Lev Menand: The Fed Unbound: Central Banking in a Time of Crisis

Lev Menand’s The Fed Unbound is an important and provocative book that deserves to be read by anyone interested in the Fed’s role in the financial system and the economy. And everyone should be extremely interested, given the extraordinary expansion of that role since 2008, which Menand thoroughly documents. But his conclusion that this expansion primarily reflects the need to support an unregulated shadow banking system is questionable. He clearly understands that an unbound Fed, although useful in the short-run to manage crises, can in the long-run have deleterious effects. But rather than narrowing the Fed’s role, he supports the Fed’s issuance of a central bank digital currency (CBDC), which would expand its role to a greater extent than anything the Fed has done to date. It seems that his concern is not that Fed is unbound but with how it has used its unbounded authority. An alternative way forward would be for Congress to bind the Fed to its essential but limited role as a lender of last resort and prevent it from embarking on further adventures in credit allocation.

As Menand documents, the expansion of the Fed’s role began in 2008, when it responded to runs on certain nonbank financial institutions, which Menand calls shadow banks, by reviving and aggressively and creatively deploying its authority under Sect. 13(3) of the Federal Reserve Act to lend to any individual, partnership, or corporation under “unusual and exigent” circumstances. The Fed’s actions in 2008 almost surely reduced the impact of those runs on the regulated but inadequately capitalized global banking system and on the U.S. and global economy. Then, when economic disruptions associated with the COVID-19 pandemic in early 2020 again created the specter of depression, the Fed not only reintroduced many of the emergency lending programs that it employed in 2008 but also went much further. Using authority and credit support provided by Congress in the CARES Act, it created lending programs to backstop virtually the entire investment-grade segment of the corporate bond market, including bonds issued by nonfinancial as well as nonbank financial corporations, and to backstop short-term debt issuance by certain investment-grade state and local governments. Finally, it responded to severe and unprecedented dysfunction in the Treasury and agency MBS markets by buying massive quantities of those securities. As in 2008, these actions almost surely reduced the near-term adverse effects of the pandemic on the U.S. economy. But they involved the Fed in credit allocation to a far greater extent than in 2008 and transferred credit risk and interest rate risk from private sector investors to the federal government.

Menand argues that the principal problem that has given rise to the Unbound Fed is shadow banking. Menand never precisely defines shadow banking but seems to regard any type of nonbank financial institution as a shadow bank.1 Specific examples he cites include primary dealers, money funds, issuers of asset-backed commercial paper (ABCP), and issuers of Eurodollar deposits. He is correct that it was largely runs on these types of institutions that motivated the initial expansion of the Fed’s role in 2008. But these types of firms played a much smaller role in the March 2020 crisis. In 2008, the largest investment banks either failed and were purchased by bank holding companies (BHCs) or organized their own banks and became BHCs. In contrast, of the 25 primary dealers in late 2022, only four were nonbanks, and all of the largest primary dealers were subsidiaries of bank holding companies. Money funds were always subject to regulation, albeit by the SEC rather than the Fed, and after 2008 the SEC, with significant input from the Fed, introduced new regulations designed to reduce their vulnerability to runs. ABCP was issued by special-purpose funding vehicles, the vast majority of which were organized by banks, and changes to banking regulations after 2008 have effectively moved these bank-sponsored programs within the perimeter of banking regulation and thereby shrunk them to irrelevance. Eurodollar deposits are issued by banks, which generally are subject to consolidated supervision and regulation, either by the Fed or by other U.S. and foreign authorities that apply internationally agreed regulatory requirements, which were tightened substantially between 2008 and 2020.

The disturbances in financial markets in March 2020, including the unprecedented dysfunction in the U.S. Treasury market, reflected a widespread “dash for cash,” in part by some of the firms typically identified as shadow banks, such as hedge funds, but primarily by others, including unleveraged investors such as pension funds and bond funds, nonfinancial corporations, and even foreign monetary authorities. As noted above, reflecting these widespread pressures and concerns, the Fed’s lending programs provided taxpayer support for an extraordinary range of borrowers, including a wide range of nonfinancial corporations and state and local governments. The corporate programs backstopped bonds, long-term obligations that are not susceptible to runs. For the most part, the borrowers most vulnerable to runs already are within the perimeter of regulation, either by the Fed itself or by other domestic or foreign regulators. Extending the regulatory perimeter to all financial and nonfinancial corporations or to state and local governments seems unwise and, in any event, impractical. Nor, given experience to date with regulation of banks and especially of money funds, should it be assumed that extending the perimeter would achieve stability. Liquidity regulation remains very much a work in progress, with results thus far amply demonstrating the difficulty of reducing vulnerabilities and the potential for unintended consequences.

