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THE FED TURNS 100: LESSONS LEARNED
OVER A CENTURY OF CENTRAL BANKING

HEARING
BEFORE THE

SUBCOMMITTEE ON MONETARY
POLICY AND TRADE
OF THE

COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION

SEPTEMBER 11, 2013

Printed for the use of the Committee on Financial Services

Serial No. 113–42

(
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WASHINGTON

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HOUSE COMMITTEE ON FINANCIAL SERVICES
JEB HENSARLING, Texas, Chairman
GARY G. MILLER, California, Vice Chairman
SPENCER BACHUS, Alabama, Chairman
Emeritus
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
SHELLEY MOORE CAPITO, West Virginia
SCOTT GARRETT, New Jersey
RANDY NEUGEBAUER, Texas
PATRICK T. MCHENRY, North Carolina
JOHN CAMPBELL, California
MICHELE BACHMANN, Minnesota
KEVIN McCARTHY, California
STEVAN PEARCE, New Mexico
BILL POSEY, Florida
MICHAEL G. FITZPATRICK, Pennsylvania
LYNN A. WESTMORELAND, Georgia
BLAINE LUETKEMEYER, Missouri
BILL HUIZENGA, Michigan
SEAN P. DUFFY, Wisconsin
ROBERT HURT, Virginia
MICHAEL G. GRIMM, New York
STEVE STIVERS, Ohio
STEPHEN LEE FINCHER, Tennessee
MARLIN A. STUTZMAN, Indiana
MICK MULVANEY, South Carolina
RANDY HULTGREN, Illinois
DENNIS A. ROSS, Florida
ROBERT PITTENGER, North Carolina
ANN WAGNER, Missouri
ANDY BARR, Kentucky
TOM COTTON, Arkansas
KEITH J. ROTHFUS, Pennsylvania

MAXINE WATERS, California, Ranking
Member
CAROLYN B. MALONEY, New York
´
NYDIA M. VELAZQUEZ, New York
MELVIN L. WATT, North Carolina
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
MICHAEL E. CAPUANO, Massachusetts
´
RUBEN HINOJOSA, Texas
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
STEPHEN F. LYNCH, Massachusetts
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
GWEN MOORE, Wisconsin
KEITH ELLISON, Minnesota
ED PERLMUTTER, Colorado
JAMES A. HIMES, Connecticut
GARY C. PETERS, Michigan
JOHN C. CARNEY, JR., Delaware
TERRI A. SEWELL, Alabama
BILL FOSTER, Illinois
DANIEL T. KILDEE, Michigan
PATRICK MURPHY, Florida
JOHN K. DELANEY, Maryland
KYRSTEN SINEMA, Arizona
JOYCE BEATTY, Ohio
DENNY HECK, Washington

SHANNON MCGAHN, Staff Director
JAMES H. CLINGER, Chief Counsel

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SUBCOMMITTEE

ON

MONETARY POLICY

AND

TRADE

JOHN CAMPBELL, California, Chairman
BILL HUIZENGA, Michigan, Vice Chairman
FRANK D. LUCAS, Oklahoma
STEVAN PEARCE, New Mexico
BILL POSEY, Florida
MICHAEL G. GRIMM, New York
STEPHEN LEE FINCHER, Tennessee
MARLIN A. STUTZMAN, Indiana
MICK MULVANEY, South Carolina
ROBERT PITTENGER, North Carolina
TOM COTTON, Arkansas

WM. LACY CLAY, Missouri, Ranking
Member
GWEN MOORE, Wisconsin
GARY C. PETERS, Michigan
ED PERLMUTTER, Colorado
BILL FOSTER, Illinois
JOHN C. CARNEY, JR., Delaware
TERRI A. SEWELL, Alabama
DANIEL T. KILDEE, Michigan
PATRICK MURPHY, Florida

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CONTENTS
Page

Hearing held on:
September 11, 2013 ..........................................................................................
Appendix:
September 11, 2013 ..........................................................................................

1
41

WITNESSES
WEDNESDAY, SEPTEMBER 11, 2013
Bivens, Josh, Research and Policy Director, Economic Policy Institute .............
Gagnon, Joseph E., Senior Fellow, Peterson Institute for International Economics ...................................................................................................................
Goodfriend, Marvin, Friends of Allan Meltzer Professor of Economics, Tepper
School of Business, Carnegie Mellon University ...............................................
Meltzer, Allan H., Gailliot and Scaife University Professor of Political Economy, Tepper School of Business, Carnegie Mellon University .........................
Pollock, Alex J., Resident Fellow, American Enterprise Institute ......................
White, Lawrence H., Professor of Economics, George Mason University ...........

12
11
5
3
7
9

APPENDIX
Prepared statements:
Bivens, Josh ......................................................................................................
Gagnon, Joseph E. ............................................................................................
Goodfriend, Marvin ..........................................................................................
Meltzer, Allan H. ..............................................................................................
Pollock, Alex J. .................................................................................................
White, Lawrence H. ..........................................................................................

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42
57
69
79
97
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THE FED TURNS 100: LESSONS LEARNED
OVER A CENTURY OF CENTRAL BANKING
Wednesday, September 11, 2013

U.S. HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON MONETARY
POLICY AND TRADE,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The subcommittee met, pursuant to notice, at 1:46 p.m., in room
2128, Rayburn House Office Building, Hon. John Campbell [chairman of the subcommittee] presiding.
Members present: Representatives Campbell, Huizenga, Pearce,
Posey, Stutzman, Mulvaney, Pittenger; Clay, Peters, Foster, Sewell, and Kildee.
Ex officio present: Representative Hensarling.
Chairman CAMPBELL. Good afternoon, everyone. The Subcommittee on Monetary Policy and Trade will come to order. Without objection, the Chair is authorized to declare a recess of the subcommittee at any time.
With the concurrence of the ranking member and of the witnesses, we are beginning this hearing a little bit early in order to
accommodate the vote schedule that we will have this afternoon.
My understanding is that the votes will be called at 2:10, so we will
continue the hearing until probably about 2:15, at which time we
will recess while we go down for votes. There are 3 votes, which
should take approximately 30 minutes. Then we will come back,
and we will continue the hearing until whenever questions are finished, the witnesses need to leave, or the next vote is called, which
I think is supposed to be around 4:15-ish, and we will adjourn the
hearing at that point.
So as the Chair, I now recognize myself for 5 minutes for the
purpose of an opening statement. But before I go into the opening
statement, I would like to note that today is the anniversary of the
attacks on America on 9/11. And although I am sure you all have
seen and I have seen and we have seen the memorials and the moments of silence in New York and here in Washington and elsewhere around the country, I don’t ever think we can do it too much.
So I would first ask that we all observe a moment of silence in remembrance of those who perished on 9/11.
Thank you.
Now, I will continue my opening statement—which will be brief,
because we are mainly here to hear all of you—which is just to explain what we are doing here. This year is the 100th anniversary
of the Federal Reserve. And we felt that after 100 years of an insti(1)

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2
tution, it is a good time to stand back and look at it and say, okay,
why was it formed? What has it done? What has it changed? How
did it start out? What did it do in the middle? Where is it now?
And to take a look at the past 100 years of the Fed with the idea
of trying to understand better—I don’t think anyone in this room
was here in 1913 when it was founded, so given that none of us
personally saw it, I think it is good to take a look at what happened and what has happened in the last 100 years and where we
are today so that we can begin to think about, what does the next
100 years of the Fed look like? What should it look like? What have
we done right? What have we done wrong? What successes have we
had? What mistakes have we made? And what can we learn from
those successes? What can we learn from those mistakes? What can
we learn from what we did right and learn from what we did
wrong?
I am looking forward to the testimony of all of the witnesses this
morning as we begin a series of hearings on the Federal Reserve
and on where it has been and then perhaps where it might be
going.
So with that, I would like to recognize the ranking member, the
gentleman from Missouri, for his opening statement.
Mr. CLAY. Thank you so much, Mr. Chairman, for holding this
hearing on the Federal Reserve Bank then and now.
As you mentioned, in 1913 Congress enacted the Federal Reserve
Act to provide for the establishment of the Federal Reserve Bank.
In 1978, Congress enacted the Full Employment and Balanced
Growth Act, better known as the Humphrey-Hawkins Act. This law
charges the Federal Reserve Bank with a dual mandate, both
maintaining stable prices and full employment.
Currently, the U.S. unemployment rate is 7.3 percent, the lowest
level of unemployment in 5 years. Still, millions of Americans
would like to work, but cannot get work. The Consumer Price
Index, which shows the price consumers pay for goods and services,
has increased over the past 12 months by 2 percent.
The cost of all items, less food and energy, has risen 1.7 percent
over the last year. This compares to 1.6 percent for the 12 months
ending in June. The energy index has risen 4.7 percent over the
last 12 months. It is the largest increase since the 12 months ending February 2012, and the food index has risen 1.4 percent. All
of these factors play a very important role in the U.S. economy.
And, again, Mr. Chairman, I want to thank you. And I look forward to questions that I may submit to the witnesses. I yield back.
Chairman CAMPBELL. Thank you. I thank the ranking member
for his comments and for yielding back.
In the absence of any other opening statements, we will proceed
directly to the witnesses. And we just got word that there will not
be a second series of votes, so we are going to have this one series
at apparently 2:10, and then after that, there will not be another
series, so we will just go from 2:10 until whenever the hearing finishes after that.
So, a warm welcome to all of you. And we will start with Dr.
Allan Meltzer, professor of political economy at Carnegie Mellon,
and also visiting scholar at the American Enterprise Institute. He
chaired the International Financial Institution Advisory Commis-

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3
sion, known as the Meltzer Commission, and is a founding member
of the Shadow Open Market Committee. He served on the President’s Economic Policy Advisory Board and on the Council of Economic Advisers.
Dr. Meltzer, you are recognized for 5 minutes.
STATEMENT OF ALLAN H. MELTZER, GAILLIOT AND SCAIFE
UNIVERSITY PROFESSOR OF POLITICAL ECONOMY, TEPPER
SCHOOL OF BUSINESS, CARNEGIE MELLON UNIVERSITY

Mr. MELTZER. Thank you, Mr. Chairman. I welcome the opportunity to have this discussion. I think that you asked the right
question: What can the Federal Reserve do better in the next century than what it has done in the past century? And the ranking
member’s questions about how far we have strayed from full employment and how slow we are getting back there, those are critical
questions for our citizens.
The Federal Reserve has some very good things about it. One of
them is that in its 100 years, it is one of the few institutions of
government that has never had a major scandal. That is quite an
achievement, and it is one that we should, of course, welcome.
It also has a number of blemishes. I am going to talk more about
the blemishes, because those are the things that need correction.
The 1913 Federal Reserve Act created an institution with very
limited powers. President Wilson’s compromise resolved the main
political obstacle to passing the Act. The reserve banks became
semiautonomous, controlled by their managements and directors.
Boards of directors had the power to reject portfolio decisions. The
Board in Washington had undefined supervisory responsibility.
The United States was on the gold standard, limiting Federal Reserve actions to the requirements of that rule. In addition, the new
system authorized reserve banks to discount commercial paper,
banker’s acceptances, and the like. The discounting operation was
always at the initiative of the borrower. Also, the Act prohibited
any direct purchases of Treasury debt.
All of these restrictions ended long ago. The gold standard
limped to an end in the 1930s. Discounting became an unimportant
part of the Federal Reserve’s activities, and a limited volume of direct loans to the Treasury replaced the prohibition. Far more important, reliance on open-market operations circumvented the prohibition on direct purchases of Treasuries.
Currently, and for many years, the Federal Reserve has bought
or sold unlimited amounts of Treasury securities in the marketplace at the time of the offering or at any subsequent time. The
transformation occurred in many steps, many of them in response
to major crises, especially the Great Depression, the Great Inflation, and the current prolonged recession and slow recovery, black
marks on the Federal Reserve’s record.
Within months of Benjamin Strong’s departure, Board Members
gained influence. Later, the Banking Acts of 1933 and especially
1935 shifted power toward the Board by giving the Board a majority on the new Federal Open Market Committee and eliminating
the power of reserve bank directors to decide on their bank’s participation in open-market purchases or sales.

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During the Great Inflation, Congress amended the Federal Reserve Act by adding the so-called dual mandate. After the recent
housing and financial crisis of 2007–2009, Congress approved the
Dodd-Frank Act, containing hundreds of regulations on banks, as
many as 400, according to some counts.
Among the many new regulations is the use of Federal Reserve
earnings to allocate credit toward consumers. The Fed had previously resisted credit allocation, but it will henceforth finance it
out of its earnings without any right to decide on the allocation.
This right is reserved to the Director of the consumer agency now
embedded into the Federal Reserve Act. The Director does not report to the Chairman, nor to the Congress, nor to anyone else. And
although the earnings that the Director uses would otherwise return to the Treasury as receipts, Congress does not vote on the allocation. Political decisionmaking is now unavoidable.
This change is a startling reduction in the mandated independence of the Federal Reserve. Federal Reserve independence has
often been compromised, but never before by act of Congress.
Once Congress understood the importance of monetary expansion
for employment, it took extraordinary effort and a strong Chairman
to remain independent. Paul Volcker was an independent Chairman. Alan Greenspan also remained relatively independent. Others
were willing to compromise. The current Federal Reserve has engaged in such nonmonetary functions as fiscal policy, debt management, and credit allocation.
To sum up the evolution, I conclude that the Federal Reserve
evolved under pressure of events and political responses to crises
from independent agencies with constrained powers to become the
world’s major central bank with a nearly unrestricted ability to expand. It retains a vestige of independence, but it pays the price of
much-reduced independence for its greatly expanded authority.
Within the system, power has shifted from the reserve banks to the
Board of Governors, and the reserve bank directors have a greatly
diminished role.
One of the great failures of recent years has been the failure of
Congress to find an effective way of providing congressional oversight. This is a serious lack of responsibility. We have an agency
which is increasing—has doubled and then redoubled the size of its
balance sheet without any vote by the Congress to spend that
amount of money, trillions of dollars. That is a mistake, a mistake
by the Federal Reserve, but an even greater mistake by the Congress, because under Article I, Section 8—
Chairman CAMPBELL. Thank you, Dr. Meltzer. Time has expired.
So if you have a sentence to sum up or—I think we get the point.
Mr. MELTZER. Yes, I think the most important thing that the
Congress could do to enhance its oversight and improve the performance of the Federal Reserve is to adopt a monetary rule, one
which embodies the dual mandate necessary, but adopt a monetary
rule—
Chairman CAMPBELL. All right.
Mr. MELTZER. —a rule which would tell you whether they have
done what they said they were going to do and whether you could
correctly monitor them.

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5
[The prepared statement of Dr. Meltzer can be found on page 79
of the appendix.]
Chairman CAMPBELL. Thank you. Thank you, Dr. Meltzer.
Next, Dr. Marvin Goodfriend, who is also a professor at Carnegie
Mellon, but a professor of economics, and he previously served as
the Senior Vice President and Policy Advisor to the Federal Reserve Bank of Richmond, and also worked as a Senior Staff Economist for the White House Council of Economic Advisers. Dr.
Goodfriend, you are recognized for 5 minutes.
STATEMENT OF MARVIN GOODFRIEND, FRIENDS OF ALLAN
MELTZER PROFESSOR OF ECONOMICS, TEPPER SCHOOL OF
BUSINESS, CARNEGIE MELLON UNIVERSITY

Mr. GOODFRIEND. Thank you, Mr. Chairman.
I will speak today on lessons learned from a century of Federal
Reserve last resort lending. My overarching message is that the
constraints on the Federal Reserve’s lending powers were loosened
gradually over time, resulting in the distortionary and destabilizing
implied promise of even more expansive lending in the future.
The story starts in the Depression, when Congress was reluctant
to expand the credit policy powers of the independent Fed beyond
depositories and instead established the Reconstruction Finance
Corporation to allocate credit widely to nonbank entities. So much
has changed.
But the Fed exhibited a tendency on its own to expand lending
beyond short-term liquidity assistance to banks. For instance, in
1974 Fed lending supported the insolvent Franklin National Bank,
and in 1984–1985, the Fed supported the undeclared insolvency of
Continental Illinois Bank. Then, the Monetary Control Act expanded access to the Fed’s discount window to all depositories in
1980, whether or not they were members of the Federal Reserve
System.
Anna Schwartz has documented a widespread tendency in the
1980s for Fed lending to delay the closure of insolvent banks at
taxpayer expense. In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) famously acted to limit Fed lending to undercapitalized banks, although the law would be compromised by capitalization measured largely on a book rather than
market valuation. Overlooked in FDICIA, however, was something
more important: It amended Section 13(3) of the Federal Reserve
Act to enable the Fed to lend widely to nonbanks for the first time
in the Fed’s history, as Alan Greenspan has written, granting virtually unlimited authority to the Federal Reserve Board to lend in
unusual and exigent circumstances.
Expanded Fed lending authorization unaccompanied by supervision and regulation would encourage the huge expansion of
money market finance that fueled the credit boom. And in the
2007–2008 turmoil, the Fed was put in a no-win situation. Given
its wide powers to lend, the Fed could disappoint expectations of
accommodation and risk financial collapse or take on expansive,
underpriced credit risk, as Paul Volcker put it, with the implied
promise of similar actions in times of future turmoil. The Fed chose
the latter course of action, even allowing two major investment

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6
banks to quickly become bank holding companies so they could access the Fed discount window.
In the 19th Century, the Bank of England followed Walter
Bagehot’s classic last resort lending advice, ‘‘to lend freely at a high
rate on good collateral,’’ so as not to take on underpriced credit
risk. The bank followed Bagehot’s advice because the Bank of England was a private profit-maximizing institution whose shareholders earned the profit and bore the risk of loss.
The Fed, however, is inclined to take on underpriced credit risk
when worried that not doing so threatens a systemic crisis. Why?
Because the Fed’s own funds are not at stake. The fiscal authorities receive any Fed income after operating expenses, and taxpayers bear any Fed losses.
Moreover, even when the Fed protects itself by taking good collateral, the Fed harms taxpayers if the entity to which the Fed
lends fails with a Fed loan outstanding. Why? The Fed takes collateral at the expense of taxpayers exposed to losses from backstopping the Deposit Insurance Fund or from other financial guarantees that the government may have put in place. The bottom line
is that fully independent Fed lending facilitates lending laxity and
moral hazard.
Fed credit policy works by interposing government creditworthiness, the power to borrow credibly against future taxes between
private borrowers and lenders to facilitate distressed borrowers.
Fed credit policy involves lending to private institutions with freshly created bank reserves or the proceeds from the sale of Treasuries
from the Fed’s own portfolio.
To prevent inflation in the future, the Fed must reverse the reserve creation eventually by selling Treasuries from its portfolio or
else the Fed will have to pay a market interest on reserves that
is used to finance those credit policies. Either way, Fed credit policy involves the lending of public funds to particular borrowers, financed by interest-bearing liabilities issued against future taxes.
In short, Fed credit policy is really debt-financed fiscal policy.
The Fed returns the interest on its credit assets to the Treasury,
but all such assets carry credit risk and involve the Fed in potentially controversial disputes regarding credit allocation. So credit
policy is necessarily a political fiscal policy matter that ought to be
handled by the fiscal authorities, not by the independent Fed.
That said, in my view occasional Fed lending to solvent supervised depositories on short term against good collateral is protected
against ex post losses and ex ante distortions, and so I believe the
Fed should be given a degree of operational independence with respect to such circumscribed lending to depositories that it regulates.
But Congress should insist that the Fed adhere to a Treasuriesonly asset acquisition policy, except for such occasional lending.
Moreover, I believe that any expansive Fed lending initiatives
should be authorized by a committee of Congress before the fact,
be done only as a bridge loan, and be accompanied by an explicit
taxpayer takeout, which, of course, would deter the Fed from doing
such things, except in exceptional circumstances. Thank you.
[The prepared statement of Dr. Goodfriend can be found on page
69 of the appendix.]

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Chairman CAMPBELL. Thank you, Dr. Goodfriend. Welcome back.
Next, Mr. Alex Pollock, resident fellow at the American Enterprise Institute. He also serves as lead director of the CME Group,
and was formerly the President and CEO of the Federal Home
Loan Bank of Chicago. Mr. Pollock, you are recognized for 5 minutes.
STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW,
AMERICAN ENTERPRISE INSTITUTE

Mr. POLLOCK. Thank you, Chairman Campbell, Ranking Member
Clay, members of the subcommittee, and Chairman Hensarling.
I think the most striking lesson of the 100-year history of the
Federal Reserve is how it has been able from the beginning to inspire entirely unjustified optimism about what it can know and
what it can accomplish. In contrast to the warm hopes of 1913 and
since, the Fed has not made financial disorders disappear, while it
has often enough contributed to creating them.
A high point of optimism about what discretionary manipulation
of interest rates could achieve came in the 1960s, when economists
actually came to believe in what they called ‘‘fine-tuning.’’ The finetuning notion, ‘‘turned out to be too optimistic, too hubristic, as we
collectively learned,’’ Fed Chairman Bernanke recently wrote. ‘‘So,’’
he continued, ‘‘a little humility never hurts.’’
Indeed, the performance of the Federal Reserve at economic and
financial forecasting in the last decade, including missing the extent of the housing bubble, missing the huge impact of its collapse,
and failing to foresee the ensuing sharp recession certainly
strengthens the case for humility on the Fed’s part. The Fed is as
poor at knowing the future as everybody else.
So as Arthur Burns, Fed Chairman in the 1970s and architect
of the utterly disastrous Great Inflation of that decade said, ‘‘The
opportunities for making mistakes are legion.’’
Nonetheless, the 21st Century Federal Reserve and its economists again became optimistic and perhaps hubristic about the central bank’s abilities when Chairman Greenspan had been dubbed
‘‘the maestro.’’ In the early 2000s, central bankers thought they
were observing a durable ‘‘Great Moderation,’’ but the ‘‘Great Moderation’’ turned into the ‘‘Great Bubble’’ and the ‘‘Great Collapse.’’
Then, the Dodd-Frank Act gave the Fed much expanded regulatory authority over firms deemed systemically important financial institutions, or SIFIs, in order to control systemic risk. But the
lessons of history make it readily apparent that the greatest SIFI
of them all is the Federal Reserve itself. It is unsurpassed in its
ability to create systemic risk for everybody else. Who will guard
these guardians, as the classic question goes?
In 1927, the Fed’s Benjamin Strong famously decided to give the
stock market ‘‘a little coup de whiskey.’’ In our times, the Fed has
decided to give the bond and mortgage markets a barrel of whiskey. This massive manipulation of government debt and mortgages
has almost certainly induced a lot of new systemic interest rate
risk into the economy, as well as a remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.
Central banking is not rocket science. In fact, discretionary central banking is a lot harder than rocket science, because it is not

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8
and cannot be a science at all. It cannot make reliable predictions,
and it must cope with ineluctable uncertainty and an unknowable
future.
I believe we can draw four lessons from this instructive history.
One, we should have no illusions, in sharp contrast to the 100
years of illusions we have entertained, about the probability of sustained success of discretionary central banking, no matter how intellectually brilliant and personally impressive its practitioners
may be.
Two, we should try to implement Henry Thornton’s classic advice
from 1802, ‘‘to limit the total amount of paper money issued, to let
it vibrate only within certain limits, to allow a slow and cautious
extension of it, as the general trade enlarges itself,’’ in other words,
to have the Fed focus on the medium- to long-term noninflationary
or very low inflationary expansion of base money. The Fed is much
more likely to succeed at this than in trying to manage the economy.
Three, given that the Fed is the single greatest source of systemic risk, we should reconsider who should guard these guardians. Are there appropriate checks and balances, rather than a philosopher king-like independence? This includes the question of
rules, the role of Congress, and as Allan Meltzer mentioned, the internal balance between the regional Federal Reserve banks and the
Federal Reserve Board.
Fourth and last, a serious 100-year review, as this subcommittee
is undertaking, of the 6 mandates of the Federal Reserve make
sense. It has been 78 years since the Fed was restructured by the
Banking Act of 1935, 36 years since the Federal Reserve Reform
Act of 1977, and 35 years since the Humphrey-Hawkins Act, which
the ranking member mentioned, was enacted. A careful, rigorous,
thoughtful review of the many difficult questions involved in governing the pure fiat currency, paper dollar, floating exchange rate
world we have is certainly appropriate.
Thank you.
[The prepared statement of Mr. Pollock can be found on page 97
of the appendix.]
Chairman CAMPBELL. Thank you, Mr. Pollock.
Dr. Larry H. White is a senior scholar at the Mercatus Center
and a professor of economics at George Mason University, and also
serves as a member of the Financial Markets Working Group. He
previously taught at the University of Missouri in St. Louis, and
at the University of Belfast, and worked as a visiting scholar at the
Federal Reserve Bank of Atlanta.
I want to mention, before I forget, that without objection, all of
your written statements will be made a part of the record. Also, I
did fail to mention—as Dr. Meltzer mentioned that the Federal Reserve has had no scandals in its 100-year history, I want to point
out that this body, the U.S. House of Representatives, has not had
a scandal in the last week of which I am aware.
[laughter]
And so I don’t know if that is equivalency, but I just thought I
would mention that.
With that, Dr. White, you are recognized for 5 minutes.

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STATEMENT OF LAWRENCE H. WHITE, PROFESSOR OF
ECONOMICS, GEORGE MASON UNIVERSITY

Mr. WHITE. Thank you, Chairman Campbell, Ranking Member
Clay, and members of the subcommittee. Thank you for inviting me
to testify.
In my written testimony, I argue that the actions of the Federal
Reserve during the financial crisis of 2007 to 2010 abandoned the
rule of law. That is, the Fed abandoned the principle that those in
authority should execute the law as written, predictably and in accordance with established precedent. The Fed instead took arbitrary, ad hoc measures without clear statutory authority or precedent.
The rule of law would have been a better guide to resolving the
crisis and I think a better guide to helping us avoid future financial
crises. So in enunciating this principle, I follow the historian and
philosopher David Hume in affirming that the long-term benefits
of consistently adhering to the rule of law outweigh the short-term
convenience of ad hoc measures.
Now, what measures am I talking about? You are all aware of
the Fed’s having created special purpose vehicles, the Maiden
Lane, LLC, I, II and III to protect the bondholders of Bear Stearns
by taking $30 billion of bad assets off of its books, thereby sweetening an acquisition deal for JPMorgan Chase to take over the remainder of the firm. It declined to do the same for Lehman Brothers, but it created two other vehicles to buy and hold bad assets
from the failed insurance company AIG.
There wasn’t any precedent for this. There wasn’t any apparent
legal authority in the Federal Reserve Act for such a special purpose funding operation. That is well-known.
Equally worthy of note, but not often noticed, is that the Fed in
2008 assumed the role of selectively channeling credit in directions
that it favored. It began to lend funds to and purchase bad assets
from an array of financial institutions it deemed worthy, going beyond the traditional scope of its lending to commercial banks. The
Fed began lending to firms that do not participate in the payment
system for the first time—well, not the first time, but the first time
in recent memory, namely investment banks, primary dealers,
broker-dealers, and even mutual funds.
These funds it lent, as other speakers have mentioned, weren’t
allocated to it by Congress. They were created by the Fed itself out
of thin air, as they say, and in the amounts that the Fed itself decided. The total of the Fed’s credits outstanding at the end of 2008
stood at over $1.5 trillion, more than double the size of the Treasury’s bailout authority.
Now, the Fed has an established role as a lender of last resort.
What does that role involve? That role involves injecting cash into
the system to keep the broader money stock from shrinking. It does
not call for the Fed to inject capital into failing firms by overpaying
for assets or by lending at below market rates, actions that, as
Marvin Goodfriend said, put taxpayers at risk.
The Fed’s statutory authority to lend is actually limited, even in
exigent circumstances, and was never meant to encompass the sort
of capital injections that the Fed took in 2008 through its Maiden
Lane vehicles.

