The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets

The Fed's Economists Can't Correctly Predict and Control the Economy

Reviewed by Larry Schweikart

Martin Mayer has been writing books on banking for years, and never lacks for a publisher. His books tend to ramble, however, and this one is no exception. Worse, they tend to reinforce erroneous notions about the supposed need for government intervention in financial markets and institutions.

Mayer begins with a history of central banks. He argues that they are necessary by claiming that banks in the private sector wait too long to act on emergencies. That conventionally statist assumption puts the book on the wrong track from the very beginning.

Throughout his discussion, Mayer seems unaware of the volumes of recent scholarly research which have shown that before the establishment of central banks, there were, in Scotland and antebellum America, long periods of banking stability and solvency. He also seems oblivious to the extensive research which has shown that interstate branch banking by itself, had it been permitted, may have been sufficient to keep the 1930 economy from plunging into the Great Depression. In short, Mayer makes the standard errors of underestimating the ability of market institutions to adjust smoothly to changes in economic conditions and of failing to see that their apparent shortcomings were due to governmental interference.

In view of those errors, it is surprising that Mayer manages to get the S&L crisis right. He argues that it was a case history of moral hazard in which “the federal government removed incentives for S&L operators to behave prudently.” Although the S&L debacle doesn’t directly bear on the Fed, this is one of Mayer’s occasional good observations that redeem the book in part.

Another valuable insight the author provides is that there has been a steady shift in which the Fed, not the Federal Deposit Insurance Corporation (FDIC), has become the “lender of last resort.” Mayer points out that with this shift from the FDIC to the Fed also came a regulatory responsibility that formerly rested with the Comptroller of the Currency and the Treasury. In essence, the Fed not only became the lender of last resort, but also the financial regulator of last resort. This created its own set of problems, because the Fed was neither chartered nor equipped to do the job of the Comptroller in conducting examinations or strong-arming banks into compliance. Mayer details the ways in which banks can easily cheat the Fed’s supervisory efforts.

When he arrives at the 1970s, Mayer notes that a “revolution in banking” occurred when banks moved from asset management (the right mix of loans and investments) to liability management (buying deposits to ensure a constant flow of money). This was a result of the near hyperinflation of the era, but it anticipated a period in which the emphasis would go from an abundance of lendable funds to a shortage. In reviewing the Volcker years, though, Mayer falters, arguing that the Fed chairman had stopped inflation only by imposing “interest rates high enough to throttle enterprise.” The high interest rates of the period were caused by the high rate of inflation, not the cure for it. Having lived through the booming ’80s, I must have missed that “throttling of enterprise.” In fact, enterprise took off as soon as Volcker got money creation under control and Reagan lowered taxes.

The rise of mass securities markets, such as those developed by Michael Milken, which had virtually no regulator except the consumer, put banks in a position where they began to eclipse even the Fed’s ability to restrain them. Lamenting the ineffectiveness of congressional directives to force banks to lend money to bad risks, such as the Community Reinvestment Act, leads Mayer to conclude that “the United States is moving back toward the old days when people who didn’t have much money would be served by high-margin cheapjacks.” Mayer clearly believes that governmental interference in credit markets would be good for the poor, writing, “The Fed’s untroubled supercilious tolerance of these developments reminds us that there are people in high places who still believe government should not interfere with the freedom of contract between the loan shark and the needy.”

Yep, that’s me! It is not government’s–nor the Fed’s–place to interfere with such contracts. Trying to direct capital to people who are poor credit risks leads to a waste of capital rather than lifting people out of poverty.

Mayer doesn’t grasp that the Fed’s economists can’t correctly predict and control the economy, and that the nation has paid dearly for failing to allow a true market-based banking system to develop. While this book gets some things right, on the big question-whether we benefit from having government interference in our financial markets-it leads the reader straight into quicksand.

Larry Schweikart teaches history at the University of Dayton.

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