Yellen vs. the Fed critics

By Douglas Holtz-Eakin
November 13, 2013

The confirmation hearing of Federal Reserve Chairwoman nominee Janet Yellen on Thursday will be an opportune moment for Fed critics to air their grievances. ¬†There is plenty of fodder for disagreement and debate — ranging from the Fed‚Äôs supervisory track record, to the rules for tapering large-scale asset purchases, to the criteria for ending its zero-interest rate stance.

Yet, one sure criticism is sharply at odds with the facts: That the Fed’s crisis response was an insider affair, run by and for a handful of too-big-to-fail banks.

While the Fed’s actions in response to the 2008 financial crisis are certainly open to criticism, the creation and expansion of various credit and lending programs were aimed at calming the financial markets and maintaining the liquidity of specific financial instruments. It was not about befriending winners and giving the cold shoulder to losers.

The exception that proves the rule was the Fed‚Äôs early institution-by-institution firefighting; for example, addressing the problems of Maiden Lane I-III, Bear Stearns and American International Group. In each of these cases, the Fed provided support to individual firms in order to avoid a disorderly collapse. However, as a financial ‚Äúdisturbance in the force‚ÄĚ started to move through the system — slowly at first, and then rapidly — the Fed attempted to provide liquidity with the hope of containing the disruption.

The Fed was practicing an amped-up version of its lender of last resort role by ‚Äúlending freely, against good collateral,‚ÄĚ as prescribed by Walter Bagehot‚Äôs famous 1873 dictum.

When the Fed acts as the lender of last resort, it is providing temporary liquidity support to healthy, solvent institutions — not rescuing insolvent companies from failure. The support is intended to help sound, strong¬†banks overcome periods in which they do not have enough cash on hand to meet short-term obligations.

Banks can experience these occasional episodes of illiquidity, particularly during periods of financial instability. Discount window lending, directly from the Fed, and other temporary programs to provide funding to financial institutions, are important aspects of central banking and help promote overall financial stability. Keeping solvent institutions insulated breeds confidence and supports economic activity.

In the modern financial system, satisfying liquidity needs is easier said than done. Complicated counterparty relationships between institutions, new financial instruments and the rise of the shadow banking system all add up to a less straightforward application of traditional policy tools than in Bagehot’s time.

As¬†documented¬†in an analysis earlier this year by the American Action Forum‚Äôs Satya Thallam, the credit and lending streams created had low barriers to entry — in an attempt to encourage wide participation among financial institutions. For example, the discount window, a source of overnight funding, was altered in several ways to encourage use: reduction of the discount rate; extension of maturities, and use of auctions to reduce the stigma that somehow the financial institution using it, was not solvent.

The Term Auction Facility, one of the earliest of the crisis response tools, dating back to December 2007 and organized under the Federal Reserve Act‚Äôs Section 10B authority, was a means of providing one-month to three-month loans — but without the stigmatizing effect of the discount window. In the end, more than 400 institutions participated in this.

Other efforts were aimed at supporting various submarkets or feeding demand for particular liquidity needs: repos, to address lending between financial institutions; central bank currency reserves, to address the dollar funding market overseas; the commercial paper market, to ensure short-term financing for financial institutions; money markets, to address mutual funds; asset-backed securities (including mortgage-backed securities) and Treasuries of assorted maturities.

Confirmation hearings provide a useful, if often theatrical, opportunity for policymakers and the public to openly debate important policy issues. Stress tests, new capital rules, strenuous supervision and ‚Äúliving wills‚ÄĚ — management plans to deal with an insolvent bank — are among the Fed‚Äôs efforts to stick with its preferred approach and avoid the impact on incentives experienced by Bear Stearns or AIG-style interventions. Ultimately, firms cannot operate on the assumption that Fed interventions are commonplace.

Rather than re-litigating the exceptions, senators would be better served by a focusing on the use of those tools.

The Federal Reserve undertook a major program of providing liquidity during the 2008 financial crisis. Despite the program’s scope and novelty, the facilities used were really an extension of traditional tools that central banks have used to keep markets functioning. The deviations from that lender of last resort role, though conspicuous, were not the focus of the Fed.

Yes, the Fed helped big banks. But its efforts were broader and fairer than that narrative suggests.


PHOTO (TOP): Janet Yellen, vice chairwomen of the Board of Governors of the U.S. Federal Reserve System, is due to have her confirmation hearing to be board chairwoman on Thursday. She is shown here at the University of California, Berkeley in Berkeley, California, November 13, 2012. Y REUTERS/Robert Galbraith

PHOTO (INSERT): President Barack Obama (C) announces his nomination of Janet Yellen (L) to head the Federal Reserve at the White House in Washington October 9, 2013. Also pictured is current Fed Chairman Ben Bernanke (R). REUTERS/Jonathan Ernst


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@Douglas Holtz-Eakin, why do we have so many Wall Street apologists. Wall Street brought this country to the verge of bankruptcy and we saved them with free money.

Now we have a bunch of zombie banks that are even bigger than before the crisis.

Oh, and our economy, and our “economic recovery” is dependent on the $85 billion the Fed is printing every month and pouring into the economy. Without it, we would be contracting.

Posted by KyleDexter | Report as abusive


the Fed is supplying just enough grease to keep the gears from seizing


the Fed is supplying liquidity to finance capital intensive endeavors…….that focus profits into fewer hands, yet produce nothing else.

Posted by Robertla | Report as abusive

Anyone remember the definition of insanity? But the Fed will continue the QEs, hoping for a different outcome.

Posted by AZreb | Report as abusive

it is true that banks/investment companies put us into the second depression, but the govt allowed it to happen by reversing glass-steagall, which kept our banking secure from the first depression up to 2007. if glass-steagall had been left in force banks could not have co-mingled their assets with investment houses, nor could they have invested in the now poison mortgage backed credit swaps and derivatives. the argument used in 1999 to reverse glass-steagall was that the banking and investment business could police themselves and maintain the system(that worked out really well).
point being – lesson learned, make sure it doesn’t happen again, separate banks and investment companies again, and string up anyone that wants to give fed regulated banks more leeway in the future.

Posted by jcfl | Report as abusive

Ask the tens of millions of people who had retirement savings that were decimated by the Fed policies whether they think it is fair. After six years, these people are still being screwed. Guess they’re just the Pee-Ons who don’t count.

The Fed is now the lynchpin of the government of the people, by the Plutocracy and for the very, very rich.

“But its efforts were broader and fairer than that narrative suggests.”

The effect is much, much broader than indicated, but it is certainly not at all “FAIR”. The arrogance in support of the Plutocracy seems to have no limits.

Posted by ptiffany | Report as abusive

I’d agree. There wasn’t collusion between Wall Street banks and the Fed. I would argue that the lack of collusion makes the end results of Fed intervention even worse. Why? Assuming no collusion, what the economy has ended up with is a central bank that clearly doesn’t understand the unintended consequences of it’s continuing easy money policy. We now have people such as Andrew Huszar going public saying “We were working feverishly to preserve the impression that the Fed knew what it was doing.” The implication of that statement is telling, don’t you think?

We’re swimming in a sea of liquidity and yet the velocity of money is low. This clearly isn’t what the Fed intended. Rather than embarking on a new bold course the Fed simply continues the same old techniques. These liquidity injections were never effective and are even less so over time. If we were the only economy embarking on an easy money QE course, perhaps we’d have better results. Everyone is doing it now. Even the ECB. A race to the bottom never benefits anyone.

Posted by Missinginaction | Report as abusive