The Once and Future Fed
Yesterday I introduced this two-part column on our ‘Broken Scissors’ of public finance. That is, I began a discussion of our ill-fated recent history of attempting to separate credit-allocative and credit-modulatory policies as carried out by our primary instrumentalities of public finance – our Fed and our Treasury. Today I continue and complete this story, drawing a moral and sketching how we can restore both the blades of the scissors. Having ended yesterday with Section IV of this story, then, we pick up today with Section V and bring it all home…
V. How the Scissors Broke: Glass & Warburg Meet Wicksell & Fisher
The allocative with which Fed we began was founded by adherents of a once popular and half-right idea known as the ‘Real Bills Doctrine’ (RBD). Prominent among these founders were Paul Warburg and Carter Glass, the latter of Glass-Steagall renown.
The RBD in its crude formulation held that so long as the lending of endogenous credit-money was kept productive, not speculative, inflation and deflation would be not only less likely, but effectively impossible. And the experience of German banks during Germany’s late 19th century Hamiltonian ‘growth miracle,’ with which the German immigrant Warburg, himself a banker, was intimately familiar, appeared to verify this. So did Glass’s experience with agricultural lending in the American South.
This is all that good modulation’s following ‘automatically’ upon good allocation could mean, once you think about it. It would mean there is no separate modulatory function to attend to just so long as the allocative function is well aimed at production and not speculation. But this was a fallacy – conflating necessity with sufficiency – because it assumed that the sole source of monetary disturbance is speculation – the phenomenon that productive lending avoids. Yet in fact there are other possible sources of monetary disturbance, the effects of which demand-responsive endogenous lending can then procyclically amplify pursuant to the recursive dynamic that I noted above.
A sudden stoppage of fuel exports by OPEC nations in the 1970s, for example, or a sudden influx of silver into Spain four hundred years earlier, can rapidly alter the money/goods balance, inducing the start of an inflationary or deflationary episode. That can in turn induce changes in project lending demand since supplies will be cheaper or dearer, and endogenous project lending will then accommodate and thus amplify those changes.
Once underway, this can continue, like any inflation or deflation, without limit – again pursuant to the recursive dynamic I tried to exposit above. There is in other words no single unique equilibrium to which the dynamic here tends – the absence in turn being a hallmark of recursive macrodynamics.
In effect, this is the general form of the celebrated ‘cumulative process’ that Wicksell identified in the late 19th century, but which Anglo-Americans didn’t learn about in its fullness until many decades later when Wicksell was finally translated into English. The ‘Austrians’ and their progeny, on the other hand, ‘got’ it but either surrendered to it (Mises) or morbidly feared it so much that they over-reacted by futilely trying to end money endogenity itself (Taylor). But again I digress …
Now, something much like this happened in the early 1930s after the twinned real estate and stock market crashes of the late 1920s. One exogenous money boost came in the 1920s as American industry temporarily out-produced and out-exported its would-be competitors abroad, which had been devastated by the First World War. Another was war debt money, as the US had financed much of the Allied war effort even before entry into the war. The 1928-29 Crash that followed the boom was simply the bust in which all bubbles end.
After the Crash, many Americans were left with negative net worth – owing more than they owned – much as they were to be 80 years later in 2008-09. This drove-down project borrowing demand and thus the endogenous money supply, inasmuch as money was generated only pursuant to the project-demand-driven Real Bills criterion then employed by the Fed. And thus we had very tight money in a very tight time – disaster.
What was needed after 1929 was an exogenous infusion, a boost to the by-then only transaction-driven money supply, to counteract the endogenously amplified exogenous contraction in the money supply wrought by the Crash and ensuing debt deflation itself’s effect upon project lending demand. (Ever wondered why Keynes soon afterwards distinguished so carefully among distinct sources of money demand? Here is part of our answer.)
But the Fed Board of the time, in thrall as it was to a crude and incomplete, not sophisticated and comprehensive, rendition of the RBD, judged that the money supply must by definition be adequate to money demand, and thus took no exogenous countercyclical action. The ‘golden fetters’ of a still-operative gold standard didn’t help in the crisis’s first two years either. The Depression accordingly deepened, procyclically, precisely as Real Bills lending unsupplemented by exogenous modulatory infusion will always do.
So how did that lead to our separating modulation and allocation, monetary and fiscal policy, Fed and Treasury? Well, as suggested before, we over-reacted. We effectively decided that, since allocation did not of itself handle the whole of necessary modulation, we would henceforth attend solely to modulation – that is, to modulation alone.
This was precisely half-right! It was very good news, on the one hand, that the (now reorganized) Federal Reserve Board finally discovered the second-greatest economist you’ve possibly never heard of, Irving Fisher, and through him learned some of the mechanics of credit-fueled asset price bubbles and post-crash debt-deflations. Those operate as demand shocks in the lending markets and thereby destroy money – rendering the modulatory task maximally urgent.
