This is Chapter 8 of Dan Riker's Let's Do What Works and Call it Capitalism.
Chapter 8. The Reagan Legacy Lives On
“(T)he parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;”
- Deputy Treasury Secretary Lawrence H. Summers testifying before the Senate Committee on Agriculture, Nutrition, and Forestry, 1998 in opposition to possible regulation of the derivatives market.
“Change We Can Believe In”
- Motto of the 2008 Presidential Campaign of Barack Obama.
Despite the fact that Democrats have won four of the last six Presidential elections, progressive government practices have not come back to life. Neither Bill Clinton, nor Barack Obama initiated dramatic reversals of conservative policies and many continue to dominate government policies and political dialog.
The last tax increase proposed and enacted by a Republican occurred when President George H.W. Bush violated his own “read my lips, no new taxes” campaign pledge. Many blame his defeat on that, but there were other factors that probably were more important. After doing a masterful job of assembling a huge international coalition to eject Saddam Hussein's Iraqi army from Kuwait, Bush stopped short of completing the conquest of Iraq and left Hussein in power. Many in the U.S. and in the international community, were greatly disappointed and disillusioned. His son felt compelled to solve the problem, to our everlasting shame. His appointment to the Supreme Court of Clarence Thomas, a conservative black of questionable qualifications, who also had a record of sexism as demonstrated in his Senate hearings, alienated many women.
The key legacy of this Bush Presidency, other than leaving Iraq unsettled, was the resolve among Republicans not to support any tax increases in the future. And except for agreeing to raise the top tax rate slightly in a compromise to save most of the George W. Bush tax cuts from expiring, they have kept to this resolve ever since.
The moderate Arkansas Democrat Bill Clinton achieved something that his two conservative predecessors never did. Greatly assisted by a huge bubble in the stock market that generated large increases in capital gains tax revenues, and substantial increases in consumer spending, he balanced the federal budget for the first time since 1969, and then ran a surplus in the fiscal years, 1998, 1999, 2000, and 2001.
The impact of massive investments by companies in information technologies in the 1980s and early 1990s are credited with the productivity gains that resulted in some of the economic growth during Clinton's Administration, and some of the 20% increase in the average income of the middle class. The Clinton years were the only years in the period between 1979 and 2012 that there was any substantial increase in average income, but much of that was wiped out in the two recessions that occurred during George W. Bush's administration.
The major progressive effort of the Clinton Administration, an attempt by Hilary Clinton to win Congressional approval of some form of national health care, failed to gain any substantial support. Overall, Clinton was far from progressive. He expanded the Reagan Administration's policy that caused jobs to leave the country when he signed the North American Free Trade Agreement into law. He curbed some important progressive regulations and programs of the New Deal.
In the name of reform, he dramatically reduced welfare, which weakened the safety net for the poor – with devastating results during the current recession.[1] Single mothers were required to go to work, rather than collect welfare, but somehow the fact that the cost of childcare could not be covered by the meager incomes many uneducated poor women could earn eluded the Washington crowd that never had this kind of problem.
He also signed two changes in financial regulation which later contributed to the 2008 financial crisis, the repeal of the portion of the Glass-Steagall Act which had separated investment and commercial banks, and an act that legalized over-the-counter derivatives without providing any regulation of them. These two acts by Congress and the President played decisive and tragic roles in the Great Recession under President Bush because they lessened the ability of the federal government to protect the public from uncontrolled financial capitalism.
Brooksley Born, the chair of the Commodities Futures Trading Commission, attempted to get Congressional approval to regulate the derivatives market. Her effort failed because of the opposition of Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Deputy Treasury Secretary Larry Summers, who succeeded Rubin in 1999.
The July, 1998, testimony of Summers before the Senate Agriculture Committee, which had jurisdiction over commodities and commodities regulation, is very revealing of prevailing thought in the late 1990s, which basically was no different from that of Theodore Roosevelt's “malefactors of great wealth.” The only good regulation was no regulation.
