Policy Dialogue Project on Improving Governance of the Government Safety Net in. Financial Crisis, directed by L. Randall Wray and funded by the Ford
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!!#!CONTENTS Preface and Acknowledgments 4 Chapter 1 . Summary of Project Findings 7 L. Randall Wray Chapter 2 . Watchful Waiting Interspersed by Periods of Panic : Fed Crisis Response in the Era of Shadow Banking 22 Mathew Berg Chapter 3 . A Detailed Analysis of the Fed Õs Crisis Response 51 Nicola Matthews Chapter 4 . The Repeal of the Glass -Steagall Act and Consequences for Crisis Response 85 Yeva Nersisyan Chapter 5 . Shadow Banking and the Policy Challenges Facing Central Banks 100 Thorvald Grung Moe Chapter 6 . On the Profound Perversity of Central Bank Thinking 122 Frank Veneroso Chapter 7 . Minsky Õs Approach to Prudent Banking and the Evolution of the Financial System 140 L. Randall Wray Chapter 8 . The Federal Reserve and Money: Perspectives of Natural Law, the Constitution, and Regulation 154 Walker F. Todd Chapter 9 . Conclusions: Reforming Banking to Reform Crisis Response 172 L. Randall Wray

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!!$!PREFACE AND ACKNOWLEDGMENTS This is the fourth research report summarizing findings from our project, A Research and Policy Dialogue Project o n Improving Governanc e of the Government Safety Net i n Financial Crisis, directed by L. Randall Wray and funded by the Ford Foundation with additional support provided by the Levy Economics Institute of Bard College and the University of Missouri ÐKansas City. 1 In this report we firs t describe the scope of the project, and then summarize key findings from the three previous reports. We then summarize research undertaken in 2014. We will also outline further work to be completed for a planned edited volume that will bring together the research and include policy recommendations. Project Scope This project explores alternative methods of providing a government safety net in times of crisis. In the global financial crisis that began in 2007, the U nited States used two primary responses : a stimulus package approved and budgeted by Congress , and a complex and unprecedented response by the Federal Reserve. The project examines the benefits and drawbacks of each method, focusing on questions of accountability, democratic governance and tran sparency, and mission consistency. The project has explored the possibility of reform that might place more responsibility for provision of a safety net on Congress, with a smaller role to be played by the Fed. This could not only enhance accountability bu t also allow the Fed to focus more closely on its proper mission. In particular, this project addresse s the following issues: 1. What was the Federal Reserve Bank Õs response to the crisis? What role did the Treasury play? In what ways was the response to this crisis unprecedented in terms of scope and scale? 2. Is there an operational difference between commitments made by the Fed and those made by the Treasury? Wh at are the linkages between the Fed Õs balance sheet and the Treasury Õs? 3. Are there conflicts arising between the Fed Õs responsibility for normal monetary policy operations and the need to operate a government safety net to deal with severe systemic cris es? 4. How much transparency and accountability should the Fed Õs operations be exposed to? Are different levels of transparency and accountability appropriate for different kinds of operations: formulation of interest rate policy, oversight and regulation , resolving individual institutions, and rescuing an entire industry during a financial crisis? 5. Should safety net operations during a crisis be subject to normal congressional oversight and budgeting? Should such operations be on – or off -budget? Should extensions of government guarantees (whether by the Fed or by the Treasury) be subject to congressional approval? !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!1 Ford Foundation Grant no. 0120 -6322, administered by the University of Missouri ÐKansas City, with a subgrant administered by the Levy Economics Institute of Bard College.