It was very bad news, on the other hand, that it ignored the possibility of a more sophisticated rendition of the RBD, pursuant to which both allocation and modulation must be attended to. (Ironically, no less an authority than Adam Smith had argued to this effect less than two centuries earlier, in response to French Finance Minister John Law’s early version of the RBD which came a cropper in the Mississippi Bubble of the early 18th century! But I digress again…)
The place where our wrong-lesson-learning first manifest was the Banking Act of 1935. Under the influence of Fisher’s rendition of the Quantity Theory of Money (QTM), the Banking Act focused almost exclusively on money modulation, conceived technocratically as Fisher had done. It accordingly took the Fed largely out of Treasury and Treasury largely out of the Fed, and established the Federal Open Market Committee (FOMC) in DC as a new instrument of Fed monetary policy formulation and execution. Our great schism between modulation and allocation now opened.
While the ’35 Act did not mandate that FOMC-guided open market operations on Wall Street be the sole mode of Fed monetary policy execution, the Act seems to have been in effect taken that way by the Fed, which has ever since engaged almost solely (at best) in modulation on Wall Street, with little, when any, allocation on Main Street. Combined with the Fed-Treasury Accord of 1951, which formalized separation of a non-allocative Fed from an allocative Treasury that largely abandoned productive allocation over the 1970s, this is precisely what has enabled productive erosion and ‘financialization’ ever since.
For a time the impossibility of working this separation indefinitely was masked by a number of allocative institutional compensations whose modulatory significance was overlooked, presumably owing to the same inattention I am here trying to rectify. From the early 1930s through the late 1940s, to begin with, as I noted in introducing this essay the explicitly allocative RFC maintained offices in all of the regional Federal Reserve District Banks. This made effectively for something a lot like the once-again ‘Spread Fed’ I’ve been advocating for some time now.
After the RFC was wound-down, in turn, banking and thrift regulation performed a modulation-assisting credit-allocative function until the end of the 20th century. Regulation Q, for example, enabled mortgage-financing thrifts to attract more deposit moneys than would otherwise have been possible, thereby directing more credit to home purchase by America’s growing post-WWII middle class.
Restrictions on interstate banking and branching, for their parts, kept commercial banks local, which in turn kept bank-generated credit flowing to smaller, more locally focused businesses across the nation. And of course other federal institutions of home-, small business, and agricultural finance – all of them former subsidiaries of the RFC – functioned as continuing federal action in modulation-assisting credit allocation.
But these remaining vestiges of forthright public allocation of public capital withered on the vine over the 1980s and 1990s. Poor modulation in the 1970s led to inflation necessitating deregulation of thrift institutions, which in turn led to their destroying themselves through speculative investments in ‘junk bonds’ and the like. (In this sense poor modulation destroyed our means of allocation, just as relinquishing allocation by 2000 destroyed our means of modulation.) Interstate banking and branching restrictions for their part were phased-out by 1997. The RFC-descended Small Business Administration (SBA) was shrunken.
Public agricultural credit increasingly aided large agribusiness firms, not ‘small family farms.’ And the repeal of Glass-Steagall and prohibition of derivatives regulation, respectively, by the Financial Services Modernization Act of 1999 and the Commodity Futures Modernization Act of 2000, completed the process of enabling credit-flows to run massively toward speculative betting on price movements in secondary financial and tertiary derivatives markets in the northeast, not productive manufacturing and services firms in our continent-spanning republic’s interior.
And so we have had more and more to use deliberately speculation-encouraging, bubble-inflating modulatory tools – including QE post-2008 and further bubble-inflating innovations since 2020 – to prevent macroeconomic collapse in the face of now decades-long, poor-allocation-associated productive decline. For the same recursive collective action predicaments described above in connection with bubbles and busts have led individual investors rationally to seek immediate profits in secondary and tertiary market bets rather than long-term wealth creation through ‘patient capital’ investment in our productive sectors.
Absent concerted collective agency in the name of productive capital allocation, these ongoing collective action predicaments – a ‘deep structural’ condition of all disaggregated market exchange when it is how things are arranged even on the capital supply side, not just the product demand side, of our macroeconomy – will continue to hollow us out. The ‘endgame’ is terminal decline toward terminal collapse. Unless, that is, we can recombine concerted public credit-allocative action with concerted public credit-modulatory action as we used to do so well.
Glass and Warburg, along with all others who feared a Northeast-focused Fed and productive atrophy, are accordingly now rolling in their proverbial graves. This isn’t the Fed that we founded. Nor is our Treasury now Hamilton’s development- and hence productive-allocation-focused Treasury. And nor, in that connection, is our Comptroller, whom we treat now as a mere ‘safety and soundness’ regulator of our banks within Treasury rather than a credit-based currency controller and credit-allocative portfolio shaper. Can we restore them in updated form?