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Now, the Dodd-Frank Act properly places limits on this kind of
lending, but in other ways, the Dodd-Frank Act enshrines the Fed’s
discretion to lend. It enshrines the too-big-to-fail doctrine, the application of which inherently involves arbitrary judgments. I think
it thereby erodes the rule of law, increases the probability that taxpayers will be funding bailouts in the future, and it weakens the
market discipline between risk and reward.
In justification of these actions, the Fed during the crisis repeatedly invoked the lender of last resort rule, but I think in so doing,
they were stretching the term beyond its proper meaning. The Fed,
of course, conducts monetary policy. Lender of last resort should be
thought of as an adjunct to monetary policy; that is, it is injecting
enough cash into the system to keep the money supply from
shrinking.
It does not involve preferential credit allocation, which is what
the Fed has gotten into. Subsidizing, papering over inadequate net
worth, delaying the resolution of insolvent institutions, that has
nothing to do with keeping the money supply from shrinking.
So the lender of last resort rule doesn’t require, and the traditional guidelines of Walter Bagehot that have been mentioned actually forbid, providing insolvent firms with capital injections or
loans at below market interest rates. In fact, the lender part of the
lender of last resort is actually an anachronism. As Professor
Goodfriend mentioned, the Fed can inject cash without making
loans to particular banks by purchasing securities, and it doesn’t
need to purchase securities from those banks. It can purchase
Treasuries in the open market.
The Fed claimed legal authority for its actions—
Chairman CAMPBELL. If you could wrap up, because your time
has expired.
Mr. WHITE. —under 13(3) of the Federal Reserve Act, but I think
even as amended, Section 13(3) did not convey unlimited or carte
blanche authority.
So, in conclusion, I think we should be concerned to prevent arbitrary credit allocation by the Federal Reserve, however well-meaning the Members of the Board undoubtedly are. Thank you.
[The prepared statement of Dr. White can be found on page 104
of the appendix.]
Chairman CAMPBELL. Thank you, Dr. White.
There are three votes on the Floor right now, so we will recess
the hearing for the moment. According to the people on the Floor,
these votes should be over about at 2:50, and so we will return in
about 30 minutes or so, and we will reconvene at that point, and
continue with Dr. Gagnon and Dr. Bivens. So, the hearing is in recess.
[recess]
Chairman CAMPBELL. All right. The committee will return to
order. And we will continue with the testimony on the part of our
witnesses. We will now turn to Dr. Joseph Gagnon, a senior fellow
at the Peterson Institute for International Economics. He previously served as the Associate Director of Monetary Affairs at the
Federal Reserve Board of Governors and as an Economist at the
U.S. Treasury Department.
Dr. Gagnon, you are recognized for 5 minutes.

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STATEMENT OF JOSEPH E. GAGNON, SENIOR FELLOW,
PETERSON INSTITUTE FOR INTERNATIONAL ECONOMICS

Mr. GAGNON. Thank you, Chairman Campbell, Ranking Member
Clay, and members of the subcommittee. I welcome this opportunity to testify.
In my view, the Federal Reserve has performed at least as well
over its first 100 years as could have been expected, given the powers it was granted and the evolving understanding of how the economy operates. The key to improving performance in the future is
to give the Fed the tools it needs to do its job, to allow the Fed free
reign in using those tools, to demand that the Fed explain its actions fully, and to hold the Fed accountable for any failure to
achieve its objectives.
My biggest worry is that the Fed faces more restrictions on its
powers than any of the world’s other major central banks, raising
the risk that it may be unable to achieve its objectives at some
time in the future. Under U.S. law, the Fed has been asked to foster a sound and stable financial system which will help to achieve
its broader goals of full employment with low inflation.
Historically, however, the Fed has had three major failures.
First, the Fed did not have the tools to prevent a leveraged equity
bubble in the 1920s, and it did not use its tools adequately to prevent the bursting of this bubble from causing the Great Depression.
Second, through a protracted period of passivity in the late 1960s
and 1970s, the Fed allowed inflation to ratchet upward to damaging levels. Third, through insufficiently aggressive use of its supervisory and regulatory authorities, the Fed allowed a leveraged
housing bubble to develop in the 2000s, but it did a better job of
responding to the ensuing crisis than it did in the 1930s.
I group the lessons learned from Fed history into four categories:
monetary objectives; monetary rules; policy tools; and emergency
lending. On monetary objectives, I support the dual mandate. Experience shows that successful central banks do not focus solely on
inflation, even if that is their only mandate. Stabilizing employment is a socially valuable objective in itself and it helps to stabilize inflation. Making the employment mandate explicit is an acknowledgement of reality that has benefits for credibility, transparency, and accountability.
It might be helpful, but not essential, for political leaders to
specify a numerical goal for inflation. We are all aware of the dangers of inflation that is too high. And the evidence is mounting of
the harm from inflation that is too low. The target should not be
set below 2 percent, and some believe that a slightly higher target
would be beneficial, perhaps as high as 4 percent. I don’t have a
strong view on that, but I note that an average inflation rate of 4
percent in the late 1980s was widely viewed as a huge success.
On rules versus discretion, it is not possible to design a policy
rule that can allow for all contingencies. The best strategy is for
the Fed to use various rules in assessing the stance of policy.
Whenever it deviates noticeably from popular rules, the Fed should
explain clearly why it is doing so.
The difficulty of using policy rules is highlighted by the experience of the past 5 years, when some proposed rules called for large
negative interest rates that are not technically feasible. The Fed’s

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response was to engage in quantitative easing, or QE, an unconventional policy that was not contemplated by the existing policy
rules.
My own call for more QE back in 2009 was based on the fact that
the Fed did not forecast a return to full employment and target inflation within 3 years. Looking forward over the next 3 years, there
still seems to be some room for easier Fed policy, but the case is
less strong than it was back in 2009.
On policy tools, I note that of the world’s major central banks,
the Fed faces the greatest restrictions on its powers. It can buy
only government- and agency-backed debt. Other central banks can
buy corporate debt, equities, and even real estate. As long as there
is sufficient transparency and accountability, there is no reason to
restrict the Fed’s ability to achieve its mandate. I note that the
Bank of Japan is buying broad baskets of Japanese equity and real
estate as part of its fight against deflation.
Another important tool is the ability to impose loan-to-value limits and/or debt-to-income limits on consumer and business loans.
Strict lending limits kept the equity bubble of the 1990s from causing excessive damage when it burst in 2000. We need to make it
easier for the Fed to impose similar limits on leverage in real estate. We also need higher capital standards for banks.
Finally, on lender of last resort, during the recent crisis the Fed
made emergency loans to specific institutions, which attracted considerable criticism. Yet, the Fed was scrupulous in requiring sufficient collateral on its loans, as evidenced by the fact that all of its
loans were fully repaid at a profit to the taxpayer.
The new limit on the Fed’s ability to make emergency loans
raises the risk of disorderly failures in the future. And it is not
clear how much of this risk is offset by the advanced resolution
plans that are now required of large-scale financial institutions.
Thank you. This concludes my opening remarks.
[The prepared statement of Dr. Gagnon can be found on page 57
of the appendix.]
Chairman CAMPBELL. Thank you, Dr. Gagnon.
And last but not least, Dr. Josh Bivens is research and policy director at the Economic Policy Institute and conducts research on
macroeconomics, globalization, social insurance, and public investment. Dr. Bivens, you are recognized for 5 minutes.
STATEMENT OF JOSH BIVENS, RESEARCH AND POLICY
DIRECTOR, ECONOMIC POLICY INSTITUTE

Mr. BIVENS. Thank you. I would like to thank the members of
the subcommittee for the invitation to testify today. I have submitted written testimony for the record.
The year of the 100th anniversary of the Federal Reserve would
always be an appropriate time to assess its role in the American
economy, and the current swirl of questions surrounding its conduct in the wake of the Great Recession makes it especially so.
I am going to make essentially five quick arguments today. First,
the economy remains far from fully recovered from the Great Recession, and the obvious barrier to this full recovery is clearly deficient aggregate demand for goods and services.

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Second, this demand shortfall has been aggravated in recent
years by too contractionary fiscal policy.
Third, given this demand shortfall and given this contractionary
fiscal policy, the Fed’s current efforts to boost economic activity and
employment through unconventional monetary policy are entirely
appropriate and talk of reducing the extent of this economic boost,
or tapering as it is sort of called in the popular press, is clearly premature.
Fourth, the lessons of the burst housing bubble and the consequent Great Recession for the Fed should be that: one, it is crucial to keep asset market bubbles from inflating in the first place;
and two, we cannot rely solely on conventional monetary policy to
return the economy to full employment after they burst.
This unique episode again illustrates that monetary policy has to
balance too many competing demands and will encounter too many
contingencies over any window of time to make very simple, tailored rules the optimal policy.
And fifth, as the Fed in the future becomes a hopefully more vigilant financial regulator, it should follow the complete version of
what are often referred to—and people on the panel have referred
to it—the Bagehot rules, should lend freely during a crisis, but at
a penalty rate against collateral that is valuable during noncrisis
times, and only to fundamentally solvent institutions.
And to be clear, I find little to fault with how the Fed managed
the crisis of 2008–2009. I think it was balancing many things. We
were not well-prepared for such a financial crisis. And it chose the
path that would support economic activity and employment, even
at the expense of perhaps giving some financial aid to specific financial institutions that engaged in too many excesses. That said,
we should be better prepared for next time. Hopefully, the DoddFrank legislation has, indeed, made us better prepared for next
time.
To expand just a little bit, as of June 2013, a full 4 years after
the official end of the Great Recession, the gap between actual economic output and what could be produced if all productive factors
were fully utilized is nearly $900 billion in annualized terms. This
is $900 billion of pure economic waste that persists because we
have not engineered a full recovery from the Great Recession.
This output gap is mostly driven by deficient aggregate demand.
And, again, that has been aggravated in recent years by
contractionary fiscal policy. Given this, it is premature to argue the
Fed should begin tapering its own support for the economy.
There has been a lot of uncertainty about the estimates of how
much the Federal Reserve quantitative easing programs have
boosted the economy over the past couple of years. It is important
to realize that none of the estimates say it has damaged economic
activity or employment growth over that time. There may be considerable uncertainty about just how much it has boosted this activity, but it is important to realize that it has boosted it and the
economy has needed a boost.
Trying to engineer a recovery using just monetary policy when
fiscal policy is going in the wrong direction is far from optimal, but
flying an airplane on one engine is a lot better than zero.

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Lastly, the source of the Great Recession is as clear as day:
There was an $8 trillion bubble in home prices that formed and
then burst. The Federal Reserve and all other macroeconomic policymakers were far too reluctant in the run-up to that bubble to deflate it before it formed to such damaging levels, and they were too
confident in their ability to use conventional monetary policy,
short-term interest rate cuts to neutralize its effects when it burst.
These lessons should be heeded. In going forward, the Fed needs
to be willing to intervene to keep destructive financial sector excesses from providing tinder for another crisis, and it has a greatly
expanded menu of tools to do this, with legislation that has passed
since the crisis, and not least of which is simply public comment.
We all have seen recently, for good or bad, that just public comment on the part of Fed officials can move financial markets. It
should be cognizant of this power. And it should use it to deflate
destructive asset market bubbles before they reach crisis levels.
They should be willing to use these new tools in the future.
Thank you. I would be happy to answer any questions the subcommittee may have.
[The prepared statement of Dr. Bivens can be found on page 42
of the appendix.]
Chairman CAMPBELL. Thank you so much, Dr. Bivens.
I will now recognize myself for 5 minutes for questioning. And
I have in this 5 minutes just one question, which I will ask all of
you to answer, and then in the second round, I will have a second
question for all of you, because I am sure we will be able to do a
second round here.
My first question—and I will go in reverse order. We will start
with you, Dr. Bivens, and go down this way. Is the Federal Reserve
today more or less independent than it was at its founding or somewhere near its creation? And is it more or less independent in your
judgment than it ought to be? Dr. Bivens?
Mr. BIVENS. On the first question, more or less independent than
at its founding, I am afraid I am going to have to defer to experts.
My sense is, it is an independent institution. That independence
means being willing to break the economy when it—or to break
economic growth when it is going too fast and threatening inflation,
but it also means having the freedom to reflate the economy when
in the Fed’s judgment that is what is needed. I think it retains that
independence today, and so I think the idea that it has become too
tied to the winds of other economic policymakers is not a criticism
I endorse.
Chairman CAMPBELL. So in your opinion, its independence is
proper at the current time?
Mr. BIVENS. That is correct.
Chairman CAMPBELL. Adequate.
Mr. BIVENS. Thank you.
Chairman CAMPBELL. Dr. Gagnon?
Mr. GAGNON. Yes, I would agree that its independence is proper.
Having worked there, I was always quite struck—and I worked in
other parts of the government as well—by how independent the
Fed really is. Throughout almost all the process of decision-making,
it is only thinking about what is right and any thought about political influence is very small, as far as I could tell.

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Chairman CAMPBELL. From a historical perspective?
Mr. GAGNON. From a historical perspective, I think at the founding of the Fed until the 1930s, independent, well, it was certainly
independent from Washington. It may have been too independent
and too closely tied to regions of the country and the banking industry, and I think that was changed, appropriately so, in the
1930s to give it more control from Washington.
And yet the balance was struck right, because you have these
long fixed terms, even though they were appointed by Washington.
They then had the freedom to go out and, without short-term pressure, do what they think is in the national interest.
Chairman CAMPBELL. Dr. White?
Mr. WHITE. There are at least two meanings of independence.
One is that the Fed gets to choose its own goals, and the other is
that the Fed gets to choose its own operations, but given a set of
goals. When the Fed was founded, it was understood that the gold
standard would constrain the monetary system, so the Fed’s independence to set its own goals was very limited.
That, of course, has changed. There is no longer that kind of constraint on the Fed. We have gone from a gold standard to a PhD
standard. That is how monetary policy is made these days.
I think the Fed is probably too independent. I think it should be
accountable. And to the extent that is at variance with independence, understood as they get to choose their own goals, then I am
in favor of less independence for the Fed.
Chairman CAMPBELL. That is a fascinating concept which deserves more delving into, but, Mr. Pollock?
Mr. POLLOCK. Thank you, Mr. Chairman. The Fed in the beginning was a complicated balancing of a lot of interests—the political
board that Woodrow Wilson insisted on, the bankers in the regional
banks, and the Secretary of the Treasury who was, under the original Act, ex officio a Member of the Board.
Throughout the history of the Fed, there have been cycles of
being more or less independent. During the Second World War, the
Fed was completely unindependent. It was entirely the slave of the
Treasury, and the purpose was to finance the war. That happens
in wars.
William McChesney Martin, the longest-serving Chairman, the
one who has the best record on average inflation in the postwar
era, used to talk about ‘‘independence within the government,’’ by
which I guess he meant independent, but not quite. And by the end
of his term, he was giving way to the politicians to let inflation rise
to finance the combined Johnson social initiatives and war.
So if anything, I think when you look at the Fed, it is a good example of the constant debate between philosopher kings, as in
Plato, and checks and balances, as in the theory of republics.
Chairman CAMPBELL. Okay, I need to—
Mr. POLLOCK. We need to address that balance.
Chairman CAMPBELL. Dr. Goodfriend?
Mr. GOODFRIEND. I would concur that the gold standard constrained the Fed early on. And the gold standard is no longer with
us. So in that sense, the Fed was less independent, and I think appropriately so.

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The 14-year terms for Board of Governors officials meant a lot
more in the early days, when the pay meant that people could stay
for 14 years. One of the striking things about Federal Reserve
Board Members these days is that they stay something like 3 or
4 years. I really don’t know the exact number. And that means
there are more chances for appointments by politicians. In that
sense, I think the Federal Reserve Board has become a lot less
independent than it was in the early days.
I would also add a couple of things. The discussion of the Chairman’s succession also indicates that the personality of the Chairman has a lot more discretion these days than it used to. In the
old days—maybe Allan Meltzer can tell me otherwise—I doubt the
whole country would be focused on who became the Fed Chairman.
These days, it is indicative to me of the idea that there is a lot of
discretionary that has been piled in.
In that sense, the Fed is more independent, but inappropriately
so. As I would say, based on my testimony, the Fed’s power should
be restricted so that it isn’t doing—
Chairman CAMPBELL. Okay.
Mr. GOODFRIEND. —fiscal policy of Congress—
Chairman CAMPBELL. Okay. I am going to run a little over, but
don’t worry, I will give an equal amount of time to you, Mr. Clay,
so we keep it even here. But just so Dr. Meltzer can—and we can
get all six on this.
Mr. MELTZER. In the best academic tradition, I am going to give
you two answers. Politically, the Fed is less independent than it
was in 1913–1914. As an example, President Wilson would not invite Board Members to White House parties because he didn’t want
to influence them. There was really a very close, very distant separation of the board from the political system.
But in another sense, the Fed is completely unrestrained. It has
quadrupled the size of its balance sheet. And the failure there is,
I believe, as I said in my testimony, a failure by Congress to monitor, control, and limit what the Fed—it is your responsibility
under Article I, Section 8, to decide what the monetary policy of
the United States is. The Fed is your agent, and you don’t have a
very effective means of regulating your agent.
Chairman CAMPBELL. Okay—
Mr. MELTZER. And let me just say one last thing. In a year in
which the Fed finances 75 percent of the U.S. Government’s borrowing, how can we think of the Fed as independent of the political
process?
Chairman CAMPBELL. Thank you, Dr. Meltzer.
I now recognize Mr. Kildee. Because we started the hearing
early, he wasn’t able to get here for his opening statement, so he
is going to be recognized for 8 minutes, which gives him the opportunity to give an opening statement and then proceed to ask you
all questions and divide that 8 minutes in whatever way he would
like.
The gentleman from Michigan is recognized for 8 minutes.
Mr. KILDEE. Thank you, Mr. Chairman, and thank you to Mr.
Clay for allowing me to step in and for allowing me to sit here. It
is probably not something I am going to experience for quite some
time, but I enjoy the chance.

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Chairman CAMPBELL. These seats aren’t any different, you may
have noticed.
Mr. KILDEE. They are not? All right.
Chairman CAMPBELL. They are not that special.
Mr. KILDEE. Well, that one is.
So I will make some opening comments, and I will refer back to
the first two instances when I served here, when the Chairman of
the Federal Reserve came to address us, and ask you to comment,
particularly a couple of you to comment on some questions that I
have around the strength of America’s municipal governments and
their effect on what is a significant part of the Fed’s dual mandate,
the effect on the economy, particularly on employment.
It is interesting that this hearing, of course, marks 100 years.
And when you think back to the period when the Federal Reserve
was initiated, I think about America’s great cities. I am from Flint,
Michigan. Some of you might be familiar with that place, the birthplace of General Motors.
But when I think back to 100 years ago, GM was 5 years old.
Many older industrial cities in the United States were really just
beginning to get their legs under them and were about to experience an unprecedented period of growth and expansion. We became
a highly productive society, and somewhere along the way, most
point to around the 1930s, 1940s, we began to see the tremendous
productive capacity of our society also begin to deliver pretty significant wages to the workforce, creating a growing and really significant middle class in the United States.
In my own hometown, interestingly enough, about the time that
the dual mandate was recognized and initiated by Congress, it was
about the peak employment for the auto industry. And you could
point to that period roughly for a lot of the larger industrial communities, older industrial communities in our country.
The reason I lay that preface is that when Mr. Bernanke was
here—and I would ask some of you to comment on this—I pressed
the question of whether or not the sustainability of these old industrial cities has any implications for the mandate of the Fed and
whether or not the Fed itself, either through advice or through policy, could address what is, I think, a growing problem of inequality.
And I reference—and, Dr. Meltzer, you mentioned two answers
to one question. It is a common theme. What I have seen, what we
witnessed in this country for many American cities is that during
the periods—particularly recently—of great economic expansion,
significant economic expansion, for example, in the 1990s, many
older American cities were left behind.
And so we had this situation where much of the country was
doing extremely well, with unemployment at relatively low levels,
with wages at reasonable levels, with productivity growing, but
some significant parts of America, some of which I represent, were
not doing well at all and, in fact, didn’t participate in any of that
growth in economic expansion.
So from an economist’s point of view, one might say that some
parts of the country were doing very well, a few parts were not
doing very well at all, but on average, the country was doing just
fine. And so what I want to ask you, first—and if I could start with
Mr. Gagnon and Mr. Bivens, but also ask others to comment on

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whether or not you think the Federal Reserve has any interest or
role in helping municipal governments.
There had been a point in time not too long ago when I know
there was some consideration for playing a role in stabilizing municipal governments by offering or considering the development of
a credit facility to finance municipal securities, for example. And
if you could just—not just so much on that, but comment on whether or not you think somewhere in the charge to the Federal Reserve is an interest in municipal governments.
And I will just preface one more thing. When I asked Mr.
Bernanke, he said, well, the Fed historically has not become involved, nor the Federal Government involved in the issue of municipal insolvency. And I just pointed out that there are many things
about which we could say the Federal Reserve had not been involved or the Federal Government had not been involved until a
need arose to do so.
If I could start with Mr. Bivens, Mr. Gagnon, and then if others
would like to comment, I would appreciate it.
Mr. BIVENS. As to whether there is active interest at the Fed in
this, I don’t know. Whether or not they are—what I guess the Fed
would say on this is a couple of things.
I think they would say, one, if you look at distressed municipalities around the United States, the number-one thing that can help
them is a better national economy and a lower unemployment rate
across-the-board, and they would say they are working hard on
that, and I tend to largely agree with that. I think the Fed right
now is, indeed, trying to boost the overall economy, and is, indeed,
trying to boost employment growth, and presumably that should
have some good spillover effects even to specific municipalities.
I would say—and I think they are right on this, as well—that
they would say that the problem with a lot of municipalities, say,
the ones that are entering financial crises is that there is a real
fundamental mismatch between revenues and outlays in those cities. It is not necessarily a malfunctioning financial market. If it
was a malfunctioning financial market, the Fed might really have
a role in making sure it is well-greased. If you are talking about
a fundamental mismatch between revenues and outlays, I think
the argument would be, those are much better addressed by fiscal
transfers, and I know politically the prospects for that are pretty
low these days, but it is the most direct and genuinely helpful way
that could be done.
And then last thing I would also say that I think you have to
look at other aspects of economic policy, in terms of hitting really
distressed municipalities. And I would talk about international
trade policy. Detroit specifically has been hammered by the decline
in manufacturing employment, which to me, in the 2000s, was
overwhelmingly a problem of an overvalued dollar, and I think that
gets beyond the Fed’s mandate into exchange rate policy.
Mr. KILDEE. Mr. Gagnon?
Mr. GAGNON. Yes, I think—having worked inside the Fed, I think
the reluctance you probably heard from Chairman Bernanke reflects a desire to think of Fed policy as only things that affect the
entire country as equally as can be, and that if one gets into municipal lending, then one eventually, inevitably, gets into decisions

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about who is more creditworthy and how do you make that equal,
and that gets to be politically difficult for the Fed.
I think you could say, well, what about the emergency loans to
Wall Street firms? Didn’t that help New York? And I think the only
thing in response I could say is the Fed felt that a breakdown of
the financial system would have hurt everybody and they got collateral for those loans. And I don’t know what kind of assurance
the Fed could get in municipal loans that would be comparable to—
the Fed was made whole in those loans in the crisis from the collateral, which I don’t know how that would work.
Mr. WHITE. Yes, I would agree with Dr. Bivens. It is a fiscal policy issue. It is not appropriately charged to the Fed. They are—
some people think the Fed can just create loanable funds, but if the
Fed is directing credit one place, it is necessarily reducing the supply available elsewhere, and that is not the sort of call the Fed
should be making.
Chairman CAMPBELL. The gentleman’s time has expired. We will
now move from one part of Michigan to another part of Michigan,
as we will go to the vice chairman, Mr. Huizenga. You are recognized for 5 minutes.
Mr. HUIZENGA. Thank you, Mr. Chairman.
And, yes, it is true, I get the pretty sunset side of the State, not
that the east side isn’t a great spot. My mother is from Flint, as
well, but—it is a great place to be from, the gentleman just said,
so, but—no, we are—the pure Michigan ads are true. Come on up.
We would love to see everybody up there.
So I want to—before I turn into a total infomercial, I would like
to actually return to our policy question here. And, Dr. Gagnon, I
would like to—I have a quick question for you. On page seven,
there is sort of your discussion about the Fed and the rule and
quite a bit of discussion about the Taylor rule and the Svensson
rule.
And after one of the recent FOMC meetings, President Bullard
from the St. Louis Fed, whom I believe has been in front of our
committee, the full Financial Services Committee, argued that the
FOMC has not stuck to its intermediate target guidance. As Professor Svensson noted, forecast targeting is meaningless without
some sort of mechanism for commitment to an optimal rule.
Obviously, Chairman Bernanke feels a little differently. He has
argued that his guidance is ‘‘similar’’ to the Svensson approach.
But isn’t it really true that Chairman Bernanke isn’t following a
real meaningful forecast or targeting rule, like the one advocated
by even Professor Svensson?
Mr. GAGNON. Yes, I would say the thing about the Svensson rule
is that you should set your policy so that you should hit your target. And at a minimum, you should hit your target in your own
forecast, but that is obviously a low bar. The Fed isn’t even hitting
that. The Fed is—
Mr. HUIZENGA. Yes, which I think you point out on page eight.
So basically, they are not operating under a rule, as you—
Mr. GAGNON. Under that rule or—yes, that is right. And other
forecasters would agree.

