The Logic and Limits of the Federal Reserve Act

Lev Menand is Associate Professor of Law at Columbia Law School. This post is based on his recent paper.

Over the past fourteen years, the footprint of the Federal Reserve, the U.S. central bank, expanded dramatically. The Fed repeatedly rescued overleveraged financial companies, backstopped foreign financial institutions, and purchased trillions of dollars of mortgage-backed securities. In 2020, it even created a set of novel facilities to assist medium-sized enterprises and municipal governments.

In the wake of these actions, a debate has emerged about whether the Fed went too far, or not far enough. Defenders of the Fed’s expansion argue that its 2020 nonfinancial lending programs should not be repeated outside of a pandemic context, but that its Wall Street lending and asset purchase initiatives are bulwarks of a working monetary-financial system. They are content with a largely reactive central bank that preserves the integrity of a sprawling private financial sector. Others meanwhile are calling on the Fed to continue its 2020 programs and use its power to create money to address other crises facing the country, such as climate change and crumbling infrastructure. If the Fed is able to create money to boost asset prices and save financial firms, why shouldn’t it directly tackle problems that hurt ordinary households and businesses?

Who is right? What is the Fed for? Why is it using its power to create money to aid financial firms and support asset prices? And are there any problems the Fed shouldn’t tackle?

In a new paper, I seek to clarify the nature and stakes of this debate by recovering the logic and limits of the Federal Reserve Act. I argue that to understand the Fed—including its place in the federal administrative state, its initiatives since 2008, and its various possible futures—it is necessary first to understand the U.S. system of money and banking. That system uses government chartered, investor-owned banks to issue most of the money supply. Over the course of the nineteenth and twentieth centuries, Congress constructed an elaborate legal regime to govern these banks the purpose of which was to render the delegation of monetary powers to private investors politically and economically durable. I call this regime the American Monetary Settlement.

The Fed is the capstone to this system. Congress designed it to strengthen the government’s control over the investor-owned banking system. Drawing on the text, structure, and legislative history of the Federal Reserve Act, I argue today’s Fed is built to address three problems with monetary outsourcing that contemporary scholars and commentators tend to overlook, underplay, or misunderstand: (1) deflation and monetary contraction—the tendency of the investor-owned banking system to intermittently shrink its collective balance sheet, generating economic instability and unemployment; (2) maldistribution—the propensity of profit-oriented bank managers to mistreat smaller competitors, issue new money unevenly across the country, and divert resources toward speculative activities; and (3) a lack of public accountability and control—the inability of traditional government regulators to address problems like deflation and maldistribution, leading to a politically destabilizing legitimacy gap.

Conceptualizing the Fed as the administrator of the banking system helps to explain otherwise perplexing aspects of the institution’s past, present, and future. First, it reveals that the Fed’s organizational structure is coherent (which is not to say optimal): interest rate policy and emergency lending, even though they are often treated differently by practitioners and scholars, are both varieties of bank regulation; the Fed’s twelve regional banks reflect the role of investor interests in, and the diffuse nature of, the American banking system; and the Fed’s independence from the President is consonant with a three-century history of insulating monetary functions from executive control.

Second, it renders the Fed’s recent activities legible. The rise of shadow banks—firms that issue alternative forms of money without a bank charter—has impaired the Fed’s traditional tools for managing the money supply. Since Congress has done little to address the growing gap between the Fed’s mandate and its abilities, the Fed has responded by attempting to carry out its statutory mission of monetary expansion in a world that has evolved beyond the imagination of the legislators who crafted its enabling act.

Finally, the paper identifies and clarifies the fault lines in the debate about the Fed’s remit. As the Fed has taken on tasks it was never meant to handle, different visions have emerged about how elected officials, technocrats, and private investors should share responsibility for creating the money supply (and governing the economy). While Congress designed the Fed to oversee a monetary system centered on chartered banks, the Fed has evolved to manage a system in which unchartered shadow banks predominate. If certain voices prevail, the Fed might evolve further still to crowd out both banks and shadow banks and use its balance sheet to execute public policy directly. This evolution is not a costless development: as the Fed continues to depart from the statutory scheme, it further tears at the legal fabric for money and banking, undermining key legislative goals and jeopardizing its long term political and economic durability. To understand the stakes and begin to assess the various positions in this debate, we need a theory that explains the fit between the Fed’s institutional design and its responsibilities. That is what The Logic and Limits of the Federal Reserve Act seeks to provide.

The complete paper is available for download here.

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