Establishing Independence?

The accord was a public statement made by the Fed acknowledging that it had reached “full accord” with the Treasury on debt management and monetary policy in an attempt to prevent the financing of government debt by printing money, what experts call the “monetization” of debt. This compromise between the Fed and Treasury was necessary because just a few years prior, during World War II, the Fed had agreed to Treasury demands to keep interest rates at stable, low levels to ensure that government interest costs did not spiral out of control. This agreement during the war represented a clear violation of central bank independence, but it was accepted because of the extraordinary circumstances the war had brought on.

Thus, the standard interpretation of the accord is that it represented a return to independence for the Fed after the war. As former central bankers Ben Bernanke and Janet Yellen wrote, the accord “separate[d] government debt management from monetary policy” and freed the Fed to “fight inflation.”

What this interpretation ignores is the Fed’s central role in the creation of the repurchase agreement (or “repo”) market, a continued violation of central bank independence after the accord that helped cheapen government borrowing. While this may seem like ancient history, the repo market has had tremendously important consequences for the US economy. Many will remember the broker-dealer Lehman Brothers, which went bankrupt in the global financial crisis; at the time of its insolvency, Lehman Brothers was receiving nearly half of its financing through repo markets.

Coming out of World War II, the Federal Reserve sought to raise interest rates. This was easier said than done — the Truman administration wanted to keep the cheap financing it had received during the war for as long as possible. In a textbook case of political pressure on a central bank, President Harry Truman pushed Fed chairman Thomas McCabe in December of 1950 to continue to support the government’s borrowing at the onset of the Cold War, writing, “I hope the Board will realize its responsibilities and not allow the bottom to drop from under our securities. If that happens, that is exactly what Mr. Stalin wants.”

The Fed looked for ways to bend and not break under pressure, seeking to keep government borrowing costs low while regaining a modicum of independence from the Truman administration’s Treasury. Their solution was clever: they began to subsidize participation in the government debt market through the use of repos. While complex in their structure, repos were nothing more than collateralized loans from the Fed to what were then called “government securities dealers” (upstart financial institutions that made their living in the government securities market), with the collateral being government debt.

To keep government debt cheap, the Fed timed these loans to dealers just before Treasury offerings (when the government looked to borrow money), so that dealers would take the influx of cash from the Fed and lend to the Treasury. Dealers were incentivized to participate in these exchanges because the Fed priced the interest rates on these loans below the interest rate on US Treasuries, effectively guaranteeing dealers risk-free profit. The Fed was picking winners. (That the Fed structured these collateralized loans as a repurchase agreement — a sale and repurchase of government securities — was important because it could not legally loan money to financial institutions that were not regulated as banks.)

If this doesn’t sound like a private, independent market, that’s because it wasn’t. The central bank was loaning money at very low interest rates to private entities so that those private entities could make low-interest loans to the Treasury while still turning a profit. Government securities dealers were the epitome of financial middlemen.

Through its repo support of the dealer system, the Fed was able to keep government borrowing costs low while increasing interest rates elsewhere in the economy. So while the Fed looked like it had regained its independence in 1951 after the accord, in reality, it was still intervening in the bond market to support cheap government borrowing.

Breeding Instability

The most important part of the story is what came next: learning from their interactions with the Fed, government securities dealers began to conduct repos of their own with private corporations. In other words, corporations made collateralized loans to government securities dealers, replacing the Fed.

Yet while dealers considered repos a collateralized loan, from the perspective of corporations, these transactions looked a lot like deposits in commercial banks. Corporations took their savings, placed them with a financial institution on a short-term basis, and earned a small bit of interest. What difference did it make if it was with megabank Bank of America or government securities dealer Salomon Brothers?

One main difference was that government securities dealers paid better. Because dealers were not technically banks and repos were not technically deposits, dealers were not subject to banking regulation like “Regulation Q,” which prevented banks from paying interest on deposit accounts. Because government securities dealers could pay higher interest rates on money deposited in repo than commercial banks could pay on deposits, corporations were incentivized to place their savings with dealers. This led to a massive flow of corporate savings out of the regulated commercial banking sector to government securities dealers.

However, because dealers were not technically banks, this also meant that any money deposited in repo was not subject to regulations like FDIC insurance — the centerpiece of the Glass–Steagall Act, the landmark New Deal banking legislation. No FDIC insurance meant that if a government securities dealer went bankrupt, there was no insurance fund to make its depositors whole. The lack of regulation in the repo market threatened the stability of the financial system.