The OTC derivatives market is a vast, increasingly global industry. By some estimates, the market now has a notional value of around $26 trillion, with contracts of more than $4 trillion undertaken in 1997 alone. The dramatic growth of the market in recent years is testament not merely to the dynamism of modern financial markets, but to the benefits that derivatives provide for American businesses.
By helping participants manage their risk exposures better and lower their financing costs, derivatives facilitate domestic and international commerce and support a more efficient allocation of capital across the economy. They can also improve the functioning of financial markets themselves by potentially raising liquidity and narrowing the bid-asked spreads in the underlying cash markets. Thus, OTC derivatives directly and indirectly support higher investment and growth in living standards in the United States and around the world.
Any disruption to this market brings two large potential costs. First, it could inhibit the use of an important risk management tool, thus reducing the efficiency of our financial markets in channeling capital to its most effective use.
Second, uncertainties of this kind threaten the position of the United States relative to other global trading centers, thereby depriving our economy of the multiple benefits which this activity affords. [2]
Summers went on to tell the committee that the derivative market did not have the characteristics normally requiring regulation:
• First, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;
• Second, given the nature of the underlying assets involved -- namely supplies of financial exchange and other financial instruments -- there would seem to be little scope for market manipulation of the kind seen in traditional agricultural commodities, the supply of which is inherently limited and changeable.
To date there has been no clear evidence of a need for additional regulation of the institutional OTC derivatives market, and we would submit that proponents of such regulation must bear the burden of demonstrating that need.[3]
Stripping this testimony to its essence, Summers was telling Congress that a great number of important people, many of whom were friends of both Summers and the Senators, were making huge amounts of money in the rapidly growing derivatives market, and would be very unforgiving if Congress allowed any regulation. He cited, as a positive, the size of the derivatives market, which at that time was more than twice the GDP of the United States, and then blandly said the institutions involved were “imminently capable of protecting themselves...”
They were not, of course, and partly because he was wrong about the protection of the existing banking and securities law regulations. In 1999 Summers was instrumental in the repeal of portions of the Glass-Steagall Act, which had restricted combinations of investment and commercial banks.
He also was wrong about the potential for manipulation. The bursting of the housing bubble that was caused by manipulation of the mortgage market brought a flood of ruin from which no combination of the institutions involved could protect themselves.
In 2001 when George W. Bush became President, the United States was in the strongest position economically, militarily, and politically that it ever had been. Not long after Bush took office, American Heritage devoted an entire issue to a history of the American economy by historian John Steele Gordon that contained some language somewhat similar in outlook to that noted earlier of Calvin Coolidge.[4]
“Today, the United States is pre-eminent in the world militarily, technologically, scientifically, and culturally as no state has been since the apogee of the Roman Empire 1,800 years ago,” [5]Gordon wrote euphorically at the beginning of the issue. It seemed that America had weathered the many storms of the 20th Century and that in June, 2001, when this issue was published, things could only get better.
Echoing Steinbeck's description of 1929 just before the Crash, Nobel Prize-winning economist Paul Krugman described the stock market frenzy that gripped the nation in 1999:
“In late 1999 – about the time when George W. Bush first announced his tax-cut plan – I had lunch at a beer-and-pizza joint, the sort of place that has a TV over the bar where the patrons can watch ESPN. But the TV wasn't tuned to ESPN – it was showing CNBC. I thought to myself, 'This will end badly.' And it has.”[6]
In
The Great Unraveling, Krugman explained that dramatic increases in federal tax revenues that enabled Bill Clinton to balance the budget were due in large part to capital gains taxes paid on stock gains in a booming stock market that was reaching the bubble stage by 1999. By 2001, when George H. Bush's tax cut – which significantly cut the capital gains tax – was approved by Congress, the stock market bubble of the late 1990s had already burst and federal revenues already were in decline. Either those in charge didn’t notice this, or they did know, and lied about it.[7] In any case, the budget surpluses vanished almost overnight, and after the tax cut, revenues plummeted, setting the stage for the greatest increases ever in the National Debt.
