I’ve been very much enjoying Philip’s posts—I hope they have convinced our readers to buy his book and take his arguments seriously.
One place where Philip helpfully sharpens our different views of law and the financial crisis is on the Fed’s controversial decision not to extend emergency lending to Lehman Brothers sufficient to stave off the firm’s bankruptcy. Philip thinks my interpretation of the relevant statute—the infamous section 13(3) of the Federal Reserve Act, prior to its amendment in 2010—is a “rather unusual reading,” a “kind of reduction ad absurdum” that would all the Federal Reserve to “become a de facto fiscal authority.”
There are four problems with Philip’s assessment, based each in law, economics, history, and politics. I’ll briefly explore each one.
First, law. Philip doesn’t really offer an alternative legal reading of the statutory text. Our dispute is whether the operative requirement that any emergency loan be “secured to the satisfaction of the Federal reserve bank” provides anything other than discretionary authority to the Fed. Philip argues that my reading of this requirement means that it is “just an obligation to weigh the question of security (collateral) in the decision to make a loan. Then, having so reflected, the Fed may make the loan even if it has no expectation that it will ever get repaid.”
But that mischaracterizes my interpretation. I read the requirement to mean, well, that the relevant Federal Reserve Bank must be satisfied by the collateral presented. If the Federal Reserve Bank looked at the collateral and said “Well, folks, we can have no expectation that we will ever be repaid on this collateral,” then that doesn’t sound like “satisfaction” to me. Here is a crucial point: my argument isnot that the Fed acted illegally by failing to save Lehman; it is that it failed to exercise its wide Congressionally-granted discretion to do so.
Here is where Philip’s characterization of § 13(3) (in his book) as both “vague” and “ambiguous” is confusing to me. The delegation of authority to both the Board of Governors and the relevant Federal Reserve Bank is broad. There is no question that this is true. But breadth is no ambiguity. It is not an exaggeration to say that Congress designed a lender-of-last-resort regime that allowed the central bank to choose who gets what according to an only barely-defined set of parameters. To the extent that there are limits, they are on the governance of that emergency lending authority, not on the specific transactions (more on this important distinction below).
Second, and closely related, is the economics of emergency lending. Philip “hastens to concede that ‘solvency’ is not a terribly well-defined concept, and the difference between well-secured loans and inadequately-secured loans is a murky one.” It may be true in idiosyncratic crises—the one-off failure of a local bank that bet too big on a set of perhaps questionable loans that have tied up its more liquid assets and therefore caused a failure based as much on illiquidity as insolvency—that the line is “murky” here. But in a systemic crisis, the problem of determining whether a specific asset class is sufficiently valuable to justify its temporary exchange for cash isn’t just “murky,” it can be impossible to determine. This is true for two reasons: first, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency. There is essentially no way, in the depth of a crisis, to draw the line meaningfully between solvency and illiquidity.
After Lehman, the Fed recognized this and extended loans through 13(3) so quickly on so many different kinds of collateral that we saw an explosion in its 13(3) lending. My favorite example is that the Fed accepted the primary loan secured by the Crossroads Mall, in Oklahoma City; when the mall stopped paying, the Fed foreclosed and became the mall’s owner. In the 1990s, my friends and I did our part to keep the mall solvent by purchasing many drinks from Orange Julius, not realizing we were in the shadow of the Federal Reserve System.
The point is that “satisfaction,” in the midst of a financial crisis, is an entirely discretionary concept. Once we understand this standard as a discretionary one—and Philip seems to do this when he admits that “when the Fed interprets its own statutory responsibilities under § 13(3), it is necessarily making a discretionary judgment”—the argument is essentially over.
Third, history. Philip resists the idea that a plain-language interpretation of § 13(3) would give the discretionary authority that it appears to give because it would turn the Fed into a “de facto fiscal authority” rather than a central bank. Or, as he put it on Twitter, conceding that 13(3) granted almost complete discretion “would make the Fed nearly omnipotent.”
