The Fed’s own origins are evidence for this point. It is usually argued that the Fed was created to avoid the banking crises that plagued the United States in the late 19th century. That is true to an extent. What it misses is that those crises were the product of the regulations of the National Banking System, such as the limits on branch banking and the kinds of assets banks could hold to back their issues of currency, which had the effect of making it difficult for banks to expand the money supply when the demand for currency rose due to harvest season needs or because customers wished to leave troubled banks. A number of observers between the last of those panics in 1907 and the creation of the Fed in 1913 argued, rightly, that removing these existing regulations would have made the system much less vulnerable to crisis.
Unfortunately, the Progressive Era belief in enlightened technocrats joined forces with the self‐interest of big New York City banks, who wished to maintain their market power by blocking nationwide branch banking, to support a solution that expanded government powers over one that would have relied on deregulation. The resulting Federal Reserve System was a political compromise all around. For one thing, it was a “decentralized central bank,” with each of the 12 district banks having significant autonomy. Second, it was found politically acceptable by the small, rural bankers because they believed that legalizing interstate banking, which was part of the deregulatory alternative, would have enabled New York bankers to buy them up. So despite their distrust of a central bank, the rural bankers went along to avoid a worse outcome. Ironically, the New York district bank wound up with a vastly disproportionate part of the system’s power, which it largely still has today even as the Fed has become more centralized. Whatever else is true, the Fed was not created as some pristine, ideal solution to the problems of the 19th century. The flaws inherent in such a political beast haunted monetary policy for the rest of the century.
Faced with a steep increase in the demand for money after the stock market crash in 1929, the Fed failed to do the exact job it was designed to do, which was to ensure the “elasticity” of the money supply. In fact, it allowed the money supply to fall 30 percent in the early 1930s, which was the primary reason what would have otherwise been a short, and perhaps moderately severe, recession became a very severe depression lasting over a decade. In the wake of its own failure, rather than take responsibility, or suggest it was not up to the task, the Fed did what government agencies tend to do: claim it did not have the powers it needed. The result was the Banking Act of 1935, along with a number of other regulations as well as the end of the domestic gold standard, that gave the Fed increased powers to manipulate the money supply by buying and selling U.S. government bonds. It also centralized much of that power at the Fed’s headquarters in Washington, but still gave the New York district Fed the privilege of being the buyer and seller of those securities.
The bank failures of the early 1930s were largely the result of the still‐extant limitations on nationwide branch banking. Canada, which had no such limits, had only one bank failure during the same period that thousands of U.S. banks failed. The response in the United States was the expansion of government powers through federal deposit insurance, rather than removing the very regulations that had caused the problem. Deposit insurance was a classic example of treating the symptoms and not the underlying disease. Until banks could diversify by operating nationally, they would always be unable to minimize the riskiness of their portfolios. Tacking deposit insurance on top of that simply meant that banks would not bear the full costs of risky loans, encouraging them to make their portfolios even riskier.
The increased money supply powers of the Fed sowed the ground for the inflation of the 1970s and early 80s, which in turn put savings and loans with fixed‐rate mortgages into financial turmoil. The response was again to increase the degree of government involvement by increasing the deposit insurance coverage for banks and savings and loans. The result was the S&L crisis of the 1980s, as S&Ls used the higher insurance coverage as a green light to take even more risky loans to gain back their losses.
The Fed, particularly former chair Alan Greenspan, also bears significant responsibility for the current problems facing housing lenders. A few years back, Greenspan said that the Fed could, and would, do nothing to stop “asset bubbles” from happening, but would stand by to cushion the fall if such bubbles occurred. In ways much like the expansion of deposit insurance, the so‐called Greenspan Doctrine encouraged banks to engage in excessively risky loans under the belief that if those loans went bad, the Fed would come to their rescue. This is the problem of moral hazard: when you insure someone against a negative outcome, the insured has less reason to take precautions against causing that outcome.
Recent events, such as the expansion of the Fed’s lending powers to investment houses via a “special lending facility,” are exactly what banks were counting on. Even though Bear Stearns eventually got acquired, it hardly paid the full cost of its errors and neither have other financial firms. In the wake of the housing crises and the troubles at Bear Stearns, the Fed has asked for expansive powers to regulate non‐bank financial intermediaries to avoid such problems in the future. Once again, financial regulators are asking for more powers to avoid messes for which they themselves are largely responsible. Such expansions of power have, in the past, only served to create new problems that could have been avoided by stepping away from the temptation of new regulations.
The history of banking in the United States and elsewhere does not show that the industry is beset by market failures that require regulatory intervention. To the contrary, almost every major crisis faced by the banking system has been the consequence of already‐existing regulations, many of which came about as responses to previous crises caused by older regulations. Countries, like Canada, where some of the worst of these regulations were absent, have not had the same history of crises as has the United States. Perhaps this time we will learn from history and avoid a new regulatory regime that will create new threats to an already somewhat shaky U.S. financial system. However, given the history and the powerful interests at stake, the possibility of deregulation may be wishful thinking.