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Mr. HUIZENGA. Okay. Mr. Bivens, you were nodding your head,
as well. Would you care to chime in on that? And I would love to
hear from everybody else.
Mr. BIVENS. Yes, from my perspective, I think they are missing
any conceivable unemployment target, in terms of unemployment
is too high for any reasonable target, and they are missing inflation
on the low side. Inflation is too low for their target.
And so that to me says, when you are missing on both sides like
that, it definitely says you should not be talking about tapering off
support to the economy, because that is just going to make them
miss worse on both sides.
Mr. HUIZENGA. I am not trying to argue whether we need more
easy money or less easy money. I am trying to get at, are they actually operating under a rule? Because it seems to me, not really.
Mr. BIVENS. I think that is fair to say, yes.
Mr. HUIZENGA. Okay, all right. Would anybody else care to chime
in on that quickly?
Mr. MELTZER. I agree with you, that is, they are not operating
under a rule—
Mr. HUIZENGA. Dr. Meltzer, if you wouldn’t mind just pulling
that microphone a little bit closer to you?
Mr. MELTZER. There were only two periods in Federal Reserve
history where they came close to operating under a rule. They happened to be the two best periods in Fed history: 1923 to 1928; and
1985 to 2003. In the first case, they operated under some form of
the gold standard; in the second, under the Taylor rule, more or
less, not slavishly, but more or less. And those were the two, the
only two periods in the Fed history that have low inflation, relatively stable growth, small recessions, and quick recoveries.
Mr. HUIZENGA. And so I am assuming, based on that answer, you
would advocate that it would be a good idea for the Fed to get a
rule? We can talk—
Mr. MELTZER. I believe—
Mr. HUIZENGA. —Svensson rule, Taylor rule, PhD rule, some sort
of rule, though, that is predictable and able to hit.
Mr. MELTZER. Any rule that the Congress can agree on and monitor. That is important.
Mr. HUIZENGA. A key element, it seems.
Mr. MELTZER. A key element is not only to bind them to doing
sensible, consistent things that everyone can understand, but also
to get you, the Congress, to say, look, you told us that we would
have this inflation and that unemployment and you haven’t done
it. That is a statement you can make which is very consistent with
your authority and responsibility for monitoring the way the monetary system works.
Mr. HUIZENGA. I am not sure most people would accept ‘‘sensible’’
and ‘‘Congress’’ all in the same sentence, but I appreciate those
sentiments. Anybody else, quickly here in the last 30 seconds? Mr.
Pollock?
Mr. POLLOCK. Congressman, I might just add that the 1977 rule,
which is usually called the dual mandate, which has been referred
to, is, in fact, a triple mandate. If you simply read the letter of the
law, it was stable prices, which we don’t have, maximum unemployment, and moderate long-term interest rates, that third man-

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date from Congress. I think it is impossible for the Fed to do all
three, but Congress did tell them to do all three.
Mr. HUIZENGA. Okay.
And, Mr. Goodfriend, very quickly?
Mr. GOODFRIEND. Very briefly, if you go back to May 22nd, when
Chairman Bernanke hinted, I think somewhere on Capitol Hill, at
a Joint Economic Committee meeting, that they would consider a
taper, you saw a tremendous surprise in markets, as if it came out
of nowhere. The 10-year yield jumped 1 percentage point within a
month. That is evidence that the Fed is not following a rule, because—by virtue of the fact that it was a discretionary rhetorical
action that Bernanke took that just was not understood by anybody.
Mr. HUIZENGA. So, basically, we need to smooth out the edges
and a rule can do that?
Mr. GOODFRIEND. A rule would tend to mitigate surprises and
basically give you outcomes for which people could plan.
Mr. HUIZENGA. All right. Thank you, Mr. Chairman.
Chairman CAMPBELL. Thank you.
And now we will get back to regular order, and we will recognize
the ranking member, but he gets an extra 2 minutes, because I
took an extra 2 minutes, so we will give him 7 minutes. The gentleman from Missouri, Mr. Clay, is now recognized for 7 minutes.
Mr. CLAY. Thank you, Mr. Chairman, especially for your generosity.
This is a panel-wide question. Currently, the U.S. unemployment
rate is 7.3 percent, the lowest level in 5 years. Currently, the unemployment rate for African-American citizens stands at 13 percent in August. This is an increase of unemployment rate from 12.6
percent in July. The difference in the U.S. unemployment rate and
the African-American unemployment rate is 5.7 percent.
Studies have shown communities with high unemployment rates
have a higher crime rate compared to communities with low unemployment rates. Do you believe high unemployment rates are at
least a national issue? And what course of action do you believe the
Federal Reserve Bank should take to lower the higher than average unemployment rate in African-American communities and in
other high unemployment rate communities throughout the United
States?
I will start with Dr. Bivens.
Mr. BIVENS. I absolutely think that the excessively high unemployment rate in the U.S. economy right now is our biggest economic challenge. I think from the point of view of the Federal Reserve, the main thing they can do to bring it down, both overall
and for groups that have disproportionately high unemployment
rates, is to continue what they are doing in terms of asset purchases to boost economic activity and jobs.
That is what they are trying to do with their monthly purchases.
They are trying to keep long-term rates low. They are trying to ensure that demand does not fall so low that we see that unemployment rate tick up even further. I would like to see them continue
it. I would actually even like to see them be a bit more aggressive
on that front. I think they are greatly hampered by the fact that

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fiscal policy has gone in absolutely the wrong direction and is dragging on growth.
So, in my view, of all the economic policymaking institutions
right now that seem most concerned with keeping that unemployment rate low, the Federal Reserve seems to be the one that is
most concerned with that.
Mr. CLAY. And you don’t think the banks should raise the interest rates?
Mr. BIVENS. No.
Mr. CLAY. Thank you.
Dr. Gagnon?
Mr. GAGNON. Yes, I would agree with Dr. Bivens. I think, to the
extent that the Fed can bring down the total unemployment rate,
I suspect the African-American rate will come down proportionately
more. And I think that is the right—that, to me, is also job number
one for economic policy in this country. And I agree that the Fed
does seem to be focused on it more than almost anyone else, but
I don’t think they are doing enough.
I think they are too concerned about the potential costs of quantitative easing tools, which to me are quite low. Those costs are
quite low and the benefits are quite high, so I don’t quite—I don’t
think they are getting the balance right, but at least they are worried about it.
Mr. CLAY. Dr. White?
Mr. WHITE. Yes, we have had a very slow recovery, and so unemployment has not dropped the way it normally does in a recovery.
We are many months behind where we would normally be, in
terms of unemployment coming down.
And it is not clear that looser monetary policy would help speed
the process. I think a large part of the problem is that investment
is sitting on the sidelines. There needs to be greater regime certainty, greater tax certainty, greater monetary policy certainty, so
that the investment climate becomes more favorable, and that will
be helpful to economic growth and, thereby, bring down unemployment.
Mr. CLAY. So you contend that some of the reason is market-driven?
Mr. WHITE. Yes.
Mr. CLAY. Okay. Mr. Pollock?
Mr. POLLOCK. Thank you, Congressman. I think the best thing
any central bank can do for employment is a medium- to long-term
stability in monetary behavior and stability in prices. I think managing short-term economic consequences, such as the ones you have
mentioned, is beyond the competence of a central bank.
Mr. CLAY. And so what effect would raising the interest rates
have on it? Do you think it would have any effect?
Mr. POLLOCK. We have extraordinarily low interest rates, of
course, negative real interest rates, extremely low long rates. That
is due to the current manipulation of the markets by the Fed. At
some point, those rates have to return to normal. That would be
healthy, again, in a medium- to long-term basis.
What gets the Fed or any central bank in trouble, in my opinion,
is trying to react all the time to short-term conditions, which it
can’t know enough about or influence enough to do successfully.

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Mr. CLAY. Thank you for that response.
And Dr. Goodfriend?
Mr. GOODFRIEND. What I would add to these comments is that
the Federal Reserve doesn’t really control the interest rates that
matter, which are the long-term interest rates. I get back to the
comment I said before. What is happening is, markets are looking
forward 10 years to figure out what is likely to happen. So it is
kind of, I think, a little bit of an illusion to think that the Fed is
having a big effect on long rates.
It was able to appear that the Fed had an effect on long rates
when the recession started. Now that we are moving toward the
exit, when we look out 2 or 3 years, the market is already projecting what is likely to happen. So I think this is largely superfluous, unless you want to argue that the Fed should continue to
keep short rates so low as to create some sort of inflation problem
in which long rates would go up even more.
In other words, the Fed does not, I believe, have a lot of leeway
to have much effect either way, except being excessively inflationary. What it is doing now is basically treading water.
Mr. CLAY. And, Dr. Goodfriend, why has the economy had such
a difficult time in growing jobs?
Mr. GOODFRIEND. Job growth is based in part on two things: people need to spend; and then people need to invest. And it is clear
that the spending—people’s willingness to spend in the future,
among those people who have the money to spend, is they are not
willing to really gear it up. Why? Because the people who have the
money to spend are worried about higher future taxes, and they
are basically keeping their powder dry.
So one thing we need to do on the spending side is put—I believe
simplify the tax code so that people who have the money are not
going to be penalized for having more money in the future. And
then they might begin to spend some of it. And on the other side,
they might be willing to invest to increase jobs, and you get both
job growth and spending going in tandem, and then you have a
good recovery.
What is impeding that is that there is an open-ended question
about how high taxes might stay or even go higher in the future.
Mr. CLAY. Thank you. And my time is up.
Chairman CAMPBELL. Thank you, Mr. Clay.
We will move now to the gentleman from South Carolina, Mr.
Mulvaney. You are recognized for 5 minutes.
Mr. MULVANEY. Thank you, Mr. Chairman.
And thank you, gentlemen. I am going to go down a line of questions that I didn’t anticipate doing before the gentleman from
Michigan, Mr. Kildee, asked his questions, because I think he was
asking the questions around the fringes of an issue that I want to
explore.
His questions pertain to the advisability, perhaps, of the Federal
Reserve getting involved in helping some of America’s financially
struggling cities. It is something I know that is certainly near and
dear to his heart, and perhaps rightly so, but let me ask it a different way. Does the Federal Reserve have the authority to do
that? Do they have the authority to bail out cities, to bail out
States? Dr. Gagnon is saying yes. Why is that?

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Mr. GAGNON. I am not recommending it. I am just saying the
powers—
Mr. MULVANEY. I am not interested in recommendations. I am
interested in whether or not the Fed actually has the legal authority to do that and, if so, what would it look like?
Mr. GAGNON. The Fed has the legal authority to buy municipal
debt up to 6 months’ maturity.
Mr. MULVANEY. And that would be directly or that would be on
the secondary market?
Mr. GAGNON. Oh, in secondary markets, but that would presumably help conditions in the primary market.
Mr. MULVANEY. All right. Now, when I asked that question of Dr.
Bernanke at a previous hearing, he said that he didn’t have the authority to bail out cities, and then he mentioned the exact same
thing, that he could only buy 6-month debt. So help me reconcile
those two statements, gentlemen. Don’t everybody jump up at once.
Dr. Meltzer?
Mr. MELTZER. Yes, it has to be debt which is not in default,
which is highly rated. It is just the opposite. He can buy short-term
debt from cities as part of his open-market operations, but he can’t
finance cities which are on the verge of bankruptcy.
Mr. MULVANEY. Because it wouldn’t meet the credit requirements?
Mr. MELTZER. Because he would be taking a market risk that
was not intended to be taken by the Federal Reserve. He has to—
as some of the witnesses here have said, he was very careful about
seeing that what he did when he was lending was always
collateralized safely, protecting the taxpayers from losses. If he
starts buying up bad debt or debt which is about to go bad, he is
not doing that.
Mr. MULVANEY. And I am not a conspiracy theorist—or at least
I am trying hard not to be after 3 years here—but if I imagine a
circumstance in which the Federal Government has issued a guarantee of that municipal debt, that would get around your restrictions, wouldn’t it, Dr. Meltzer?
Mr. MELTZER. Yes, but that would not be a Federal Reserve action. That would be something which you in the Congress have to
do.
Mr. MULVANEY. True, but then he would be able to buy that debt
and issue that credit.
Mr. MELTZER. Yes. But, of course, once you gave it a guarantee,
he wouldn’t need to do that.
Mr. MULVANEY. Okay. Dr. Bivens, you looked like you were
agreeing or—you had some thoughts on that?
Mr. BIVENS. I actually disagree with that last statement. If there
was a guarantee, he could buy it, but he wouldn’t have to.
Mr. MULVANEY. Okay. Are there any other methods other than
buying municipal debt that the Federal Reserve has the authority
to bail out—for lack of a better term; and I don’t mean that term
to be used in a narrow sense, but a broad sense—a city or a State?
Is municipal debt the only tool available to it? Dr. White?
Mr. WHITE. It is certainly not part of the Federal Reserve’s mandate in terms of monetary policy. It doesn’t fall under their bank—

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Mr. MULVANEY. You just heard Mr. Kildee make the argument
that will be made at some point in the future—perhaps not with
Detroit, but with the State of Illinois or the State of California,
which is that if California tanks, it will drive up unemployment nationwide and, therefore, it will call on the Federal Reserve or some
will call on the Federal Reserve to get involved under that part of
its dual mandate.
Mr. WHITE. The Fed can certainly offset any effects that California has on the banking system and on the money supply without
bailing out California.
Mr. MULVANEY. Okay. Dr. Goodfriend?
Mr. GOODFRIEND. I want to make a point by analogy to the mortgage-backed security purchases by the Fed.
Mr. MULVANEY. Okay.
Mr. GOODFRIEND. These mortgage-backed securities have a guarantee of sorts, and the Fed is buying them. You might think that
the Fed doesn’t need to buy them, so you can imagine, why doesn’t
the Fed swap out the mortgage-backed securities to somewhere else
in the government and take on Treasuries on its balance sheet?
The Fed won’t do that, and the government won’t agree to that, because mortgage-backed securities, while they have a guarantee,
they don’t have as much of a guarantee, what we like to call full
faith and credit, that U.S. Treasuries have. And therefore, there is
a spread on these.
So there would still be pressure, perhaps—I don’t know whether—we just don’t know—for the Fed to finance these—whatever
you want to call them, the municipals, even if the municipals got
a credit enhancement from the government, just because they
might trade at a higher rate than Treasuries.
And so, there might be pressure on the Fed to finance these
things, rather than have the private sector finance at a higher rate
or to have the U.S. Treasury borrow on behalf of municipals to
fund them.
In other words, the guarantee to municipals is not going to be
as good as the full faith and credit of Treasuries. And therefore,
there will be pressure for the Fed to buy these at a lower rate or—
Mr. MULVANEY. Thank you, gentlemen. It is an interesting topic
that I think bears additional consideration, but I am out of time.
Thank you, Mr. Chairman.
Chairman CAMPBELL. Yes, I think all of the questions and answers have been interesting, and I am sure that will continue with
the gentleman from Illinois, Mr. Foster, who is now recognized for
5 minutes.
Mr. FOSTER. At the risk of drifting a little bit further off-topic,
I think almost everyone present in the room or who has been
present in the room comes from States that are huge losers in the
redistribution of wealth that is happening due to the Federal Government. I know that about $20 billion a year flows out of Illinois,
I think about $5 billion a year out of Michigan, and I think some
number north of $10 billion a year flows out simply because of the
imbalance between Federal taxes and money spent by the Federal
Government, which is more than enough to bail out Detroit and
others. And so, I think that is something which has to creep into
our thinking, if not the Fed’s directly.

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And actually, in the opposite direction, it strikes me in a lot of
the political debate that we are having over things like monetary
policy that we don’t—we have this single compartment model in
our minds of the economy that is insufficiently globalized. When
you talk about trying to pressurize the whole system with money
to support asset values in the United States, what Mr. Bernanke
will pressurize the U.S. economy and then see it pop out as an
asset bubble in foreign countries.
And that this really changes the calculus. It means that any of
these simple rule-based things don’t have a chance of working unless the rule is so complex that it includes all the major economies
in some manner. I spent a little while to see if these sort of
macro—international macro models even exist and they are woefully simplified, by necessity. But I think this is a major problem
in, really, the thinking of both parties, because it generates
unsolvable problems.
And I was wondering generally if you have any comments, anyone, on the Fed’s role or the central bank’s role in fighting asset
bubbles, which—if I step back from the financial crisis, by several
years now, if I had my choice of getting rid of the banking crisis
or the housing bubble, it is not even close. I would prefer to get
rid of the housing bubble. The damage that has done to the net
worth of the middle class is incomparably larger than the banking
crisis, which, by and large, we fixed within a couple of years.
And so I was wondering if you have any words of wisdom on how
the Fed should balance its duties of keeping the banking system
solvent and keeping the—and stabilizing, particularly housing bubbles, which I think are the big dog and the pain that we are still
living through.
Mr. MELTZER. Think of how the problem arises of a bubble. Take
the housing market. Returns to investment in housing are 20 percent, 30 percent at the instant. You raise the interest rate by 1 percentage point, 2 percentage points, 3 percentage points, that is
enough to kill the rest of the economy, perhaps. It is not going to
have a big effect on the 30 percent. That is the basic problem. That
was the problem in 1929. It was the problem in 1968. And—
Mr. FOSTER. Right. And so in other countries, then, they have
independently controlled, for example, the downpayment on housing from the interest rates. And one of the fundamental problems
with—you had mentioned like triple mandates. And it is a fundamental theorem of control theory—I am a physicist, so forgive me—
is that you cannot control three variables with one actuator, all
right?
And so that if—is the problem that the Fed actually has to consciously manipulate both the leverage allowable in the housing
market and other asset markets with the interest rates? And—
Mr. MELTZER. The housing bubble occurred at least in largest
part because of the desire, the understandable desire on the part
of the Congress and the Administration to spread housing ownership down the income distribution. So it gave the opportunity for
Fannie Mae and Freddie Mac to make loans, no-downpayment
loans, in which the owner didn’t own anything except an option to
perhaps benefit if the housing prices continued to rise at 20 percent
or 30 percent a year, which is not a likely event.

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Now, people like Angelo Mozilo saw an opportunity to package
these loans and sell them to Fannie Mae and Freddie Mac, and he
walked away—
Mr. FOSTER. No, I understand that narrative. Let’s say, if I
could—yes, Alex, do you have a—
Mr. POLLOCK. Yes, I agree, the international dimensions are central and make the problems much harder. Yes, with multiple mandates—in my testimony, I suggest the Fed has six—and you can’t
possibly do them all. Yes, the housing bubble was much worse than
other financial bubbles. Yes, we should attack it through controlling leverage, which in housing is also equally controlling down
payments or loan-to-value ratios. And likewise, in other markets,
it is how much margin you allow that sector to run on. That is a
key control variable which I think should be used.
Mr. FOSTER. Any other comments on—
Chairman CAMPBELL. One more quick comment, and then we
will—
Mr. GAGNON. Yes, just ask yourself why the equity bubble crash
in 2000 had much—it was billions of dollars—smaller effects than
the housing bubble crashing in 2008. And I think the difference is
leverage. You want to reduce leverage.
Chairman CAMPBELL. Okay. I’m sorry, Mr. Goodfriend. I will
just—and perhaps if Mr. Pittenger would like to hear that answer—the gentleman from North Carolina is recognized for 5 minutes.
Mr. PITTENGER. You are welcome to respond for 30 seconds, if
you can.
Mr. GOODFRIEND. Just 30 seconds. I think leverage matters
mainly because of access to money market short-term financing of
illiquid housing mortgage products. That was an important component to remember about this. It is always advantageous to finance
in the money market where interest rates are low, because people
expect to get liquidity out of it. The problem was, there was too
much liquid money market finance of this stuff via leverage that
caused the system to be fragile. That is my own addition.
Mr. PITTENGER. Thank you, Mr. Chairman. I will proceed.
Chairman CAMPBELL. Yes. Yes, please, go ahead.
Mr. PITTENGER. Dr. Meltzer, you have argued that the Fed is at
its best when it follows clear monetary policy rules. Do you believe
that this applies even in emergency situations?
Mr. MELTZER. No. In an emergency situation—no rule is going to
work under—in a world of uncertainty, under all conditions. It is
just not in our ability to write such a rule. So, no, there have to
be—the way in which I would run that rule is to say they should
come to you and say, we have to deviate, and this is why we are
deviating, and then it is the public interest served by your saying
okay.
Mr. PITTENGER. So there is some accountability. Mr. Pollock, in
your view, has the Federal Reserve adequately planned and modeled for interest rate risk?
Mr. POLLOCK. In my view, the Federal Reserve has, in current
times, through its huge bond market manipulation, created a massive amount of interest rate risk, and we will see how it all works

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out. Nobody knows enough to know how it will, but it will certainly
be coming home to roost as we go forward.
Mr. PITTENGER. Sure. As a follow up, I would like to ask—earlier
this year, you described the Fed as meeting its own criteria for
classifying an institution as too-big-to-fail. What monetary policy
decisions in your view have led to the Fed becoming too-big-to-fail?
Mr. POLLOCK. That was an article I was having a lot of fun with,
Congressman, but I think it is true, that if you apply their criteria,
they are exactly a too-big-to-fail bank themselves. And, of course,
what has caused that is the massive bond investments which they
have undertaken. The Fed at the moment owns about $2 trillion
of long Treasury bonds—not Treasury bills, but Treasury bonds of
long duration, and $1.3 trillion of long-term mortgages. This is a
risk position which, if any of their bank charges had it, they would
be all over them, firing the management and making them unwind
it.
Mr. PITTENGER. Sure, thank you.
Professor Meltzer, you have described a number of mistakes that
seem to be repeated by the Fed over the course of its history, from
the inability to consider the effect of policy over the intermediate
or long term to its lack of independence from its fiscal policy decisions by the Treasury. Why do you think these mistakes are continually repeated? And what can we do to help ensure that they are
not repeated over the next 100 years of the Fed?
Mr. MELTZER. Thank you. I think that is the critical question,
that is, the successful policies were periods where policies—Mr.
Volcker is a wonderful example. When he took on the inflation
problem, he knew he wasn’t going to solve that in a month or 6
months. He knew it was going to take a while. It took a couple of
years, right?
But he had a consistent policy of trying to lower the inflation
rate. He deviated at times because events required him to, but he
always went back to doing that. That is what the Fed does not do.
Take the current example. It has over $2 trillion of excess reserves. It is not going to get rid of those in a a week or a month.
It is going to get rid of them over several years, if then. So it needs
to have a long-term strategy. Does it have a long-term strategy?
No. It says it depends upon the next unemployment rate and
whether it is this or that. What earthly reason could there be for
thinking that the next unemployment rate is going to have very
much to do with whether they successfully manage to bring down
$2 trillion? They need a long-term strategy. They don’t have it.
Mr. PITTENGER. Yes, sir, Mr. Pollock?
Mr. POLLOCK. Thank you, Congressman. May I just comment
that the well-deserved plaudits Mr. Volcker gets for bringing down
inflation was bringing down an inflation created by the Federal Reserve itself.
Mr. PITTENGER. Yes, sir, Mr. Gagnon?
Mr. GAGNON. Just one point. I don’t think the Fed needs to bring
down the reserves. It will pay interest on them, and that will make
people happy to hold them. I think that is its plan.
Mr. MELTZER. Maybe.
Mr. PITTENGER. Thank you very much. I yield back my time.

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Chairman CAMPBELL. Thank you. Gee, and I thought it was—
was it Carter or Ford who had those little buttons, ‘‘Whip Inflation
Now?’’ It was Ford. That is what I thought, yes. So I thought that
is what did it. Yes, WIN, whip inflation now, oh, boy. Okay.
The gentleman from New Mexico, Mr. Pearce, is recognized for
5 minutes.
Mr. PEARCE. Thank you, Mr. Chairman. I appreciate the presentation that you each made.
I was looking at an article from Forbes earlier this year and talking about looking at the stock market, it is just booming. The housing market is bouncing back. CPI, it is not even moving the needle.
Gold, we have crushed it. Everything is great. Move forward, Mr.
Gagnon—that would be you—move forward, print more money,
more QE.
But then they go on and say, but Spain, hopelessly bankrupt, can
borrow money at 5 percent, 60 percent of the home purchases in
the major markets are being made by cash, by hedge funds, and
inside groups. The Dow and S&P are hitting highest—record highs,
while 47 million people are on food stamps. Official unemployment
rate is going down, while the number of people not working is
going up, CPI less than 2 percent.
This is what I find in my district. We are 47th in per capita income. Mr. Gagnon, do you have a rebuttal to this idea that it is
just an insider’s game, that is the conclusion here, that what we
have done is we have made this economy so complex that only the
insiders are going to do okay, and everybody else is going to suffer
and suffer pretty badly? You are one who is saying, print more
money. Would you like to address the positions in this article?
Mr. GAGNON. I haven’t read the article. I am worried about inequality of income. It seems to me, though, that what the Federal
Reserve is doing benefits probably the lower end of the income distribution more than anything, because buying the MBS has helped
keep mortgage rates low, which rich people usually don’t need to
borrow as much as poor people do to get a mortgage—
Mr. PEARCE. If I could address that piece—
Mr. GAGNON. —to get a house—
Mr. PEARCE. —that it is somehow helping the people on the low
end of the spectrum, let me tell you what I hear at my town halls.
I hear people say, ‘‘We lived our life correctly. We put money into
savings accounts. We have 401(k)s. We paid for our house. Now,
the house is worth half what we paid for it. We get zero, 0.25 percent, interest on our money.’’
Seniors are more likely to use cash and cash equivalents than
any other segment of society. What the printing of money is doing
is driving everyone to these speculative, higher rates of return that
threaten our seniors more than ever. And so, I don’t find that the
seniors are sitting here applauding the strategies.
You also make the comment in your paper that—in your statement that Bear Stearns—or that Lehman didn’t have enough resources to bail them out. When I look at a list, I see that Bear
Stearns had 34 to 1 asset to equity ratio, Morgan Stanley 33 to 1,
Merrill Lynch 32 to 1, Lehman 31 to 1. It was the best of those
four. Why do you say that they didn’t have enough assets and the
others did? Bear Stearns did.

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Mr. GAGNON. Actually, I am about to release a paper that looks
at the balance sheets of all those institutions you named. And what
is really striking is that even though it had a little bit less leverage, as you say, the value of the assets were vastly inflated for
Lehman. Lehman was just overstating the value of its assets to a
degree that was much higher than the other institutions. And so—
Mr. PEARCE. Okay.
Mr. GAGNON. —in hindsight, it has lost a lot more.
Mr. PEARCE. So you think there is a relationship between debt
and asset value? What do you think about the United States’ offbalance-sheet accounting?
Mr. GAGNON. The United States—
Mr. PEARCE. In other words, we have about $202 trillion that we
don’t consider as debt. That is Medicare, Medicaid, and Social Security. So you declare that Lehman had off-balance-sheet assets
that were stated incorrectly. Do you have a position on the U.S.
Government’s off-balance-sheet nonassets, loans that are stated incorrectly?
Mr. GAGNON. One thing I would say is that a lot of these obligations are not legal liabilities like bonds. They can be changed legally over time, and we can find ways to save money on health
care, for example, and so that can affect them in a way that you
can’t do to a bondholder.
Mr. PEARCE. Yes, so you are saying that they are not really—that
we really don’t owe that money. I would challenge you to come out
to one of my town halls and sit and listen to seniors who, by God,
will tell you that you are going to pay their Social Security. They
are going to be there with pitchforks. I will tell you, this—the
anger in the American people is neck-deep.
The anger at the insider game that is going on here and the way
that this economy is being manipulated, it is not understood by the
unsophisticated. They just know they have been had. And the
printing of money is one of the biggest ways they have been had,
and this Federal Reserve is the key to that. I yield back.
Chairman CAMPBELL. Thank you. We are going to go one more
round. I know Dr. Meltzer has to leave at 4:00, so—but we will
make one more quick round. There are 4 Members here, so we
need 20 minutes, and then we will be all set.
So I will yield myself another 5 minutes, and this time I will
start with Dr. Meltzer, because you have to leave soon, I know.
And my question this time is, in the 100 years of the Fed, what
is the best action they have taken, the best thing they have done?
And what is the worst action they have taken, the worst thing that
has been done?
Mr. MELTZER. As a policy, the best action they have taken was
ending the inflation and more or less following the Taylor rule, because that gave us the longest period of any period in Fed history
with low inflation, stable growth, and small recessions, just what
we wanted.
And since—if I looked at the current period, I would say, after
providing $2 trillion or more of QE reserves, I would look around
and say, why are we getting so little effect? And the answer is,
maybe we have the wrong strategy. Maybe, as Mr. Gagnon sort of

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suggested at one point, it is not a monetary problem. Those are not
his words; those are my words. It is not a monetary problem.
But as he said, it is a tax problem. You tell people who are investors, if you invest more, I am going to want to tax you more. There
is nothing in economics which says that is the correct strategy. In
fact, there is everything in economics which says that is a silly
strategy. You may want to tax more at some point, but you certainly don’t want to get out of a recession by taxing people more.
And regulating them? Regulating them to death. When you go
around and talk to businessmen, they talk about the costs of regulation, so they don’t invest in labor. And we have—we all know
that—of the employment benefits that we see going up, most of
them are part-time jobs. Part-time jobs. Why? Well, we know why.
It is because of the silly parts—
Chairman CAMPBELL. Okay.
Mr. MELTZER. —of the Obamacare law.
Chairman CAMPBELL. Okay. Thanks, Dr. Meltzer.
Dr. Goodfriend?
Mr. GOODFRIEND. For the best, I would say Paul Volcker’s moment. When the Fed restrained inflation, that was very tough to
do. It was a huge success.
For the worst, I want to set aside the Great Depression, because
that is obviously the worst mistake, but there is another mistake
that I want to emphasize. In the early stages of the Great Inflation,
there was a mistake that the Fed made analytically that it thought
the Phillips curve, the tradeoff between inflation and unemployment, was stable. So the Fed thought it could create a reduction
in unemployment by creating higher inflation.
That collapsed, because the so-called correlation—Phillips curve
correlation proved to collapse as soon as the Fed tried to exploit it.
That is a very famous analytical mistake which everybody teaches—
Chairman CAMPBELL. I remember. I was at UCLA in economics
then. I remember that stuff.
Mr. GOODFRIEND. Yes, but there is another mistake, which is
really the same mistake. Now, I was at the Federal Open Market
Committee as a back-bencher until 2005. And I remember, in the
run-up to the housing—the credit turmoil, people at the Fed would
say, there has never been a nationwide house price collapse. In
other words, it looked like, if you diversified your mortgages across
the United States, you were safe.
But that correlation—or the lack of that correlation collapsed
when the markets tried to exploit it. House prices became highly
correlated in the end, and they all collapsed together. But that is
an analytical mistake which is equivalent to the Phillips curve mistake, in the sense that you look back at history and you see, in this
case, a lack of correlation that is a safe bet that we won’t have a
housing crisis.
It was exactly the same analytical mistake in a slightly different
context made by our policymakers, only this time it was in the
credit markets and it caused a boom and bust in housing.
Chairman CAMPBELL. Okay. Mr. Pollock?
Mr. POLLOCK. Mr. Chairman, I would say the best thing the Fed
has done is actually create a working elastic currency, which was

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the principal assignment they got in the Federal Reserve Act of
1913, and that has been done and fully achieved.
The worst thing they did, I think, was the Great Inflation of the
1970s, which set up the amazing and horrible financial catastrophes of the 1980s.
If I may nominate a second worst thing, it was making the market believe in the Greenspan put in the 1990s and the early 2000s.
Chairman CAMPBELL. Dr. White?
Mr. WHITE. Rather than look for—I agree with what has been
said about high points and low points, of course. But if we look at
the 100 years of the Fed and sort of come back to the theme of this
hearing, if you compare the Federal Reserve track record on inflation and on inflation unpredictability, price level unpredictability,
and on stability in the real economy, it hasn’t done better than the
far-from-perfect system that preceded it.
Inflation has been much higher. The predictability of the price
level has been much lower under the Fed, which is why you don’t
have 50-year railroad bonds anymore—besides not having railroads. You don’t have 50-year corporate bonds anymore. And in
terms of business cycles, the Fed has not succeeded in ironing out
business cycles, with some rare exceptional periods that have been
mentioned. So—
Chairman CAMPBELL. Okay, if I can catch—I am going to be
strict with time because we have to give up this room.
Mr. Foster, if you want to continue on that line of questioning,
you may, or whatever you like. You are recognized for 5 minutes.
Mr. FOSTER. Yes, sure. Does anybody want to finish up on my
last question? Then I will go on to—just, first, to make a comment
actually on what has been happening in our economy. When people
ask me to report in a simple way, I go to household net worth. And
in the last 18 months prior to March of 2009, households and families in America lost $16 trillion. Then, we passed the stimulus and
a number of very aggressive interventions into our economy. And
since then, households in America have regained more than $18
trillion. So we have more than made up. And so the—this government intervention in an emergency is one of the crucial—it would
be nice if we didn’t have emergencies, but there are times when it
is necessary.
And one of the things I would like to—back to the unemployment
thing is, there used to be this thing that was called the Okun rule,
which you are probably all familiar with, that says when the economy gets better, that unemployment goes down, a correlation between the rate of GDP growth, I think, and the drop in unemployment.
And so what we have seen during this time, the $18 trillion rebound of household net worth, we have also seen a V-shaped rebound in business profitability, in GDP, and just everything you
can name, but the unemployment has been much slower. This is
called by some, that Okun’s rule broke.
And I was wondering if you have any comments on this. Is this
really just a structure change, the triumph of capital over labor,
the fact that machine thought is now up to the point where you can
actually replace a lot of human brains with automation? Or is it—
is there something else going on here?