What Philip misses, I think, is that the statute actually does have a clear limit, just one based in governance rather than function. Philip, like virtually everyone else, assumes the Fed is an “it,” not a “they” (to paraphrase and repurpose Kenneth Shepsle’s observation about Congress). But section 13(3) is careful to deposit three triggers in two different decision-making bodies within the Fed. First, at least five members of the Board of Governors must agree that the situation is “unusual and exigent,” statutory terms that are undefined and left to the discretion of the Board to assess and debate. Second, the relevant “Federal reserve bank” must be satisfied with the security presented to authorize the loan. And third, the same Federal Reserve Bank must “obtain evidence” that the Fed’s counter-party has tried and failed to secure alternative funding.
As with almost all legislation regarding the Federal Reserve in its first twenty years—what I call in my book the “First Federal Reserve”—the Fed’s emergency lending authority, then, balances this extraordinary authority between two different, sometimes warring factions within the Federal Reserve System: the Federal Reserve Board and the Federal Reserve Banks. When section 13(3) was first passed in 1932, the Fed was far from a central bank—it was still a sea of twelve central banks with mostly autonomous policies loosely (and often ineffectually) coordinated by the DC-based Federal Reserve Board. And while the Banking Act of 1935 ushered in the “Second Federal Reserve” that mostly undid the Wilsonian Compromise and concentrated more authority in the newly named Board of Governors, the reality is that the Federal Reserve Banks continue to wield extraordinary authority within the System.
The point here is that Philip is wrong to conclude that there are no checks within the plain-language interpretation of 13(3) that I offered in my earlier post. The governance of 13(3) maps onto the governance of the First Federal Reserve. Even today, if a central banker like, for example, Jeffrey Lacker refused to give his bank’s satisfaction to the Board of Governors for an emergency loan in his district, that would be the end. Such a loan without the Federal Reserve Bank’s approval would be illegal.
One last point on history. The idea that lender-of-last-resort authority looks more “fiscal” than “monetary” is exactly correct. This is why the use of 13(3) has become such an important topic of discussion after the crisis, why Paul Volcker was so skeptical of the Fed’s use of 13(3) in Bear Stearns, and why the question of complete discretion remains such a hot one in public policy disputes. But whether the Fed and Treasury should share fiscal authority in banking emergencies is a separate question from whether the Federal Reserve Act does give the Fed such a role. Philip regards this frank acknowledgment that the Fed starts to exercise authority that looks more fiscal than monetary in nature is a reductio ad absurdum from a political economy perspective. I think it just shows that the Fed is a lender of last resort.
Finally, politics. This is the most perplexing point about Philip’s defense of the Fed’s “Sorry, a loan to Lehman would have been illegal” argument. Politics, as Philip well documents, were everywhere between March 2008 and the Bear Stearns “bailout” through § 13(3) and the extraordinary events that summer and fall. The Fed knew this. It was not legally required to seek political cover for its legal authority, but it did so anyway, bringing in Treasury Secretary Henry Paulson throughout the discussions and their aftermath. And the Fed paid a political price and faced criticism, including from Paul Volcker (part of whose discussion of Bear Stearns is Philip’s book’s epigraph). After Bear, as Philip documents, the government, primarily through Paulson, was publicly committing the Treasury and Fed against a Bear-like treatment for Lehman. The political consequences for Paulson and Bernanke, for the Bush Administration and for the Fed, were enormous if they had reversed course. This strategy almost succeeded. Lehman and the U.S. government almost convinced three different entities to buy the firm. But then these efforts failed, and the global financial crisis exploded beyond almost anyone’s expectations.
The point is not to say, as many have said, that the Bernanke Fed and the Paulson Treasury were incompetent in their Lehman decision. I don’t buy that critique. Indeed, I’m not even sure, based on what was known at the time, that the right policy decision—the right balance between moral hazard and financial stability—was to use 13(3) to prevent a Lehman bankruptcy. It looks that way in hindsight, but that is not the best tool we should use in assessing the quality of the decision-making process that lacked that benefit.
Instead, my argument—and critique—is that Bernanke, Paulson, Geithner, and others made a decision. They exercised the discretion they were entitled to make. They made these decisions knowing that there would have been enormous political fallout if they had bailed out another Wall Street “bank.” And they made it knowing that the legal authority to go in another direction was broad, robust, and entirely left to the discretion of two bodies of decision-makers within the Federal Reserve System. The Fed wasn’t legally obliged to do anything. But nor was it legally prevented from doing something.