World

The Fed Can’t Fix Our Broken Banking System

On May 4, 2022, the Federal Reserve announced a plan to reduce the size of its balance sheet. $9 trillion large, and ten times bigger than it was before the 2008 financial crisis, the Fed’s accumulation of assets has helped to lower borrowing costs across the economy, lift stock and real estate prices to unprecedented heights, and fuel record profits for financial conglomerates.

Now the Fed tells us it can reverse course and unwind the emergency measures it first launched back in 2008.

Unfortunately, given the underlying structure of our financial system today, the Fed is not likely to get very far. The last time Fed officials attempted “policy normalization” was in 2017. Facing considerably more mild macroeconomic conditions, the Fed reduced its balance sheet by a modest twenty percent (to about $3.6 trillion) before renewed turmoil on Wall Street led it to resume purchasing financial assets in 2019.

Months later, in March 2020, another 2008-style financial panic broke out. To prevent a new meltdown from causing a second Great Depression, the Fed extended trillions of dollars of loans to financial companies and foreign central banks. It set up scores of ad hoc lending facilities to backstop capital markets and make it easier to trade corporate securities. It did more than it had ever done to keep Wall Street from running aground.

And given all the help the Fed was providing to the financial sector, its leaders expanded further. They set up programs to lend directly to ordinary enterprises. And they invented new facilities to backstop state and local governments. Seeing the Fed’s growing footprint, politicians and policy makers are now suggesting that the Fed use its balance sheet to stabilize commodity markets, make transfer payments directly to households, and more. (Naturally, partisan attention on Fed nominees has also spiked—with recent confirmation fights focused on whether the central bank should play a greater role in combatting climate change.) Indeed, for over a decade now, the Fed has remained stuck in emergency mode, expanding its programs with each new economic shock.

The root causes of this transformation, however, go much deeper than the Fed itself. The problem is our broken banking system. Since 2008, Congress has failed to address the dramatic expansion of unregulated money creation by “shadow banks,” firms that operate like banks without complying with bank regulation. Some of the best-known and biggest shadow banks—like Lehman Brothers and Bear Stearns—collapsed or were conglomerated with chartered banks in 2008. Today, some shadow banks operate as standalone hedge funds or broker dealers; others are part of banking conglomerates; yet others operate overseas under the jurisdiction of other governments. But whatever their form and wherever their location, our economy depends on the money instruments they shadow banks issue and these firms depend on, and expect, public backing from the Fed when times get tough.

To understand the role that shadow banks play in our economy today, it is necessary to take a step back and examine the structure of the U.S. monetary framework. Congress designed the Fed to administer a network of government-chartered banks. These banks—which range in size from local community banks to conglomerates like Bank of America, JPMorgan Chase, and Wells Fargo—are designed to create most of the money in the economy. They money they create is called deposits. Although the Fed issues the cash we carry around in our wallets, bank deposits (not cash) are what employers generally use to pay salaries (e.g., “direct deposits”) and households use to pay credit card bills. There are $18 trillion of deposits circulating today, with only around $1 trillion of cash in use domestically.

The government does not run these banks itself. It outsources that work to private investors and management teams they select. But it subjects banks to rigorous terms and conditions. It bars them from engaging in ordinary commercial businesses and taking excessive financial risks. It also subjects them to intensive supervision by special government officials. And it explicitly backstops banks with deposit insurance and access to cash from the Fed, the central bank. The Fed’s job is to ensure that the banking system operates smoothly, creating enough deposits to keep the economy growing at its full potential.

Shadow banks are nonbank firms that figured out how to copy the lucrative part of the banking business—issuing liabilities that function as a form of money—without complying with the restrictive rules that prevent banks from collapsing during economic downturns. Shadow banks first emerged decades ago, offering businesses and large investors instruments called repurchase agreements (or repos), eurodollars, financial and asset-backed commercial paper, and money market mutual fund shares, which they began to use instead of bank deposits. By 2007, there was more of these deposit alternatives in circulation than bank deposits.

The consequences have been major breakdowns such as the massive run on shadow banks in 2007 and 2008. That run took down Lehman Brothers, shrunk the money supply, froze credit channels, and triggered the worst recession since the Great Depression.

Holding together the shadow banking system is why the Fed initially pumped up its balance sheet in 2008. It bailed out Bear Stearns and AIG. It lent hundreds of billions to broker dealers on Wall Street and foreign central banks abroad. By 2008, these institutions were too critical to fail; businesses relied on the money they issued and without a functioning money and credit system, trade and commerce would rapidly contract.

When the Fed’s lending was not enough, it started to buy up financial assets to bolster shadow bank balance sheets and heal the damage that the crisis inflicted on ordinary households and businesses by reducing borrowing costs across the economy and limiting defaults. But the economy, still dependent on shadow banks, never returned to its pre-crisis growth path. And with shadow bank money still outside traditional regulatory control, the Fed has been on alert to backstop its issuers.

This arrangement is deeply damaging. The Fed’s programs transfer wealth to the financial sector and it’s efforts at stabilization inflate asset prices, enriching those who own financial claims and real estate and further marginalizing the majority of Americans who do not.

In order for the Fed to truly and sustainably normalize monetary policy, the government first must repair the U.S. monetary system. Congress must reassert public control over the creation of dollars and dollar substitutes. Shadow banks should either become banks and follow bank regulations or stop operating like banks.

If legislators do not act soon, another 2008-level crisis (or worse) will eventually force their hand. When that happens, the economic, political, and social costs could be catastrophic. Let’s make sure it does not come to that.


Contact us at [email protected]

Leave a Reply

Your email address will not be published.

Related Articles

Back to top button
WordPress Ads