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Mr. BIVENS. My view is that Okun’s rule is actually holding up
pretty well over this recovery. What we really have is a very slow
growth recovery. We don’t have a particularly slow employment
growth contingent on GDP growth.
If you look at productivity, which should be the wedge between
how fast GDP is growing and how fast employment is growing, it
has actually been slower in this recovery than previous ones. We
still are just far too below potential. We still have far too deficient
demand in the economy. And so to the degree to which employment
growth is disappointing, it is because GDP growth is disappointing.
We did a lot of good things in the wake of the first housing bubble burst, but I think we withdrew lots of them too soon. The Fed
is one thing that was not withdrawn too soon, but all the talk of
the taper makes me worried that the one engine that is still pushing the economy forward may soon be sputtering, as well.
Mr. GAGNON. There is a secular decline in sort of how much of
GDP goes to workers versus capital, which I don’t fully understand
myself, but it is—
Mr. FOSTER. It was first observed by Senator Paul Douglas,
whom my mother worked for in the 1950s, the famous economist
from the University of Chicago. Anyway, just a side point. But do
you have any deep thoughts on this or—and it is outside the realm
of anything the Fed can do? This is just a secular shift and—
Mr. GAGNON. I don’t see—I worry about this, but I don’t make
it my special area of study, because I don’t see what the Fed can
do. I think it is a huge issue, and I think a Member over there
raised it, too. And I wish I knew what the Fed could do about it.
It seems more of a micro, regulatory, education, structural issue,
not a macro, monetary issue.
Mr. POLLOCK. Congressman, Goodhart’s paradox in economics
and monetary policy is that whenever you find a statistical relationship that looks reliable and you then try to make it into a tool
to manage the economy, it breaks down.
Mr. GOODFRIEND. On the point about the rising so-called labor
share of national—on falling labor share of national income, that
has to be related to the globalization of labor markets in a way
that is hurting—it actually has a bifurcating effect on countries
around the world. Those people positioned to benefit from
globalization and what they do are getting benefits, but most people are having their real income constrained by competition from
other parts of the world.
And this is happening in countries all around the world. It is a
global phenomenon. There is very little an independent central
bank can do in a country about it.
But on a note of optimism, I would say, it is going to take years
for this to end, but it is already beginning to end in China. In other
words, China’s benefits over the last 20 years have been because
they have been able to sell goods by exploiting their own labor.
They are coming to the end of the line with that policy, as workers
from the interior moving to the cities are becoming more scarce,
and so wages have had to be paid up. And so wages—
Mr. FOSTER. Yes, but there is also the flattening of corporate
structures. Middle management can be smaller with good software.
A lot of it is internal. It is not all foreign wage pressure.

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Mr. GOODFRIEND. That is true, but my feeling is that—
Mr. FOSTER. That is the domino effect?
Mr. GOODFRIEND. —this is being driven by global trade, which is
going to come to an end, if we can be optimistic about that.
Chairman CAMPBELL. Okay, the gentleman’s time has expired.
I now recognize the gentleman from Michigan, Mr. Huizenga, for
5 minutes.
Mr. HUIZENGA. Thank you, Mr. Chairman. I appreciate that. And
I wish that Dr. Meltzer was still here. He was giving us that classic
economist two-sided answer about whether the Fed was more constrained or less constrained or less independent.
And it seemed to me, as he was going through that, it struck me,
as he was talking about the expansiveness that the Fed has taken
on, that it hasn’t just been on their own volition, that there has
been some direction, and certainly they have been allowed and
have not had much push-back, maybe, on this committee, led by
our Chairman Hensarling and a few others, but I want to talk a
little more specifically about QE and quantitative easing and reading Dr. Gagnon’s piece that he had submitted to us in arguing that
it should have been more aggressive and earlier.
I want to delve into that a little bit more and maybe get somebody else’s—Dr. Goodfriend or Dr. White, somebody else, because
it seems to me that what we have done is we have artificially lowered interest rates. It seems to me that—I know that the chairman
takes a bit of umbrage at that description, but I don’t know how
you describe it any other way.
The reverse of that is, my kid set up a lemonade stand at the
end of the driveway, and they are curious why Mom is the only one
who bought the $2 glass of lemonade. It is because everybody else
is waiting for the 50 cent cup of lemonade.
And we have done the exact opposite. We have gone in and said,
hey, who wants to buy? Not many hands have gone up, except for
Treasury. Or the Fed. And so suddenly we are finding ourselves in
this era that we are trying to call it as a free-market decision, but
it really isn’t. Isn’t that the case? Dr. Goodfriend or Dr. White?
Mr. GOODFRIEND. I will start briefly. I think you are referring to
the mortgage-backed securities that the Fed is financing. Essentially, the Fed is financing 75 percent to 80 percent of new mortgages in the United States. And in doing so, it impairs the free
market’s ability to do that, because by virtue of the fact what the
Fed is trying to do, it’s cutting the spread, the mortgage-backed
spread relative to Treasuries so low that it is not profitable for private markets to go in and resume funding of mortgages. It is a
problem.
And my view is, the Fed should set a strategy by which it intends to exit that market so that people can—so that businesses
can plan to resume their financing of mortgages in America, and
the Fed has not done that. This is an example of what Allan
Meltzer was saying and what I said earlier.
The Fed needs to give guidance to markets about its strategy so
markets can then plan for their re-entry into this mortgage market.
Not giving guidance is just making it impossible for markets—private people to resume and plan for re-entry into the mortgage market in America. It should have started already, and I hope it starts

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as soon as possible. The Fed needs to provide a plan for its own
exit from the mortgage market.
Mr. HUIZENGA. Mr. Pollock, do you care to try to—we will see
how far down I will go.
Mr. POLLOCK. Congressman, I will comment on the very low interest rate strategy, if I may. As was pointed out before, short-term
rates are extremely low. In fact, in real terms they are negative.
For a long time, rates on 10-year Treasuries were negative in real
terms, in inflation-adjusted terms. This has crushed savers, as the
Congressman pointed out. I think one way to think about this—
Mr. HUIZENGA. Can I add a little something in there?
Mr. POLLOCK. Yes.
Mr. HUIZENGA. Has that benefit, I think, as Dr. Gagnon was arguing, about the lower-income homeowner purchaser, does that
outweigh what my friend from New Mexico is hearing in his town
hall meetings and what I am hearing from my own elderly parents
and from other constituents?
Mr. POLLOCK. In my opinion, no, because the other set of regulatory overreactions has cut out a lot of those borrowers. But it is
a trade-off. Of course, the point has been to favor borrowers at the
expense of savers. That is a political decision made by the Fed.
Once you have a bubble, if I can just finish this thought, there
is no easy, pleasant outcome. There are only bad outcomes and
painful outcomes. The losses have occurred, the losses have to be
taken by someone. The Fed’s strategy has put a large amount of
those losses on savers, just as a matter of fact.
Mr. HUIZENGA. Dr. White?
Mr. WHITE. Yes, I share your concern about artificially low interest rates. One of the big contributors to the housing bubble was the
Fed holding interest rates too low for too long, from 2002 to 2005,
and we don’t want to repeat that episode. So as the recovery proceeds, the Fed should be ready to let interest rates rise.
Chairman CAMPBELL. Okay. The gentleman’s time has expired,
so thank you.
Next, we will move to the gentleman from South Carolina, Mr.
Mulvaney.
Mr. MULVANEY. Thank you, Mr. Chairman.
Chairman CAMPBELL. You are recognized for 5 minutes.
Mr. MULVANEY. Thank you, Mr. Chairman. Of course, the purpose of the hearing today on the 100th anniversary of the Fed is
to sort of look back over the last 100 years and maybe look forward
to the next 100 years. And it strikes me that one of the things that
may be very, very different, at least for the next several years, was
referred to by Mr. Pollock in one of his earlier answers about interest rate risk and what—the interest rate risk the Fed has currently
exposed itself to over the—as a result of the immense growth in its
balance sheet.
I want to talk a little bit about the combined earnings of the Fed
and about how the Fed funds itself. My understanding is that the
Fed earns money in a couple of different ways. They provide a couple of services, but they also earn interest on their balance sheet.
I would consider those in my old line of work to be sources of cash
or earnings. They also have expenses. They have to pay for them-

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selves, and they also have to pay interest on the reserves that various financial institutions hold at the Federal Reserve.
It strikes me—and I could be wrong about this—that ordinarily,
that that was a positive number over the course of the last 100
years. Again, I wish Dr. Meltzer was here, because he knows more
about it off the top of his head than I think everybody else put together, but my understanding is that generally speaking, that
number has been positive, and the Fed has made enough money off
of its combined earnings to fund itself.
I think it is very easy to anticipate a circumstance in the near
future where that number will turn negative, that as you start
unwinding, if you start tapering, not only will there be a tremendous balance sheet loss, in terms of the value of the assets on the
balance sheet—but, of course, that is not earnings—but also in the
amount of money that the Federal Reserve has to pay out on the
reserves on which it pays interest that the financial institutions
are holding with it.
So I ask you the question, gentlemen, that if we go into this—
in this hypothetical situation, I suppose, where the Federal Reserve
is not—does not enough combined earnings to fund itself, where
will its money come from?
We will start with Dr. Goodfriend and then go Mr. Pollock, and
to anybody else who wants to respond.
Mr. GOODFRIEND. Okay, you are absolutely right. There is a situation in our future where it is doubtful the Fed will be able to
withdraw reserves and shrink its balance sheet back before it has
to pay interest on reserves to get overall interest rates in the economy higher to act against inflation.
And so what will happen is—the possibility of what we call a
negative cash flow problem may very well occur, and the Fed
should prepare for it, talk about it to you all, because it is going
to be a fiscal policy drain. It becomes a matter of the Congress
about how the Fed plans for this. So the Congress needs to ask the
Fed, how do you plan for this?
Mr. MULVANEY. I asked that question, and he said he was going
to create—is it a deferred asset? I forget the name of the term. He
would create that, and I didn’t really understand what that meant,
because it is a term I think that in accounting only makes sense
at the Fed.
Mr. GOODFRIEND. If I may, let me describe something which is
interesting. The Fed a few years ago put out a warning for commercial banks, ‘‘Please take care of the interest rate risk on your
balance sheet.’’ The Fed is worried about whether the commercial
bank system will prepare for the day when long-term rates rise,
and the commercial banks will have to pay higher rates on their
deposits.
And the Fed said, ‘‘You should hold more surplus capital, build
up now against those losses which you will certainly have to deal
with as the economy normalizes.’’ But the Federal Reserve has
never built up its surplus capital. It has never taken its own advice
that it gives to the commercial banks to prepare for the day in
which it is going to need that kind of residual financial tinder.
Mr. MULVANEY. And when it does need that financial tinder,
where is it going to come from?

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Mr. GOODFRIEND. That is the point. Banks build up—the Fed
should withhold—
Mr. MULVANEY. But they haven’t done that.
Dr. Gagnon, it looked like he had the answer—an answer or—
help me understand.
Mr. GAGNON. Yes, because I was at the Fed when we were planning for this. And you are right that the Fed can book an asset
which will make it look as if it is solvent, and that is what you
were talking about, but what really matters is the cash flows. And
you are right. The Fed, I believe, will have negative cash flows at
some point in the future, and it will pay that just by creating more
reserves to pay the interest on the existing reserves, and it can do
that without limit if it wants.
This situation won’t last forever. It is unfortunate, but, Marvin,
I—it is my understanding is that the Fed isn’t allowed to keep capital. It has to hand over its profits to Treasury every year, according to a formula. It would have liked to have kept reserves, because
it has been earning a lot of money lately, and it would like—
Mr. MULVANEY. And those are the remittances—
Mr. GOODFRIEND. That is not actually true.
Mr. GAGNON. What?
Mr. GOODFRIEND. There is a gentleman’s agreement between
Congress and the Fed that was established in the period before, or
right after World War II, and it is a gentleman’s agreement, to my
understanding. It is an understanding. The Fed, if it wanted to,
could retain surplus capital against interest rate risk.
Mr. MULVANEY. Mr. Pollock is actually saying no. And this is
what I love about this discussion.
Mr. POLLOCK. I think it is true that it could, but if it did, it
would increase the budget deficit. The Fed makes a lot of money.
The Federal Reserve banks are almost always, measured by return
on equity, the most profitable banks in the country, and the money
goes to the Treasury, by and large, after a small dividend and
small expenses.
If it comes to the point that payment on reserve balances exceeds
the yields on the assets or assets are sold at a loss, generating negative cash, then those payments to the Treasury will disappear.
That will make the deficit go up.
But you raised an accounting point. There is a debit there when
that happens. Normal people would think the debit would go to net
worth, but, in fact, under the Federal Reserve accounting, it goes
to a ‘‘deferred payment to the Treasury’’—
Mr. MULVANEY. Okay, I have to—
Mr. POLLOCK. —intangible asset.
Mr. MULVANEY. I have to give back. I hear—because we have to
give up the room. So—
Chairman CAMPBELL. Thank you.
Mr. MULVANEY. —thank you, gentlemen. Thank you, Mr. Chairman.
Chairman CAMPBELL. Thank you. So the gentleman from New
Mexico, Mr. Pearce, is recognized for the final 5 minutes.
Mr. PEARCE. Okay, thank you, Mr. Chairman.
Mr. Pollock, you had addressed the idea of an elastic currency,
and so I will ask—first of all, to make an observation, I had my

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dad carry me to where I was born, and it was a dirt floor chicken
place. They ran the chickens out. And so I was—Dad got a raise,
and he started working for $2.62 an hour, raised 6 kids on $2.60
an hour.
So I was—I have been contemplating that. How could Dad do
that? How could he raise so many on $2.62? So the staff—I had
them digging around on it—so we want to consider 100-year periods, because the Federal Reserve has been in operation 100 years.
So the first 100 years of our country’s operation, we were on a gold
standard. And what you could buy for $1 in George Washington’s
day, 100 years later, cost you 50 cents. There were economies of
scale, transportation, competition came in. So you basically had a
double—your wage doubled because the money was worth more.
But then if we look at the last 100 years, what $1 would buy 100
years ago takes $24 today, so my dad was actually making about
12 times, half—it was about 50 years ago, so half that time. So he
was working for the equivalent of about 242 at $2.62—or $24 an
hour at $2.62. So, again, I see what the Federal Reserve is doing
is waging a war on the poor with this elasticity.
And I would appreciate your evaluation, your observation of that
critical nature I have of the Federal Reserve. If it is incorrect, I
would appreciate you telling me.
Mr. POLLOCK. Thank you, Congressman. I haven’t checked your
math, but something like that is certainly right. Elastic currency
I think is a good thing, because it is very useful in crises, which
is why it was created.
If you look at the long-term inflation rates, they are basically
flat, and then, starting in the 1930s, they go up for the next 80
years. We always forget about the power of compound interest. As
you are pointing out, a 2 percent inflation, 2 percent compound interest, extended over many years, creates a tremendous change. I
point out in my testimony, 2 percent inflation, the Fed’s stated target, will quintuple prices in a normal lifetime. So my answer is yes.
Mr. PEARCE. Okay. Mr. Bivens, you seem to think that the idea
of lenders of last resort, bailouts, whatever you want to call it, is
an adequate task. Now, the firms that we bailed out made hundreds of billions of dollars in very risky assets, so you feel like that
a taxpayer, say in New Mexico, who makes an average of $31,000—
I have one county where it is closer to $14,000—the taxpayer who
is making $14,000 a year should bail out somebody who is getting
$1 million bonuses on Wall Street from making crazy, crazy risks
where they were leveraged 33 to 1, 40 to 1. Do you think that is
an appropriate assignment of risk for taxpayers in New Mexico to
have to bail that out?
Mr. BIVENS. No, not at all. I would—
Mr. PEARCE. And so you think, then, that the lender of last resort, if they take the risk, if they take risks that do not pan out—
for instance, maybe it is going to pan out okay on Fannie and
Freddie, but I remember Mr. Paulson coming downstairs at the
Capitol saying, if you will guarantee the whole thing on Fannie
Mae and Freddie Mac, you won’t have to pay a thing. He was about
$200 billion wrong on that assessment. But so you think that is an
appropriate use of taxpayer dollars?
Mr. BIVENS. If you could more specific on what—

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39
Mr. PEARCE. Fannie and Freddie. To bail Fannie and Freddie out
at $200 billion.
Mr. BIVENS. Yes, I—
Mr. PEARCE. Okay, that is fine. When does the stuff hit the fan
here? We have been printing money. Mr. Gagnon, maybe—it
doesn’t work in Argentina. When is it going to stop working here?
Mr. GAGNON. You want a middle-of-the-road, you want a moderate target. Countries who have chosen inflation targets that are
too low, like New Zealand and Japan, have changed their mind and
decided to raise them. I think 2 percent seems like a moderate
level.
Mr. PEARCE. Let me go ahead and reclaim my time. I have 14
seconds. The reason that it works, I think, is because we can export
inflation. We are the world’s reserve currency. In the last year, the
BRIC nations have said they are no longer going to trade in our
currency. I feel like that we are going to get all that inflation back
inside our country at one fell swoop. I think that there is a major
problem looking at us in the face when those BRIC nations actually
begin to trade in something other than dollars.
Again, maybe the scheme won’t work out, but right now it looks
like it is on thin ice. I yield back my time, Mr. Chairman.
Chairman CAMPBELL. Thank you, Mr. Pearce.
And I thank all of you on the panel, very much. I don’t know
about you, but I think this is pretty fascinating. I thought there
was some very interesting discussion, and it is all helpful, and I
appreciate all six of you and Dr. Meltzer in absentia that—for your
contributions to the beginning of this, as I hope you can see, very
wide-ranging and open discussion about how did we get here, what
does it look like now, and what should it look like going forward.
The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing.
Without objection, the hearing record will remain open for 5 legislative days for Members to submit written questions to these witnesses and to place their responses in the record. Also, without objection, Members will have 5 legislative days to submit extraneous
materials to the Chair for inclusion in the record.
With that, and without objection, this hearing is now adjourned.
[Whereupon, at 4:27 p.m., the hearing was adjourned.]

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APPENDIX

September 11, 2013

(41)

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Testimony prepared for the Subcommittee on Monetary Policy and Trade, Financial Services
Committee, U.S. House of Representatives, for a hearing on "The Fed Turns 100: Lessons
Learned from a Century of Central Banking"
Josh Bivens, Ph.D.
Research and Policy Director, Economic Policy Institute

The Federal Reserve is the primary economic policymaking institution tasked with
insuring macroeconomic stability. How it came to have this role, and whether or not it bears
too little or too much of the overall responsibility for this task are interesting questions in their
own right, but this is no doubt at all that this is its role. Given this, it seems useful to provide an
assessment of the appropriateness of Federal Reserve policies in the recent past and near
future, as well as of lessons that should have been learned over the last decade of American
economic experience. In my testimony today, I will make the following arguments:

-The U.S. economy remains far from fully recovered from the Great Recession (much further
than would be thought by looking, for example, at the overall unemployment rate), and the
barrier to a full recovery remains deficient aggregate demand for goods and services

-Fiscal policy in recent years has severely aggravated this aggregate demand shortfall,

particularly compared with previous business cycles. Specifically, if government (federal, state
and local) spending had followed the normal course seen in previous business cycle recoveries,
it would be roughly 20 percent higher today, and the U.S. economy would have roughly 5
million more jobs (the majority of which would be private-sector jobs) than it currently has.

-This aggregate demand shortfall argues that the Fed should continue (or even expand) its asset
purchases to keep interest rates low and to keep inflationary expectations anchored.

-This aggregate demand shortfall also argues that accelerating inflation is not a serious short or
even medium-term risk

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-There are several important lessons that can be taken from the Great Recession and its
aftermath for monetary policymakers. Among these, the Fed should be far more vigilant in
insuring that financial sector imbalances do not inflate to levels that can threaten the
macroeconomy, and it should be far less confident that monetary policy tools can by
themselves neutralize negative demand shocks stemming from burst asset bubbles.

-lastly, as the Fed has been given the primary role for financial regulation in the post DoddFrank era, it should balance its necessary role as a lender of last resort and guarantor of

systemic financial stability with vigorous efforts to insure that the problem of moral hazard in
the behavior of large, complex financial institutions is addressed. Specifically, this means that
adequate capital buffers for these institutions should be maintained, that new resolution
authority for insolvent institutions passed in Dodd-Frank is used appropriately, and that it is
financial system/unctions and not incumbent financial institutions, that the Fed intervenes to
support during crises.

The U.S. economy remains far from fully recovered from the Great Recession
As of the middle of 2013, the U.s. economy remained far from fully recovered from the
Great Recession. The "output gap" between actual GDP and potential GDP - how much could
have been produced had unemployment and capacity utilization not been depressed due to
insufficient aggregate demand - stood at 5.8 percent of potential GDP, or roughly $900 billion.
This was, by far, the largest output gap remaining this far from either the previous business
cycle peak or the trough of the recession, and the cumulative lost output since the beginning of
the Great Recession is nearly double the amount lost during any other recession since the Great
Depression (and will in coming years surely rise to more than double any other previous losses).
Perhaps worst of all, this gap had barely budged in the previous two years - shrinking by only
0.5 percent of GDP since the beginning of 201l.
This stubbornly high output gap is mirrored by an agonizingly slow recovery in the
employment to population ratio of those aged 25 to ,54. This group of "prime-age" workers
tends to have very strong labor force attachments during normal economic times. Yet this ratio

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fell by 5.3 percentage pOints during the Great Recession, and as of June 2013 was essentially
exactly where it was in four years earlier, when official recovery from the Great Recession
began.

<Figure A here>

The stubbornly slow progress of recovery has consistently surprised policymakers. The
figure below shows the projected course of recovery as forecast by successive iterations of the
Congressional Budget Office's (CBO) Budget and Economic Outlooks. As can be seen, the return
to full economic potential has consistently been moved back in time in successive CBO releases.

<Figure B here>

However, the roots of this slow recovery are far from mysterious: the very large
negative shock to aggregate demand provided by the bursting housing bubble (starting in 2007)
has never been fully neutralized by policy measures to boost demand. Worse, the decades
before the Great Recession convinced far too many policymakers that efforts to fight aggregate
demand shortages could consist entirely of reductions in the short-term "policy" interest rates
controlled by the Federal Reserve. However, these short-term rates have been set at
essentially zero since the end of 2008, and yet the economy remains far below potential. This
state of the world - economic weakness persisting even as short-term policy rates are at zerohas often been called a "liquidity trap", or characteristic of an economy stuck "at the zero lower
bound (ZlB) of interest rates".

Macroeconomic policy in a liquidity trap: monetary and fiscal

liquidity trap conditions argue for two primary responses. First, the Federal Reserve
should undertake unconventional measures to force down interest rates besides the short-term
policy rates they control directly. Second, fiscal policy stabilization should take center-stage.
The first response has happened - the Fed has indeed begun buying longer-term assets directly

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in an effort to keep these interest rates low. This has clearly been to the economy's benefit.
While it is very hard to make precise empirical estimates as to how much the Fed's asset
purchases have boosted the economy, it is important to note that essentially none of these
estimates indicate that they have done anything but push the economy closer to fullemployment. Further, some estimates of the asset purchase's effect are non-trivial- with
Chung et al. (2012) estimating that the purchases undertaken before November 2012 (ie, QEs 1
and 2) could have lowered the overall unemployment rate by well over a full percentage point.
This represents more than a million Americans who found work because of the effect of these
programs.

1

The second response (increased fiscal support) has, however, largely not happened.
During the recessionary phase of the Great Recession, as job-losses reached a staggering
750,000 per month, passage of the American Recovery and Reinvestment Act (ARRA) did
significantly boost growth in real federal government expenditures.
This fiscal support broke the downward spiral and halted the economy's free-fall by mid2009, and even provided rates of growth sufficient to reliably push down measured
unemployment by late 2010. However, the fiscal boost provided by ARRA was both temporary
and left the economy well short of full-employment. Since the official end of the Great
Recession (in June 2009), overall fiscal policy has been sharply contractionary when compared
with historical averages, particularly once one factors in state and local expenditures. Figure C
below shows real (inflation-adjusted) government spending (federal, state, and local) during
recessions and subsequent recoveries.

<Figure C here>

The most striking comparison is with the recovery following the steep recession of the
early 1980s. The output gap at the trough of the early 1980s recession was actually larger than
that at the trough of the Great Recession, yet two years following the trough, 80 percent of the

I Chung, Hess, Jean-Philippe laforte, David Reifschneider, and John C. Williams (2011). "Have We
Underestimated the Probability of Hitting the Zero lower Bound? (568 KB PDF) "Working Paper 201101. San Francisco: Federal Reserve Bank of San Francisco, January.

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output gap had been erased. Yet four years following the trough of the Great Recession, less
than 20 percent of the output gap has been erased. Even more striking, the scope for monetary
policy boosting recovery in the wake of the early 1980s recession was much larger -the federal
funds rate was dropped by almost 10 percentage points following the onset of recession.
Given the similar size of output gaps at the trough of these recessions, and given as well
that subsequent recovery was likely to be aided much more by monetary policy going forward
from 1982, it seems axiomatic that a larger fiscal expansion was needed after the end of the
Great Recession to spur full recovery. Yet real government spending four years into recovery is
essentially 20 percent below what it would have been had it matched typical growth during
recoveries. Had this degree of fiscal impulse been replicated in the current recovery, then
roughly 90 percent today's output gap would be closed.

