Perhaps it’s best to stop calling these numbers “astronomical.” A better term might be “economic numbers”—dollar amounts so vast they dwarf time and space. When you are tossing around those kinds of numbers, what is another $800 billion program for mortgage-backed securities and credit-related assets? And as long as we still have some checks left, we might as well do a government-engineered takeover by JPMorgan Chase of Washington Mutual. The government tried to do the same with Citigroup and Wachovia, but Wells Fargo swooped in with a higher offer, suggesting that even in Bailout Nation, private capital still has its place.
As a nation, we went from never bailing out anyone to somehow finding a seemingly inexhaustible supply of bailout candidates.
I can’t wait to see what the hell is gonna happen next month.
Chapter 2
The Creation of the Federal Reserve, and Its Role in Creating Our Bailout Nation
I am a most unhappy man. I have unwittingly ruined my country. A
great industrial nation is controlled by its system of credit. Our system
of credit is concentrated. The growth of the nation, therefore, and all
our activities are in the hands of a few men. We have come to be one of
the worst ruled, one of the most completely controlled and dominated
Governments in the civilized world.
—President Woodrow Wilson1
As much as I tried to steer clear of writing a history of central banking, it was all but impossible. Any examination of bailouts in the United States would be incomplete if the role of the Federal Reserve System were omitted. I will endeavor to keep it brief and relatively painless.
It is crucial to understand the role of the Fed, and how it has radically expanded over time, if you are to have any hope of comprehending the modern era of Bailout Nation. Since March 2008, so many different financial bailouts have been funded directly by the Fed—into investment banks, government-sponsored enterprises (GSEs), brokerage firms, money market funds, even the overall stock market—that we could not discuss bailouts intelligently and avoid mentioning the Fed. It is front and center in this mess.
The role of emergency fixer was not part of the Fed’s original mission statement. At the end of the eighteenth century, prior to the creation of a central bank, currencies from as many as 50 nations were circulating in the United States. A single currency, backed by a strong authority, was needed to maintain some semblance of order. For any young and growing country, this was a necessity.
As originally conceived, the central bank had a narrow task. It was brought into existence for eminently reasonable and defensible purposes: to establish financial order, to allow for the creation of needed credit for the country, and to resolve the issue of the fiat currency (money that has value by virtue of the government declaring it has value).
From those relatively modest monetary and fiscal powers, the Federal Reserve has evolved into something that would be unrecognizable to its founders. Under the guise of economic expediency, the Fed has grabbed power, dramatically widening the areas of its responsibility. Since the 1990s, the Federal Reserve System, a private corporation registered in the State of Delaware, has behaved as though it were in charge of anything economic—moderating the swings of the business cycle, maintaining interest rates, supporting the value of depreciating assets, even intervening in the stock market.
During the economic collapse and credit crises, there was a distinct lack of financial leadership in the United States. With President Bush’s approval rating at historic lows, the White House showed little inclination to face the storm. As the many crises began heating up in 2007, the leadership vacuum was apparent. It was into this empty space that the Fed inserted itself, seizing more and more authority. It wasn’t so much a power grab as a reluctant filling of the void. Steve Matthews, writing for Bloomberg, observed, “What started as a meltdown in the market for subprime mortgages has turned into a worldwide credit and economic crisis. Bernanke, now the Fed chairman, has responded with the most aggressive expansion of the Fed’s power in its 95-year history.”2
Paul Volcker, the well-regarded former Fed Reserve chair, was aghast at how much authority the central bank had claimed as its own. Following the Fed-financed shotgun wedding of Bear Stearns and JPMorgan Chase, he told The Economic Club of New York: “The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.”3
The Federal Open Market Committee (FOMC), the Federal Reserve’s principal tool for implementing monetary policy, has even gone so far as to state that its charge includes preventing “panic” in the markets, a far cry from its official dual mandate of price stability and full employment.
None of these duties were ever part of the Fed’s charter.
The fourth time’s the charm: The institution we know as the United States Federal Reserve is actually the fourth attempt at creating a central banking system in the United States.
To truly appreciate how a limited facilitator of banks evolved into the most powerful central bank in the world, we need to understand a bit of its history. All three previous attempts at creating a central bank in the United States were met with equal measures of concern and controversy. Thomas Jefferson, the principal author of the Declaration of Independence, argued that since the Constitution did not specifically empower Congress to create a central bank, doing so would be unconstitutional. “Banking establishments are more dangerous than standing armies,” Jefferson famously declared, and went on to say:
The central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution. I am an Enemy to all banks discounting bills or notes for anything but Coin. If the American People allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the People of all their Property until their Children will wake up homeless on the continent their Fathers conquered.4
The change from the Jeffersonian view toward the Federal Reserve to the modern public’s attitude is nothing short of extraordinary.