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!!%!6. Is there any practical difference between Fed liabilities (bank notes and reserves) and Treasury liabilities (coins and bonds or bills)? If the Fed spends by Òkeystrokes Ó (crediting balance sheets, as Chairman Bernanke said), can or does the Treasury sp end in the same manner? 7. Is there a limit to the Fed Õs ability to spend, lend, or guarantee? Is there a limit to the Treasury Õs ability to spend, lend , or guarantee? If so, what are those limits? And what are the consequences of increasing Fed and Treas ury liabilities? 8. What can we learn from the successful resolution of the thrift crisis that could be applicable to the current crisis? Going forward, is there a better way to handle resolutions, putting in place a template for a government safety net t o deal with systemic crises when they occur? (Note that this is a separate question from creation of a systemic regulator to attempt to prevent crises from occurring; however, we will explore the wisdom of separating the safety net Õs operation from the ope rations of a systemic regulator .) 9. What should be the main focuses of the government Õs safety net? Possibilities include: rescuing and preserving financial institutions versus resolving them , encouraging private lending versus direct spending to create aggregate demand and jobs , debt relief versus protection of interests of financial institutions , and minimizing budgetary costs to government versus minimizing private or social costs. 10. Does Fed intervention create a burden on future generations? Does Treasury funding create a burden on future generations? Is there an advantage of one type of funding over the other? 11. Is it possible to successfully resolve a financial crisis given the structure of today Õs financial system? Or, is it necessary to reform finance first in order to make it possible to mount a successful resolution process? A major goal of the project is thus to provide a clear and unbiased analysis of the issues to serve as a basis for discussion and for proposals on how the Federal Reserve can be reformed to improve transparency and provide more effective and democratic governance in times of crisis. A supplementary goal has been to improve understanding of monetary operations, in order to encourage more effective integration with Tr easury operations and fiscal policy governance. In the first chapter we summarize the major findings of project research undertaken over the past four years. See all of the projectÕs research documents at our webpage, http://www.levyinstitute.org/ford -levy/governance/. Acknowledg ments Research consultants : Dr. Robert Auerbach, University of Texas at Austin; Dr. Jan Kregel, Tallinn University of Technology, Levy Economics Institute of Bard College , and University of Missouri ÐKansas City; Dr. Linwood Tauheed, University of Missouri ÐKansas City; Dr. Walker Todd, American Institute for Economic Research; Frank Veneroso, Veneroso Associates; Dr. Thomas Ferguson, University of Massachusetts Boston; Dr. Robert A. Johnson, Institute for

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!!’!CHAPTER 1 . SUMMARY OF PROJECT FINDINGS L. Randall Wray In this chapter we first summarize findings from the previous three reports, and then briefly summarize the findings presented below in this research report. Improving Governance of the Government Safety Net in Financial Crisis, April 2012 The first report looked at the nature of the global financial crisis (GFC), examined the Fed Õs resp onse Ñproviding a detailed accounting of the response Ñcompared the response this time to actions taken in previous crises, and assessed the Òtoo -big -to-fail doctrine Ó and the remedies proposed in the Dodd -Frank Act. We argued that the Federal Reserve engag ed in actions well beyond its traditional lender -of-last -resort role, which supports insured deposit -taking institutions that are members of the Federal Reserve System. Support was eventually extended to non insured investment banks, broker -dealers, insuran ce companies, and automobile and other non financial corporations. By the end of this process , the Fed owned a wide range of real and financial assets, both in the United States and abroad. While most of this support was lending against collateral, the Fed also provided unsecured dollar support to foreign central banks directly through swaps facili ties that indirectly provided dollar funding to foreign banks and businesses. This was not the first time such generalized support ha d been provided to the economic system in the face of financial crisis. In the crisis that emerged after the German decla ration of war in 1914, even before the Fed was formally in operation, the Aldrich -Vreeland Emergency Currency Act of 1908 provided for the advance of currency to banks against financial and commercial assets. The A ct, which was to cease in 1913 but was ext ended in th e original Federal Reserve Act (or ÒFRA Ó), expired on June 30, 1915. As a result, similar support to the general system was provided in the Great Depression by the Òemergency banking act Ó of 1933 , and eventually became section 13 (c) of the FRA . Whenever the Federal Reserve acts in this manner to support the stability of the financial system, it also intervenes in support of individual institutions, both financial and non financial. The Fed thus circumvents the normal action of private market processes while at the same time its independence means the action is not subject to the normal governance and oversight processes that generally characterize government intervention in the economy. There is usually little transparency, public disc ussion , or congressional oversight before, during, and even after such interventions. The very creation of a central bank in the United States, which had been considered a priority ever since the 1907 crisis, generated a contentious debate over whether the bank should be managed and controlled by the financial system it was supposed to serve, or whether it should be the subject to implementation of government policy and thus under congressional oversight and control. This conflict w as eventually resolved by a two fold solution. Authority and

