The Fed Is A ‘Development Bank’ – Make It Our Development Bank Again
Here’s something you might not have known. The Fed is a national development bank – our national development bank. Its mandate originally was and remains that of a facilitator of local business and productive community bank lending across the entire nation, not a bottomless liquidity hole for Wall Street high rollers.
This is why we have regional Federal Reserve Banks all over the country with board members nominally representing local business, labor, and community banking interests, rather than just one Federal Reserve Bank of New York (FRBNY) aiding high finance in Lower Manhattan. It also is why the Federal Reserve Board in DC functions as a coordinator of the Federal Reserve ‘System’ of regional development banks, ensuring the network as a whole doesn’t over- or under-supply credit in aggregate.
It is together that the Board and the Regional Feds constitute one Federal Reserve System, with a New Deal era Federal Open Market Committee (FOMC) functioning as later-added mediating link. Think of the Board as the ‘macro,’ credit-modulatory tier of our System. Think of the regional Federal Reserve Banks as the ‘micro,’ credit-allocative tier of this System. And think of the FOMC as a means of coordinating the modulatory and allocative roles more closely than proved possible during the Fed’s first twenty years.
This Federal Reserve System as originally conceived is a work of genius – genius attributable largely though not wholly to Paul Warburg and Republican Senator Nelson Aldrich, who studied development banking in Europe, especially rapidly industrializing Germany, after the 1907 panic here in the US. It finely balanced the interests of macro-modulation and micro-allocation in a manner that tracked our federalism’s balance of local and national governance.
What Warburg, Aldrich, and their fellow founders of the Federal Reserve System learned from the (likewise federated) German experience, especially after further consulting with populist agrarians like William Jennings Bryan (Democratic President Wilson’s Secretary of State) here at home, was that to get national credit-modulation right, you have to get local and regional allocation right. You have to ensure credit’s flowing to productive, not speculative uses, and that’s an inherently localized function.
Productive credit deployment brings steadily growing, inclusive, and hence sustainable prosperity. Merely speculative credit deployment brings bubbles, busts, and blame – not to say steadily worsening wealth and income inequality, and consequent secular stagnation, over time.
The way Warburg, Aldrich, and their Fed-founding colleagues devised to ensure well allocated productive, not poorly modulated speculative, credit flows was borrowed in part from the ‘discounting’ practices of German industrial banks and Germany’s central bank. These were banks that themselves were, ironically, inspired by our own Alexander Hamilton and his First Bank of the United States, which itself was both a ‘central’ and a ‘development’ bank in the now unfortunately bifurcated, modern senses of those terms.
‘Discounting’ in the late 19th and early 20th century sense means something a bit different from what you might think of now. It is essentially the monetization of commercial paper issued by firms with good business plans – not just to help with ‘liquidity crunches,’ but to facilitate continuous productive activity. Sound plans of this sort ensure that returns on investment (ROI) are tied to production, not speculation.
Tying money growth to productivity growth in this manner as it does, discounting fuels growth and development without stoking inflation or permitting deflation. Monetary instruments become, in the idiom of an earlier and more productive time, ‘real bills.’ But this only works if (a) the immediate ‘discounters’ are locally embedded so as to be able to assess the productive prospects of business plans, and (b) an economy-wide credit-modulator can act counter-cyclically, a.k.a. ‘macroprudentially,’ to reverse contractions or inflations that occasionally occur notwithstanding the best efforts of local discounters.
This is why Warburg, Aldrich, and their Fed-founding colleagues bequeathed us the system we have to this day. It is why we have regional Fed banks in every distinct part of our union along with a coordinating Board in DC and, since the 1930s, an FOMC that binds them. It is also why you still hear the term ‘Discount Window’ in connection with innovative Fed lending programs designed under Section 13 – the ‘discount lending’ provision – of our Federal Reserve Act.
