citigroup, Goldman Sachs, J. P. Morgan Securities, Merrill Lynch, Morgan Stanley, and Wells Fargo Securities) that serve as regular counterparties in the Fed's bond purchases...