If it’s not the shadow banking system, what is driving the expansion of the Fed’s role? As Menand remarks at one point, the “Fed remains stuck in emergency mode.” To be sure, since Menand wrote his book, the Fed has stood down. But it seems clear that in any future emergency it is quite prepared to do “whatever it takes,” even if that requires stretching its legal authority. For example, if it has no authority to purchase a particular type of asset, it sees nothing wrong with creating and funding a legally separate special-purpose vehicle (SPV) for the purpose of buying those types of assets. In so doing, it has been encouraged by the Congress and the Executive Branch. Although the Dodd–Frank Act placed various limits on the Fed’s emergency lending authority, it did not curb its use of SPVs to purchase assets that the Fed is prohibited from purchasing. And the CARES Act enabled the Fed to create its corporate and municipal facilities while complying with the limits that Congress put in place. The Treasury repeatedly approved more expansive uses of the Fed’s emergency lending authority.

Menand argues that an unbound Fed, however, useful in the short-run for cushioning shocks to the economy, has deleterious consequences in the long-run. With its corporate and municipal lending programs the Fed has taken on responsibilities for which it is not well designed and which it is unlikely to undertake effectively. As he concludes, without bounds, pressures will build for the Fed to provide even broader support to households and businesses. With deep political divisions making legislation difficult, Fed credit programs may be seen as an attractive alternative to action by Congress. Moreover, as the Fed becomes an ever more important actor in the economy, the Fed itself will become the subject of increasing bitter partisan fights. Nominations to the Fed Board and the selection of Reserve Bank Presidents could generate the kind of rancor that has engulfed the Supreme Court in recent years. It is hard to imagine that an unbound Fed would continue to be allowed the degree of independence that most would agree is essential for the performance of its critical monetary policy functions. Moreover, as Menand notes, an unbound Fed effectively exercises fiscal powers that appropriately are exercised by Congress, not by an independent monetary authority.

What then, is the best way forward? Because Menand has concluded that the principal problem giving rise to an unbound Fed is an insufficiently regulated shadow banking system, he quite logically sees bringing shadow banks within the regulatory perimeter as the solution. As noted above, however, most of the entities that he identifies as shadow banks have long been within the regulatory perimeter or came within the regulatory perimeter between 2008 and 2020. The financial market disruptions seen in 2020 were primarily the result of a widespread dash for cash rather than fire sales of assets forced by runs on shadow banks.2 In particular, when market participants came to doubt their ability to promptly turn Treasury securities into cash, they rushed to sell their Treasuries. Primary dealers initially met these demands and purchased an unprecedented amount of Treasuries but their capacity for meeting these demands was quickly overwhelmed, and only the massive Fed purchases of Treasuries restored the balance. The balance sheet capacity of dealers, which are overwhelmingly bank-affiliated dealers, had not kept pace since 2008 with the enormous growth of Treasury debt outstanding, in part because severe and nonrisk-based capital requirements and other elements of the post-2008 bank regulatory regime discourage banks and their nonbank dealer affiliates from engaging in low-risk, low-margin businesses such as Treasury market and Treasury repo market intermediation. Many believe those aspects of regulation should be modified and can be modified without rendering the banking system less resilient.3

This reviewer believes that the only solution to the problem of an unbound Fed is action by Congress to reimpose effective limits on the Fed that prohibit it from allocating credit among competing private uses. The Fed’s authority to purchase assets is limited to U.S. government securities (Treasury and agency securities and agency MBS) and might appropriately be further limited to Treasury securities. Lending to entities other than banks should be fully collateralized by Treasury securities and such fully collateralized loans could be extended to any and all solvent borrowers. Most important, the illogical loophole that allows the Fed to purchase assets through an SPV created and funded by the Fed that the Fed itself is prohibited from buying should be closed before its full potential to be used for credit allocation is realized.

Surprisingly, given his concerns about the Fed’s expanding role, Menand would apparently go far in the opposite direction. Concerned by the development of crypto currencies and the lack of an effective framework for their regulation, he understandably proposes to extend the regulatory perimeter to cover issuers of cryptocurrency. But he also suggests Congress authorize the Fed issue a dollar CBDC. If a CBDC proved attractive, it could lead to a massive expansion of the Fed’s role, both as a provider of deposits to the public and also as an allocator of credit. The Fed would need to invest those deposits to avoid a corresponding contraction of credit to those sectors of the economy that had previously been funded by banks and nonbank financial intermediaries (for example, money funds). Given Menand’s concerns about an unbound Fed, this could be seen as a bug, but Menand sees it as a feature. He sees creation of a CBDC as a way for the government to rectify predatory and exclusionary practices in the private banking system that he believes have significantly harmed low-income and minority communities by making it hard for them to open and maintain bank accounts.4 He also sees it as an opportunity to redirect credit to what Menand would see as more productive uses than the uses to which banks are currently directing it. Evidently, Menand believes that the problem is not that the Fed is unbound but that it is not using its unbound authority in ways that Menand would prefer.

Patrick M. Parkinson

is a Senior Fellow, Bank Policy Institute, Washington, DC, USA, former Director of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, Washington, DC, USA.