How did we fall away from that? Well, this is a long story better told elsewhere. But the short-plying version is that overly sanguine, then overly cautious, adherents of the so-called ‘real bills doctrine,’ most of whom also backed the gold standard, overlooked the need of macro-modulation to supplement micro-allocation in the 1920s and early 1930s, respectively. That enabled bubbles, then bust and protracted depression, ultimately leaving ‘real bills’ with a misunderstood bad name.
That bad name has since haunted us, as the Fed never got back in a serious way to productive, not speculative, regional lending. Instead ‘anything goes,’ with Wall Street speculation now dominant in recent Fed thoughts and attentions. A good fifty years of fiscal-cum-monetary dysfunction is the upshot – our tragic bipolar fate.
But now here is the problem as currently manifest… As readers will know, our nation’s states, cities, and small businesses are now being fiscally and financially obliterated by a national pandemic to which there has been virtually no coordinated national response. While the White House crows over one man’s putative triumphs amid record death, bankruptcy, and unemployment rates, we and our cities and businesses are left essentially to fend for ourselves.
The one ray of hope thus far has been the Fed’s offering of new discount lending services to our states, cities and small businesses under Section 13(3) of its enabling act and the CARES Act. The very names of these programs – the Municipal Liquidity Facility and the Main Street Lending Facilities – nicely resonate with the Fed’s original role as a network of regional development banks.
But why, then, are they housed in the Federal Reserve Banks of New York and Boston alone? And why are they being run, not by people with knowledge of local community and small business needs, but at least partly by Wall Street bond traders and hedge funds?
The MLF, to begin with, is housed in the Federal Reserve Bank of New York just off of Wall Street. Having worked there, I can attest that many of our nation’s most brilliant and public-minded civil servants still work there. But it’s as crazy as it is unfair to those gifted people to saddle them with responsibility for all of our nation’s small towns. And it’s a scandal to have brought in to run MLF, only last March, a bond trader who seems to think ‘ratings,’ ‘market rates,’ and ‘penalty rates’ as fitting for cities that didn’t cause Covid or White House incompetence as they are for too big to fail (TBTF) banks that bring on their own failures.
The Main Street Lending Facilities suffer a similar infirmity. I’ve worked with Boston Fed colleagues as well as New York Fed colleagues, and they too are brilliant and dedicated public servants. But it’s unfair to them to expect them to know all the needs of Tania’s Tractor Repair in Billings or Ned’s Nails in Los Angeles, or of the local community banks that normally lend to such businesses.
These infirmities are not mere blemishes. They are significantly abortive of the new discount lending facilities before they have even got started in earnest. They are tragic as well. For in both the Municipal Liquidity and the Main Street Lending Facilities we are faced with a truly unique opportunity – the opportunity to recover, for the first time in well over half a century, our Fed’s original role as a network of regional development banks.
What should we do, then? That’s easy: SPREAD THE FED. And admit that the Municipal Liquidity and Main Street Lending Facilities are effectively local development aids, not Bagehot-style ‘lender of last resort’ (LOLR) bailouts for Wall Street megabanks.
Distribute administration of both the new Municipal Liquidity and Main Street Lending Facilities over all of the regional Fed Banks. Let San Francisco handle the Northwest and Dallas the Southwest. Let Chicago, Cleveland, and Minneapolis handle the Upper Midwest, Kansas City and St. Louis the Heartland, and Atlanta and Richmond the South.
SPREAD THE FED. Restore it – give it back its original mission. Establish new regional Fed Banks as well, for the western half of the country has filled in since the Fed’s founding in 1913. There should be Denver, Los Angeles, Salt Lake City, and Oahu Feds just as surely as there’s a Philadelphia Fed. It makes no sense to have two Feds in Missouri and one in California. Nor need we reshuffle – just open more. Our country and economy are bigger now than they were a century ago, after all.
Restore, then, our development bank Fed. Spread it, grow it, and refocus it on financing productive development, not backstopping destructive speculation.
And for Heaven’s sake, take the bond traders and hedge funds out of it. These are public investment institutions, investing public capital for publicly productive purposes. Wall Streeters have opportunity enough on Wall Street. Don’t give them Main Street with Covid cherries on top too.