On May 4, 2022, the Federal Reserve announced a plan to reduce the size of its balance sheet. At $9 trillion and ten times more than before the 2008 financial crisis, the Fed’s asset accumulation has helped reduce borrowing costs across the economy, push up share and real estate prices to all-time highs and to generate record profits for financial conglomerates.
Now the Fed is telling us that it can reverse the trend and undo the emergency measures it first launched in 2008.
Unfortunately, given the underlying structure of our current financial system, the Fed is unlikely to get very far. The last time Fed officials tried to “normalize policies” was in 2017. Faced with considerably softer macroeconomic conditions, the Fed reduced its balance sheet by a modest twenty percent (to about 3 $.6 trillion) before further turmoil on Wall Street led him to resume financial buying. active in 2019.
Months later, in March 2020, another 2008-style financial panic erupted. To prevent another collapse from triggering a second Great Depression, the Fed extended trillions of dollars in loans to foreign financial firms and central banks. It has set up dozens of ad hoc loan facilities to support capital markets and facilitate trading in corporate securities. He did more than he ever did to keep Wall Street from failing.
And given all the help the Fed was giving to the financial sector, its leaders grew even further. They have programs in place to lend directly to mainstream businesses. And they invented new facilities to support state and local governments. Seeing the Fed’s growing footprint, politicians and policymakers are now suggesting that the Fed is using its balance sheet to stabilize commodity markets, make transfer payments directly to households, and more. (Understandably, partisan attention on the Fed’s nominees has also increased — with recent confirmation fights centering on whether the central bank should play a bigger role in tackling climate change.) Indeed , for more than a decade now, the Fed has been stuck in emergency mode, expanding its programs with each new economic shock.
The root causes of this transformation, however, run much deeper than the Fed itself. The problem is our failing banking system. Since 2008, Congress has failed to address the dramatic expansion of unregulated money creation by “shadow banks,” companies that operate like banks without complying with banking regulations. Some of the best-known and largest shadow banks – such as Lehman Brothers and Bear Stearns – collapsed or merged with chartered banks in 2008. Today, some shadow banks operate as stand-alone hedge funds or broker-dealers. ; others are part of banking conglomerates; still others operate overseas under the jurisdiction of other governments. But whatever their form and wherever they are, our economy depends on the monetary instruments that shadow banks issue, and these companies depend on and expect public support 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 US 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. The money they create is called deposits. Although the Fed issues the cash we carry in our wallets, bank deposits (not cash) are what employers typically use to pay wages (e.g., “direct deposits”) and households use to pay credit card bills. There are $18 trillion in deposits in circulation today, with only about $1 trillion in cash used domestically.
The government does not run these banks itself. It outsources this work to private investors and management teams they select. But it subjects banks to stringent conditions. It prohibits them from engaging in ordinary business activities and taking excessive financial risks. It also subjects them to intensive surveillance by special government officials. And it explicitly supports banks with deposit insurance and access to cash from the Fed, the central bank. The job of the Fed is to keep the banking system running smoothly, creating enough deposits to keep the economy growing at its full potential.
Shadow banks are non-banking businesses that have figured out how to copy the lucrative part of banking – issuing liabilities that function as a form of currency – without complying with the restrictive rules that prevent banks from collapsing during downturns. economic. Shadow banks first emerged decades ago, offering corporations and large investors instruments called repurchase (or repos) agreements, Eurodollars, financial and asset-backed commercial paper and fund shares. money market mutual funds, which they began to use instead of bank deposits. In 2007, there were more of these deposit alternatives in circulation than bank deposits.
The consequences were major blackouts such as the massive run on shadow banks in 2007 and 2008. This run destroyed Lehman Brothers, reduced the money supply, froze credit channels and triggered the worst recession since the Great Depression.
Maintaining shadow banking is why the Fed initially bloated its balance sheet in 2008. It bailed out Bear Stearns and AIG. It has lent hundreds of billions to Wall Street brokers and foreign central banks abroad. In 2008, these institutions were too critical to fail; businesses relied on the money they issued and without a functioning monetary and credit system, trade and commerce would quickly contract.
When Fed lending wasn’t enough, it began buying up financial assets to bolster shadow banks’ balance sheets and repair the damage the crisis has inflicted on ordinary households and businesses by reducing borrowing costs in economy as a whole and by limiting payment defaults. But the economy, still dependent on shadow banks, never regained its pre-crisis growth path. And with shadow banking money still outside traditional regulatory control, the Fed has been on high alert to support its issuers.
This arrangement is deeply damaging. The Fed’s programs transfer wealth to the financial sector and its stabilization efforts inflate asset prices, enriching those who own financial claims and real estate and further marginalizing the majority of Americans who do not.
For the Fed to truly and sustainably normalize monetary policy, the government must first fix the US monetary system. Congress must reassert public control over the creation of dollars and dollar substitutes. Shadow banks should either become banks and follow banking regulations or stop operating as banks.
If lawmakers don’t act soon, another 2008-level crisis (or worse) will eventually force their hand. When this happens, the economic, political and social costs can be catastrophic. Let’s make sure it doesn’t come to that.
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