The Federal Reserve We Need : It’s the Fed We Once Had

This article considers the empirical record of the 1942-1951 period of Federal Reserve history when the Fed was more politically accountable and more independent of private financial interests. During the 1940s, federal spending was nearly twice as high as today, and federal borrowing was more than three times higher. Yet, from 1942 to 1951, the Federal Reserve was directed by the White House and Treasury to peg interest rates at 3/8 of one percent on short-term Treasury borrowing and 2.0 to 2.5 percent on long-term borrowing. The U.S. economy grew at a real annual rate of 15 to 20 percent and more than doubled in output during the war. Meanwhile, the Federal Reserve imposed strict lending standards on its member banks, including interest rate ceilings and selective credit controls to raise margin requirements on private borrowing for purchases of corporate securities, housing, automobiles, and consumer durables. The experience of the 1940s suggests that the Fed could accommodate much larger federal deficits to energize a sustainable economic recovery. Instead, the Fed has been pushing reserves into the banking system in exchange for toxic assets while hoping the banks will lend to consumers and businesses in an environment of severe economic insecurity. The Keynesians of the 1930s criticized this approach as “pushing on a string” and largely ineffective. Since the fall of 2008, the Federal Reserve has been pushing on a big string. Its balance sheet has expanded by some $2 trillion, including $1.25 trillion in purchases of toxic mortgage-backed securities from private financial institutions, including banks with ownership interests in the regional Federal Reserve Banks. In addition, the Federal Reserve has lent more than $1.5 trillion to those same private financial institutions in exchange for more toxic assets as collateral. Instead of investment in the real economy, this strategy has been one of spending on toxic paper assets. While the Fed's private constituency of large Wall Street banks and hedge funds has enjoyed interest-free loans and outright sweet-heart purchases of their toxic assets, governments at all levels must borrow at higher interest rates and are forced to slash budgets, cut public services and payrolls, and thereby undermine the fragile economic recovery