This story was originally published by ProPublica.
Law professor Lev Menand has a new book out on that strange institution, the Federal Reserve, what it does and how its power and responsibility have grown over time.
Menand is an associate professor at Columbia Law School specializing in finance and regulation. Before he joined the law school, he held various roles at the Treasury Department during the Obama administration and was an economist at the Federal Reserve Bank of New York, helping to oversee large lenders.
I recently sat down with him to discuss the Fed, the economy, the capital markets, whether we are facing another financial crisis and why he thinks over-reliance on the Fed is bad for our economy and our democracy.
This conversation has been edited for length and clarity.
Thanks very much for joining me. Can you summarize the thesis of your book, “The Fed Unbound: Central Banking in a Time of Crisis”?
The Federal Reserve is an organization created by Congress for a limited, very important purpose to do a difficult job, which is to manage the U.S. money supply.
When you log on to a Bank of America or Citigroup account and you see a balance there, that’s the money that the Fed is managing. Those are not the same thing as green pieces of paper. And the Fed’s job is to ensure that you treat them the same, that you think of them the same. And that the amount of those Bank of America bucks is growing at a rate that is appropriate for the economy to put all of its resources to work, including all of its people.
The thesis of the book is that monetary liberalization, deregulation of the banking system and a lot of choices made during the second half of the 20th century caused the Fed to become “unbound.” Basically, what you have is the rise of a “shadow banking” system. All these financial companies that aren’t under the Fed’s purview, they start creating money. The Fed doesn’t have the tools to manage them, and then they run into problems during economic downturns, and the Fed pulls out all the stops and tries to backstop them — bail them out.
That’s the 2008 financial crisis. And that fundamental dynamic is still with us.
Essentially what you’re saying is that this institution, which is about 100 years old, the Federal Reserve, was created to manage money so that when there was a financial crisis, the Fed would come in and lend to them and cushion that blow. But over time, the Fed’s mandate had grown and its power had grown and we’re trying to figure out why that happened and whether that’s a good thing or a bad thing. Is that fair enough?
Following the Great Depression, the Fed was very successful. We didn’t have intermittent banking panics. Every time there was a recession, people didn’t run on banks. We thought that we had solved monetary instability and financial crises until 2008. And what was 2008? It was a run on shadow banks. A whole group of financial institutions had come along and started to do what banks do. They started to create deposits of their own called different things. And they were exposed to the same run dynamics that you saw in the 19th century before the Fed was created. And the Fed decided if we don’t come in and backstop this system, it will collapse. But it was never expected that this would be how the Fed [acted]. The Fed was not designed to stabilize the shadow banking system.
Let’s just back up. You’ve given a preliminary definition of shadow banking, but walk us through it. These are not bank deposits that are backstopped by the federal government, by the Federal Deposit Insurance Corp. Give us a really simple example. A money market fund is part of the shadow banking system, right? So it’s not like it’s an obscure financial system for the elite. Most middle-class Americans touch the shadow banking system.
Yeah. So there are three major types of shadow banking that I talk about in the book. You mentioned one, that’s the one that ordinary Americans are most likely to have encountered. The other types are primarily wholesalers for businesses, not ordinary individuals, but basically what they all have in common is they are non-bank firms that do not have a bank charter that are trying to reproduce the bank business model. The Fed doesn’t have the same set of tools to ensure that the money market fund [and other shadow bank institutions aren’t] taking too many risks.
The shadow banking system is huge, right?
In 2007, which was the peak of the shadow banking system, a peak we will eventually return to if further reforms are not made, it’s estimated that there were about $15 trillion of shadow bank-issued money instruments against $7 or $8 trillion of bank deposits and less than $1 trillion of government-issued cash.
In the aftermath, the shadow banking system got a lot smaller because we had a lot of major shadow banks fail like Lehman Brothers. And then over the last 10 to 15 years, it has grown again.
So now we’re back where the banking system is much bigger. There’s $18 trillion of deposits. And the shadow banking system is probably around the same size, maybe slightly smaller. It’s very hard to estimate the size, well, because it’s in the shadows… Continue Reading…