Yes, we can. Really, not just rhetorically, … we can.
VI. The Road Not Taken: Allocate the Endogenous, Modulate the Exogenous
Before turning next to how we can restore what we once had, let’s pause and imagine what the Fed could have done after 1935…
What it could have done is continued to allocated credit-money locally and productively through the regional Feds’ Discount Windows as before 1935, while also modulating credit-money aggregates nationally through open market transactions with ‘dealer banks’ to avert speculative excesses like those of the mid-1920s and debt-deflations like those of the early 1930s. The OCC and Treasury more broadly, for their parts, could have complemented the Fed in this task.
That would have been a Fed that modulated from DC and NYC against exogenous shocks, while allocating in endogenously productive, counter-speculative manners from each of its twelve Regional Feds. If only we’d done that!
So what about now? Well, in a sense I have just now addressed that, or at least teed it up. We can still have that Fed – the ‘Both Scissors Blades Fed’ – that I’ve just described.
All legislation passed since the original Federal Reserve Act in 1913 has supplemented, not switched-out, basic Fed functionalities. We now have a Fed that’s equipped both to do productive project lending regionally, and to attend to credit-money aggregates and associated interest rates nationally. We have, in other words, a Fed that can both allocate and modulate, both of which must be done if a financial system’s to be both productive and stable.
Because I have written extensively elsewhere on just how to do this, I will spare you the details in this writing. What I will leave you with, instead, is the summary version. That’s what I call the InvestAmerica Plan, introduced late last summer, which my colleagues at New Consensus and I have been pushing and further elaborating since just after Election Day last year, and which I’ve put out as a draft bill – the National Reconstruction and Continuous Development Act of 2021 – as well.
The Plan is, in a fuller sense than you might at first think, thoroughly Hamiltonian in spirit. It re-centers public and private finance on production, not speculation. And, like Hamilton himself, who founded both our Treasury and our first central bank — the Bank of the United States, whose name should be understood in comparison to other central banks like the Bank of England and the Bank of Japan — it works through both fiscal and complementary monetary policy. That is, it re-consolidates modulation and allocation.
VII. Scissors Repaired: InvestAmerica
The InvestAmerica Plan gives us a Fed-Treasury complex like that which we should have established no later than 1935. And in this sense, it restores certain features to the Fed, the Treasury, and their collaboration that we once had – even while retaining the supplementary functionalities added in 1935 and later. Here’s what we do…
Pillar I: A National Reconstruction and Development Council
First, configure all members of the White House Cabinet who have jurisdiction over the nation’s primary infrastructures and industries into a National Reconstruction and Development Council (‘Council,’ ‘NRDC’). The Council will be Chaired ex officio by the President and Vice President, and officially by the Fed Chair and Secretary of the Treasury – a bit like the Financial Stability Oversight Council (‘FSOC’). Its task will be to formulate and regularly update a ‘National Development Strategy’ (‘NDS’) analogous to the ‘National Defense Strategy’ updated each year by the nation’s defense and security agencies.
The NDS will identify the sustainable industries of tomorrow that are in need of jump-starting today, and will likewise identify the most polluted and ‘left-behind’ regions of the country and segments of our citizenry in need of a green boost. It will earmark specific project fields and public investment projects – wind, solar, geothermal, electric … – in which to invest, since incumbent carbon-committed firms won’t, to make national development both environmentally sustainable and once again never-ending.
A cardinal intellectual and policy blunder of the past 50 years has been both to segregate ‘national development’ from justice and sustainability, and to treat it as a one-off achievement instead of a perpetual process of technical and productive renewal. Going forward, we must remember the words of the great development economist Bob Dylan – ‘he not busy being born is busy dying’ – and remind ourselves that these words are as true of societies as they are of individuals. The Council will be the embodiment of that recollection. And as a subset of the White House Cabinet, it will be both democratically accountable and able to plan our ongoing green development coherently instead of in ‘siloed’ fashion.
Pillar II: An Upgraded Federal Financing Bank
Second, use the Treasury’s already-existing Federal Financing Bank (FFB) as the Council’s investment arm. Currently FFB uses Congressionally appropriated funds to finance all our federal agencies through lending and credit support. Two simple tweaks, one at the intake and one at the output end, will transform FFB into a permanent and environmentally sensitive national development bank alongside the Council.
At the output end, authorize FFB to invest in sub-federal units of government, and public-private development partnerships, as well as in federal agencies as currently. Let it also take equity stakes in addition to credit instruments, where appropriate, as financing instruments. For in some cases boardroom ‘voice’ will be helpful in overseeing projects, and earned revenue will be welcome as well.