Like Presidents Jefferson and Wilson, the American people genuinely feared giving this much power to a group of unelected, unaccountable private bankers. The fairly blasé response to the Fed’s current expansion of its authority—and trillions in new Fed credit lines—is rather surprising. In light of the antipathy and worry previous central banks had historically evoked, the power grab by the Bernanke Fed and Treasury Secretaries Paulson and Geithner are all the more remarkable. Other than gold bugs and economists from the Austrian school, the public response has been tepid.
The first attempt at creating a central bank was made in 1791. The new nation needed a depository for the levies and taxes it collected, and the government required a way to take short-term loans to fill temporary revenue gaps. A simple fiscal institution was created and called the First Bank of the United States. But just to be safe, it had a 20-year charter, which expired in 1811.
Without the existence of a central lending authority, the War of 1812 left the underfinanced nation with a “formidable debt.”5 Private banks issued an ever-increasing amount of notes, leading to a serious bout of monetary inflation. The need for some form of a central bank was readily apparent. Thus, the Second Bank of the United States was chartered in 1816, five years after the demise of the First Bank. It had more funding and therefore greater influence than its predecessor. While both banks were controversial, it was the Second Bank of the United States that was perceived as especially threatening. It became so powerful that “many citizens, politicians, and businessmen came to view it as a threat to themselves and a menace to American democracy.”6
When the Second Bank’s charter lapsed in 1836, there was hardly an appetite for a Third Bank of the United States. But as the young nation grew, its financ
e and banking system grew haphazardly. Lacking a coordinating central authority, the first hundred years of the country’s financial development became a patchwork of private banks, notes, and currencies. Many individual states issued their own legal tender, and private banks had the authority to commission engravers to design banknotes. Insurance companies, railroads, import and export firms, and others all had a similar ability. The anarchy that ensued made the dozens of foreign currencies circulating in the republic’s early days look almost organized. In A Nation of Counterfeiters, Stephen Mihm writes:
By the 1850s, with so many entities commissioning banknotes of their own design (and in denominations, sizes, and colors of their own choosing), the money supply became a great confluence of more than 10,000 different kinds of paper that continually changed hands, baffled the uninitiated, and fluctuated in value according to the whims of the market. Thousands of different kinds of gold, silver, and copper coins issued by foreign governments and domestic merchants complicated the mix. Such a multifarious monetary system was not what the framers of the Constitution had intended.7
And those were just the legal currencies, notes, and specie. Counterfeiting was fairly commonplace. Estimates were that as much as 10 percent of all currency in circulation was fake.8
Beyond forgery, bank runs were common, and bank failures occurred with increasing regularity. It was apparent that the financial system, left to its own devices, could not function properly. It was operating—quite literally—in the Wild West.
The nation’s third foray into central banking came about with the National Currency Act (1863), later amended to the National Banking Act (1864 and 1865). This legislation provided for the creation of nationally chartered banks. Requirements included stringent capital minimums, lending limits, and regular bank examinations by the Office of the Comptroller of the Currency. Near-modern banking regulation and supervision thus came into existence.
Although these national banking acts were a significant improvement over the previous regulatory regime, eventually they too proved inadequate. Currency growth was tied to the bond market, not the broader economy. For a rapidly growing young nation, this proved insufficient. An inelastic currency and nonexistent national reserve system led to wild swings in the economy, with oscillating periods of booms and busts. Depressions became a surprisingly common cyclical phenomenon.
These “early experiments in central banking,” as the Federal Reserve Bank of Boston called these pre-twentieth-century attempts, were almost quaint in comparison to modern times. The Boston Fed explained:
As the American economy became larger, more urban, and more complex, the inelastic currency and the immobile reserves contributed to the cyclical pattern of booms and busts. These wide gyrations were becoming more and more intolerable. Financial panics occurred with some frequency, and they often triggered an economic depression. In 1893 a massive depression rocked the American economy as it had never been rocked before. Even though prosperity returned before the end of the decade—and largely for reasons which this nation could not control—the 1893 depression left a legacy of economic uncertainty.9
How did we end up with such a powerful central bank if the country was originally so opposed to one? After those first three attempts failed, we need to fast-forward to the Panic of 1907. In its aftermath, we find the genesis of the modern Federal Reserve Bank.
As so often happens, a long stretch of cyclical growth led to a boom, bust, panic, and renewal. Rapid industrial growth was the key to the recovery from the depression of 1893. Soon, twentieth-century America was booming. From the mid-1890s to 1906, the nation’s annual growth rate was 7.3 percent. 10
How did the country go from prosperity to panic? It would take a complete book to explain (I recommend Bruner and Carr’s The Panic of 1907). In brief, the San Francisco earthquake revealed trouble beneath the surface of the nation’s finances. The massive scope of the damage impacted financial activity around the world. Relief funds were sent to help resolve nearly $500 million in damages caused by the quake and the ensuing fires. London, Germany, France, New York City, and other financial centers saw significant capital migrate westward.
