December 29, 2011 11:18AM

The Ever‐​Expanding Federal Reserve

Two Cato scholars have offered devastating critiques of the Federal Reserve in the op‐​ed pages of the Wall Street Journal over the last two days.

This morning, in “The Fed’s Mission Impossible,” adjunct scholar John Cochrane takes a look at the latest list of bank regulations under Dodd‐​Frank. Although the proposal “opens with an eloquent ode to the evils of too‐​big‐​to‐​fail,” he writes, it then “spends 168 pages describing exactly how it’s going to stop any large financial institution from ever failing again.”

According to Cochrane, the proposal “exemplifies” the core problem withWashington’s heavy hand: “Everything under the sun gets regulated, with no attempt to measure benefits or costs.” This scenario, of course, is nothing new:

For 70 years, our government has sought to stop crises by guaranteeing more and more debts, explicitly with deposit insurance, or informally with predictable too‐​big‐​to‐​fail bailouts. Guaranteeing debts gives obvious incentives to gamble at taxpayer expense, so we try to limit risks with regulation. But big banks still have every incentive to avoid, evade and financial‐​engineer their way around the rules, and they have lots of lawyers, lobbyists and ex‐​politicians to pressure regulators to use their wide discretion. The government has lost this arms race time and time again.

Unfortunately, it seems to be taking this arms race across the Atlantic. Yesterday, in “The Federal Reserve’s Covert Bailout of Europe,” Cato senior fellow Gerald P. O’Driscoll, Jr., examined the Fed’s bailout of European banks through what is called “a temporary U.S. dollar liquidity swap arrangement”—an operation that has gone “largely unnoticed here.” O’Driscoll explains:

Simply put, the Fed trades or “swaps” dollars for euros. The Fed is compensated by payment of an interest rate (currently 50 basis points, or one‐​half of 1%) above the overnight index swap rate. The ECB, which guarantees to return the dollars at an exchange rate fixed at the time the original swap is made, then lends the dollars to European banks of its choosing.

Why are the two central banks doing this? O’Driscoll explains that they are engaged in this “Byzantine financial arrangement” because “each needs a fig leaf” for past transgressions:

The Fed was embarrassed by the revelations of its prior largess with foreign banks. It does not want the debt of foreign banks on its books. A currency swap with the ECB is not technically a loan.

The ECB is entangled in an even bigger legal and political mess. What the heads of many European governments want is for the ECB to bail them out. The central bank and some European governments say that it cannot constitutionally do that. The ECB would also prefer not to create boatloads of new euros, since it wants to keep its reputation as an inflation‐​fighter intact. To mitigate its euro lending, it borrows dollars to lend them to its banks. That keeps the supply of new euros down. This lending replaces dollar funding from U.S. banks and money‐​market institutions that are curtailing their lending to European banks—which need the dollars to finance trade, among other activities. Meanwhile, European governments pressure the banks to purchase still more sovereign debt.

Recently Cato scholars Lawrence H. White and George Selgin asked, “Has the Fed Been a Failure?” Read much more on the Federal Reserve and monetary policy here.