At the input end, authorize FFB also to issue its own credit instruments, and to form Special Purpose Trusts to fund fully diversified portfolios of specific project types. Let private sector investors purchase stakes in these funds too, so as both to add private to public capital in financing perpetual national development, and to give pension funds something more productive than Wall Street to invest in.
The World War I era War Industries Board (‘WIB’) and War Finance Corporation (‘WFC’), as well as the World War II era War Production Board (‘WPB’) and Reconstruction Finance Corporation (‘RFC’), paired up much as I am envisaging the NRDC and the FFB pairing up here. In the case of the earlier pairings, the US had to finance and ramp-up war production quite quickly. The aforementioned institutions accordingly planned and financed both conversion of existing factories and the establishment of new factories to produce steel, rubber, jeeps, tanks, ships and planes, taking both debt and equity stakes in the relevant firms. They financed these operations, in turn, with public capital, private capital, and retained earnings.
Today we are faced not with war, but with what the American philosopher William James called ‘the moral equivalent of war.’ Working together, then, the NRDC and upgraded FFB can, from the output end, plan and finance decarbonizing projects from municipal installation of electric vehicle charging ports at all parking meters, through the building of multiple battery and wind turbine factories in scores of impoverished communities, on down to the retrofitting of all sizable buildings in the country. And at the intake end they can form investment pools for all project types – e.g., a ‘solar fund,’ a ‘battery fund,’ a ‘wind power fund,’ etc. – in which anyone can invest.
Pillar III: A ‘Spread Fed’
Third, ‘Spread the Fed.’ Americans have forgotten that the Fed was initially established as a network of regional development banks. While today the regional Fed District Banks function mainly as think tanks, in the Fed’s early decades they purchased short-term commercial paper issued by small businesses and agricultural concerns, as per the RBD described above. That assured adequate liquidity and short-term funding to our nation’s primary drivers of technological development and productivity growth. Today the Fed doesn’t operate like that, yet its enabling Act still authorizes this form of development support — and now the Fed also has adequate modulatory tools to supplement allocative functions, unlike in the 1920s as described above.
All that the Fed has to do is once again open its ‘Discount Window’ to businesses of the kind that it used to support, while in this case ‘prioritizing’ firms that the Council finds to be developing green technologies and socially just labor practices – including worker ownership or codetermination. Socially just and environmentally friendly small firms all over the country – that is, in all twelve of the Fed’s Districts – would then benefit. A startup firm developing new air- or water-treatment methods, for example, or perhaps better solar or battery technologies, would be the new paradigms of ‘productive’ for Fed lending purposes.
If the newly ‘spread Fed’ limits this revamped facility to financing only such Council-endorsed productive green projects in the Main Street economy rather than speculative gambles in the Wall Street economy, it will both (a) more productively deploy the nation’s investment capital and (b) take the wind out of overblown Wall Street sails. And since the Fed Chair will be Co-Chair of the aforementioned Development Council, s/he will have no trouble discerning what has been democratically determined to ‘count’ as justly and sustainably productive.
Pillar IV: A Universal Digital Savings and Payments Platform
Finally fourth, provide smartphone-accessible digital banking to all citizens, businesses, and legitimate guests of our country. Any American person or business already can open an account with the US Treasury through its TreasuryDirect (‘TD’) system, out of which one can purchase and into which one can redeem Treasury Securities. All we need do to convert TreasuryDirect into a socially inclusive universal savings and payments platform is (a) convert TD Accounts into inter-operable P2P digital wallets, and (b) allow digital dollar bills – that is, Federal Reserve Notes – to be held alongside the Treasury Bills and Notes now in those wallets. Et voila, no more ‘unbanked.’
U.S. Digital Service, an executive agency said to be loved by Vice President Harris, avers it could do the just-mentioned upgrading by summer. In time, we could then migrate the system over to the Fed to integrate into the Fed’s broader monetary policy apparatus. Fed ‘helicopter drops’ or UBI then would be easy. Moreover, all of the green public investing described above in the first three planks of the Plan could be done through these wallets, as could the sending of relief checks, stimulus payments, and more. An NRDC-mandated FFB investment in a new green-tech firm, for example, could be made instantly over the new digital platform. In effect, then, this platform would be the full liability-side counterpart to the asset-side augmentation entailed by the first three Plan-planks just elaborated.
Conclusion: Walking with Two Legs
All four planks of the Plan are designed to be implementable even without House or Senate majorities. The Biden Administration could, in other words, do all of these things under existing authority. But since we have those majorities, why not mandate what would otherwise be discretionary, and ‘go big’? It’s the easiest way to assure larger majorities in 2022, and to Build Back Better – and Greener – at an ever-accelerating, ‘snowballing’ rate. In case you are interested, Congress, here is a draft bill all ready.