But it was primarily in London, the capital of the British Empire and the financial center of the world, where the monetary problem gestated. Insurance companies were shipping enormous amounts of gold to San Francisco as policies were paid out. As a result, the money supply in England was becoming inordinately tight. With capital scarce, bankers in the United Kingdom decided to do something about it. Printing presses and helicopters were not a ready solution in 1906; instead, the Bank of England raised rates from 3.5 to 6 percent to attract capital. Soon after, other European banks followed. Money flows to where it’s treated best, and after the rate hikes, lots of money found its way back to England.
Consider this modern example of how the more things change, the more they stay the same. In October 2008, after its banking system was devastated by the credit crunch and investment losses, Iceland’s central bank hiked its rates to 18 percent for the same reason the Bank of England did a century earlier: to attract capital.
To those who regularly advocate for the dismantling of the Federal Reserve, perhaps the previous tale may prove instructive. Unless all nations agree to do so simultaneously, the dissolving of a central bank amounts to the economic equivalent of unilateral disarmament.
In the United States in 1907, there was no such comparable mechanism to compete with the Bank of England. While the promise of great riches attracts capital during a boom, liquidity flees once the boom turns to bust. The legacy of economic uncertainty tracing back to the 1893 depression, combined with America’s acute need to attract capital, set the stage for what came next.
In 1908, Congress was desperately searching for an answer to the ongoing financial crises. Its response was to create the National Monetary Commission, a panel studying potential solutions to the nation’s monetary problems. It took five years of political maneuvering, public debate, and legislative proposals to decide whether the United States should have a central bank, and what that bank should look like. It would take yet another book to explain precisely how the Federal Reserve was created in 1913 (and G. Edward Griffin’s The Creature from Jekyll Island11 is the Fed hater’s standard tome).
For the purpose of understanding how the United States became a Bailout Nation, we need only note that the Federal Reserve System was indeed created, granted extraordinary powers, and set loose upon the world. As we will see, the results of this act will have unforeseen consequences that were not remotely imagined back in 1913.
Chapter 3
Pre-Bailout Nation (1860-1942)
Capitalism is not really the best word to describe this arrangement. (The term was coined in the late 19th century as a way to describe the ideological opposite of communism.) Some decades later, people began to use a better term, “the American system,” in which the government involved itself in the economy primarily to develop what we would now call infrastructure—highways, canals, railroads—but otherwise let economic liberty prevail. I prefer to call this spectacularly successful arrangement “financial democracy”—a largely free system in which the U.S. government’s role is to help citizens achieve their best potential, using all the economic weapons that our financial arsenal can provide.
—Robert J. Shiller1
The United States as a Bailout Nation is a relatively new phenomenon. In the early and middle parts of our history, the country did not engage in rescue operations of corporations; speculators who got into trouble were on their own.
Government assistance was more likely to be made available during the birth pangs of a new industry—not during a single company’s death rattle.
Venture capital firms were nonexistent in the nineteenth century. The early days of the republic did not have the equivalent of a Sand Hill Road. Sometimes Congress was called upon to fund start-ups and new technologies. Classic examples can be found in the expansion of the nation�
��s railroads westward and in the development of the telegraph industry. Both of these industries found a coaxable benefactor in Washington, D.C., and received a helpful push from taxpayer subsidies. Commercialization of the first telegraph line was jump-started by congressional funding; railroads received land grants and other forms of enabling assistance to help them expand westward.
The government’s preference was to fund industries that would facilitate the nation’s physical expansion, stimulate infrastructure development, and aid economic growth. Once these industrial sectors were up and running, however, they were left to succeed or fail on their own. How charming! How quaint! What a novel idea!
Inventors and entrepreneurs were a key part of this process. The telegraph industry began when Samuel F. B. Morse, the inventor of the Morse Code, managed to wrangle $30,000 of taxpayer money out of Congress in 1844. He was credited with establishing the first telegraph line between Washington, D.C., and Baltimore.2
So too began the railroad industry. Government grants in 1850 provided lands to Illinois, Mississippi, and Alabama in aid of the Illinois Central Railroad, along with the Mobile and Ohio Railroads. Illinois Central obtained these subsidies through the efforts of a young country lawyer by the name of Abraham Lincoln. The Illinois Central Railroad later repaid the favor by helping Lincoln get elected president in 1860. Perhaps it wasn’t such a favor after all; once in office, Lincoln signed land grants to railroads totaling more than 150 million acres of public land. Of the five transcontinental railroads of the day, four of them owed their existence to these enabling subsidies.
The life cycle of all new industries is the same: New technologies experience a period of rapid growth. The opportunities attract competitors. The new industry expands rapidly and soon makes lots of money. This attracts further competition: more companies, people seeking jobs in these growth areas, and even more capital and greater investment. Fresh competition helps the industry develop and mature. Eventually, the boom reaches the point where overinvestment and excess capacity become endemic, leading to brutal price competition and shrinking margins. Strong firms survive while most of the weaker companies fail. Those with poor management, insufficient capital, or inferior technology soon find themselves on the wrong side of Darwin’s law. This is a cycle that repeats over and over in the system of free market capitalism.
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