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!!(!jurisdiction would be split among a system of reserve banks under control of the banks it served, and a Board of Governors in Washington under control of the federal government. In the recent crisis , these decisions, which resulted in direct investments in both financial and non financial companies, were made (mostly) by the Fed. 2 Criticism of these actions included the fact that such decisions should have been taken by the Treasury and subject to government assessment and oversight. In the Great Depression , such intervention with respect to the rescue of failed banks was carried out through a federal agency, the Reconstruction Finance Corporation. This time, most of the rescue took place behind closed doors at the Fed, with some participation by the Treasury. In a sense, any action by the Fed Ñfor example , when it sets interest rates Ñinterferes in the market process. This is one of the reasons that the Fed had long ago stopped intervening in the long -term money market, since it was thought that this would have an impact on investment allocation decisions thought to be determined by long -term interest rates. In the current crisis, the Fed once again took up intervention in longer -term securities markets in the form of qua ntitative easing. As a result of these extensive interventions in the economy and its supplanting of normal economic processes , both Congress and the public at large became concerned not only about the size of the financial commitments assumed by the Fed on their behalf, but also about the lack of transparency and normal governmental oversight surrounding these actions. The Fed initially refused requests for greater access to information. Many of these actions were negotiated in secret, often at the Federa l Reserve Bank of New York ( New York Fed ) with the participation of Treasury officials. The justification was that such secrecy is needed to prevent increasing uncertainty over the stability of financial institutions that could lead to a collapse of trou bled banks, which would only increase the government Õs costs of resolution. There is, of course, a legitimate reason to fear sparking a panic. Yet, when relative calm returned to financial markets, the Fed continued to resist requests to explain its actions even ex post. This finally led Congress to call for an audit of the Fed in a nearly unanimous vote. Some in Congress are again questioning the legitimacy of the Fed Õs independence. In particular, given the importance of the New York Fed , some are worried that it is too close to the Wall Street banks it is supposed to oversee and that it has in many cases been forced to rescue. The president of the New York Fed met frequently with top management of Wall Street institutions throughout the crisis, and reporte dly pushed deals that favored one institution over another. However, like the other presidents of district banks, the president of the New York Fed is selected by the regulated banks rather than being appointed and confirmed by governmental officials. Crit ics note that while the Fed has become much more open since the early 1990s, the crisis has highlighted how little oversight the congressional and executive branches have over the Fed, and how little transparency there is even today. There is an inherent conflict between the need for transparency and oversight when public commitments (spending or lending) are involved and the need for independence and secrecy in formulating monetary policy and supervising regulated financial institutions. A democratic !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!2 The Treasury did obtain approximately $800 billion from Congress, initially used f or asset purchases, but ultimately mostly used to increase bank capital. This is discussed only briefly in this report as it is outside the scope of the project.