2

This is an important lesson. Calls to address the jobs-crisis with a fiscal boost
commensurate to the scale of the problem are often greeted by implicit claims that this would
constitute a wild and historically unprecedented degree of public spending. It's not so-we've
had this amount of fiscal support for recoveries before, in the not-so-recent past. There is
nothing either economically or historically "unrealistic" about the prospects of ending the jobscrisis by ending austerity.

Balancing monetary policy risks going forward
Given that the economy remains severely demand-constrained, and given as well that
the current trajectory of fiscal policy looks extremely contractionary, the clearest current risk
facing monetary policymakers is that unemployment will remain elevated for a significantly
longtime.
This argues strongly that talk of "tapering" - reducing the pace of asset purchases under
the quantitative easing programs - is premature. There is, in fact, strong reason to believe that
an even greater break from conventional monetary policy interventions is needed (see, for

22

For more context on this comparison, see http:Uwww.epi.org/blog!years-recovery-austeritys-toll-3-miliionl

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example, Romer (2013), who speaks of the need for a "regime-shift" in monetary
policymaking).

3

The persistent demand shortfall and contractionary fiscal policy stance also make clear
that worries about incipient runway inflation are severely misplaced. Measures of core inflation
since the Great Recession began have actually declined (see Figure 0 below).

<Figure 0 here>

Further, there is little sign that financial market participants expect a rise in inflation
anytime soon. The spread between ten-year inflation protected Treasury securities and
traditional Treasuries indicates that inflation expectations remain low (and are just now
recovering a bit after a long decline).

<Figure E here>

Finally, a key determinant of inflation is unit labor costs (see the UlC and core inflation
relationship since 1959 in Figure F below). Unit labor costs have remained extraordinarily low
since the recovery from the Great Recession began, rising, for example, by well under 2 percent
in 2012.

<Figure F here>

In fact, in the non-financial corporate sector, if only unit labor costs mattered, prices
would have declined since the recovery's beginning. However, because profit margins have
risen by 55 percent over that period (from 9.7 percent to 15 percent), prices for non-financial
corporate sector output have risen even in the face of falling unit labor costs. A clear
implication of this is that future increases in wages and economic activity will not necessarily

3 See Romer, Christina (2013), "It Takes a Regime Shift: Recent Developments in Japanese Monetary Policy Through
the lens of the Great Depression", Working Paper
http://elsa.berkeley.edu/-cromer/lt%20Takes%20a%20Regime%20Shift%20Written%20(Second%20Revision).pdf

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translate one-for-one into higher prices, as historically high profit margins can provide a buffer
(as they traditionally have).

lessons from the 2000s
Currently, all risks facing the economy point to excessive unemployment, not excess
demand, high interest rates, or inflation. But this is, of course, not always the case. In 2006, for
example, when unemployment reached 4.3 percent, driven in large part by an unsustainable
bubble in housing markets, it would been bad Federal Reserve policy indeed to undertaken
hundreds of billions of dollars of long-term asset purchases to lower long-term interest rates.
And in fact, the Fed had by 2006 been steadily raising its policy interest rates.
However, it is true that the Fed (and other policymakers) were too slow in recognizing
the grave macroeconomic damage posed by the housing bubble. Part of this may have been a
function of what has too often been described as the "mild" 2001 recession following the burst
stock market bubble. This episode perhaps led to excess confidence on the part of
macroeconomic policymakers that the negative demand shock from burst asset market bubbles
could always be neutralized by loose monetary policy. But, employment growth following the
2001 recession was extraordinarily slow, and the unemployment rate and employment to
population ratios reached at the peak of the late 1990s/early 2000s business cycle were never
reached during the recovery and expansion of 2001 to 2007, even with the benefit of a long
period of loose monetary policy and an extraordinarily large (if inefficient) fiscal impulse
provided by the Bush-era tax cuts and spending increases.
Given that modest short-term policy rate increases were insufficient to stop the
inCipient housing bubble from inflating and rate declines were insufficient to inoculate against
the negative demand shock when the bubble burst, it seems clear that the Federal Reserve
should expand its tool-kit to find policy levers that keep asset bubbles from inflating to such
damaging levels in the first place. While a range of policy tools have been identified by a
number of researchers (including increased margin requirements for stock buying, asset-based
reserve requirements, guidelines for mortgage issuance, and restrictions on destabilizing
international capital flows), it is also important to note that the Federal Reserve has enormous

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power even when just making public comments. If the Federal Reserve had issued reports and
had governors make speeches that presented the huge evidence on overvaluation of home
prices in the early 2000s, it is hard to imagine that the bubble could have inflated to the heights
it did.
An instructive, if unfortunate, example of this "power of speech" could be seen in recent
months as long-term interest rates rose following some perceived ambiguity about how long
the current pace of asset purchases would continue. Even though no actual change in
purchases happened, just the communication (or failure of communication, in this case) was
able to move financial markets. Given this episode, it is hard indeed to imagine that an
organized, sustained campaign of communication about the Fed's professional diagnosis that a
particular asset market was characterized by a speculative bubble would have been ignored by
these same financial markets.
It should be reiterated that the stakes to failing to rein in bubbles in real-time now look
potentially enormous. The cumulative output losses inflicted by the Great Recession and failure
to fully recover since already total over 80% of one year's GDP and look set to continue rising in
coming years.

Lessons from 2008 and after
It became clear by the end of 2008 that large, complex financial institutions not only
allowed financial sector imbalances to grow to dangerous levels, but that these same
institutions suffered badly from a moral hazard problem, knowing that after the panic following
the collapse of Lehman brothers that policymakers were extremely unlikely to allow them to
fall into bankruptcy. This "too big to fail" problem is not just unfair, it is economically inefficient
(among other things, too big to fail banks have a competitive advantage over competitors in
raising funds, as creditors factor in the reduced likelihood that policymakers will allow them to
go bankrupt).
One of the most promising (if still largely untested) changes made to American finance
by the Dodd-Frank was improved resolution authority for financial regulators, including the
Federal Reserve. The "living will" provisions of Dodd-Frank take away the excuse that insolvent

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financial firms cannot be allowed to fail during financial crises. This is a key regulatory
improvement.
The key lender of last resort role that the Federal Reserve needs to fulfill during financial
crises - and which it clearly did fulfill in the Great Recession - remains vital. Advice to central
bankers during crises has actually not improved much since the Bagehot Rule that the central
bank should lend freely, at a penalty rate, on collateral that is valuable during non-crisis
periods, but only to fundamentally solvent institutions. The ability of the Federal Reserve to
backstop entire markets -like its backstop of the commercial paper market in November 2008
indicates clearly that they can keep financial intermediation services intact without providing
a blanket guarantee to all incumbent financial institutions.

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Figure A
Ratio of actual to potential gross domestic product, and the employment-to-population ratio
for prime-age workers, 2000-2012
1}:)6

0.1l4

104

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__. -____.__.__, _____ " ____, -______.__---.-.,------, _____________

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2000-! 2001-! 20G2·-! 2003-! 2C<04-1 2005-1 2006-1 2007-1 2003-! 2009-1 201{!-! 2011-! 2012-!

Analysis Nat!onaffn(Om~~fJndProdl1ct AC\~ounts (fable LL6j, (on~lre$sicnal
Current Population Surv.;-y public data ser!<:'-5

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Figure B

(BO's projections for full economic recovery continue to be pushed back
Q.

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FigureC
Real government expenditures in recessions and subsequent recoveries, 1948-2013
125
Average of all

t2

previous recessions

'-...
Early 1980s recession

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FigureD
Measure of core inflation: personal consumption expenditures, 1989-2013
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SOlJrce: ,Author's analysis of Federal

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13

55

300%

FigureE
Expected inflation from TIPS-spreads, 201 0-2013

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56
FigureF

Unit labor costs and core inflation, 1959-2013

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201302.

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15

57
What Have We Learned from 100 Years of Federal Reserve History?
Joseph E. Gagnon, Peterson Institute for International Economics
Testimony before the House Subcommittee on Monetary Policy and Trade
September 11, 2013
In my view, the Fed has performed at least as well over its first 100 years as could have been
expected given the limits of, and evolution in, our understanding of how the economy operates
and given the Fed's institutional structure and political environment. The key to improving
performance in the future is to give the Fed the tools it needs to do its job, to allow the Fed free
rein in using those tools as it sees fit, to demand that the Fed explain its actions to the public
contemporaneously, and to hold the Fed accountable for any failure to achieve its objectives that
could reasonably have been prevented. My biggest worry is that the Fed faces more restrictions
on its powers than any of the world's other major central banks, raising the risk that it may be
unable to achieve its objectives at some time in the future.

Objectives ofthe Federal Reserve
Congress created the Federal Reserve System in 1913 "to furnish an elastic currency, to afford
means of rediscounting commercial paper, to establish a more effective supervision of banking in
the United States, and for other purposes." I'm not sure what other purposes Congress had in
mind, but the rest of the preamble strikes me as eminently sensible and still relevant 100 years
later. The creation of the Fed was in large measure a response to the banking panic of 1907.
There was a strong desire for a more stable economy and the path to a more stable economy was
a more stable financial system.
In the 1970s Congress added an explicit monetary policy objective "to promote
effectively the goals of maximum employment, stable prices, and moderate long-term interest
rates." This new language brought the concept of an elastic currency into the modem age, while

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retaining the objectives related to the financial system. Basically one can summarize the Fed's

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2
objectives as to encourage the flow of credit in a sound and stable financial system in order to
have a strong and stable economy with low inflation.
Many students of central banking, including my colleague Adam Posen, have made the
case for central bank independence in the context of democratic institutions. In their view,
which I share, central bank objectives should be set by political leaders; central banks should
have operational independence and the tools to achieve those objectives; and central banks
should be transparent and accountable to political leaders for their performance (Posen 2013).
Successes and Failures
1914-39
I pass over the first few years of the Fed's existence as it may have been too soon to for it to have
had a systematic economic effect and those years were disrupted by the first world war. The
1920s were a period of rapid growth with low inflation, an apparent success of Fed policy.
However, late in the decade, a leverage-fueled bubble emerged in the stock market. Given the
tools it had, it is not clear what, if anything, the Fed could or should have done to minimize the
bubble. Afterwards, the Banking Act of 1933 gave the Fed authority to determine margin
requirements on stock loans. I believe that strict enforcement of these requirements (currently 50
percent) has been hugely beneficial, a point to which I will return later.
The aftermath of the 1929 stock market crash gave rise to the Fed's greatest failure-the
Great Depression. The work of Milton Friedman, Anna Schwartz, Ben Bernanke, Allan Meltzer
and others has led to widespread agreement that the Fed turned a recession into a depression by
allowing the money supply to contract and allowing prices to fall by 25 percent from 1929
through 1933 (Friedman and Schwartz 1963, Bemanke 2002, and Meltzer 2003). Recovery

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began with the loosening of the gold standard, the devaluation of the dollar, and the bank holiday

59
3
of 1933 (Romer and Romer 2013). But it is important to recognize that very few people at the
time understood the Fed's role in enabling the Great Depression, so perhaps we should not
expect the leaders of the Fed to have known any better.

1940-65
World War II and the decades immediately afterward were a golden era for the US economy,
with rapid growth and generally low inflation. To some extent, this may reflect a certain amount
of good luck. Perhaps also, it may reflect that the heavily regulated financial system of the era
was not allowed to run amok.

1966-1979
In light of the concerns expressed by many about the consequences ofrecent Fed policies for
future inflation, it is important for us to understand how and why inflation got out of control in
the 1960s and 1970s. The Fed's good luck began to run out in the late 1960s when the Vietnam
War and the Great Society caused the US economy to overheat. The rise of inflation was not a
single event and not a consequence of a single Fed error. Rather, as shown in the attached chart,
inflation rose in three separate waves. During each wave, the Fed was initially reluctant to fight
inflation, but it eventually tightened policy enough to reverse the upward drift in inflation. After
the first two waves, the Fed eased policy before inflation was truly defeated. It was only under
the tenure of Paul Volcker that high inflation was conquered for good.
When one reviews the statements of Fed officials and the FOMC during the period of
escalating inflation, what is apparent is a denial of responsibility and a blaming of other forces
for rising inflation. Also, as described by Christina and David Romer (2013), the Fed at times
argued that it had little power to counteract the inflationary forces at work. Over time, this

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abdication of responsibility caused expectations offuture inflation to become unanchored. When

60
4
the oil shocks of [974 and 1979 hit, firms and workers rushed to raise prices and wages because
they thought, in part correctly, that the Fed would allow inflation to ratchet up once again.
The upward drift of inflation and inflation expectations did not happen all at once. The
Fed had many opportunities to fight inflation and regain credibility. And when Paul Volcker was
appointed chairman, it finally did. The lesson for today is that inflation is not baked in the cake
years in advance. It responds to Fed policy with a lag of a year or two. The key is a firm and
predictable Fed tightening whenever inflation threatens to rise above a narrow range around its
target.
1980-2003
The Great Moderation, as it is sometimes called, reflected a combination of good luck and good
policies. Economists still do not fully agree on the balance between luck and policy. In my
view, good policy was important. After Paul Volcker, the Fed learned the lessons of its previous
errors and did not allow inflation to drift upwards. I note, however, that during the 1980s,
inflation stabilized around 4 percent and this was viewed as a great success. In a shift that has
come to be known as "opportunistic disinflation," targeted inflation dropped to 2 percent after
the recession of 1990-91, where it has remained (Orphanides and Wilcox 2002).
2004-13
This is the period of the housing bubble and the Great Recession. Some observers say that the
Fed kept interest rates too low in 2003-05 and that this was the most important cause of the
housing bubble (Taylor 2007). I agree that policy was too easy in 2004 and 2005, but the
overheating this caused was minor by historical standards. Moreover, as my colleague Adam
Posen (20 II) has written, there is no systematic evidence connecting loose monetary policy with

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financial bubbles. Rather, I and many others blame the Fed for lax regulation of the mortgage

61
5

market and for turning a blind eye to off-balance-sheet risks at commercial banks. Other
regulatory agencies also share considerable blame. The main lessons I draw are that leverage
and dcbt burdens of borrowers were too high, capital at banks and other financial institutions was
too low, and the complexity of structured financial products proved to be a huge vulnerability
when the system was tested.
During and after the financial crisis, the Fed eased policy quickly and made extraordinary
efforts to stabilize thc financial system. I agree with Chairman Bernanke (2012) that the size of
the 2008 shock-in terms of loss of wealth, bankruptcy, forced deleveraging, and global reachwas probably greater than that of 1929. The only reason we are not in the midst of a second
Great Depression is that policymakers in the United States and elsewhere responded much better
in the current episode.
But bettcr is not necessarily best. As I argued back in 2009, the Fed should have engaged
in much more quantitative easing (QE) at an early stage (Gagnon 2009). Doing so would have
put the US economy on a stronger growth path, keeping millions more employed and reducing
the federal budget deficit. Paradoxically, more aggressive monetary ease in 2009 and 2010
would have pulled forward the time we return to more normal interest rates and probably
prevented the need to launch QE2, Operation Twist, and QE3. Given the unprecedented nature
of, and controversy surrounding, QE, it is perhaps unfair to criticize the Fed for not doing more
sooner. But the current episode demonstrates that being too timid can be just as risky as being
too bold.
Lessons Learned

Objectives

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Would the Fed's objectivcs be improved by making them broader or narrower or numerically

62
6
specific? With respect to financial stability I don't see any useful modification. With respect to
macroeconomic stability, the discussion centers around whether the Fed should be given a single
target or a dual target and whether the target or targets should be specified numerically.
Experience shows that successful central banks do not focus solely on inflation even if that is
their sole legislated objective (Posen 2013). Stabilizing employment is a socially valuable
objective in itself and it helps to stabilize inflation. Making the dual mandate explicit is an
acknowledgment of reality that has benefits for credibility, transparency, and accountability.
It is widely agreed that central banks should not be given a numerical goal for

employment, but many believe that political leaders should specify a numerical goal for
inflation. We are all aware of the dangers ofinflation that is too high and the evidence is
accumulating of the harm from inflation that is too low. The target should not be set below 2
percent, and some believe that a slightly higher target would be beneficial, perhaps as high as 4
percent (Blanchard et al. 2010 and Ball 2013). I don't have a strong view on that, but I note that
an average inflation rate of 4 percent in the late 1980s was widely viewed as a huge success. If
the simplicity of a single target has strong appeal, then one might consider targeting growth of
total spending, or nominal GDP, at 5 percent. I

Rules versus Discretion
A policy rule is a mathematical relationship between the value of an economic policy indicator
and underlying economic variables. The most famous monetary example is the Taylor rule,
which relates the short-term interest rate to the inflation rate and the gap between actual and
potential output (Taylor 1993).

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1 Nominal GOP is the product of output, or real GOP, and the price of output. Because employment is tightly linked
to output, nominal GOP combines both elements of the dual mandate. Growth of nominal GOP at 5 percent would
yield average inflation of 2 percent if output grows at 3 percent on average or inflation of 3 percent if output grows
at 2 percent. The Fed has little control over the long-run average growth rate of output, but any outcome for
inflation in this range would be acceptable.

63
7

The chief economic arguments for strict observance of a policy rule are that it provides
greater certainty to market participants and that it eliminates the temptation of a policymaker
with a short-term outlook to boost output and employment now at the expense of higher inflation
later. Experience has shown, however, that it is possible to eliminate the problem of the shortsighted policymaker by appropriate structuring of the policymaker's mandate and accountability.
The chief arguments against strict observance of a policy rule are that there is no
agreement on the optimal policy rule and that it is probably impossible to design a policy rule
that can allow for all possible contingencies. John Taylor showed that his rule provided a
reasonably good characterization of Fed policy during a part of the Great Moderation and thus it
may have distilled an important principle of good monetary policy. But the period Taylor
examined was short and we don't know whether some other rule might have been even better,
especially if other shocks had been hitting the economy. A number of researchers have written
papers arguing that Taylor's rule can be improved in important ways, but there is no agreement
on anyone rule.
The best strategy is for the Fed to continue to study policy rules and to use various rules
in assessing the appropriate stance of policy. Whenever it sets policy far from the dictates of
historical rules, the Fed should have a good reason and should communicate that reason clearly
to the public to avoid confusion and uncertainty.
If one is searching for a guiding principle for formulating and communicating policy, the
optimal forecast approach of Lars Svensson (2003) has much to commend it. Variants of this
approach are implemented by some foreign central banks. Under this approach, the Fed would
set its policy to minimize forecasted deviations from its objectives in the future, with deviations

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in the distant future discounted more than those in the near term. lfthe Fed were to provide the

64
8
market with its own forecast of monetary policy, it might learn whether private forecasters agree
with its forecasts of how closely it will achieve its objectives. Any disagreements could lead to a
dialogue between the Fed and market participants that would help each to understand the
different views of the other and to reduce uncertainty.
In recent years, the Fed has undershot both its employment and inflation objectives
repeatedly, despite setting policy, via QE, lower than the original Taylor rule would imply.
Other versions of the Taylor rule, however, called for large negative policy rates, which might be
interpreted as calling for even more QE. Depending on whose policy rule you like, Fed policy
was either too loose or too tight. My own call for more QE back in 2009 was based on the fact
that the Fed itself did not forecast a return to full employment and target inflation within three
years. According to the Svensson approach I just described, this was a clear example of a policy
error. Looking forward over the next three years, there still seems to be room for easier Fed
policy, but the case is less strong than it was back in 2009. 2
Policy Tools
The resort to QE in recent years highlights an important issue. Of the world's major central
banks, the Fed has the most restrictions on its powers. It can buy only government-issued or
government-guaranteed debt, including that of government agencies. Other central banks can
buy corporate debt, equities, and even real estate.
As long as the Fed has a clear mandate, with sufficient transparency and accountability,
there is no reason to restrict its ability to achieve that mandate. Indeed, arbitrarily restricting the
Fed's powers could have serious consequences, particularly if the housing agencies are wound
down and the pool of agency-backed debt diminishes. Restricting the Fed's operations to

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2 In my testimony on March 5, 2013, I noted that there are potential costs to QE but that the benefits currently
appear to be greater than the costs (Gagnon 20(3).

65
9
Treasury securities might dangerously reduce its capacity to influence the economy, especially if
at some future time Treasury securities in private hands are scarce.
In order to avoid the appearance or reality of favoritism and corruption, Fed operations in
private securities should be ordinarily conducted in broad-based baskets, preferably as wide as
possible and using weights based on market capitalizations. The Bank of Japan is buying
Japanese equity and real estate on this basis as part of its fight against deflation.
Another important tool is the ability to impose loan-to-value limits and/or debt-to-income
limits on consumer and business loans. Strict margin requirements kept the equity bubble of the
1990s from causing excessive damage when it burst in 2000. We need similar limits on leverage
in real estate. 3 Also needed are higher capital standards for banks and plans for orderly
resolution of systemically important financial institutions. It remains to be seen how effective
the new Dodd-Frank regulations will prove in achieving these goals.

Lender ofLast Resort
During the recent crisis the Fed made a number of emergency loans to specific institutions,
which attracted considerable criticism. In research I hope to release soon, my colleague Bill
Cline and I show that the Fed was scrupulous in requiring sufficient collateral on its loans, as
evidenced by the fact that all of its loans were repaid with interest and profits that exceeded the
Fed's own cost of funds. The one prominent case of a loan that was denied was that of Lehman
Brothers. My research supports Chairman Bernanke's statement that the Fed was not able to
lend to Lehman because Lehman lacked sufficient collateral for a loan. It is arguable whether,
on balance, the taxpayers might have been better off if the Fed had prevented a disorderly
bankruptcy by Lehman even at the cost of significant loan losses. Personally, I think the

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3 To some extent, the Fed and other financial supervisors have this tool, but the inter-agency process of using it is
cumbersome. Moreover, supervisors fear the political backlash that would result from significantly increasing
down-payments on home mortgages or tightening terms on other forms of credit.

66
10
recession would have been essentially the same if Lehman had not failed. But others may take a
different view. In any event, what is clear is that the Fed took both its mandate for financial
stability and the legal limits on achieving that mandate seriously.
The new limits on the Fed's ability to make emergency loans do raise the risk of
disorderly failures in the future, and it is not clear how much this risk is ameliorated by the
advance resolution plans that are now required oflarge-scale financial institutions.

References
Ball, Lawrence. 2013. The Case for Four Percent Inflation. Central Bank Review (Central Bank
of the Republic of Turkey) May.
Bernanke, Ben. 2002. On Milton Friedman's Ninetieth Birthday. Remarks at the Conference to
Honor Milton Friedman, University of Chicago, November 8.
Bernanke, Ben. 2012. The Federal Reserve's Response to the Financial Crisis. Lecture at George
Washington University, Washington, March 27.
Blanchard, Olivier, Giovanni Dell' Ariccia, and Paolo Mauro. 2010. Rethinking Macroeconomic
Policy. IMP Staff Position Note 10/03. Washington: International Monetary Fund.
Friedman, Milton, and Anna Schwartz. 1963. A Monetary History of the United States, 18631960. Princeton, NJ: Princeton University Press.
Gagnon, Joseph. 2009. The World Needs Further Monetary Ease, Not an Early Exit. Policy Brief
9-22. Washington: Peterson Institute for International Economics.
Gagnon, Joseph. 2013. America Needs More Expansionary Monetary Policy. Testimony before
the House Subcommittee on Monetary Policy and Trade. www.piie.com. March 5.
Meltzer, Allan. 2003. A History of the Federal Reserve. Volume 1: 1913-1951. Chicago:
University of Chicago Press.
Orphanides, Athanasios, and David Wilcox. 2002. The Opportunistic Approach to Disinflation.
International Finance 5 (I): 47-71.

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Posen, Adam. 20 J 1. Monetary Policy, Bubbles, and the Knowledge Problem. Cato Journal3!
(3), Fall.

67
II

Posen, Adam. 2013. Testimony before the Joint Economic Committee. www.piie.com. April 18.
Romer, Christina, and David Romer. 2013. The Most Dangerous Idea in Federal Reserve
History: Monetary Policy Doesn't Matter. American Economic Review 103 (May).
Svensson, Lars. 2003. What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy
through Targeting Rules. Journal ofEconomic Literature 41 (2): 426-77.
Taylor, John. 1993. Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference
Series on Public Policy 39: \95-214.

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Taylor, John. 2007. Housing and Monetary Policy. In Housing. Housing Finance. and Monetary
Policy: A Symposium Sponsored by the Federal Reserve Bank of Kansas City. Kansas City, MO:
Federal Reserve Bank of Kansas City.

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69
Lessons Learned from a Century of Federal Reserve Last Resort Lending

Testimony before the
Subcommittee on Monetary Policy and Trade
Committee on Financial Services
U.S. House of Representatives
Washington, D.C.

Marvin Goodfriend]
Friends of Allan Meltzer Professor of Economics
Tepper School of Business
Carnegie Mellon University
and
Research Associate
National Bureau of Economic Reserach
September 11,2013

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Fonner Senior Vice President and Policy Advisor, Federal Reserve Bank of Richmond, 1993-2005.

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I am pleased to be invited to testifY before the Subcommittee on Monetary Policy and Trade
of the House Committee on Financial Services on "The Fed Turns 100: Lessons Learned from a
Century of Central Banking." I will emphasize the following five points in my testimony "Lessons
Learned from a Century of Federal Reserve Last Resort Lending."
i) The Federal Reserve's last resort lending powers were gradually and vastly expanded during the
last century.
ii) Federal Reserve last resort lending is insufficiently disciplined by Walter Bagehot's (1873)
advice to the 19th century Bank of England-to lend freely at a high rate against good collateral in a
banking crisis.
iii) The reason is that the Bank of England's shareholders earned the profit and bore the losses,
while the fiscal authorities receive net Fed income and taxpayers bear any Fed losses.
iv) As the Fed expanded its lending reach in scale and scope, markets expanded the use of
inexpensive but fragile short-term finance counting on the protection of last resort lending.
v) Federal Reserve last resort lending should be carefully circumscribed to put a stop to these
destabilizing banking and money market dynamics.

A CENTURY OF LAST RESORT LENDING
The constraints on the Federal Reserve's lending powers were loosened gradually over
time. 2 The original Federal Reserve Act of 1913 authorized the Fed to extend credit only to member
banks of the Federal Reserve System. Lending to other entities was not permitted at all until 1932,
when Section 13 (3) gave the Fed the authority to lend to "individuals, partnerships, and
corporations" in "unusual and exigent circumstances" as determined by the vote of at least five
members of the Board of Governors. However, Fed credit extended to nonbanks in the 1930s was

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2

71
relatively insignificant because collateral requirements in 13 (3) were highly restrictive even after
being relaxed by a 1935 amendment. Instead, Congress established the Reconstruction Finance
Corporation to allocate credit widely to nonbank entities. 3 Apparently, Congress was uncomfortable
expanding the credit policy powers of the independent central bank.
Nevertheless, the Fed exhibited a tendency on its own to expand the scope oflast resort
lending to depositories beyond short-term liquidity assistance, especially whenever it worried that
not doing so threatened a systemic financial crisis. For instance, the Fed encouraged depositories in
1970 to borrow from the Fed discount window to support the commercial paper market in the wake
of the Penn Central bankruptcy. In 1974, Fed lending supported the insolvent Franklin National
Bank until it could be purchased by a group of investors. Similarly, Fed lending from May 1984 to
February 1985 supported the undeclared insolvency of Continental Illinois Bank until it was
resolved. 4
The Federal Reserve's lending reach was expanded significantly when the Depository
Institutions Deregulation and Monetary Control Act of 1980 gave all depositories access to the Fed
discount window, whether or not they were members of the Federal Reserve System. By the end of
the deeade Schwartz (1992, p. 68) observed:
" ... By the 1980s hundreds of banks rated by regulators as having a high probability of
failure in the near term and which ultimately failed were receiving extended accommodation
at the discount window ... [tJhe change in discount window practices, by delaying closure of
failed institutions, increased the losses the FDIC and ultimately taxpayers bore."
Motivated by the above record, in the aftermath of the Savings and Loan crisis the 1991 Federal
Deposit Insurance Corporation Improvement Act (FDICIA) contained provisions intended to limit

, See Jones and Angly (I 951).
4

Schwartz (1992), pp. 62-4.