It’s natural to think that the Federal Reserve, just twenty years after the Great Depression, would have rushed to regulate government securities dealers and their repo transactions with corporations as banking under another name. However, the Fed declined to apply existing banking law to the repo market because regulating it would have made it more difficult for the government to borrow cheaply. By first creating and then refusing to regulate the repo market, the Fed succumbed to political pressure to cheaply finance government debt, setting the stage for another financial crisis down the road.

With the explosion of the US public debt in the latter half of the twentieth century, the repo market grew into one of the most important markets in the world. As the US economy became more and more financialized, the repo market became a part of the broader “shadow banking” system that would later collapse in the global financial crisis. The key change in this latter era is that instead of using government debt as collateral in repo markets, dealers like Lehman Brothers began to use housing debt. Thus, when the housing market collapsed, and Lehman’s counterparties realized that the assets they were holding as collateral were worthless, a massive banking crisis emerged, tanking the US and world economy.

For a Democratic Fed

What does this story tell us about the Trump administration’s current attacks on Fed independence? For one thing, the two episodes are not isolated historical events. The violation of central bank independence in the 1950s directly contributed to the global financial crisis through the creation of the repo market and the flow of corporate savings out of the regulated financial system. That crisis, in turn, fed disillusionment with technocratic politicians and financial elites and fueled support for populist campaigns like President Trump’s in 2016.

There are, of course, differences in each case — Truman’s pressure on the Fed was applied mostly in private and was motivated by attempts to cheaply finance government spending on national security, infrastructure, and social welfare. President Trump’s more public pressure on the Fed has been far more delegitimizing and seems to be motivated primarily by a desire to stimulate short-term economic growth to pad his approval ratings.

Still, today’s more personalized form of executive pressure on the Fed should be understood as part of a longer trajectory of challenges to central bank independence: in both situations, executive power was used to pressure the Federal Reserve to cut interest rates on government debt. This suggests that while President Trump’s pressure on the central bank will hurt the economy in the long run, the solution is not to simply return to the pre-Trump status quo at the Fed.

Successful reform of the Fed and the broader financial system will involve balancing two sometimes competing objectives: first, the Fed must be able to make policy independent of the short-term goals of vulnerable politicians. Second, the Fed cannot simply be a captured bureaucracy beholden to financial interests. In the case of the global financial crisis, it was the combination of the dominance of private financial interests and state interests in cheap financing that produced our unstable financial system; eliminating this type of backdoor dealing between state and financial elites is key to any proposed reform at the Fed.

Lasting reform, in that case, will not be the product of politics as usual. Both parties have, for the most part, been unwilling to seriously confront the intimately related problems of financialization, financial instability, and growing public debt. While Trump’s supporters include those hurt by financialization and deindustrialization, the administration has simultaneously weakened financial regulation. This has occurred partly through the loosening of capital requirements on banks but also through the ardent support of the cryptocurrency industry and the industry’s new version of shadow banks — stablecoin issuers.

Because violations of central bank independence are a symptom of broader political and financial system dysfunction, there are no easy fixes. Part of the solution will come through a much greater role for Congress in overseeing the financial system and its interactions with the executive branch, similar to the role it played from 1933 to 1950. In short, Congress needs to publicize and document inappropriate pressure by the executive on the Fed.

Another part of the solution may come through reassessing the consequences of growing public debt. While the Left has been correct to criticize the frequently hyperbolic claims that the national debt is an immediate, existential threat to the United States, there are maladies associated with its growth, such as financialization — which, in turn, contributes to increasing inequality.

One potential avenue for financial system reform involves taking seriously the notion that the privilege of creating deposits should be limited to certain entities (banks), which are regulated closely to ensure financial stability. Key to this reform is Congress monitoring the Fed to ensure that it regulates new financial institutions that look like banks — even if those financial institutions help bring down the cost of government borrowing like government securities dealers did in the 1950s.

Another more ambitious proposed reform is to offer what some call a “public option” for banking. This would enable citizens and businesses of all kinds, not just banks, to hold bank accounts at the Fed. These “FedAccounts” would be similar to commercial bank accounts except there would be no fees or minimum balances, the interest rate on balances would be the same as “Interest on Reserves” (IOR) rate the Fed currently pays to banks, and balances would be pure money that is guaranteed by the Federal Reserve. This public option for banking would eliminate the advantage currently held by banks that allows them to receive huge sums of money on IOR balances at the Fed as well as reduce the likelihood of runs on banks and shadow banks like we saw in the global financial crisis.

In any case, our ambitions for the Federal Reserve have to go beyond mere anti-Trumpism — we need to tackle the political pressures and financial interest dominance that have distorted Fed policy and bred financial instability long before our current president was in the White House.