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!!)!gove rnment cannot formulate its budget in secret. Budgetary policy must be openly debated and all spending must be subject to open audits, with the exception of national defense. However, it is argued in defense of the Fed Õs actions that monetary policy canno t be formulated in the open Ñthat a long and drawn -out open debate by the Federal Open Market Committee (FOMC) regarding when and by how much interest rates ought to be raised would generate chaos in financial markets. Similarly, an open discussion by regul ators about which financial institutions might be insolvent would guarantee a run out of their liabilit ies and force a government take over. Even if these arguments are overstated and even if a bit more transparency could be allowed in such deliberations by the Fed, it is clear that the normal operations of a central bank will involve more deliberation behind closed doors than is expected of the budgetary process for government spending. Further, even if the governance of the Fed were to be substantially ref ormed to allow for presidential appointments of all top officials, this would not eliminate the need for closed deliberations. And yet the calls to Òaudit the Fed Ó have come again from some quarters. The question is whether the Fed should be able to commi t the Congress in times of national crisis. Was it appropriate for the Fed to commit the U.S. government to trillions of dollars of funds to rescue U.S. financial institutions, as well as foreign institutions and governments? When Chairman Bern anke testifi ed before Congress about whether he had committed the Òtaxpayers Õ money ,Ó he responded ÒnoÓÑit was simply entries on balance sheets. While this response is operationally correct, it is also misleading. There is no difference between a Treasury guarantee of a private liability and a Fed guarantee. When the Fed buys an asset by means of Òcrediting Ó the recipient Õs balance sheet, this is not significantly different from the U.S. Treasury financing the purchase of an asset by Òcrediting Ó the recipient Õs balance sheet. The only difference is that in the former case the debit is on the Fed Õs balance sheet an d in the latter it is on the Treasury Õs balance sheet. But the impact is the same in either case : it represents the creation of dollars of government liabilities in support of a private sector entity. The fact that the Fed does keep a separate balance sh eet should not mask the identical nature of the operation. It is true that the Fed runs a profit on its activities since its assets earn more than it pays on its liabilities, while the Treasury does not usually aim to make a profit on its spending. Yet Fed profits above 6 percent are turned over to the Treasury. If its actions in support of the financial system reduce the Fed Õs profitability, fewer profits will be passed along to the Treasury, whose revenues will suffer. If the Fed were to accumulate massiv e losses, the Treasury would bail it out Ñwith Congress budgeting for the losses. It is clear that this was not the case, but however remote the possibility, such fears seem to be behind at least some of the criticism of the Fed , because in practice the Fed Õs obligations and commitments are ultimately the same as the Treasury Õs, but the Fed Õs promises are made without congressional approval, or even its knowledge many months after the fact. Some will object that there is a fundamental difference between spending by the Fed and spending by the Treasury. The Fed Õs actions are limited to purchasing financial assets, lending against collateral, and guaranteeing liabilities. While the Treasury also operates some lending programs and guarantees private liabilit ies (for example, through the FDIC and Sallie Mae programs), and while it has purchased private equities in recent bail outs (of GM, for example), most of its spending takes the form of transfer payments and purchases of real output. Yet, when the Treasury engages in lending or guarantees, its funds must be provided by Congress.

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!!*+!The Fed does not face such a budgetary constraint Ñit can commit to trillions of dollars of obligations without going to Congress. This equivalence is masked by the way the Fed Õs an d the Treasury Õs balance sheets are constructed. Spending by the Treasury that is not offset by tax revenue will lead to a reported budget deficit and (normally) to an increase in the outstanding government debt stock. By contrast, spending by the Fed lead s to an increase of outstanding bank reserves (an IOU of the Fed) that is not counted as part of deficit spending or as government debt and is off the government balance sheet. While this could be seen as an advantage because it effectively keeps the suppo rt of the financial system in crisis Òoff the balance sheet ,Ó it comes at the cost of reduced accountability and diminished democratic deliberation. There is a recognition that financial crisis support necessarily results in winners and losers, and the socialization of losses. At the end of the 1980s , when it became necessary to rescue and restructure the thrift industry, Congress created an authority and budgeted funds for the resolution. It was recognized that losses would be socialized Ñwith a final acc ounting in the neighborhood of $200 billion. Government officials involved in the resolution were held accountable for their actions, and more than one thousand top management officers of thrifts went to prison. While undoubtedly imperfect, the resolution was properly funded, implemented, and managed to completion , and in general it followed the procedures adopted to deal with bank resolutions in the 1930s. By contrast, the bail outs in the much more serious recent crisis were uncoordinated, mostly off budg et, and done largely in secret Ñand mostly by the Fed. There were exceptions, of course. There was a spirited public debate about whether government ought to rescue the auto industry. In the end, funds were budgeted and government took an equity share and a n active role in decision making, openly pick ing winners and losers. Again, the rescue was imperfect , but ex post it seems to have been successful. Whether it will still look successful a decade from now we cannot know, but at least we do know that Congres s decided the industry was worth saving as a matter of public policy. No such public debate occurred in the case of the rescue of Bear Stearns, the bankruptcy of Lehman Brothers, the rescue of AIG, or the support provided to a number of the biggest global banks. Our most important finding in this report was that the Fed originated over $29 trillion in loans to rescue the global financial system. While our estimate first met with widespread criticism Ñon the argument that it is not the total amount of loans originated that matters, but rather the peak outstanding stock of loans made Ñour approach eventually was embraced by others, including some researchers at the Fed. This is a legitimate measure of the unprecedented effort undertaken by the Fed, and is not m eant to measure the risk of loss faced by the Fed. Full details are provided in the 2012 report, and summarized below in this report.

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