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Fed lending to undercapitalized banks. Unfortunately, the effectiveness of the law would be
compromised where capitalization was measured largely on book rather than market valuation. s
The Fed made few loans to non-depositories under 13 (3) after the 1935 amendment took
effect in 1936. But following the 1987 stock market crash policymakers were persuaded to relax
restrictions on Fed lending to nonbank financial firms. And Section 473 ofFDICIA amended the
Federal Reserve Act so that the only collateral test remaining under 13 (3) was "satisfactory
security," the same test that applied to borrowings of depository institutions. 6 Alan Greenspan
(2010, p. 17) has written that in 1991
" ... atthe urging of the Federal Reserve Board of Governors, Section 13 (3) of the Federal
Reserve Act was considered, and amended by Congress. The section grant[ed] virtually
unlimited authority to the Board to lend in "unusual and exigent circumstances."
Ironically, although FDICIA is better known for a compromised attempt to restrict Fed lending to
insolvent depositories, FDICIA actually expanded the Fed's lending powers well beyond
depositories.
Since then, financial innovation and regulatory arbitrage of minimum capital requirements
have fueled a huge expansion of securitization and structured finance of longer-term illiquid cash
flows for funding in money markets via shadow banking.7 By 2007, money markets accounted for a
share of financial intermediation that rivaled depository intermediation in scale. Importantly,
potential Fed lending in support of money markets was not accompanied by Fed supervision and
regulation as it was for depositories with access to the Fed discount window. The fact that money
markets could expect support from expansive Fed credit policy in a crisis directly, or indirectly via
lending to depositories, probably encouraged the vast expansion of money market finance.

The Fed's lending to insolvent banks is discussed in Clouse (1994) and Schwartz (1992). Goodfriend (1994), p. 574
proposes a Fed· Treasury "Accord" so that Fed lending does not keep insolvent banks open at taxpayer expense.
6 Todd (1993), p. 20.
7 Goodfriend (20 lIb).
5

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In the 2007-8 credit turmoil the Fed was put in an untenable position given its wide powers
to lend-disappoint expectations of accommodation and risk a systemic financial collapse, or lend
expansively and feed expectations of even more expansive lending. Fed last resort lending again
exhibited the tendency evident earlier to expand its lending reach in time of crisis, this time in an
unprecedented enormous increase in reach, scale, maturity, and eligible collateral. 8 Unbridled last
resort lending drew the Fed into a massive expansion of credit "with the implied promise of similar
actions in times of future turmoil.,,9
The problem confronting independent Fed credit policy is this: last resort lending has the
capacity to create ever-greater boom and bust cycles in banking and money markets while
simultaneously undermining the Fed's independent legitimacy within government. The nature of
the problem is explored and a solution is proposed below.

BAGEHOT'S RULE, THE BANK OF ENGLAND, AND THE FEDERAL RESERVE
Federal Reserve last resort lending is widely regarded as a natural extension of 19th century
last resort lending by the Bank of England famously encouraged by Walter Bagehot (1873).
However, the Federal Reserve and the 19th century Bank of England have pursued their last resort
lending powers very differently as a result of their governance. When Bagehot urged the Bank of
England to lend in a banking crisis against good collateral at a penalty rate, he needn't say more.
Bagehot's problem was to encourage the Bank to pre-announce the lending policy that it would
follow in a banking crisis once the U.K. Treasury temporarily suspended the gold reserve
requirement against its paper banknotes. Bagehot could be sure that the Bank would lend at a
profitable penalty rate, since the Bank was a private, profit-maximizing institution whose
shareholders earned the profit and bore the risk of loss. Likewise, Bagehot could be sure that the
8
9

See Goodfriend (201Ia), and Goodfriend and Lacker (1999), pp. 14-15.
The quote is from Voleker (2008), page 2.

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Bank would lend against good collateral so as not to take on credit risk. Bagehot needn't be
concerned that last resort lending could subsidize and distort credit flows. There was no need, since
it was the monetary features of last resort lending (the elastic provision of banknotes) at a modestly
elevated interest rate ceiling that mattered for stabilizing banking and financial markets.
The problem with regard to Federal Reserve last resort lending today is just the opposite-it
is to limit the Fed's lending reach. The independent Fed is inclined to lend rather than risk a panic
by not lending, even if forced to take relatively poor collateral at inordinately low interest, because
its own funds are not at stake--the fiscal authorities receive net Fed income after operating
expenses and taxpayers bear any Fed losses. Moreover, the Fed puts taxpayers at risk even if it
protects itself by taking good collateral. The reason is this: If the entity to which the Fed lends fails
with a Fed loan outstanding, the Fed takes collateral at the expense of taxpayers exposed to losses
from backstopping the deposit insurance fund, or from other financial guarantees that the
government may have put in place. The set-up facilitates lending laxity and moral hazard.
Since the credit turmoil of2007-8, the Fed has employed expansive credit policy initiatives
for purposes beyond boundaries ordinarily regarded as legitimate for an independent central bank.
Whether justified by the need to act in a timely manner, or by the need to act in lieu of paralyzed
fiscal authorities, expansive credit policy initiatives that reach beyond such boundaries rightly draw
scrutiny, in part because they necessarily favor one sector or another. Expansive credit initiatives
undermine the Fed's legitimacy and potentially its capacity to pursue stabilization policy
effectively. Moreover, expansive independent credit policy that bypasses the legislative process for
whatever reason creates complexity and opacity that favors insiders and weakens the public's
confidence in government and the rule of law.

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HOW FED CREDIT POLICY WORKS AND HOW IT SHOULD BE CIRCUMSCRIBED 10
Fed credit policy works by interposing the government's creditworthiness-the power to
borrow credibly against future taxes-between private borrowers and lenders to facilitate credit
flows to distressed borrowers. Specifically, Fed credit policy involves lending to private institutions
(or acquiring non-Treasury securities) with freshly created bank reserves or proceeds from the sale
of Treasuries from the Fed's portfolio. To prevent future inflation, the Fed must reverse the reserve
creation eventually by selling Treasuries from its portfolio, or else the Fed will have to pay a market
interest rate on the reserves. Either way, Fed credit policy involves the lending of public funds to
particular borrowers financcd by interest-bearing liabilities issued against future taxes. The Fed
returns the interest on its credit assets to the Treasury, but all such assets carry credit risk and
involve the Fed in potentially controversial disputes regarding credit allocation.
Occasional Fed lending to solvent, supervised depositories on short term, against good
collateral is protected against ex post loss and ex ante distortion. Such circumscribed lending
deserves a degree of operational independence. However, credit initiatives that extend the Fed's
credit reach in scale, maturity, and eligible collateral to unsupervised, or potentially insolvent
institutions, or the purchase of non-Treasury securities, inevitably carry credit risk, excite questions
of fairness, and threaten the legitimacy of both the Fed and the fiscal authorities. Hence, Congress
in its oversight role should clarify the boundary of the Fed's responsibilities for taking expansive
credit actions and correspondingly restrict its independence in doing so. Congress should insist that
the Fed adhere to a "Treasuries only" asset acquisition policy, except for occasional last resort
lending to depositories. lI

This section draws on themes developed extensively in Goodfriend (201 I a).
Goodfriend and King (1988) and Schwartz (1992) expJain that the Fed can usually exercise its lender oflast resort
responsibilities solely through open market operations without the need to lend to individual institutions through the
discount window.
10
11

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The 2010 Dodd-Frank Act recognizes the problem and requires Fed lending extended
beyond depositories to be approved by the Treasury Secretary and to be part of a broad program not
directed to any particular borrower. The Dodd-Frank requirements do not address the problem
adequately, however, because the Administration is no more authorized to commit taxpayer
resources than the independent central bank--only Congress can do so. And the Treasury is as likely
as the Fed has been to favor expansive last resort lending in a financial crisis rather than risk an
immediate financial collapse.
To deal effectively with the potential for an expanding and ultimately self-destructive Fed
lending reach, taxpayer representatives should be involved more prominently in the oversight of
expansive Fed credit policy. Expansive lending should be authorized before the fact by Congress in
its oversight role, and only as a "bridge loan" accompanied by a "take out" arranged and guaranteed
in advance by Congress. The authorization process should include a clear, explicit, public
discussion of the fiscal risks alert,ing taxpayers in a clear and explicit way to the potential cost of
expansive Fed credit initiatives. An expectation of taxpayer reluctance to bear the cost of expansive
Fed credit policy could then credibly bend down market expectations of the Fed's lending reach so
that banking and money markets would better insure themselves against liquidity risk. Strong
legislative action would defuse the implied promise of expansive Fed credit policy actions in the
future, help prevent a repetition of the boom and bust cycle in money market finance, and preserve
an important limited role for Fed credit policy.

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REFERENCES
Bagehot, W. 1873. Lombard Street: A Description of the Money Market. London: Kegan, Paul and
Co. [Reprinted 14th edition, 1927 by John Murray, Alhermarle Street, W.]

Clouse, J. 1994. "Recent Developments in Discount Window Policy." Federal Reserve Bulletin 80,
no. II, November, pp. 965-77.

Goodfirend, M. 1994. "Why We Need an "Accord" for Federal Reserve Credit Policy: A Note,"

Journalo/Money, Credit, and Banking, vol. 26, no. 3, part 2 (August), pp. 572-80; reprinted in
Federal Reserve Bank of Richmond Economic Quarterly, Winter 2001, pp. 23-32.

_ _ _ _ _. 2011 a. "Central Banking in the Credit Turmoil: An Assessment of Federal Reserve
Practice," Journal 0/ Monetary Economics, January, pp. 1-12.

_ _ _ _ _ ' 2011b. "Money Markets," Annual Review o/Financial Economics, vol. 3, R.
Merton and A. Lo, eds. pp. 119-37.

Goodfriend, M. and J. Lacker. 1999. "Limited Commitment and Central Bank Lending," Federal
Reserve Bank of Richmond Economic Quarterly, Volume 85, no. 4, Fall, pp. 1-27.

Goodfriend, M. and R. G. King. 1988. "Financial Deregulation, Monetary Policy, and Central
Banking," in Restructuring Banking and Financial Services in America, W. Haraf and R.
Kushmeider, eds. American Enterprise Institute, pp. 216-53; reprinted in Federal Reserve Bank of
Richmond Economic Review, May/June 1988, pp. 3-22.

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Greenspan, A. 2010. "The Crisis." Greenspan Associates mimeo, second draft, March 9

Hackley, H. H. 1973. The Lending Functions o/the Federal Reserve Banks: A History. Washington,
DC: Board of Govemors of the Federal Reserve System, Washington, DC.

Jones, J. H. and E. Angly. 1951. Fifty Billion Dollars: My Thirteen Years with the RFC (19321945), New York: The Macmillan Company.

Schwartz, A. 1992. "The Misuse of the Fed's Discount Window," Federal Reserve Bank of St.
Louis Economic Review (September/October), pp. 58-69.

Todd, W. 1993. "FDICIA's Emergency Liquidity Provisions." Federal Reserve Bank of Cleveland

Economic Review 29, no. 3, Quarter 3, pp. 16-23.

Volcker, P. 2008. "Remarks by Paul Volcker at a Luncheon of the Economic Club of New York,"
April 8.

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Title Page

Reforming the Federal Reserve for the 21 st Century

By Allan H. Meltzer
Gailliot and Scaife University Professor of Political Economy
Carnegie Mellon University and
Distinguished Visiting Fellow, the Hoover Institution

Testimony
House Financial Services Committee
Washington, DC

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Evolution at the Federal Reserve

The 1913 Federal Reserve Act created an institution with very limited powers. President
Wilson's compromise resolved the main political obstacle to passing the act. The Reserve banks
became semi-autonomous, controlled by their managements and directors. Boards of directors
had the power to reject portfolio decisions. The Board in Washington had (undefined)
supervisory responsibility.
The United States was on the gold standard, limiting Federal Reserve actions to the
requirements of that rule. In addition, the new system authorized Reserve banks to discount
commercial paper, banker's acceptances, and the like. The discounting operation was always at
the initiative of the borrower. Also, the act prohibited any direct purchases of Treasury debt.
All of these restrictions ended long ago. The gold standard limped to an end in the
1930s. Discounting became an unimportant part of the Federal Reserve's activities, and a
limited volume of direct loans to the Treasury replaced the prohibition. Far more important,
reliance on open market operations circumvented the prohibition on direct purchases of
Treasuries. Currently, and for many ears, the Federal Reserve has bought or sold unlimited
amounts of Treasury securities in the market at the time of the offering or at any subsequent
time.
This transformation occurred in steps, many of them in response to major crises
especially the Great Depression, the Great Inflation, and the current prolonged recession and
slow recovery.
The Reserve banks won the initial struggle for control. Under the leadership of Benjamin
Strong, Govemor of the New York bank, they dominated policy decisions in the 19205 until
Strong's retirement in 1928. The Board did not have a vote at meetings of the Federal Open
Market Committee. Although Board members attended at times, they were not committee
members.
Within months of Strong's departure, Board members gained influence. Later, the
Banking Acts of 1933 and especially 1935 shifted power toward the Board by giving the Board a
majority on the new Federal Open Market Committee and eliminating the power of Reserve bank
directors to decide on their bank's participation in open market purchases or sales.

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During the Great Inflation, Congress amended the Federal Reserve Act by adding the socalled dual mandate. After the recent housing and financial crisis of 2007-09, Congress
approved the Dodd-Frank bill containing hundreds of regulations on banks. The act farther
reduced the much diminished role of Reserve bank directors.
Among the many new regulations is the use of Federal Reserve earnings to allocate credit
toward consumers. The Fed had previously resisted credit allocation, but it will henceforth
finance it out of its earnings without any right to decide on the allocation. The right is reserved
to the director of the consumer agency now embedded into the Federal Reserve Act. The
director does not report to the chairman, the Congress or anyone else. And although the earnings
that the director uses would otherwise return to the Treasury as receipts, Congress does not vote
on the allocation. Political decision-making is now unavoidable.
This change is a startling reduction in the mandated independence of the Federal Reserve.
Federal Reserve independence has often been compromised but never before by act of Congress.
Earlier examples, discussed in my History of the Federal Reserve (2003, 2009) include financing
wartime deficits, acceding to pressure from Secretary Morgenthau in the 1930s, maintaining
pegged interest rates after World War II until the 1951 Accord, financing 1960s and 1970s
budget deficits and recent decisions to purchase mortgage-backed securities, a fiscal operation,
and to manage the debt.
Once Congress understood the importance of monetary expansion for employment, it
took extraordinary effort and a strong chairman to remain independent. Paul Volcker was an
independent Chairman. Alan Greenspan also remained relatively independent. Others were
willing to compromise. The current Federal Reserve has engaged in such non-monetary
functions as fiscal policy, debt management, and credit allocation.
To sum up the evolution, I conclude that the Federal Reserve evolved under pressure of
events and political responses to crises from an independent agency with constrained powers to
become the world's major central bank with nearly unrestricted ability to expand. It retains a
vestige of its independence, but it pays the price of much reduced independence for its greatly
expanded authority. Within the system, power has shifted from the Reserve banks to the Board
of Governors, and the Reserve bank directors have a greatly diminished role.
From the start of the system, the popular view saw the Reserve banks as representatives
of business and the Board as reflecting political influence. Increased power of the Board shows

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increased political influence that rose with diminished independence. No one familiar with
political Washington should be surprised to find that increasing Board power greatly increased
political influence and much reduced independence. Looking across the Atlantic, we find that
the tightly constrained European Central Bank according to its original charter has become much
more responsive to political pressure also.
Among the notable failures of recent years is the failure of Congressional oversight. As
noted, Dodd-Frank creates a virtually unconstrained consumer credit agency. The Federal
Reserve has doubled and redoubled its balance sheet in the recovery from recession without any
vote of approval by members of Congress. This violates the principle of checks and balances
and Congressional oversight of spending that is fundamental in our federal system.
I believe that Congress has the urgent task of asserting that the Constitution gives
Congress control of money creation. To reclaim its responsibility to control its agent, the
Federal Reserve, it must impose a rule that the Federal Reserve must follow. One such rule that
embodies the dual mandate is known as the Taylor rule. The Federal Reserve should be required
to follow that rule and should inform the Congress and the public of what it expects
unemployment and inflation to be two or three years in the future. If it fails to meet its preannounced targets, it must offer an explanation and resignations. Congress or the administration
would be empowered to accept the explanation or demand resignations. That closes the large
gap between Federal Reserve authority and political responsibility. In the years since 1985 when

r proposed this control to the New Zealand Reserve Bank, more than 20 countries have adopted
some form of the rule. The Congress should do so to maintain its constitutional responsibility
under Article I, Section 8.

Why Independence Declined
The principal reason for central bank independence is to separate money creation from
the financing of government. It has long been understood that financing government by creating
money causes inflation. Enforcing and maintaining independence is often difficult. Wartime is
one example. Society's main interest is winning the war, so concern about inflation diminishes.
Inflation rose during most wars followed by deflation or disinflation after peace returned.
After World War II governments proposed systematic monetary actions to manage
unemployment and economic activity. They agreed also to maintain fixed but adjustable

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exchange rates. When the United States' domestic policy came into conflict with its obligations
to reduce balance of payments deficits (or a declining surplus), policy actions supported
employment. In the 19605, as inflation rose, the Kennedy and Johnson administrations adopted
controls to manage the payments problem temporarily. The Federal Reserve considered the
balance-of-payments to be a Treasury problem. It cooperated with the administration by lending
money to the Treasury to finance so called swap arrangements that financed U.S. borrowing of
foreign exchange. These direct loans to the Treasury's Exchange Stabilization Fund were called
"warehousing" to hide the violation of direct lending to the Treasury. Bordo, Humpage, and
Schwartz (20 II), has a full account of the swap operations. (See also Meltzer 2003)
The fixed exchange rate system ended in 1971 when President Nixon stopped further
gold sales. Attempts to revive the system failed; in 1973 these efforts ended. The Federal
Reserve continued to intervene in the exchange market at times. The Treasury requested some of
the intervention.
One of the major mistakes made by the Federal Reserve in the 1960s became known as
policy coordination. The main idea was to keep interest rates from rising during periods of fiscal
expansion. Coordinating policy actions meant that the Federal Reserve financed large parts of a
fiscal deficit by issuing money. In principle, but not in practice, the Federal Reserve would raise
interest rates when the Treasury ran a surplus to slow or stop inflation. Policy coordination in
the recent recovery took the form of financing large parts of the government deficit at very low
interest rates. The unwinding of that massive operation is a major economic challenge of the rest
of this decade.
Two major flaws soon appeared when policy coordination occurred in the 1960s. The
Treasury did not achieve surpluses and did not coordinate with the Federal Reserve to reduce
inflation. The Federal Reserve sacrificed its responsibility for an independent monetary policy.
And it could not, or did not, prevent inflation from rising during the 19605 and 1970s. In part,
Federal Reserve failures in the 1960s reflected Chairman Martin's belief that since the Federal
Reserve was part of government, it should not refuse to finance large parts of a budget deficit
that Congress approved and the president signed. But it also reflected the political decisions of
the Bums era.
The policy failure ended in 1979-80 when Paul Volcker, as Federal Reserve chairman, set
out to reduce inflation. To succeed, he abandoned policy coordination, dismissed the Phillips

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Curve relating unemployment and inflation, reduced control of short-term market interest rates,
announced the Federal Reserve's intention to control bank reserves and monetary aggregates,
and he adopted a medium-term strategy to reduce inflation. Like his predecessors, he had one
main objective. Theirs was lower unemployment; his was lower inflation.
Volcker rejected the idea that inflation rose as a trade-offfor lower unemployment. He
emphasized, correctly, that the two measures both rose in the 1970s and he predicted they would
decline together under his policy. He was right. The anti-inflation policy that he managed
reduced both inflation and unemployment in the 1980s.
Volcker gave many speeches and much testimony in Congress claiming that the way to
lower unemployment was to lower inflation. This is the anti-Phillips Curve policy. It worked
very well from 1985 to about 2003. The current Federal Reserve restored the Phillips Curve, a
repeat of the mistakes of the 1970s.
There is much more that can be said about Federal Reserve errors that are costly to the
public. Let me tum instead to the periods of greatest success. In its 100 year history, there are
only two periods in which the Federal Reserve achieved both relatively stable growth and low
inflation. In both periods, the Federal Reserve followed a rule, not precisely but consistently.
The first period is 1923-28, when the Fed was on a gold exchange standard and several
major countries Germany, Britain, and in 1928 France restored a fixed gold price rule. Other
countries joined also.
The Federal Reserve's commitment to the rule was not complete. The principal
exception was that it would not inflate, so it sterilized most gold inflows. This led to the
breakdown of the rule; countries losing gold had to deflate, but the principal countries receiving
gold - France and the United States

chose to sterilize the inflow.

Britain was the main country required to deflate. France and the United States were the
principal recipients. Nevertheless, when the rule was generally observed, from 1923 to 1928, the
United States had growth, a mild recession in 1926, and low inflation.
The second rule-based period is 1985 to 2003, during which the economy had a long
period of relatively stable growth, mild recessions and low inflation. The dates are not known
precisely. The rule is the Taylor (1993) rule or a variant that weights unemployment and the
expected inflation rate. The choice of variables are the same as in the dual mandate that

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Congress adopted. Inflation has a large weight to assure that inflation raises nominal interest
rates.
Discretionary policy never produced comparable results. Its best period is probably
1953-57 before the recession of the later year. I exclude wartime years from the comparison
because the Federal Reserve's actions, like those taken by the other institutions, concentrated on
actions that helped to finance the war.
Economic theory, following Kydland and Prescott's (1977) paper shows that central
banks must follow a rule to achieve an optimum outcome. The evidence from Federal Reserve
history shows that evidence supports theory. Rules help the country to achieve economic
stability; but we live in an uncertain world, so I must add that surprises and disappointments will
occur under rules or rule-based policy. Of course, the same is true of discretionary policies.
The Federal Reserve recently sacrificed independence by engaging in fiscal policy
actions, debt management, credit allocation, and by supplying hundreds of billions of dollars of
bank reserves. I believe the only way to restore independence would be to adopt a rule that the
Congress accepts. Then the Federal Reserve must make rule-based policy credible by following
it. If events compel departure, announce the departure and offer its analysis of the decision along
with offers to resign.

The Fed's Principal Errors
Any organization that must repeatedly make judgments about future events will, at times,
make errors. In an uncertain world, we expect errors of forecast and errors in the action based on
those forecasts. In my history of the Fed, I compare quarterly forecast errors in real GDP and
inflation to the data revisions. For the period I studied, the 1970s and 1980s, forecasting errors
are substantially larger than data revisions. (Meltzer,2009) For other years, I compared the
Fed's forecast errors to forecasts by others. On average, the Fed forecast errors were about the
same as others. (Meltzer, 1987)
In my 1987 presidential address to the Western Economic Association, I summarized
errors reported by forecasters for quarterly values of real and nominal GNP growth rates and for
inflation. Federal Reserve errors are not very different. To compare these data to a benchmark, I
report the mean growth rates of the variables for 1970-85. Average real GNP growth rate was
2.7 percent, average inflation was 6.7 percent, and the growth rate of nominal GNP was 9.5

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percent for 1967-82 and 9.9 percent for 1970-83. I Comparison of these data to the average
growth rates shows that the reported root mean square errors (RMSE) are a sizeable fraction of
the actual growth rates for real and nominal growth. Using twice the value of the RMSE as the
range within which real GNP growth can fall during the quarter covers the range from deep
recession to strong boom. As one example, the median RMSE reported by Zamowitz for 1970 to
1983, 3 percent exceeds the 2.4 percent average growth for the period. On average forecasters
do not distinguish between booms and recessions beginning in the same quarter.
Table I here
The Federal Reserve history shows many examples of forecast errors leading to mistaken
actions. When Congress in 1967 at last approved the tax surcharge that President Johnson had
finally requested, the Federal Reserve and the administration forecast a recession. The Federal
Reserve reduced interest rates. The temporary surcharge did not slow spending growth.
Inflation rose instead of falling as forecast.
From the mid-1970s to the early 1980s, the Federal Reserve inflation forecast was below
actual inflation for 16 consecutive quarters. The staff used a Phillips Curve to forecast inflation.
There is considerable research showing that Phillips Curve forecasts of inflation are unreliable. 2
When Paul Volcker became chairman of the Board of Governors, he told the staff that its
inflation forecasts were inaccurate. He repeated the message publicly and in Congressional
testimony. As chairman, Alan Greenspan told the staff that he did not find the inflation forecasts
useful. Like Volcker, he explicitly rejected the Phillips Curve. Under chairman Bernanke,
Phillips Curve forecasts have been restored.
Paul Volcker not only rejected use of the Phillips Curve, he developed and promoted
what I call the anti-Phillips Curve. Unlike the staff approach relying on quarterly data, Volcker
emphasized longer-term responses. His approach, based on empirical observation, was that
during the 1970s, inflation and real growth or the unemployment rate rose and fell together.
There was no tradeoff in the longer period. In a television program as early as 1979, shortly after
announcing his new policy procedure of targeting reserve growth and allowing interest rates to
be set in the market, he was asked what he would do when unemployment rose and his policy

I The percentages are computed from data reported at the time. Subsequent data version may change the growth
rates.
2 One reason is that the data Phillips used are mainly for the years in which Britain was on the gold standard. The
gold standard restricted expected inflation.

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reduced inflation. His reply cited the co-movement for the 1970s when unemployment rates and
inflation rates rose together. He predicted that they would fall together under his policy. They
did. His prediction was correct.
One result of his successful policy of lowering the inflation and unemployment rates was
widespread acceptance of his anti-Phillips Curve analysis: the way to get a low unemployment
rate was to follow policies that yielded low inflation rates. Such policies encouraged investment
and growth. Reliance on the Taylor rule to guide policy from the late 1980s to the early 2000s
reinforced this good result.
Unfortunately, reliance on a policy rule to guide actions ended when officials and market
participants incorrectly forecast deflation after 2003. Policy shifted to discretionary action that
helped to finance a housing boom. By keeping interest rates low, the Federal Reserve financed
much of the housing boom. Federal Reserve policy was not the main cause of the housing boom
and collapse. Housing policy by both political parties endorsed no down payment mortgages for
buyers with no credit rating. Government agencies bought a large share of the risky mortgages
and offered bankers and mortgage broker's large profits for supplying mortgages to the
government mortgage companies.
Volcker knew that policy would not lower the inflation rate quickly. He adopted a
longer-term strategy. He did not ignore current data, but he continued to also act to achieve his
longer-term goal.
When reading transcripts of open market meetings through 1986, I was surprised to tind
little attention or discussion of expectations of medium-term results of the actions decided at the
meeting. No statements are found such as "if we take this action today, I expect growth and
inflation to be in the following range next year." Members see Board staffforecasts of future
events made before policy action is selected. Most have their own staff forecasts. Rarely do the
members explore differences. Members submit quarterly forecasts of future economic
conditions, but these also do not appear to be influenced by the action taken at the meeting.
The result is that current events, market and administration or Congressional pressures
drive decisions to focus heavily on near-term events over which monetary actions have little
effect and too little on achieving medium-term stability with low inflation and relatively stable
growth. As I have emphasized here and elsewhere, in the two periods when the Fed more or less
followed rules, policy was more successful than under discretion. A main reason, I believe, is

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that following rules stabilizes policy actions by forcing more attention on achieving mediumand longer-term outcomes based on the rule. The very successful Deutsches Bundesbank
combined short-term market information and medium-term objectives by choosing a monetary
growth rate to indicate that policy actions tightened or eased too much or too little to maintain
medium-term price stability or low inflation.
Adopting and following a rule would induce the policymakers to givc more weight to
medium- and longer-term objectives. An explicit rule provides infonnation to markets, investors
and consumers that they use to make their plans. In the absence of a rule markets are more
volatile. They have less information about the path to be followed, so they interpret statements
by the chairman and other members. The excess variability generated is costly and wasteful.
A problem closely related is the excessive attention given to short-term data. Standard
economic theory distinguishes between temporary or transitory and permanent or persistent
changes. To gain confidence that policy distinguishes between persistent and transitory events,
policy actions must of necessity allow enough time to pass to avoid over-response to transitory
changes. Many economic variables of interest are noisy. Real GDP growth and unemployment
rates are examples of particular interest.
The Federal Reserve responds to temporary changes in reported inflation rates by
removing volatile changes in the prices of food and fuel. All such changes are not transitory, so
this procedure is flawed. A better way to separate temporary price changes would use the
procedures developed in Muth (1960).
Some Federal Reserve officials deny my claim that their actions overweight relevance of
current and near-term data. It is true that the chairmen and many others talk about medium- or
longer-term objectives. Statements about future inflation, emphasizing determination to prevent
it, are familiar. But statements differ from actions.
Minutes or transcripts during the period of rising inflation in the 1970s contain many
statements about the importance of acting to reduce rising inflation. When unemployment rose,
anti-inflation policy ended, replaced by actions to lower interest rates in response to higher
unemployment. A main result was that both inflation and the unemployment rate rose. Market
participants and the public learned that reducing unemployment had priority. Expected inflation
did not decline as it had in 1966.

