Mort Zuckerman: Keep Congress Away From the Federal Reserve

When the professionals at the Federal Reserve Board review the epic diary of our economy, their lament must be “How soon they forget.” It has been 30 years since America was in the grip of double-digit inflation, with seemingly no hope of escape. The professionals look back with justifiable pride on the brave ac­tions of the Fed under Chairman Paul Volcker. Memorably, it raised interest rates to nearly 20 percent. Unemployment rose. The political firestorm was more turbulent than any­thing since the days of Herbert Hoover and the Great ­Depression. But the Fed’s extraordinary action broke the back of the “Great Inflation,” launching us into the “Great Moderation,” a 25-year pe­riod of high employment and prosperity with very limited inflation.

This was an exemplary illustration of Federal Reserve independence. Imagine if Congress had called the shots. Can anyone believe it would have acted with such reso­lution—and in an election year?

When the stock market crashed in 1987, the Fed restored confidence. It came to the rescue again after 9/11 created the financial ­disruption of 2001. How soon they forget! It has been only a year since our overleveraged system buck­led. Fear and panic paralyzed normal mar­ket functions. We were on the verge of en­during a freeze-up of the entire financial system that would have plunged our econ­omy into another Great Depression. What pulled us back from the chasm was the intervention of the Federal Reserve Bank.

The Fed led off by cutting ­interest rates aggressively, bringing them close to zero. That by itself didn’t do the trick. The Fed swiftly realized that the too-big-to-fail ­financial institutions, which account for roughly half of our banking, had seized up because their own financial assets had collapsed. The smaller banks didn’t have the means to bridge the gap. Understandably, households and busi­nesses cut their debt, so spending fell just when we needed to increase demand to prop up the economy. The Fed real­ized that unconventional policy tools were urgently need­ed to keep equity and debt capital flowing. It responded with great creativity and ingenuity through unique lending and asset purchase programs. It rebuilt confidence in the system through a series of “stress tests” that looked at which banks’ policies had gotten out of whack, lending too much on the basis of inadequate capital. The unprecedented mea­sures that the Fed took restored confidence and liquidity without provoking sharp increases in inflation. The rescue could not have happened without the Fed’s credibility and independ­ence from short-term political pressures.

In the process, the Fed has stoked public anger by bail­ing out, with billions of tax dollars, the same people and financial firms that got us into so much trouble in the first place. By bailing out individual firms, the Fed broke its long-standing policy of creating money completely separate from the decision of who benefited. It was necessary to do this because a general easing would not prevent the domino effect whereby one firm’s col­lapse would lead to runs on the others, thus threatening the health of the entire finan­cial system that lies at the core of our free-market economy.

As the chairman of the Fed, Ben Ber­nan­ke, put it, “That could have rivaled the Great Depression in length and severity.” The Fed’s choices were limited to allowing a major financial firm to fold, raising the pos­sibility of a systemic risk, or supporting the firm with taxpayer money. The choice of the latter course was even braver than the Fed’s assault on inflation in the 1980s.

These are but a few examples of why we must preserve the Federal Reserve’s ability to foster financial stability and promote economic recovery.

It could fairly be said that the Fed did not take timely steps to correct a generally ­unperceived structural transformation of the financial world. Money market funds emerged that undermined deposit ac­counts in banks; commercial paper trans­formed the business of short-term lending to big corpo­rations; high-yield bonds had the same effect on lending to smaller companies.

Then there were the many complex debt securities. Those in the financial world relied on third-party insurers who they believed would immunize them against failure mainly through so-called credit default swaps. When that proved illusory, the result was a panic that shattered confidence and raised the possibility of systemic failure. The financial world seemed so stable and predictable that it was a tremendous shock to find that we were living on top of the San Andreas Fault. Indeed, we now live with sec­ondary tremors because the imbalances that created the cri­sis, such as excessive leverage and collapsing asset values, have not yet disappeared (see Dubai). Huge potential vul­nerabilities remain.