9-11 came soon after the tax cut, and before long there were American soldiers in Afghanistan, and later, there was the conquest and occupation of Iraq. The Bush Administration decided to pay for both wars through off-the-books deficit spending. Unlike what was done in World War I and II, no attempt was made to increase federal revenues to pay for the wars. In fact, Bush got another tax cut approved. He then won approval for the Medicare Part D prescription program, also paying for it with deficit expenditures, rather than new taxes, or increased Medicare withholding.
Maybe all of this would have worked, or at least not caused as much of a problem, if someone in the White House had paid attention to what was going on in the housing and derivatives markets. Because of what had happened during the Clinton Administration, there were no protections against the avarice and greed that gripped the unregulated derivative markets. In the few years that followed those actions of the late 1990s when safeguards were removed, and unregulated derivatives were permitted, trillions of dollars of highly unstable financial instruments had been created and sold into the world market. When housing prices collapsed in 2006, the derivatives lost value, in many cases, all of their value. The President and a majority in Congress were persuaded that a massive government bailout was necessary to prevent a collapse of the entire banking system, which they were told would have caused an economic disaster without historical precedent. There still are no adequate protections against something similar happening again.
A 1997 book, F.I.A.S.C.O.,[8] by a Morgan Stanley trader, Frank Partnoy, detailed the risks of the derivative market. The Afterword to the 2009 edition of the book provides both a comprehensive and easy to understand description of the entire subprime mortgage derivative scandal that nearly brought down the entire banking system in 2008. Many people were aware of the pending disaster. Partnoy wrote in his Afterword that some hedge fund managers shorted the subprime derivatives before the housing market collapsed and made billions of dollars. This knowledge somehow eluded the Bush Administration, or was ignored.
In the late 1990s, Wall Street firms began selling a new type of derivative, a right to a stream of income from a number of home mortgages batched together. The interest rate payments were made attractive by the inclusion in each batch of mortgage streams a number of high risk mortgages, known as subprime mortgages, that because of their risk carried higher interest rates. However, because the entire package included many mortgages considered completely safe, the rating services, Standard & Poors and Moody's. Gave the highest ratings of safety, AAA. In addition the derivatives contained an insured guarantee of their safety. Thus, with interest payments higher than normal AAA rated instruments, and the guarantee, the derivatives had enormous appeal to sophisticated investors, mostly other financial institutions, pension and other funds. They were not sold to the public, and they had been exempted from federal regulation.
These derivatives became so popular that the demand for them soon exceeded the normal supply. The kicker was that each package had to contain a certain amount of the subprime loans, and, given existing credit requirements, there were not enough risky mortgages to be able to meet the demand. Wall Street wanted more subprime mortgages, and the mortgage-making community cooperated. With the government not paying attention, credit requirements for mortgages, particularly for “jumbo” mortgages were significantly loosened. Dozens of mortgage-making companies sprung up. All they did was to make the mortgages, often with little or no credit checking, or even appraisals of the homes. Not long after the closings, the mortgages were sold to the Wall Street banks and packaged into the derivatives.
The easy mortgage money pushed housing values way above all-time highs in 2006.[9] Subprime mortgages typically had a low initial interest rate that bumped up rather dramatically within a short period of time, in many cases, as little as one year. As these interest rate bumps began to hit in quantity, many of the affected homeowners defaulted on their mortgages. The value of the derivatives began to drop, and the bubble burst, with a massive collapse of both the value of the derivatives and home values in general.
The giant insurance company, AIG, had so over-committed on insuring derivatives that it had to reneg on the guarantees. That caused a complete collapse of the home mortgage derivative market, and the resulting failures of Wall Street giants Lehman Brothers, Merrill Lynch and Bear Stearns. Bank of America was forced to buy Merrill Lynch, and J.P. Morgan was forced to buy Bear Stearns. Lehman Brothers was allowed to go into bankruptcy.
When the bubble burst, houses on average across the country lost nearly a third of their value, (but more than 50 per cent in some of the “hottest” real estate markets such as some areas of Florida, Las Vegas and Phoenix) wiping out trillions of dollars of equity and leaving millions of home owners “under water,” holding mortgages that are higher than the value of their homes, and causing a flood of foreclosures that have kept housing prices down and continue to depress the economy.