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In the summer of 20 10, many traders reported slowing growth, warning that the economy
faced renewed recession and deflation. The Federal Reserve promptly responded by announcing
an additional $600 billion of purchases oflong-term securities. Within a few months, it became
clear that the country did not face renewed recession and deflation. The forecast error cannot be
explained by the additional stimulus. Stimulus had not started or been approved; and when
adopted had little ifany effect. $500 billion of the additional $600 billion of new reserves went
to idle excess reserves.
Alarmed by reports oflow job growth and a failure of unemployment rates to decline,
Chairman Bernanke and other members ofFOMC called for additional stimulus in the summer
of2012. Initial reports of job growth for July and August 2012 showed 141,000 new jobs in July
and 96,000 in August. These data heavily influenced a decision to begin a large scale expansion
of reserves to lower interest rates, especially mortgage rates.
Shortly after the Federal Reserve announced the stimulus, job growth data changed. The
revisions added 86,000 jobs, 40,000 for July and 46,000 for August. No one can be certain that
the revised numbers are correct. Muth's (1960) model does not ignore current data. To separate
permanent from transitory changes, it applies weights based on the relative variance of
permanent and transitory changes.
Higher future inflation is a likely cost of the Fed's over-reaction to noisy employment
data. Staff and officials dismiss this problem saying that they have only to raise interest rates
enough to stop inflation. This response is extremely misleading for several reasons.
One reason is that banks have more than $2 trillion of excess reserves, so they can ignore
small changes in interest rates. Interest rates are lower than at any time in history, so small
increases will not be sufficient. And larger changes will put pressure on the Federal Reserve.
Members of Congress, the administration, business groups, labor unions, and many of the public
will object that after a long recession and years of slow growth, urging the Federal Reserve
should not permit a new recession.
Further, the U.S. Treasury debt held by the public outside government sector (including
the Federal Reserve) reached more than $12 trillion dollars at the end of July 2013, and it
continues to rise rapidly. Average maturity is about 5 years, but 40 percent has less than 2 years
to maturity. Each one percent increase in interest rates increases interest payments within two
years by at least $36 billion for each percentage point of interest rate increase, so a 3 percentage

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point rise in bond rates adds more than $100 billion to government spending. Using the average
share held by foreigners at this maturity, about 113, implies that the balance of payment deficit
rises by almost $50 billion a year. This is a conservative estimate because it neglects guaranteed
debt that adds to both deficits and privately issued debt partly owned by foreigners.
In its 100 year history, the Federal Reserve never agreed on the model of the economy.
do not find much evidence that they try to reconcile differences about how the economy works.
The Board staff has a model of the economy, but Reserve banks use different models. When
members of the Federal Open Market Committee offer forecasts, the forecasts are based on
different models often modified by judgments. I have not found any serious effort to reconcile
differences or to explain their source. There is nothing that can properly be called the Federal
Reserve forecast.
In the past, the Federal Reserve used several different models or paradigms. It has a
history of mistakes. At first, the Board relied on the real bills doctrine and the gold standard.
Later, free reserves and tone and feel guided actions, then a simple Keynesian model with an
unconstrained Phillips Curve that accepted a permanent trade-off of higher inflation for reduced
unemployment rate. None of these guided actions to achieve low inflation and relatively stable
output growth. Guidance based on the Taylor rule substantially improved performance.
Recently, the Board staff and principal members used a model based on Woodford's
(2003) elegant modeling. This, too, is deficient. In the model, money and credit do not matter
for monetary policy. And prices of assets are not part of the transmission mechanism. Only
short-term interest rates and rational expectations are relevant. How could we have a credit
crisis? Could anyone believe that the decline in housing prices was a rationally expected
response to policy?
I find it incredible that a central bank ignores changes in money and credit. Simply put,
that is a mistake that not only ignores much that economist have learned about monetary
economics from analysis and history. No less surprising is the total neglect of the role of asset
prices in the transmission of monetary impulses. Earlier work by Brunner and Meltzer (1993)
and by Tobin (1969) did not neglect asset prices or credit.
A perennial issue in many countries is the choice between domestic price stability and
exchange rate stability. No country acting alone can achieve both domestic price stability and
stability of its currency. International agreement must supplement domestic policy.

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For many years I have proposed an international arrangement that achieves both ends for
countries that choose to participate. The arrangement is voluntary and requires no meetings (0
coordinate policy. Countries that participate achieve low inflation and greater stability of
exchange rates.
Major countries agree to follow domestic policies to hold their inflation rates between
zero and two percent. The United States, the European Central Bank, and the Bank of Japan
have accepted this policy objective. If China removes exchange controls, it could choose to be a
fourth member by adopting the common inflation rate. The three or four main currencies would
float to adjust to changes in relative productivity and demand.
All other countries that chose to peg to one or more of the major countries would import
price stability and maintain a fixed exchange rate. Their decision to peg their exchange rate
permits major countries to trade with them at a fixed exchange rate. The world gains a public
benefit.
There is no organized coordination arrangement. Like the gold standard discipline is
enforced by markets. If one of the major countries runs large budget deficits, markets will
depreciate the currency. As Bordo and Schwartz (1984) showed, the system will not work
without error or deviations, but it will increase staility.
If major countries adopt and announce a rule for monetary policy, such as the Taylor rule,
market monitoring will be more effective and uncertainty about monetary policy will be reduced.
Further, of major importance, a monetary rule that limits central bank financing of government
deficits requires increased fiscal discipline.
Discretionary policy produced the Great Depression the Great Inflation and many periods
of inflation and recession. Exchange rates have varied over a wide range. Rule-based policy
will not be perfect. The future is uncertain and unanticipated changes occur. But uncertainty
about policy will be lessened.
I have often proposed that the Federal Reserve announce its provisional targets for two or
three years ahead. If it fails to achieve its targets, it would offer an explanation and resignations.
The political authorities could choose. This proposal reduces the gap between authority for
policy decisions and outcomes and responsibility to the public when policy errors occur. The
Federal Reserve has authority to act, but elected officials are punished when the economy falters.

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Finally, following the recent financial crisis and in its aftermath the Federal Reserve has
engaged in fiscal actions, debt management, and has quadrupled the size of its balance sheet. I
believe no agency of government should have as much independent authority. We profess to
have a limited government. The Federal Reserve has acquired unlimited authority. Congress
should not permit that power to continue without oversight and prior agreement.

Financial Stability
The 2007-09 financial crisis concentrated attention on financial stability. Here, again the
Fed failed to prevent the crisis, then responded appropriately to prevent collapse of the economy.
In the United States, the Dodd-Frank law brought nearly 400 new regulations according
to one count. The law is a poor substitute for a program that increases financial stability by
providing proper incentives.
The Dodd-Frank law and Federal Reserve regulation is unlikely to achieve its stated
objectives. Skepticism is warranted because the law shifts responsibility from bankers to policy
agencies. We know that regulators had agents in all the major banks prior to the 2008 crisis.
The agents observed all transactions; they did not reject any.
Further, regulators permitted financial institutions to increase leverage and ignore capital
requirements. Regulatory capture is well-known and ever present.
In its first 100 years, the Federal Reserve has never announced a rule governing its role as
lender-of-last-resort. The absence of a rule prevents banks from anticipating policy action and
preparing portfolios to prevent failure. The proper way to increase stability is to increase banks
incentive to avoid excessive risk-taking. To do that the law should require banks to hold
considerably more equity capital.
A major mistake in regulatory policy is the decision to protect bank failures. A proper
policy would protect the public by preventing collapse of the payment mechanism. The threat to
the economy comes from the collapse of the payments system and the spread of panic from one
lender to others.
In its first 100 years, the Federal Reserve has never announced a lender-of-Iast-resort
policy. Every banking crisis brings some actions, but there is never an announced rule.
Bagehot's famous criticism of the Bank of England's policy did not fault its actions. Bagehot's

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(1873) criticism was that the Bank did not announce its policy in advance. My proposals for
financial stability remove the nearly 400 regulations in the Dodd-Frank law and adopt four rules.
1.

A clearly stated rule governing the lender-of-Iast-resort. Bagehot's rule, lend
freely against good collateral at a penalty rate remains appropriate.

2.

Protect the payments system, not the bank, banks, or bankers.

3.

Implementing the first two rules, prevents the problem from spreading to other

4.

Require regulated large banks to hold at least 15 percent equity capital against all

banks and financial institutions.

assets.
When these rules were in force, they prevented bank crises.
Bagehot's criticism ofthe Bank of England applies to the Federal Reserve. By
announcing and following a policy rule, the Federal Reserve would notify banks about what it
will and will not do. It gives them an incentive to hold collateral acceptable for discount at the
Reserve Banks. It reduces uncertainty, surely a gain during crises. It also reduces the expected
gain from failing banks asking Congress to press the Federal Reserve or others for bailouts. And
if banks follow the rule by holding collateral and larger equity reserves, fewer fail.
A policy rule for too-big-to-fail should not be the main way to prevent failures. Far more
important is a rule that prevents most failures. Congress should enact equity capital standards for
banks. I propose that beyond some minimum size, equity capital requirements should increase
with asset size up to a maximum of 20 percent of assets. Losses would be borne by stockholders.
The Federal Reserve and other regulators would monitor capital requirements. Outside auditors
would certify that the requirements are met. Equity capital of 15 to 20 percent would restore
capital for large banks to where it was in the 19205. (Meltzer, 2012)
As the Federal Reserve reaches its one hundredth anniversary, it seems appropriate to
consider its strengths that should be maintained and its weaknesses that should be corrected. Its
greatest strength are its strong esprit de corps and the fact that it has adapted from the very
restricted agency created in 1913 to the world's most powerful central bank. And to its great
credit, it has not had a major scandal or impropriety. A few examples of "leaks" ended when the
Fed started to announce its decisions.
Several of the Fed's failures are well-known. The Great Depression and the Great
Inflation are part of its record. The Fed has many other flaws. One of its major mistakes is the

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excessive attention it gives to current data about which it can do little. It rarely acts to change
the medium and longer-term over which it has much more influence. When writing Fed history,
I was surprised, and dismayed, that one hardly ever sees statements about what the members
expect to happen a year from now as a result of the actions taken at its meeting. True, the staff
provides forecasts about the future, but these are made before policy action is decided. I did not
find much useful discussion of the forecasts. Both Paul Volcker and Alan Greenspan told the
staff several times that its inflation forecasts based on the Phillips Curve were not useful. But the
Phillips Curve is still central to the inflation forecasts that Chairmen Volcker and Greenspan
found useless.
Two main reasons explain why the Fed should give more attention to the medium- and
longer-term. First, many changes are transitory. The economic data in the 2012 winter are one
of many examples. Data do not tell us immediately whether the reported improvement was
temporary or would persist. We didn't learn the answer until weaker data returned in the spring.
Yes, the high, current unemployment rate is a serious human and economic problem. But
the Fed can permanently reduce unemployment only if the problem is monetary. The very
expansive monetary policies of the past four years helped during the crisis of2008-9, but not
currently.

OUf

problems are mainly, real- and long-term. With mortgage rates lower than ever

before and housing showing very sluggish recovery until recently, what can be gained by
dropping the mortgage rate another small fraction? Business investment is held back by massive
uncertainty. No one can reliably calculate the tax rates, health care costs and regulatory burden.
How can corporate officers calculate expected return when they cannot know these future costs?
That's a REAL problem, not a monetary problem. More Fed stimulus cannot permanently
reduce real problems.
From about 1985 to 2003 the Fed achieved relatively stable growth, short, mild
recessions and low inflation by more or less following a Taylor rule. That's the only long period
in postwar economic history when it achieved the dual mandate ordered by Congress. Rulebased policy brought much better outcomes than discretionary ups and downs. The Fed should
commit to that quasi-rule and follow it.
Again, the United States has serious long-term problems. Instead of more short-term
stimulus, we need a government that puts us on a path toward a balanced budget over time,
mainly by reducing spending, and gets the Fed to start gradually reducing the massive pile of

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excess reserves. Instead of denigrating and then ignoring Paul Ryan's courageous efforts, the
administration should put a program on the table to control our funded and unfunded deficits.
Evidence is growing that many think higher inflation is in our future. One sign is the
premium that investors pay to hold index-linked Treasury bonds that protect against inflation.
Another is the amount of borrowing to buy agricultural land. A third is the shift by asset owners
from holding money to holding equities and real assets. What many call "bubbles" cannot occur
without a shift from holding money to owning real assets or claims to such assets.
One of the many costs of the Fed's excessive attention to the near-term is that it will wait
until after the inflation is upon us before they do anything to stop it. Their view is that by raising
interest rates enough, they can stop any inflation. True, but not entirely relevant. Will the
politicians, the public, business and labor accept the necessary level of interest rates? Much past
history says: "Don't count on it." Better to adopt a 21 st century rule and begin gradually
reducing excess reserves now. And for the first time announce and follow a rule for the lenderof-last-resort.
You, the members of this committee can playa more effective role. Adopt a rule that the
Federal Reserve must follow. Require the chair to explain why they departed from the rule.
Enforce the rule by requiring offers of resignation along with statements explaining departures
from the rule. That will make oversight meaningful and will help you to fulfill the responsibility
the Constitution assigned to the Congress.
Following announced rules is the best way to restore Federal Reserve independence.

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Table 1
Quarterly Root Mean Square Forecast Errors, United States
Per cent Per annum

Median or
Variable

Time Period

Real GNP

1980/2-1985/1

Range

3.1

4.4

Actual

Source

3.8

McNees

(1986)"

Growth

1970 -73

2.1

Lombraand
Moran (1983)

1970/4-1983/4

2.8

3.6

3.0

Zamowitz (1986)

1970/1-1984/4

4.4 - 5.4

4.7

Webb (1985)

1980/2-1985/1

1.4-2.2

1.6

McNees (1986)"

1970/4-1983/4

2.0-2.6

2.2

Zamowitz (1986)

1970/1-1984/4

Inflation

1.8 -2.1

1.9

Webb (1985)

Nominal GNP

1967-82

5.5

Federal

growth

1973/82

6.2

Reserveb

3.8

Zamowitz ([986)

1970/4-1983/4

3.5 - 4.3

a12 forecasts early in the quarter. Median values for 3 late quarter forecasts: real GNP, 2.4,
inflation, 1.4.
bFederal Reserve "green" books, various issues.
I.Forccasts for other data that we have reviewed include interest rates, money growth,
investment, trade balance and balance of payments. Forecast errors are usually larger for these
variables relative to mean values.

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A
i

97

American Enterprise Institute
for Public Policy Research

~

Statement before the Committee on Financial Services
Subcommittee on Monetary Policy and Trade
On "The Fed Turns 100: Lessons Learned over a Century of Central Banking"

The Fed Is as Poor at Knowing the Future
as Everybody Else
Alex J. Pollock
Resident Fellow
American Enterprise Institute
Wednesday, September 11, 2013

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The views expressed in this testimony are those of the author alone and do not necessarily represent those of the
American Enterprise Institute.

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2

Testimony of
Alex J. Pollock
Resident Fellow
American Enterprise Institute
To the Subcommittee on Monetary Policy and Trade
Of the Committee on Financial Services
U.S. House of Representatives
Hearing on "The Fed Turns 100: Lessons Learned from a Century of Central Banking"
September 11, 2013

The Fed Is as Poor at Knowing the Future as Everybody Else

Mr. Chairman, Ranking Member Clay, and Members of the Subcommittee, thank you for the opportunity
to be here today. I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are
my personal views. Before joining AEI, I was President and CEO of the Federal Home Loan Bank of
Chicago from 1991 to 2004. I have published numerous articles on banking and financial systems,
including the role of the Federal Reserve and central banks in general.
A striking lesson of the 100-year history of the Federal Reserve is how it has been able from its beginning
to now to inspire entirely unjustified optimism about what it can know and what it can accomplish.
Upon the occasion of the Federal Reserve Act in 1913, an American Banker writer opined, "The financial
disorders which have marked the history of the past generation will pass away forever." Needless to
say, the Fed h~s not made financial disorders disappear, and not for lack of trying, while it has often
enough contributed to them.
In 1914, the then-Comptroller of the Currency expressed the view that with the creation of the Fed,
"financial and commercial crises, or panics ...seem to be mathematically impossible." They weren't.
The unrealistic hopes continued. As a forthcoming history says, "The bankers at the Federal Reserve
kept the money flowing in to the American economy at a pitch that held interest rates low and kept
expanding business and consumer credit... [but) there was no rise in prices. The business cycle ... had
finally been tamed-or so it seemed. Economists around the world praised the Federal Reserve. Some
even predicted that a 'new era' in economics had begun." This passage sounds like it is describing the
central bank optimism of the early 2000s with the so-called "Great Moderation," but in fact it is
describing the 1920s. We know what came next, and the Fed is widely blamed for its deflationary
blunders in the crisis of the early 19305, and again in 1937.

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In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and
hold down the interest rates on government debt, thus doing in great scale exactly what the fathers of
the Federal Reserve Act had tried to prevent: monetizing government debt. (The Fed had also lent its
full efforts to finance the government during the American participation in the First World War.)

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After enjoying the American global economic hegemony of the 1950s, the 1960s brought a new high
point in optimism about what discretionary manipulation of interest rates and financial markets could
achieve. Otherwise intelligent and certainly well-educated economists actually came to believe in what
they called "fine tuning": that the Fed and government policy "could keep the economy more or less
perfectly on course," as discussed by Fed Chairman Bernanke in his new book, The Federal Reserve and
the Financial Crisis. Some economists even held a conference in 1967 to discuss "Is the Business Cycle
Obsolete?" It wasn't.
The fine tuning notion "turned out to be too optimistic, too hubristic, as we collectively learned during
the 1970s," Bernanke writes, "so one of the themes here is that-and this probably applies in any
complex endeavor-a little humility never hurts." Very true.
Indeed, the performance of the Federal Reserve at economic and financial forecasting in the last
decade, including missing the extent of the Housing Bubble, missing the huge impact of its collapse, and
failing to foresee the ensuing sharp recession, certainly strengthens the case for humility on the Fed's
part, especially when it attempts to forecast financial market dynamics. The poor record of economic
forecasting is notorious, and the Fed is no exception to the rule.
If only the Chairman, the Governors, the Presidents and the scores of economists of the Federal Reserve
could really know the future! Then they could carry out their discretionary actions without the many
mistakes, both deflationary and inflationary, which have marked the history of the Fed. These mistakes
should not surprise us. As Arthur Burns, Fed Chairman in the 1970s and architect of the utterly
disastrous Great Inflation of that decade, said: "In a rapidly changing world, the opportunities for
making mistakes are legion."
In a 1996 speech otherwise famous for raising the issue of "irrational exuberance," then-Fed Chairman
Alan Greenspan sensibly discussed the limits of the Fed's knowledge. "There is, regrettably, no simple
model of the American economy that can effectively explain the levels of output, employment and
inflation," he said. (Since it is effectively the world's central bank embedded in globalized financial
markets, the Fed would need not merely a model of the American economy, but one of the world
economy.)
"In principle," Chairman Greenspan continued," there may be some unbelievably complex set of
equations that does that. But we [the Fed] have not been able to find them, and do not believe anyone
else has either." They certainly have not, as subsequent history has amply demonstrated. Moreover, in
my view, not even in principle can any model successfully predict the complex, recursive financial and
economic future-so the Fed cannot know with certainty what the results of its own actions will be.
Nonetheless, the 21" century Federal Reserve and its economists again became optimistic, and perhaps
hubristic, about the central bank's abilities when Chairman Greenspan had been dubbed "The Maestro"
by the media and knighted by the Queen of England. It is now hard to remember the faith he and the
Fed then inspired and the confidence financial markets had in the support of what was called the
"Greenspan put."

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Queen Elizabeth would later quite reasonably ask why the economists and central banks failed to see
the crisis coming. One lesson we can draw from this failure is that a group of limited human beings,
none of whom is blessed with knowledge of the future, with all the estimates, guesses, and fundamental

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uncertainty involved, by being formed into a committee, cannot rationally be expected to fulfill the
mystical notion that they can guarantee financial and economic stability.
In the early 2000s, of particular pride to the Fed was that the central bankers thought they were
observing a durable "Great Moderation" of macro-economic behavior, a promising "new era," and gave
their own monetary policies an important share of the credit. With an eye on a hoped-for "wealth
effect" from rising house prices, the Fed pushed interest rates exceptionally low as the housing bubble
was rapidly inflating, which many observers, including me, view as a critical mistake. Chairman
Bernanke has since insisted that the Great Moderation was "very real and striking." Yet, since it is
apparent that the Great Moderation led to the Great Bubble and then to the Great Collapse, how could
it have been so real?
Economic historian Bernard Shull has explored the paradox that throughout its 100 years, no matter
how many mistakes the Fed makes, or how big such mistakes are, it nonetheless keeps gaining more
power and prestige. In 2005, he made the following insightful prediction: "We might expect, on the
basis of the paradoxical historical record, still further enhancements of Federal Reserve authority."
Indeed, in the wake of the bubble and collapse, the political and regulatory overreaction came, as it
always does each cycle. The Dodd-Frank Act gave the Fed much expanded regulatory authority over
financial firms deemed "systemically important financial institutions" or "SIFls," and a prime role in
trying to control "systemic risk."
But the lessons of history make it readily apparent that the greatest SIFI of them all is the Federal
Reserve itself. It is unsurpassed in its ability to create systemic risk for everybody else through its
unlimited command of the principal global fiat money, the paper dollar. As former-Senator Bunning
reportedly asked Chairman Bernanke, "How can you regulate systemic risk when you are the systemic
risk?" A good question! Who will guard these guardians?
A memorable example of systemic risk is how the Fed's Great Inflation of the 1970s destroyed most of
the savings and loan industry by driving interest rates to levels previously thought impossible. In the
1980s, the Fed under then-Chairman Paul Volcker, set out to "fight inflation" ---the inflation the Fed
had itself created. In this it was successful, but the high interest rates, deep recession and sky-high
dollar exchange rate which resulted, then created often-fatal systemic risk for heartland industries and
led to a new popular term, "the rust belt." A truly painful outcome of some kind was unavoidable, given
the earlier inflationary blunders.
A half-century before that, in 1927, the then-dominant personality in the Federal Reserve, Benjamin
Strong, famously decided to give the stock market a "little coup de whiskey." In our times, the Fed has
decided to give the bond market and the mortgage market a barrel or so of whiskey in the form of socalled "quantitative easing." This would undoubtedly have astonished previous generations of Federal
Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

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How will this massive manipulation of the government debt and mortgage markets turn out? Will it
make the current Fed into a great success or become another historic blunder? In my opinion, neither
the Fed nor anybody else knows-about this all of us can only guess. It is a huge and fascinating gamble,
which has without doubt induced a lot of new systemic interest rate risk into the economy and
remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.

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In the psychology of risky situations, actions seem less risky if other people are doing the same thing.
That is why, to paraphrase a celebrated line of John Maynard Keynes, a "prudent banker" is one who
goes broke when everybody else goes broke. That other central banks are also practicing versions of
"quantitative easing" may induce the same subjective comfort. A decade ago, bankers felt a similar
effect when they all were expanding mortgage debt together.
Robert Solow recently claimed that "Central banking is not rocket science." Indeed, it isn't:
discretionary central banking is a lot harder than rocket science. This is because it is not and cannot be a
science at all, because it cannot operate with determinative mathematical laws, because it cannot make
reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future. We
should have no illusions, in sharp contrast to the 100 years of illusions we have entertained, about the
probability of success of such a difficult attempt, no matter how intellectually brilliant and personally
impressive its practitioners may be.
It is often debated whether the Fed can successfully achieve two objectives, the so-called "dual
mandate," rather than one. It does seem doubtful that it can, but the question oversimplifies the
problem, for the Fed has not two mandates, but six.
The preCise provision of the Federal Reserve Reform Act of 1977, which gives rise to the discussion of
the "dual mandate," is almost always mischaracterized, for that provision assigns the Fed three
mandates, not two. The Fed shall, it says, "promote effectively the goals of maximum employment,
stable prices, and moderate long-term interest rates." This is a "triple mandate," at least. The third
statutorily assigned goal is almost always forgotten. It is doubtful indeed that the Fed can
simultaneously do all three.
But in addition to these, the Fed has three more mandates. These are: to furnish an elastic currency, the
historically first mandate and the principal reason for the existence of the Fed in the first place; to act as
the manager of the risks and profits of the banking club, now expanded to include other "SIFls"; and
finally, to provide ready financing for the deficits of the government of which it is a part, as needed.
Let us do a quick review of how the Fed is doing at each of its six mandates.
To begin with "stable prices": this goal was in fact dropped long ago. The Fed's goal is not and has not
been for decades stable prices, but instead permanent inflation-with a relatively stable rate of increase
in prices. In other words, the Fed's express intention is a steady depreciation ofthe currency it issues,
another idea which would have greatly surprised the authors of the Federal Reserve Act. At its "target"
of 2% inflation a year, average prices will quintuple in a normal lifetime. Economists can debate
whether a stable rate of price increases rather than a stable price level is a good idea, but you cannot
term perpetual inflation "price stability" with a straight face.

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Turning to "maximum employment": Nobody believes any more, as many people believed when this
goal was added to the governing statute in 1977, that there is a simple trade-off between inflation and
sustained employment. It was still believed when the Humphrey-Hawkins Act of 1978 was passed,
although it was already being falsified by the great stagflation of the late 1970s. Humphrey-Hawkins
added a wordy provision requiring the Fed to report to and discuss with Congress its plans and progress
on the triple mandate. Did these sessions succeed? They obviously did not avoid the financial disasters
of the 1980s and 2000s, or the inflation of giant bubbles in tech stocks and housing.

