Reprinted from EkonLib
Many great films are “based on true events” – that is, some parts are true, but the details, even entire storylines, are embellished with what is sometimes called “poetic license”.
Although it’s not on the big screen (yet), Christopher Leonard Lords of Easy Money: How the Federal Reserve Broke the American Economy Hollywood version of monetary policy. Leonard explains the activities of the Federal Reserve System with a compelling narrative that reveals many of the difficulties of setting monetary policy, as well as the dangerous consequences of bad policies. However, to do this, the author crams complex economic issues into a simple storyline that gives many misconceptions about the monetary and financial system.
Thomas Hoenig plays the protagonist of this story. During his tenure at the Federal Reserve Bank of Kansas City in the 1970s and 1980s, Hoenig witnessed banks expanding their risky lending based on inflated prices and overly optimistic forecasts. By 1991, he had risen to president of a regional reserve bank and served on the Federal Open Market Committee (FOMC), which determines the Fed’s monetary policy. Hoing was later named Vice Chairman of the Federal Deposit Insurance Corporation (FDIC), where he advocated for tighter regulations on US banks.
Current Federal Reserve Chairman Jerome Powell, who began his career as a corporate lawyer and investment banker before moving into private equity with the prestigious Carlyle Group, plays the villain. Leonard focuses on Powell’s work with the Rexnord Corporation, which, according to Leonard, was forced to multiply leverage and cut costs until it was forced to lay off some of its US workforce and move operations to a plant in Mexico. Leonard also documents Powell’s transition from Fed governor and early critic of the first quantitative easing (QE) program to becoming the policy’s main proponent as Fed chairman since 2018.
A main attention Easy Money Lords such is the role of the Fed in channeling—or misdirecting—credit. As an independent central bank, the Fed’s goal is, or at least should be, to support the needs of trade and the financial system, not to influence where funds are directed and invested. Leonard details how overly expansionary policies—especially large-scale quantitative easing cash injections—can seep into overleveraged financial markets, causing asset price inflation, yield seeking, and excessive risk taking.
The bulk of the book is devoted to exposing the recurring cycle of the Fed managing financial risk by easing credit and accumulating risk throughout the financial system until the economy hits a recession. Leonard blames the Fed’s policies for a range of economic and social problems, including an increasingly fragile financial system, rising income inequality, and even offshoring of manufacturing, an ongoing trend since the 1970s.
What is true in this story and what is fiction? While we certainly need to be wary of Fed risk and credit misallocation, I am skeptical that this was a major issue during the QE period. Yes, the Fed created unprecedented trillions in new base money from 2008 to 2014. But the book barely touches on the most significant change in the Fed’s monetary policy: its transition from a corridor system of monetary policy to a minimum system when it started paying. interest on excess reserves (IOER) that banks held at the Fed.
Because the Fed paid interest to banks for holding reserves, the bulk of the money created by QE remained on bank balance sheets rather than being lent to the economy. Although this topic is controversial among economists, my recent article in Journal of Macroeconomics finds that the Fed’s IOER payment caused banks to cut back on lending, likely canceling out the effect of QE. Rather than incentivize risk in the financial system, the banks held onto the newly created ultra-secure monetary base because the Fed was paying them to do so.
Could the new money added by QE have caused asset price inflation in the wider financial system? Possibly, but it seems unlikely. Consumer price inflation has repeatedly fallen short of the Fed’s 2 percent target for nearly a decade. The Fed could have done more quantitative easing, but it could probably have achieved its goal by less QE if it cut the IOER rate, which was set higher than short-term market interest rates for most of the period. Leonard doesn’t say how to define asset price inflation, but the combination of below-target consumer price inflation, contraction in lending, and higher-than-market IOER rates seems to indicate that too little money was available during this period. so it probably didn’t cause a big price bubble in financial assets.
This criticism is especially relevant in relation to the Great Recession of 2007–2009. As Scott Sumner has shown at length, the large contraction in 2008 was due to overly tight rather than loose monetary policy. Hoenig and several other FOMC members openly opposed monetary expansion. They even suggested promotion interest rates during this period. This opposition stalled the Fed’s monetary expansion, which almost certainly made the recession worse. So while overly loose monetary policy may indeed be a problem, it does not appear to have been a problem in 2008 or the decade that followed. Of course, a larger Fed balance sheet can also lead to misallocation of credit, as George Selgin called “financial quantitative easing,” but not in the way described in the book.
The dangers of resource misallocation and heightened financial risk seem more likely in the recent QE period starting in 2020. High inflation has made proper risk analysis difficult. The Fed kept interest rates near zero despite the highest inflation in 40 years and near the lowest unemployment rate since World War II. Fed officials took no action to cut monetary stimulus and ignored warning signs of high inflation. Only time will tell if the Fed’s policies actually led to the negative effects that Leonard spoke of, such as over-leveraging and increased financial instability.
In addition to monetary policy, the book discusses how Fed officials have come under intense political pressure during the coronavirus pandemic. The Fed has been coordinating with the Treasury its monetary policy and lending programs, which, combined with the Coronavirus Relief, Recovery, and Economic Security (CARES) Act, has allowed it to expand well beyond its usual emergency lending role.
The Fed provided funds to non-banks, state and local governments, which former Fed chairmen Ben Bernanke and Janet Yellen said the Fed should not do. On the contrary, Chairman Powell vowed that the Fed would do “everything possible” to support the economy. Fed officials succumbed to political pressure to achieve climate and social goals that are clearly beyond its legal mandate.
Another thing the book is right about is Hoenig’s critique of Unite’s difficulty in regulating bank capital. Like a complex tax code, complex rules allow banks to avoid burdens or regulation. Since regulators cannot accurately determine the level of risk of each asset, complexity may encourage banks to take on more risk than usual. These rules encouraged banks to increase their holdings in highly rated MBSs and credit default bonds (CDOs), leading to the 2008 financial crisis.
Research by researchers at the Bank of England, the World Bank and the International Monetary Fund (IMF), and even the Federal Reserve Bank of New York, has shown that complex rules are no better predictors of banking risk than simple measures such as the equity ratio. . Complicated rules are high costs and small (possibly negative) benefits.
There are important lessons to be learned, and even readers who are already skeptical of the Fed will appreciate the thoroughness of Leonard’s explanations. Unfortunately, many of the “facts” and economic explanations in the book are either inadequately explained or simply wrong. Lots of small bugs and distortions. Criticism of Leonard is often politically one-sided. He regularly calls for government intervention, but generally fails to acknowledge that the government is the source of such problems or that private businesses can offer better solutions.
Perhaps Leonard is right about the degree of inflation in asset prices. Alas, the large number of factual errors in the book makes it difficult to evaluate his claims. He provides little evidence that monetary policy caused higher income inequality, lower economic productivity, or changes in production technologies all seem to be largely driven by non-monetary factors.
Easy Money Lords gives a fascinating insight into the dangers of misguided monetary policy, but readers should be skeptical of the Hollywood version. Should we criticize the Fed’s policy? Yes. Should we worry about misallocation of resources and excessive financial risk? Absolutely. Should we blame all economic problems (real and imagined) on the Fed? As Tom Hoenig would say, “With all due respect, no.”