Law professor Lev Menand has a new book out on that strange institution, the Federal Reserve, what it does and how its power and responsibility have grown over time.
Menand is an associate professor at Columbia Law School specializing in finance and regulation. Before he joined the law school, he held various roles at the Treasury Department during the Obama administration and was an economist at the Federal Reserve Bank of New York, helping to oversee large lenders.
I recently sat down with him to discuss the Fed, the economy, the capital markets, whether we are facing another financial crisis and why he thinks the Fed is bad for our economy and our democracy.
This conversation has been edited for length and clarity.
Thanks very much for joining me. Can you summarize the thesis of your book, “The Fed Unbound: Central Banking in a Time of Crisis”?
The Federal Reserve is an organization created by Congress for a limited, very important purpose to do a difficult job, which is to manage the U.S. money supply.
When you log on to a Bank of America or Citigroup account and you see a balance there, that’s the money that the Fed is managing. Those are not the same thing as green pieces of paper. And the Fed’s job is to ensure that you treat them the same, that you think of them the same. And that the amount of those Bank of America bucks is growing at a rate that is appropriate for the economy to put all of its resources to work, including all of its people.
The thesis of the book is that monetary liberalization, deregulation of the banking system and a lot of choices made during the second half of the 20th century caused the Fed to become “unbound.” Basically, what you have is the rise of a “shadow banking” system. All these financial companies that aren’t under the Fed’s purview, they start creating money. The Fed doesn’t have the tools to manage them, and then they run into problems during economic downturns, and the Fed pulls out all the stops and tries to backstop them — bail them out.
That’s the 2008 financial crisis. And that fundamental dynamic is still with us.
Essentially what you’re saying is that this institution, which is about 100 years old, the Federal Reserve, was created to manage money so that when there was a financial crisis, the Fed would come in and lend to them and cushion that blow. But over time, the Fed’s mandate had grown and its power had grown and we’re trying to figure out why that happened and whether that’s a good thing or a bad thing. Is that fair enough?
Following the Great Depression, the Fed was very successful. We didn’t have intermittent banking panics. Every time there was a recession, people didn’t run on banks. We thought that we had solved monetary instability and financial crises until 2008. And what was 2008? It was a run on shadow banks. A whole group of financial institutions had come along and started to do what banks do. They started to create deposits of their own called different things. And they were exposed to the same run dynamics that you saw in the 19th century before the Fed was created. And the Fed decided if we don’t come in and backstop this system, it will collapse. But it was never expected that this would be how the Fed [acted]. The Fed was not designed to stabilize the shadow banking system.
Let’s just back up. You’ve given a preliminary definition of shadow banking, but walk us through it. These are not bank deposits that are backstopped by the federal government, by the Federal Deposit Insurance Corp. Give us a really simple example. A money market fund is part of the shadow banking system, right? So it’s not like it’s an obscure financial system for the elite. Most middle-class Americans touch the shadow banking system.
Yeah. So there are three major types of shadow banking that I talk about in the book. You mentioned one, that’s the one that ordinary Americans are most likely to have encountered. The other types are primarily wholesalers for businesses, not ordinary individuals, but basically what they all have in common is they are non-bank firms that do not have a bank charter that are trying to reproduce the bank business model. The Fed doesn’t have the same set of tools to ensure that the money market fund [and other shadow bank institutions aren’t] taking too many risks.
The shadow banking system is huge, right?
In 2007, which was the peak of the shadow banking system, a peak we will eventually return to if further reforms are not made, it’s estimated that there were about $15 trillion of shadow bank-issued money instruments against $7 or $8 trillion of bank deposits and less than $1 trillion of government-issued cash.
In the aftermath, the shadow banking system got a lot smaller because we had a lot of major shadow banks fail like Lehman Brothers. And then over the last 10 to 15 years, it has grown again.
So now we’re back where the banking system is much bigger. There’s $18 trillion of deposits. And the shadow banking system is probably around the same size, maybe slightly smaller. It’s very hard to estimate the size, well, because it’s in the shadows.
You say that this is in the shadows, which is another way of saying it’s not fully regulated. So we had a financial crisis in 2008. You write that they essentially have two failures coming out of this. One is to not recognize the true nature of the crisis. They think of it as a 100-year flood rather than a fundamental aspect of structural fragility. And then the second thing is that we pass a sweeping financial reform, the Dodd-Frank act, that touches every corner of the financial system and yet is, I think your view would be, woefully inadequate. What does the Fed do right? What does the Fed do wrong?
So a stable and, in fact, growing money supply is an absolutely critical precondition for the sorts of economies that we live in today. If the money supply shrinks rapidly, our entire economic structure falls apart. People owe each other money. And if the amount of money in circulation starts to shrink rapidly, because the entities that have issued it are failing, then debtors can’t pay back their debts and they start defaulting. That turns into a vicious cycle.
You can think of the failure of banks a bit like the failure of power plants. If the Long Island Power Authority just shut down and stopped working, it would be very hard for any business on Long Island to continue to produce goods and services. The Fed and Congress ultimately stepped in to bail out and prevent the further collapse of this grid. Now that was necessary, otherwise we would have ended up in a great depression of the same scale or probably a larger, worse depression than in the ’30s.