102
6

On "moderate long-term interest rates": As the Treasury's servant in the 1940s, the Fed kept the yield
on long-term government bonds at 2 y,%. After this practice was ended by the "Treasury-Fed Accord" of
1951, a 30-year bear bond market ensued, which ultimately took long-term interest rates to 15% in the
early 1980s-this was not a "moderate" interest rate, to be sure. With the Fed's current massive bond
buying, rates on long-term government bonds got to 1Y,%-2%, which was zero or negative in real
terms-also not a "moderate" interest rate.
The fourth mandate stood right at the beginning of the original Federal Reserve Act in 1913. The
authors of the Act told us clearly what they wanted to achieve:
"An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency ...."
An elastic currency is most definitely what we have got, not only in the U.S., but given the global role of
the dollar, in the world. Indeed, we have one much more elastic than originally intended. This is very
handy during financial panics when the Fed is acting as the lender of last resort. The unanswered
question is: given a pure paper currency (not originally intended, of course) with unlimited elastic
powers, what limits should there be other than the demonstrably fallible beliefs and judgments of the
members of the Federal Reserve?
Charles Goodhart's monograph, The Evolution of Central Banks, makes a strong argument that it helps to
understand central banks, including the Fed, by thinking of them as the manager of the banking club,
which tries to preserve and protect the banking industry. This becomes most evident in banking crises.
It was explicitly expressed in an early Fed plaque: "The foundation of the Federal Reserve System is the
co-operation and community of interest of the nation's banks." Such candor is not currently in
fashion-the fifth mandate is now called "financial stability." As discussed, this mandate has been
expanded by Dodd-Frank beyond banks to make the Fed the head of an even bigger financial club.
Sixth is the most basic central bank function, and Fed mandate, of all: financing the government, a core
role of central banks for over three centuries. As economist Elga Bartsch has correctly written, "The
feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central
bank." Thus for governments that wish to finance long-term deficits with debt, like the United States,
central banks are exceptionally useful, which is one reason virtually all governments have one-- no
matter how disappointing the central bank's performance at stable prices, maximum employment,
moderate long-term interest rates, and financial stability may be. Needless to say, the power of
financing the government is also dangerous.
Allan Meltzer, an eminent scholar of the Federal Reserve and our colleague on this panel, near the end
of his magisterial A History of the Federal Reserve, quotes the classic wisdom of monetary thinker Henry
Thornton from 1802-- 211 years ago, who proposed:

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"to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to
borrow is strong, to some effectual principle of restriction: in no case, however, materially to diminish
the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious
extension of it, as the general trade of the kingdom enlarges itself.... To suffer the solicitations of the
merchants, or the wishes of the government, to determine the measure of bank issues, is
unquestionably to adopt a very false principle of conduct."

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7

These are sensible guidelines, as my friend Allan suggests. But another lesson of 100 years of Federal
Reserve history is that we have still not figured out how to implement them.

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Thank you again for the opportunity to share these views.

104

.~.

MERCATUS CENTER

.~. George Mason University

TESTIMONY

Bridging the gap between academic ideas and real-world problems

THE FEDERAL RESERVE AND THE RULE OF LAW
BY LAWRENCE H. WHITE
Subcommittee on Monetary Policy and Trade
House Committee on Financial Services

September 11, 2013

Chairman Campbell, Ranking Member Clay, and members of the Subcommittee, thank you for inviting me to testify, Much of what I am going to say today draws on my previous research, which is cited below.'
The principle of the rule oflaw-as opposed to the arbitrary rule of those in authority-would have helped us to
properly resolve the financial crisis of 2007-10, and can help us to avoid future financial crises. As David Hume
said more than two hundred years ago, the henefits of consistently adhering to rule of law greatly outweigh any
short-term convenience from ad hoc measures.
The approach of Federal Reserve and Treasury officials during the crisis, unfortunately, was to consider every
possible remedy but following the rule oflaw. Fed chairman Ben Bernanke was quoted by the New York Times as
declaring in 2008, at a strategy meeting with other Fed and Treasury officials, "There are no atheists in foxholes
and no ideologues in financial crises.'" The implication was that anything goes in a crisis: the Fed can ignore
durable principles and its own statutory limits.
Most notoriously, the Fed at its own initiative
1. Created an unprecedented special-purpose vehicle (called "Maiden Lane LLC") to protect the
bondholders of the failed investment house Bear Stearns by taking $30 billion of the firm's most
doubtful assets off of its books, thereby sweetening an acquisition deal for JP Morgan Chase to take
over the remainder of the firm's assets and liabilities;

2. Declined to do the same for the investment house Lehman Brothers; and
3. Created two other vehicles-Maiden Lane II and Maiden Lane III-to buy and hold bad assets from
the failed insurance company ArG.
There was no precedent, and no apparent legal authority in the Federal Reserve Act, for such special-purpose funding
operations, The Fed abandoned the rule oflaw, which requires those in authority to execute the law as written, predictably, and in accordance with established precedent.
The Fed's established monetary policy role as "lender oflast resort" directs it to inject ca.h into the system to keep the

1. Much of what follows draws on lawrence H. White, ~The Rule of Law or the Rule of Central Bankersr Cato }ourna/30 (Fall 2010), and White,
"Federal Reserve Policy and the Housing Bubble," Cato )ournaf29 (Winter 2009)'
2. Peter Baker, ~A Professor and a Banker Bury Old Dogma on Markets." New York Times, 20 September 2008.
For more information or to meet with the scholar, contact

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The ideas presented In nus dowment d~~ not represent offirJa.! pOSitions of the M(>fCatus Center or GeO! ge l'lrlason University.

105
broader money stock from shrinking, not to inject capital into failing finns by overpaying for assets or lending at subsidized rates, actions that put taxpayers at risk. The Fed's statutory authority to lend is limited and was never meant to
encompass the sort of capital injections that the Fed undertook in 2008 through the special purpose vehicles. While
the Dodd-Frank Act of 2010 properly places new limits on the Fed's discretion to conduct such bailout operations, it
unfortunately ratifies the Fed's discretion in other respects. Dodd-Frank also enshrines the "too big to fail" doctrine,
the application of which inherently requires arbitrary judgments. It thereby erodes the rule oflaw, increases the probability of future taxpayer-funded bailouts, and weakens market discipline between risk and reward.
THE RULE OF LAW
At the core of the rule oflaw concept is the constitutional principle of nondiscretionary governance, in contrast to
arbitrary or discretionary governance by those currently in executive positions. In common parlance, either we
have the rule oflaw or we have the rule ofauthorities. Under the rule oflaw, government agencies faithfully enforce
statutes already on the books, and only such statutes' Under the rule of authorities, those in positions of executive authority can make up substantive new decrees as they go along and forgo enforcing statutes on the books.
It is of course true that laws must be executed by people in authority. We also know that the referees in a football
match will be people. But they can either be referees who impartially enforce the rules of the sport as they were
known at the outset of the match-that is, referees who follow the rule of law-or they can be pseudo-referees
who arbitrarily enforce rules against one team but not the other, or (even worse) who penalize or favor one team
with novel interventions that they have improvised mid-contest.

The rule oflaw concept has deep historical roots. David Hume's classic History ofEngland, written more than two centuries
ago, famously emphasizes the value ofestablishing the rule oflaw in place of the unconstrained discretion ofgovernment
officials. Hume acknowledges that it is not always convenient in the short run to forgo ad hoc measures. He writes that
"some inconveniences arise from the maxim ofadhering strictly to law;' but Hume affirms the lesson of history that in the
long run we are better off from adhering to the rule oflaw. Accordingto Hume, "It has been found that ... the advantages
so much overbalance" the inconveniences that we should salute our ancestors who established the principle.
Consistent adherence to the rule oflaw has the great advantage, as the economics Nobel laureate F. A. Hayek has
noted, that "government in all its actions is bound by rules fixed and announced beforehand-rules which make it
possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and
to plan one's individual affairs on the basis of this knowledge.'"
In this way, the rule of law allows a society to combine freedom, justice, and a thriving economic order.' To the
extent that they can predict the actions of their government's executive branch, Americans can confidently plan
their lives and businesses, and they can coordinate their plans with one another through the market economy.
Taxpayers need not fear being burdened (by being arbitrarily placed on the hook for bailing out failed businesses,
for example) by executive branch agencies acting without authorization by their representatives in Congress.
THE FEDERAL RESERVE'S TRADITIONAL "LENDER OF LAST RESORT" ROLE
As a historian of antiquarian monetary institutions, let me take you back to what now seems like the distant past: the five

decades from 1958 to 2008. In 1958, Congress finally repealed a 1934 Depression-era amendment to the Federal Reserve
Act ("Section 13(b)") that had authorized the Fed to make loans to non-banking businesses under certain circumstances.
The praiseworthy idea behind the repeal, as economist Marvin Goodfriend has put it, was that "credit policies should
not be carried out by an independent central bank because credit allocation is inherently political and has the potential
to degrade the central bank's independence:" Then-Federal Reserve Chairman William McChesney Martin, when a bill

3. If a statute authorizes an agency to fix and announce specific rules toward a general end, and the agency does so according to public procedures called for in the statute, we may consider enforcement of such rules as enforcement of the statute.
4. Friedrich A Hayek, The Road to Serfdom: The Definitive Edition, vol. 2 of The Collected Works of F. A. Hayek. ed. Bruce Caldwell (Chicago;
University of Chicago Press, 2007), 112<
5. See Randy Barnett, The Structure of Liberty: Justice and the Rule of Law (Oxford: Clarendon Press, 1998).
6. Marvin Goodfriend, "The Elusive Promise of Independent Centra! Banking" (IMES Discussion Paper Series 2012~E~9. Bank of Japan Monetal)l
and Economic Studies, Tokyo, 2012), 40.

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before Congress in 1957 proposed that the Fed contribute financing to regional development corporations, thoughtfully
commented, "It is good government as well as good central banking for the Federal Reserve to devote itself primarily
to the objectives set for it by Congress, namely, guiding monetary and credit policy so as to exert its influence toward
maintaining the value of the dollar and fostering orderly economic progress:' Therefore "it is undesirable for the Federal
Reserve to provide the capital and participate in management functions" oflending institutions.'
The Federal Reserve System thereafter largely returned to playing the traditional central banking roles of conductingmonetary policy and (on very rare occasions, like the day after 9/11) acting as a "lender oflast resort:' Monetary
policy means controlling the quantity of money in pursuit of economic objectives. Acting as a lender oflast resort
is, in modern economic understanding, an aspect of monetary policy. It means injecting cash into the commercial

banking system to prevent the broader quantity of money from shrinking-and thereby to protect the economy's
income and payment flows from disruption-when there is an unusual hoarding of cash by banks or the public.'
The "lender" part of "lender oflast resort" has long been an anachronism. Although the Federal Reserve can inject cash
by making a loan to a particular bank, it need not do so. As it discovered many decades ago, the Fed can better provide
cash to the market as a whole without lending, namely, by purchasing securities in the open market. Bypurchasingsecurities from bond dealers at the going market price, the Fed supports the broader money stock while avoiding the danger
of favoritism associated with making loans to specific banks on non-market terms.' By purchasing only US Treasury
securities, as the Fed typically did before 2008, it avoids the potential for favoritism in purchasing some private-sector
securities over others. At the end of2007, the amount ofloans that the Fed had out.standingto commercial banks through
its "discount window" was trivial: less than $0.5 billion on a balance sheet of $800 billion.
Loans to nonbank institutions were, appropriately, zero at the end of 2007. There had been occasions after 1958
when the Fed was asked to lend to nonbanks. Fortunately, because such an action is properly understood as fiscal
policy outside the Fed's remit, the Fed consistently directed the requests to Congress. In 1970, as a chronology
by David Fettig of the Federal Reserve Bank of Minneapolis relates, "The Nixon administration asked for [Fed)
discount window assistance in response to the financial problems of Penn Central Railroad. This request stalled
in Congress:"o In 1975 the Fed properly declined to provide "emergency credit" to New York City, and Congress
took up the matter. In 1991, when the FDIC sought a loan from the Fed to replenish its depleted insurance fund,
the Fed directed the head of the FDIC to go to Congress, which properly made the Treasury, and not the Fed, the
provider of a credit line. In 2001, with the airline industry reeling following the 9/11 attacks, emergency loans
from the Federal Reserve were suggested, but the Fed refrained.
Less fortunately, the Fed was not consistent in following prudent guidelines for its loans to banking institutions.
As noted, the modern understanding of the Fed's lender of last resort role is that of preventing shrinkage in the
broad money supply. This is sometimes described less clearly as providing the market with adequate "liquidity."
Lending liquidity does not mean subsidizing, papering over inadequate net worth, or delaying the resolution of an
insolvent institution. The lender of last resort role has nothing to do with providing insolvent firms with capital
injections or loans at below-market rates. The Fed in the 1958-2008 period unfortunately did not consistently

avoid lending to insolvent banks. Two especially egregious cases stand out.
• In 1974 the Federal Reserve lent $1.75 billion to the Franklin National Bank. Later that year, the
bank was recognized to be insolvent and the FDIC placed it in liquidation.

7. "Statement of William McChesney Martin, Jr.. Chairman, Board of Governors of the Federal Reserve System. before the Subcommittee on
Small Business of the Senate Banking and Currency Committee, June 20, 1957," Federal Reserve Bulletin 43 (July 1957): 767-9.
8. By "cash," I mean what economists call the monetary base of MO, the Federal Reserve's monetary liabilities, equal to the sum of currency
held by the public plus bank reserves. By "the broader quantity of money," t mean an aggregate like M1 or M2 that includes currency plus bank
deposits held by the public.
9. Marvin Goodfriend and Robert G. King, "Financial Deregulation, Monetary Policy, and Central Banking," in William S. Haraf and Rose Kushmelder, eds., Restructuring Banking and, Financial Services in America (Washington: American Enterprise Institute, 1988).
10. David Fettig, DThe History of a Powerful Paragraph, Banking and Policy Issues Magazine (June 2008): 33-34, http://www.minneapolisfed.
org/publications_papers/pub_display.cfm?id=3485.
H

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• In 1984 the Fed joined with the FDIC to nationalize (rather than liquidate) the failed Continental
Illinois Bank. The bank was later re-privatized at a loss to taxpayers of about $1.1 billion.
More broadly, the well-known monetary economist Anna Schwartz found that the Federal Reserve lent frequently
to small-to-medium-sized failing banks. Between January 1985 and May 1991, 530 banks failed within three years
of first borrowing funds from the Fed. Of those, 437 had the worst CAMEL (soundness) rating given by the Fed's
own examiners, and 51 had the second worst rating; 60 percent of them failed while still owing money to the Fed."
The Fed discount window managers knew these ratings, so it is clear that the Fed chose to ignore the traditional
central banking rule oflending only to illiquid and not to insolvent banks.
The FDIC Improvement Act of 1991 (FDICIA) aimed to avoid a repeat of the FDIC's insurance fund becoming
depleted. But it also, in Fettig's words, "amended Section 13 [of the Federal Reserve Act] to allow the Fed to lend,
in essence, directly to securities firms during financial emergencies:'" As amended in 1991, and before it was
re-amended by Dodd-Frank in 2010, the language of section 13(3) authorized the Fed's Board of Governors, "in
unusual and exigent circumstances," which prevail Hduring such periods as the said board may determine," to
"'discount ... notes, drafts, and bills of exchange" for "any individual, partnership, or corporation'1 it chooses (not
just for commercial banks, as before 1991).
Critics of the amendment worried that such authority, expanded beyond traditionallender-of-Iast-resortpowers,
would foster favoritism and moral hazard. Schwartz warned that "the provision in the FDIC Improvement Act
of 1991 portends expanded misuse of the discount window," that is, use of the Fed's lending authority for bailouts
rather than for monetary policy objectives. Walker F. Todd, an attorney then with the Federal Reserve Bank of
Cleveland, wrote, "Ironically, while the principal tbrust ofFDICIA was to limit or reduce the size and scope of the
federal financial safety net, this provision effectively expanded the safety net:' and with it moral hazard.13 Tbese
criticisms were prescient.
THE FEDERAL RESERVE'S LIMITED STATUTORY AUTHORITY UNDER SECTION 13(3) OF
THE FEDERAL RESERVE ACT

In 2008 the Fed gave itself the new role of selectively channeling credit in directions it favored. It began to lend
funds to, and purchase assets from, an array of financial institutions it deemed worthy, no longer limited to commercial banks or participants in the payment system, including investment banks, primary dealers, and brokerdealers. These funds were not allocated to it by Congress, but created by the Fed itself out ofthin air and in amounts
it decided. The total of new Fed credits outstanding (the Federal Reserve's self-financed credit programs) stood
by the end of 2008 at $1.7 trillion, more than double the size of the Treasury's $700 billion bailout authority.
Beginning in the spring of 2008, the Fed repeatedly claimed authority in its press releases for these unorthodox
lending programs under the "unusual and exigent circumstances" provisions of section 13(3) of the Federal Reserve
Act." But Section 13(3) never conveyed unlimited authority. The Fed's authority to discount "notes, drafts, and
bills of exchange" for a financial or other firm is not the authority to purchase just any assets, and it is not the

authority to overpay for assets in order to recapitalize a firm. Thus one can doubt that adequate statutory author-

11. Anna J. Schwartz, ~The Misuse of the Fed's Discount Window. Federal Reserve Bank of St. Louis Review 74 (Sept./Oct. 1992): 58-59. As
an economist at the Federal Reserve Bank of San Francisco spells it out, "The acronym 'CAMEL' refers to the five components of a bank's condiH

tion that are assessed: Capita! adequacy, Asset quality, Management, Earnings, and liqUidity. A Sixth component, a bank's Sensitivity to market
risk, was added in 1997; hence the acronym was changed to CAMELS." Jose A. lopez, "Using CAMELS Ratings to Monitor Bank Conditions,"

FRBSF Economic letter, June 11, 1999, http://www.frbsf.org!economic-research/publications/economic-Ietter!1999!june!using-came!s
-ratings-to-monitor-bank-conditions! .
12. David Fettig. ~lender of More Than Last Resort," The Region (December 2002), http://www.minneapolisfed.org!publications_papers/pub
_display.cfm?id=3392

13. Schwartz, HOiscount Window"; Walker F. Todd, "FDIC/A's Emergency liquidity Provisions, ~ Federal Reserve Bank of Cleveland Economic
Review (Fall 1993). 16-23 ..
14. For citation of 13{3) as authority for the creation of the Maiden Lane LLC's, see the footnotes to the Fed's statements of "Factors Affecting
Reserve Balances," Federal ReserveStatisticai Release, Sept. 5, 2013, www.federalreserve.gov!releases!h41!current.

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ity existed for the Fed's actions in the Bear Stearns and AIG cases. Walker Todd commented frankly in 2008 that
"much less of [the Fed's recentllending is based on clear statutory authority than one might prefer if one cared
about the rule oflaw:' It is difficult to disagree with economist Edward Kane in his judgment that the Fed in 2008
"exercised discretion it was never given."IS

THE BEAR STEARNS OPERATION IN MORE DETAIL
Whether it recognized that it would be venturing onto thiu ice for the Federal Reserve Bank of New York (FRBNY)
itself to buy bad assets from Bear Stearns for the benefitofJPMorgan Chase, orfor some other reason, the FRBNY
created a wholly owned special-purpose subsidiary to do so.
The Federal Reserve describes what it did for JPMorgan Chase (JPMC) on its website:
JPMC was concerned about its ability to absorb a portion of Bear Stearn's [sic] mortgage trading portfolio, given the uncertainty about the scale of potential losses facing the financial system at the time and
strained credit markets.
To facilitate a prompt acquisition of Bear Stearns by JPMC, the FRBNY created a limited liability company, Maiden Lane LLC, to acquire that set of assets of Bear Stearns. The FRBNY extended credit to the
LLC, which would then manage those assets through time to maximize the repayment of credit extended
to the LLC and to minimize disruption to financial markets. MaidenLane LLC purchased approximately
$30 billion in assets from Bear Stearns with a loan of approximately $29 billion from the FRBNy'16
The Dodd-FrankActof201O placed some constraints on the Fed's discretion to make such deals for single institutions in the future. As an FRBNY web page explains, special Fed lending must now meet some additional criteria:
The Dodd-Frank Act changes the Federal Reserve's authority for lending under unusual and exigent
circumstances. Reserve Banks can no longer extend credit to an individual, partnership, or corporation

other than through a "program with broad-based eligibility:' Such emergency facilities can only be created with prior approval of the Treasury Secretary and must be for the purposes of providing liquidity to
the financial system and not to aid a failing financial company.17
I can applaud this change, but I am compelled to point out that this is not enough to reinstate the rule oflaw. Else-

where Dodd-Frank ratifies the Fed's discretion to allocate credit through lending programs with "broad-based
eligibility" and fails to constrain the Fed to limit its focus to monetary policy (including modern lender-of-Iastresort responsibility) alone. It allows the Fed to arbitrarily direct this much creditto investment banks, that much
to broker-dealers, and that much to money-market mutual funds. Such allocation decisions are not monetary
policy but rather fiscal policy. They should be considered as falling within the purview of Congress, not the Fed,
or better yet, left to the competitive financial marketplace.
If the statute law allows the Fed a wide range of discretionary actions with 50 little constraint that its future actions
cannot be predicted, then we have not the rule oflaw but the rule of central bankers. Hayek explained the difference in the following terms:

The fact that someone has full legal authority to act in the way he does gives no answer to the question
whether the law gives him power to act arbitrarily or whether the law prescribes unequivocally how he

15. Walker Todd, "The Tyranny of the Fed, ~ American Institute for Economic Research Commentaries, April 3, 2008. Bm Bergman, ~How the
Federal Reserve Contributes to Crises: Interview with Ed Kane, Martin Mayer, and Walker Todd, ~ Cfobal Research, Sept. 7, 2009. www

.globalresearch.ca/index.php?context=va&aid=15094.
16. Board of Governors of the Federal Reserve System, ~BearStearns. JPMorgan Chase, and Maiden Lane LlC: Regulatory Reform,last updated
Aug. 2, 2013, http://www.federalreselVe.gov!newsevents/reform_bearstearns.htm
17, Federal Reserve Bank of New York, HThe Discount Window," Fedpoint, March 2011, http://wwwnewyorkfed.orglaboutthefedlfedpoint

lfed18.html

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has to act.... If the law says that such a board or authority may do what it pleases, anything that board or
authority does is legal-but its actions are certainly not subject to the Rule of Law. By giving the government unlimited powers, the most arbitrary rule can be made legaUS

THE RULE OF CENTRAL BANKERS
The rule oflaw clearly does not yet prevail in our current monetary and financial system. We do not have, again
to use Hayek's words, "government in all its actions ... bound by rules fixed and announced beforehand!'" Not
when participants in financial markets hang on every word of the central banker's press conference statements,
trying to guess the central banker's future policy actions.
Defenders of the rule oflaw, who generally decry the arbitrary rule of authorities, should be concerned to prevent
the arbitrary credit-allocation powers of the Federal Reserve Board, however well-meaning members of the Board
undoubtedly are.
Discretion in monetary policy and financial regulatory policy does not give us better results. It is today widely recognized that inflation is inadvertently fostered by the discretion of central banks, where "discretion" means the absence
of precommitment to any fixed policy rule.'o It should be equally widely recognized that discretionary central bank
policy can create housing and other asset bubbles, as the record since 2001 has shown. When Fed Chairman Alan
Greenspan held interest rates so low that the real fed funds rate (the nominal rate minus the contemporary inflation rate) was negative for two and a half years, he was exercising discretion, not faithfully executing any rule on the
books. Chairman Bernanke exercises the same discretion today, and his successor will as well-unless Congress acts.

FOLLOWING THE RULE OF LAW IN A FINANCIAL CRISIS
What is the alternative? What does the rule oflaw tell monetary and regulatory authorities to do when large financial
finns are insolvent? The first thing it says is: Do not practice discretionary forbearance, turning a blind eye in the vain
hope that a failing firm's red ink will happily turn to black, that a zombie institution will come back to life, that toxic
assets will detoxify themselves. Do not arbitrarily rescue or bail out an insolvent firm at taxpayer expense. Instead,
resolve the insolvency. If nobody wants to buy the firm as a going concern without subsidy, follow bankruptcy law.
If a special bankruptcy law applies to financial institutions, follow that. In the United States, the FDIC Improvement
Act ofl991 mandates that the FDIC (Federal Deposit Insurance Corporation) resolve banks on the edge of insolvency
swiftly and at least cost to taxpayers. The authorities have been ignoring this statutory mandate. (Instead, the Treasury
"injected capital" into failing banks when it forcibly purchased preferred shares.)
Enacting a "prepackaged bankruptcy" law to swiftly resolve future failures of nonbank financial institutions would
be a good idea, but in its absence, Congress should insist that the Fed follows the laws that are on the books.
The rule oflaw in bankruptcy means not only making shareholders accept that they have been wiped out but also
consistently making creditors and counterparty institutions take the losses that are theirs. Creditors divide up the
remaining assets without discretionary authorities sheltering them from losses with taxpayer funds. Under the
rule oflaw, Bear Stearns bondholders would not have been bailed out. Consequently, the decision not to bail out
Lehman Brothers would not have been a shock to the financial market because it would have been fully expected.
The alternative to leaving the losses with Bear Stearns' and Lehman's stakeholders was arbitrarily shifting the
losses onto taxpayers, either through loss-covering handouts to those who deliberately took great risks of/oss to
enjoy the upside of great gains, or through nationalization. Viewed in a long-run perspective rather than in the
heat of the moment, both alternatives are worse than resolving major financial institutions that have reached insolvency. Both are inconsistent with the rule of law because they cannot possibly be applied consistently. Not every

18. Hayek, Road to Serfdom, 119.
19. Ibid .. 112.
20, Finn E. Kydland and Edward C. Prescott, "Rules Rather than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy 85
(June 1977).

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failed business in a country can be bailed out and kept on life support indefinitely-there is not enough money in
the Treasury. Not every firm can be nationalized-the economy will cease to function.
Consistently enforcing the rules that require insolvent firms to exit the market promptly would remove the kind
of uncertainty that followed the Lehman collapse and provide greater clarity to financial markets. It was inconsistency on this front-from abrogation of the rule oflaw in the Bear Steams case-that created the situation where
the authorities faced the choice between an ugly Lehman failure and the even uglier options of nationalization
or open-ended bailouts.
The prospect of bailouts and other favors, in violation of the rule oflaw, creates moral hazard. We have learned
the hard way that letting only shareholders bear losses while protecting creditor and counterparties at taxpayer
expense, as was done in the case of Bear Stearns, is not enough to control moral hazard. After Bear Steams was
rescued, Lehman Brothers increased its leverage and its exposure to risky mortgage assets. If creditors and counterparties think that they can count on government protection, they will be willing to lend copiously and cheaply,
enabling a borrowing firm like Lehman to hold a highly leveraged portfolio of risky assets. From the viewpoint of
the shareholders in an intermediary, the higher return on capital from "leveraging up" -relying heavily on borrowed funds-makes it a profitable strategy when lenders supply funds with very low risk premiums. From the
viewpoint of the taxpayers now on the hook, the firm takes on an overly leveraged portfolio of overly risky assets.
The most stunning examples of this over-leveraging phenomenon were Fannie Mae and Freddie Mac, but investment houses like Lehman and Bear Stearns exhibited it as well.
If everyone knows that the rule oflaw will be followed, because the Fed is strictly constrained to do so, such that
nohody will get bailed out, the incentive for imprudence disappears along with the hook into taxpayers. This does
not mean that no financial firm will ever act imprudently but rather that there won't be system-wide bad incentives
producing an epidemic of imprudence. If it is known that nobody is "too big to fail," or too well connected to fail,
then lenders will not let financial firms leverage up cheaply in the beliefthat they will be protected. Dodd-Frank
in its current state unfortunately codifies the notion
that some firms are "systemically important financial
institutions," that is, too big to fail.
:..:A"'B.:::0c;U:..:T_T:..:H.:.:E:-Ac::::U.:.T:..:H.:::O.:.R'-_ _ _ _ _ _ _ _ _ __
lawrence H. White 15 a senior scholar at the Mercatus Center and a

It cannot be denied that without bailouts and with
consistent resolution of insolvent firms, in Hume's
words, "some inconveniences arise." But it should be
recognized that the advantages "much overbalance"
the inconveniences for the good reason that pulling
the plug on failed firms is consistent with the logic of
the market economy. Those who stand to gain when
their financial strategies succeed must also stand to
lose when they fail. Nationalization and bailouts are
failed policies because they are inconsistent with the
logic of a market economy.

Thank you again for inviting me here today. I would be
happy to answer any questions.

www.mercatus.org

MERCATUS CENTERAT GEORGE MASON UNIVERSITY

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