Is the Power to Implement Fiscal Policy Being Transferred to The Fed?

The Fed as Central PlannerThe Fed

By Holly A. Bell

In an article in the Wall Street Journal (available here), John H. Cochrane of The University of Chicago accuses the Federal Reserve of moving from a central bank to a central planner by engaging in fiscal policy and determining the allocation of credit. I must say I agree. Previously the Fed engaged exclusively in “open-market” operations including the purchase of short-term Treasure debt, and providing short-term lending to banks.

However, since 2008 the Fed has been engaging in “nontraditional” actions that impact a much wider variety of markets. The Fed’s interventions include commercial paper, long-term Treasure debt, lending directly to nonbank institutions (like AIG) and assisting with mergers (like Bank of America and Merrell Lynch). They’ve also required banks to provide $25 billion in “mortgage relief” because some banks engaged in robo-signing, yet the recipients of this relief were not victims of robo-signing. These “fiscal” actions are generally reserved for an elected Congress, yet I have no representation at the Fed. These actions are exposing taxpayers to risk and move the allegedly independent, apolitical Fed toward increasingly political actions.

Creating complicated “stress tests” for banks and establishing what makes a bank “too-big-to-fail” is causing the Fed to become a central planner that gets to determine how private banks perform their day-to-day operations. Where does it end? Cochrane sees the risk of concentrating too much discretionary power in a single institution. As he states, what stops the Fed from coming into your bank and saying: “Hey, nice bank you’ve got there. It would be a shame if the Consumer Financial Protection Bureau decided your credit cards were ‘abusive’, or if tomorrow’s ‘stress test’ didn’t look so good for you. You know, we’ve really hoped you would lend more to support construction in the depressed parts of your home state”.

Think it can’t happen? If you don’t, than you don’t know the true origins of the mortgage crisis: The Community Reinvestment Act (CRA). While the motives of this act of Congress were good, it eventually morphed into the mortgage crisis. Passed in 1977 under the Carter administration, the act made it illegal for banks to “redline” certain neighborhoods as unprofitable. When a neighborhood was redlined, the banks wouldn’t issue mortgage loans there. Redlining obviously led to discrimination against hard-working people (often inner-city minorities and low-income wage earners) with good credit, who just wanted to buy an affordable home. Removing this discrimination was a good idea.

However, one problem remained. The government believed there were still not enough mortgage loans being made in these neighborhoods and to low- and moderate-income families. Why? Because these individuals often didn’t have the credit scores, down payments, or monthly income required to purchase the home. So in 1993 under the Clinton administration several changes were made to the CRA. Under these revisions the CRA required lenders to loosen their underwriting standards to provide more mortgages to poorer communities. “Sub-prime” securitized loans became the norm as the CRA required objective criteria like credit history, income verification, savings history, and the size of the mortgage to income to be replaced with other criteria like evidence that the borrower had received credit counseling. The banks were forced (by law) to engage in these practices. Did the banks take it too far when they became able to transfer risk to Fannie and Freddie? Yes. Did they really want to make these risky loans in the first place? No.

While I didn’t agree with the actions taken under the Clinton administration, it was at least our elected Congress that voted to implement them. However, when you have an unelected Federal Reserve making decisions about how banks should make mortgages or redistribute earnings ($25 billion in ‘mortgage relief’) there are no checks and balances (and we can’t vote them out of office). This does not mean I think banks should be allowed to do whatever they want, but if I’m going to be taxed directly by the government to pay down debt or indirectly through higher fees or interest rates at banks, I want representation. Just because the Fed is out of monetary options, does not transfer the power to implement fiscal policy from the Congress to the Fed.

Holly A. Bell is a business professor, author, analyst, and blogger who lives in the Mat-Su Valley of Alaska. You can visit her website at www.professorhollybell.com.

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The Fed image courtesy of vichie81

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