Millions of homeowners who were not behind in their mortgages and did not have “subprime” mortgages suffered enormous losses in their equity in their homes, which in many cases represented most of their net worth. This probably was the greatest theft in history for which no one was punished and for which no substantial help was provided to the victims. Never before had a financial bubble burst affected so many innocent people. To this date nothing has been done to help homeowners recover their lost equity, and the loss of that equity continues to be a drag on the economy. Untold numbers of people, including retirees, or people entering retirement, suffered enormous financial losses they will never recover.
With the barrier between investment banks and commercial banks no longer in existence because of the partial repeal of the Glass-Steagall Act during the Clinton Administration, the collapse of the subprime mortgage derivative market threatened to bring down the entire banking system. Subsequent investigations have revealed that in the process of creating the subprime investment packages many banks lost the documentation of the underlying mortgages, which made foreclosures illegal. In an effort to cover this up some banks forged mortgage documents, but their executives have been able to avoid criminal charges.[10]
After Barack Obama was elected President Congress passed the Dodd-Frank bill that attempted to put back in place some of the Depression-era protections against bank failures, as well as other regulations. However, in 2014, some key provisions of that Act still had not been converted into regulations because of successful lobbying by the bank industry. One of the key provisions blocked in Congress was a requirement that the value of derivatives be included in bank assets for determining how much cash reserves they had to maintain. Six years after the near collapse of the banking system, the protections needed to prevent another still were not fully in place.
In eight years the Presidency of George W. Bush managed to squander the best opportunity in modern times to control the federal debt, chose to go to war with Iraq for reasons that turned out to be bogus, and completely misjudged what that war would cost, both in lives and in dollars. While doing that, the man who caused the 9-11 attacks was allowed to escape and hide in Pakistan, and the military mission in Afghanistan was limited because of the demands of the Iraq War. His tax cuts caused enormous deficits which we still are suffering.
Not only was the George W. Bush Administration apparently oblivious to the building crisis of the subprime mortgage derivatives, and the growing housing bubble, it stopped all efforts to regulate the financial markets. Not since the Presidency of Warren Harding in the 1920s had the United States experienced such incompetence in the national government, and many believe it could have resulted in another Depression.
There may be more robber baron personalities holding great wealth today than ever before. The number of billionaires has skyrocketed to more than 400, almost 20 times as many as there were in 1980. For many of these types of people, no amount of wealth is enough. They seem to become more and more ruthless as their fortunes grow. Perhaps this explains why at a time when taxes on the rich are close to historic lows, they want even more tax reductions, and fight every effort to increase federal revenues for any purpose. The avarice of a number of prominent billionaires was never so clearly demonstrated when several publicly complained about the Affordable Care Act forcing them to provide medical insurance to their employees, most of whom work at near minimum-wage levels, and need food stamps to feed their families.
Many of this elite, which includes financial, industrial and service industry capitalists, and some with inherited fortunes, do not seem to feel any obligation to the nation that gave them, or their ancestors, the freedom, protection and opportunities to become rich. Indeed, the ancestors who built great fortunes usually built those fortunes through enormous subsidies from governments. There seems to be an attitude, reflected in the political positions they support, that they are the only citizens entitled to largesse from the government, such as the subsidies, tax breaks, non-bid contracts, bank bailouts, or bargain grants of access to natural resources.
They finance the Republican Party's efforts to cut aid to the poor, to curb the power of unions to protect people from exploitation, and to reduce, and eliminate, or cut, programs such as Social Security and Medicare. They have been very successful at the state level, where union, privacy, and voting rights have been curbed in a number of states. Through their own advertising, and the Fox television network, they lied about President Obama and distorted the record of his Administration.
In 2010 93% of all the economic gain in the United States went to the top 1% wealthiest people. Despite that, the Republican Party's “budget,” passed by the House of Representatives, contained enormous tax cuts for the wealthiest income groups and, effectively (through the elimination of some deductions), tax increases for the middle and lower income groups. It also would have eliminated Medicaid, and effectively destroyed Medicare, the critically important health insurance programs for older Americans and the poor, and middle class families with aging parents.