So the Fed’s hand in 2008 was more or less forced. If we wanted to continue to operate this economy, we were held hostage by the players that were providing the infrastructure upon which the economy was operating. Where things went wrong was a failure to grapple with the deep problems with continuing to have an economy in which the public and households and businesses are at the mercy of unregulated power plants that are able to basically profit off economic activity during good times, and then hold the entire society as it were hostage for public support during bad times. We ended up making some changes but not addressing that fundamental problem.
Today we continue to have a dynamic where a very large financial sector is profiting off implicit and explicit public backstops and is fundamentally fragile in its design.
The pandemic was exactly such a shock. The lesson that the Fed learned from 2008 was to offer even more public support for the financial sector, even faster. And in one respect that was successful. But the dynamics of that, the implications for all of the rest of us of having this government agency making $3 trillion available for a bunch of financial firms that aren’t operating in the public interest, this is deeply troubling. It’s a dynamic that will eventually lead to either the failure of our democracy or the failure of our economy.
A dynamic leading to a failure of our democracy seems pretty dire and significant. I want to obviously explore that in a second and explore the implications of this, the quiet crash, the silent crash of March 2020. In some ways the Fed never stops bailing out the economy throughout that period from late 2008 through to March of 2020.
I do think in critical respects, we are still living in a 2008 financial crisis world. The acute phase of that crisis ended in early 2009, but we have not recovered from the damage.
The last 15 years are characterized by anemic growth, worsening inequality that is in part a byproduct of the Fed’s effort to juice economic growth, which disproportionately enriches asset owners. [We have] a financial sector that is not investing in expanding the productivity of the American economy.
We didn’t actually use this period to invest in expanding capacity. And we continue to have a financial system that is fragile.
By the time 2009 comes around, you have a financial system that is very weakened. Fed officials launch a program called quantitative easing. That’s initially targeted at the housing market. And so they go and buy hundreds of billions of dollars of mortgage-backed securities.
“Quantitative easing” is this wonky phrase, but there are two things about it. One is the Fed is buying securities and it didn’t used to do that; it used to just move short-term interest rates up and down. And then the second thing is it’s buying assets to help certain sectors of the economy. It’s a dramatic change that’s happening here with the Fed, right?
Yeah. Look, the Fed is operationally a bank. It’s supposed to be a bank just for banks. And it’s generally the way that it operated from the Second World War up to the 2008 crisis was to adjust the constraints on bank balance sheets.
Then there are subsequent rounds of QE where the Fed buys Treasury securities, the federal government’s debt, in an effort to bring down longer-term interest rates in the economy and further juice economic activity. So there’s not sufficient fiscal stimulus and the economy is coming back very slowly. And the Fed has moved its interest rates down to zero so that the banks can expand their balance sheets, but they’re not expanding their balance sheets at a rate sufficient to allow the economy to rebound.
The mechanism by which QE works is to increase asset prices. So you have a booming stock market, a booming government debt market, a booming housing market, even though you have an economy, an underlying economy that is still weaker than it was before the 2008 crisis.
It’s a troubling way in my view to do economic policy. It might be the ninth-best approach. It’s making one group of people who are already very well off even more well off. It is a very unhealthy place for society to be.
My friend, Chris Leonard, has written a book called “The Lords of Easy Money” about how the Federal Reserve “broke the economy.” Here in this interregnum between crises, what you’re saying is that the Fed was flooding the markets with purchasing power that was stimulating the asset markets and it was flowing to the wealthiest people, asset holders already. And we got something that looked like bubbles too, right? We get the crypto markets, we get NFTs, we get SPACs. The Fed in some ways is trapped into this because governments around the world are not spending wisely. They’re not helping the Fed out. They’re not helping the economy. In fact, they’re counterproductive. They’re embracing austerity.
Yeah. The failure of the fiscal authorities of legislatures in the United States and also in Europe to address economic weakness is a source of the pressure and the motivation on the Fed to experiment with massive asset purchases as an alternative approach to avoiding an even weaker economy.
We need to recognize this was a very bad policy mix that we ended up in, to inject huge amounts of liquidity into the financial system as opposed to, say, writing people checks or helping keep people in their homes or investing in infrastructure the way that Chinese government does.
There’s so many other ways to manage economic weakness. But if your approach is not to do any of those things and actually to restrict the amount of money available to governments and state and local governments to spend, and to cause layoffs of public-sector employment, if you’re not going to do any of those things and you just want to flush the financial system full of liquidity, one of the problems you’re going to have is that you’re going to get bubbles in financial markets.
So let’s go back to March of 2020. It’s poorly understood. Because in some ways the government and the Fed have learned from this critique that you’re leveling. The Fed does a bunch of things it had never done before, even in the financial crisis of 2008.
Yeah. In part the lesson they took from 2008 was never let things get so bad that we have a failure of a major firm like Lehman Brothers, because that’s a disaster. And so when things started to deteriorate in March of 2020, when there was just a run on the shadow banking system, just like there was in 2008, the Fed stepped in quickly.
