by guest author, professor of Law and Public Finance, Timothy A. Canova. I’ve been at two economic conferences with Tim, and admire his intellectual integrity. Tim’s article is excellent to answer the ever-important question: Cui bono?
The 2008 financial crisis challenged many orthodox assumptions in finance and economics, including the proper role and accountability of central banks. The U.S. Federal Reserve, commonly known as the Fed, is the world’s most powerful central bank.
One major source of Federal Reserve power is its role as “lender of last resort,” lending directly to commercial banks through its so-called discount lending window. Traditionally, only commercial banks had access to the Fed’s discount lending since non-bank financial institutions were not subject to the same reserve and capital requirements as those imposed on banks. The other major source of the Fed’s power is its ability to purchase short-term Treasury securities. These restrictions on Fed lending and asset purchases helped support the central bank’s political independence from Congress and the White House by ensuring that Fed policy was socially neutral and did not favor particular sections of financial markets or particular private constituencies. But as the Federal Reserve’s lending and asset purchase powers expanded in unprecedented ways in 2008, these traditional restrictions were swept aside, exposing the flaws of central bank independence.
The Fed is also able to create money—U.S. dollars, also known as Federal Reserve notes—which means there is virtually no limit to the amount of money it can lend and no limit to the volume of assets it can purchase without adding to public-sector borrowing or deficits. During the 2008–2009 financial crisis, the Fed extended more than $16 trillion in low interest loans to all kinds of financial institutions in distress, including borrowers who traditionally lacked access to its discount window such as hedge funds and foreign commercial banks and central banks. Also, beginning in 2008, the Fed launched several asset purchase programs, known as “quantitative easing” (or QE), to purchase more than $3.5 trillion in U.S. Treasury securities and mortgage-backed securities (MBS).
But this expansion of the money supply is deceiving. Instead of lending out the funds pumped in by the Fed, banks have added more than $2.6 trillion to their excess reserves, on which the Fed has also paid them interest. This is similar to what happened during the Great Depression. Much of the money the Fed pushed into the banking system has not trickled down to the real economy.
Ben Bernanke, the Federal Reserve chairman when the QE programs were first launched, claimed that asset purchases would have a “wealth effect”: by the Fed purchasing bonds in such large amounts, bond prices would rise, yields would fall, and investors would shift into riskier securities, driving up the price of corporate shares and stock markets. Everyone would feel richer, businesses would invest and consumers would spend more. This seems much like the theory of “trickle-down” fiscal policy: that tax cuts for those with high incomes would be invested, thereby leading to the hiring of additional workers and spreading the benefits to the rest of the economy. But like the Bush administration’s tax cuts, the Fed’s monetary trickle-down has not worked so well. The Fed’s lending and asset purchase programs have effectively propped up Wall Street interests—big banks and financial markets—but they have also neglected the needs of Main Street, including the small community banks, small and moderate sized and family-owned businesses, unemployed and underemployed workers, and state and local governments.
Rest of article here for details of who really benefits from Fed policy.