That 93% was not enough was proven by the fact that since then the rich have gained more than 100% of all the growth in wealth. Everyone else has lost money. This is proof that we have reached another one of those points in history when things must be changed if our democratic capitalist system is going to survive, and thrive. The laissez-faire policies of the Reagan, and two Bush Administrations – with assistance from the Democrat Bill Clinton – created another period of enormous greed and lusting for power by the elite that has damaged the nation.
Unfortunately, the victory by Barack Obama in 2008 was not enough to stop it. The nation is bitterly divided. With the Republicans in control of the House, many Republican policies that caused the Great Recession have continued during a Democratic Administration, prolonging the nation's economic problems.
President Obama was not able to eliminate the disastrous Bush tax cuts until the beginning of 2013 when they were restored for the wealthy. He was unable to get approval for larger and more ambitious programs to stimulate the economy. For some achievements he had to agree to large cuts in federal expenditures, which slowed the recovery. The challenges to Medicare and Medicaid continue. Even some Democrats talked about possible cuts and they should be defeated in primaries by progressives.
When Barack Obama was sworn in as President in January of 2009, the possibility that the country could slide into a depression still appeared to be very great.
The government policies of essentially laissez-faire capitalism that resumed with Reagan after a hiatus of nearly 50 years, had led to a disaster, much the same as what happened at the end of the 1920s, also following a period of laissez-faire policy. Once again, unbridled capitalism had to be saved from itself. With a stimulus program that many economists thought too modest, and with close coordination between the Treasury Department and the Fed, the economic decline was halted, but no real bridle was put on financial capitalism, and there was no dramatic recovery from the Great Recession.
President Obama made a serious political mistake by not immediately pursuing punitive actions against the banks and their managements. Instead, the banks received billions of dollars in federal funds and they paid billions in bonuses to executives and senior employees. This was not the change Obama promised during his campaign, and huge numbers of his supporters were disillusioned. Despite the right-wing hate attacks, describing Obama as a radical, he was not even a real progressive, or very liberal. Basically, he was a middle-of-the road Democrat, and except in his personal morals, not much different from Bill Clinton.
The stimulus program enacted by Congress did help to stop the economic decline, but it was not large enough to spur the economy into enough growth to bring unemployment down to normal levels. It now is apparent that the Obama Administration underestimated the severity of the economic crisis, and did not give it the priority it should have received.
The Democratic filibuster-proof 60-vote majority in the Senate ended with the election of Republican Scott Brown to replace Massachusetts Sen. Edward Kennedy. The 41 Republicans from then on voted as a block, preventing any of the President's major initiatives from passing, and blocking many of his appointments. It was the most extensive use of the filibuster in history. The Republicans openly said their top priority was to prevent Obama from winning a second term, regardless of the consequences to the country.
As a result of the intransigence of the Republicans, the Bush tax cuts, which were to automatically expire at the end of 2010 and which were a major cause of the growing deficits, had to be extended in order to get Republicans to agree to other critical pieces of legislation. Nearly all of the Republican members of Congress signed the incredibly irresponsible pledge never to raise taxes, and they stuck to that pledge even though deficits continued.
Obama came under heat from both the right and left wings. The right wing kept accusing the very moderate Democrat of being a socialist – and some continued to say he was a Muslim – or wasn't born in the U.S. It was a campaign designed to undermine his legitimacy, and while it appealed to extremists, particularly racists, it drew no broad popular support.
The left wing of the Democratic Party thought he gave in too easily to the Republicans, and seemed willing to compromise too much. Many in the electorate were unhappy about the bank bailouts. The Administration misplayed its greatest achievement, the Affordable Care Act, which extends medical insurance to millions who could not previously afford it. The emergence of the Tea Party's virulent opposition was underestimated by the Administration, and little was done to counter many of the bogus claims made about the Act.