It expanded its own balance sheet enormously, very rapidly. It didn’t do anything like this in 2008. This was a shock-and-awe approach to suggest to anybody running on a shadow bank that there was no need to run, that the Fed could take all the assets onto its own balance sheet, that there wasn’t going to be a repeat of Lehman Brothers.
With some encouragement from Congress, it also sets up facilities to lend to ordinary businesses and to state and local governments. But the actual dynamic, when you look at it carefully, is they’re getting breadcrumbs and these additional programs are helping to legitimize the much, much larger and fundamentally problematic lending programs for the financial sector.
Our politics are calcified. Our political system is subject to numerous veto points. The Fed in contrast is a committee run by one guy, Jerome Powell. A defender of the Fed would say: “Look, they can act very quickly. Yes, it goes through the financial system, which helps financiers and asset holders and the wealthy disproportionately, but eventually it trickles down and saves the economy. Your criticism really is with the political system, not the Federal Reserve.”
There is this dynamic in which the more the Federal Reserve tries to use its financial system-based tools to respond to economic problems, the more pressure it takes off the political system to produce legislative solutions that are more egalitarian and more effective at solving these same problems. A key predicate of this is our democracy doesn’t work, that our politics don’t work, that fundamentally legislators can’t make good policy, that we need to rely on a couple of unelected technocratic experts to make policy that most Americans don’t understand that benefits the financial sector disproportionately, and that’s the best we can do as a society and a polity.
I reject the idea that’s the best we can do.
We are dooming ourselves to very bad dynamics over time, a declining economy really, and potentially a declining society. To reinvigorate our economy and our society, we have to move beyond our reliance on central bank medicine and to revive a meaningful economic, legislative agenda and politics. And one thing that’s encouraging in this regard is that the last couple of years you’ve seen some of that. You’ve seen the legislature act in ways that it did not act between 2008 and 2020, reflecting some sense that mistakes were made during that period.
Now we have a very interesting and troubling period because we have the Fed confronting something much more traditional. We have an overheated economy. What do you think about the Fed’s job right now? Is the Fed doing the right thing? Is this a product of the shadow banking systems frailty or is this completely separate?
I think it’s important to recognize that the current inflationary dynamic is primarily a supply-side shock. The pandemic just scrambled the normal patterns of demand for goods and services, and we ended up with shortages in certain important goods and services, which caused prices to rise.
Then we have spiking commodity and energy prices due to geopolitical conflict and also due to the pandemic in various ways. The driving factors of this inflationary dynamic are not loose financial conditions.
Here again, we stand the risk of over-relying on the Fed to solve a set of problems that require action by the government through a variety of other tools. So it’s certainly the case that some amount of interest rate hiking is necessary. Interest rates were too low and should be hiked. But the big question is should they continue to be hiked to the point where they choke off the whole overall economy, to shrink the overall economy so that it can match up in size with the amount of oil and natural gas that’s currently being produced and the amount of key goods and services that are coming through our supply chains?
We don’t need the Fed to tighten to such an extent that it induces a recession. Instead, we need other government policies targeted at supplying more of the goods and services that are experiencing this shock. It would be very unfortunate if because of the high price of oil and gas, we cause people to lose jobs all across the economy.
I am cautiously optimistic that policymakers understand this now better than they have. We will be better off tolerating some amount of inflation for some period of time while the economy adjusts to an enormous shock rather than overreacting and trying to eliminate that inflation by creating a certainty of high unemployment and a bad investment outlook and climate for the economy going forward.
It’s so frustrating. The Fed functions through the financial system disproportionately helping the wealthy. It creates asset bubbles all throughout the economy. It then starts to tighten. And in doing so, it disincentivizes companies from investing and growing while courting a recession that will throw millions of average people out of work after those millions of average people have only barely begun to benefit from a decade of loose financial conditions by having their wages grow.
Let me just add one more piece that will really make your head explode. There’s a very good chance that to the extent the Fed follows through on aggressive tightening in the coming months, that it leads to financial instability. And so at the same time, as you have the Fed pursuing policies that push up unemployment, weaken the labor market and reduce business investment, the Fed may well find itself standing up all of its emergency facilities again to support the shadow banking system.
Essentially because they created bubbles and now…
The shock of removing them, yes, is going to cause a run dynamic in the shadow banking system. It could happen at any point really.
Well, that was where I was going to end this conversation, which is: Do you think we’re headed for another financial crisis? Because the fundamental fragility of the economy — the shadow banking system — has not been dealt with, and you have a Fed that is using these very blunt tools.
I think it’s entirely possible. Part of the problem we have is it’s very hard for officials or academic observers and even market participants to have a handle on the balance sheet strength of financial institutions that fund themselves in the [shadow banking system]. And so it’s difficult to anticipate when a run might happen.
The Fed needs to be very cautious. It’s not actually dealing with a financial system that can necessarily go to that speed and absorb that shock. We’re in a very uncertain and risky time from an economic and financial perspective right now. Everybody should be on high alert and people should demand that their Congress try to tackle these issues and think about these problems, because it’ll be much better to start moderating now than to wait for another big crash, to put in place safeguards and structures that are necessary for a healthy economy and flourishing society going forward.