President Obama failed to keep energized the hundreds of thousands of young people who worked to get him elected in 2008. That enormous organization of volunteers and contributors that might have been converted into a continuing force for political change was given nothing to do, and it dissipated. By 2010, many had become disillusioned, and did not vote in the numbers they had in 2008. Voter turnout dropped by 20 percentage points. The Democrats were particularly inept in defending the Affordable Care Act against the Tea Party assault, much of which contained misinformation, or complete falsehoods. The result was the loss of control of the House in 2010 to the Republicans, as well as many important state houses.
Obama's bailout of General Motors and Chrysler was successful. The auto companies survived structured bankruptcies and by the end of 2011 were successful once again, especially General Motors, which, for a period of time, resumed its position as the world's biggest carmaker, and achieved record profits. Vice President Joe Biden later coined the slogan of the time when he said, “General Motors is alive, and Osama bin Laden is dead.”
About halfway into the 2012 campaign Obama shifted to more progressive positions, seized control of the race, and won re-election by a margin that many thought was not possible. The President took a strong progressive tone in his inauguration speech, giving hope to long suffering progressives that his second term would push a more progressive agenda. However, continued Republican control of the House blocked most of his programs. Even with enormous public support for increased gun control, in the wake of the Connecticut killings of school children, the President could not get Congressional approval of even a modest program. Following that defeat, there seemed no hope for any of the President's programs.
When the extensive penetration of American communications by the National Security Agency, some of it illegal, was revealed, President Obama defended it at first, once again alienating progressives. Later, however, he moved to curb some of NSA's spying on American communications. Further revelations of even more spying on Americans, including members of Congress by the CIA continued to be revealed in 2014.
President Obama did attempt following the 2012 election to convert his massive volunteer campaign organization into a permanent activist organization, but the effort seemed to be losing steam early in 2014, with the new round of progressive disappointment with him.
Late in 2013 the start-up of the Affordable Care Act was wrecked by massive computer problems at both the national and state levels. President Obama's popularity sagged substantially, which gave the Republicans some hope that they would not be punished in 2014 for the government shutdown they engineered. However, many of the computer problems were fixed by January, 2014, and it seemed less likely the Republicans would gain much from the early problems. If anything, with millions of people signing up for insurance through the program, the continuing hostility of Republicans seemed more likely to become a liability.
Late in 2013 the Democratic majority in the Senate ended the ability of Republicans to block Presidential appointments by filibuster. This gave the President the opportunity to fill dozens of vacant federal judgeships and other federal jobs, but with Republicans in control of the House, there was little hope for any of President Obama's legislative priorities. If Democrats did not regain control of the House in 2014, President Obama was going to find the final two years of his presidency to be very frustrating.
It is too early to do a detailed assessment of Obama's Presidency. For much of the time, he seemed more surefooted in foreign policy, and was able to accomplish more because in many cases he did not need Congressional approval. He succeeded in getting the U.S. out of Iraq, and was moving towards an exit from Afghanistan early in 2014. He seemed to have good instincts about where to get involved, and where not to. He supported, and helped with the overthrow of Ghaddafi in Libya, without putting American forces into the country. After supporting the uprising in Egypt against the dictator, Mubarek, and attempting to work with the popularly elected Muslim Brotherhood government, he turned on that government when the Egyptian people did, after it had become dictatorial. He tried to avoid involvement in the murky civil war in Syria and succeeded in forcing the Syrian government to give up its chemical weapons. However, the seizure of large parts of Syria and Iraq by the extremist ISIS Muslim radicals threatened to spark another war. At the time of this writing the U.S. was carrying out air strikes against ISIS forces, and the Administration was trying to assemble a coalition of countries to defeat ISIS. There also was uncertainty in the Ukraine over Russia’s intentions.
He was far less successful in domestic policy, where Congressional support is crucial. He never seemed to catch on to the enormous level of hostility that Republicans had for him, and that they never were going to work with him. As a result, he never devised an effective strategy to counter their opposition. The Republicans blocked virtually all his domestic program, including programs that would have spurred the economy, and then they tried to blame him for the slow recovery of the economy from the Great Recession. Obama came under considerable criticism from the liberals in the Democratic Party for even trying to negotiate with the Republicans.
In all of the emphasis in politics on the state of the economy, it is easy to overlook the fact that two of the most important elements in the economy – interest rates and the money supply – are not controlled by either the President or the Congress. The independent Federal Reserve controls both.
The Federal Reserve is the nation's central bank. Section 2A of the Federal Reserve Act specifies that its objectives are to “maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
The Fed consists of a Board of Governors that sets the interest rates and manages the money supply. There are 12 regional federal reserve banks. The Chairman and Vice Chairman are appointed to four-year terms by the President, with the approval of the Senate. However, the Fed does not report to the President. It operates autonomously, but does give periodic reports to Congress.
The Fed literally prints money anytime it wants, but usually does it when it intends to increase the money supply. Its usual practice is to buy federal bonds from major banks by depositing the cash for the purchases in the respective banks' federal accounts. These amounts usually are very large, hundreds of millions, or billions of dollars. Recently, it has been tens of billions of dollars. With this cash added to their balance sheets, banks have greater ability to lend, and the expectation is that they will, putting more money into circulation, and stimulate the economy.
The cash transferred to the bank accounts is created at the time of the purchases. It is an absolute expansion of the amount of money in circulation. This action does not need any approvals from any other branch of government. For the past 30 years the general practice of the Fed has been to maintain a tight money supply to keep inflation under control, under 2%, and it has been quite successful in achieving that goal. However, it has not done as good a job of meeting its objective of “maximum employment.”
During the Great Recession the Fed came under considerable criticism from the Keynesian economists, nicknamed the “Salt Water” economists because most of them are associated with universities on the East and West Coast. A number of them, including Nobel Prize winners Paul Krugman, of Princeton, and Joseph Stiglitz, of Columbia, argued that the nation was experiencing a liquidity trap, that not enough money was in circulation, and this stalled the economy, and helped to keep unemployment at high levels. They urged the Fed to expand the money supply and allow inflation to increase slightly. Conservatives vehemently opposed this. However, late in 2012 the Fed began what they called “quantitative easing,” i.e., expanding the money supply, by buying U.S. bonds from the banks. By 2014 the Fed had purchased approximately $4 trillion in U.S. bonds from banks and was the largest single holder of the national debt.
Unfortunately, the banks did not do with the increased cash what the Fed intended. Instead of loaning the money to businesses and individuals, something that would spur the economy, the banks were reported to have invested large amounts of the money in the stock market. This drove up stock prices, helping to make the rich even richer, and further distorting the nation's income and wealth inequality.
The Fed also lowered interest rates to near zero, but that also did not stimulate the economy. There was very little else the Fed could do to carry out its objectives.
The power of the Fed is not well understood by the American public, much of the media, and national politicians of both parties seem intent on keeping it that way. Whichever party is in opposition wants to be able to blame the President if the economy falters. The party in power wants to take credit if the economy surges.
[1] NY Times article, April 8, 2012.
[2] TREASURY DEPUTY SECRETARY LAWRENCE H. SUMMERS TESTIMONY BEFORE THE SENATE COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY ON THE CFTC CONCEPT RELEASE
http://www.treasury.gov/...
[3] Ibid.
[4] Gordon, John Steele. “The Business of America: 150 Years of the U.S. Economy – from the Railroad Revolution to the Information Revolution.” American Heritage, June, 2001.
[5] Ibid. p.7.
[6] Krugman. Paul. The Great Unraveling: Losing Our Way in the New Century. New York: Norton, 2005. p. 49.
[7] Ibid. pp 50-51.
[8] Partnoy, Frank. F.I.A.S.C.O. New York: Norton, 1997. Reissued in 2009 with a new Afterword.
[9] http://www.ritholtz.com/...
[10] For a particularly riveting account of the misbehavior of one bank, Bank of America, see Taibbi, Matt. “Too Crooked to Fail.” Rolling Stone. March 29. 2012.