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Posted on March 25, 2008

The Fed and Crony Capitalism

By Thomas Palley, AlterNet

The Federal Reserve's recent decision to grant Wall Street access to special
borrowing facilities smells of special dealing for special interests. The decision
subsidizes the biggest most powerful investment banks, thereby distorting financial
markets in their favor. Behind the decision lies the problem of excessive
representation of Wall Street interests within the Fed.
The Fed's response to the crisis, combined with its earlier massive policy failure to
address asset price bubbles, raise grave questions about its independence and
judgment. At this stage, Congress should launch formal hearings into the governance
of the Fed, which has remained largely unchanged since the 1930s.
The Fed's new Primary Dealer Credit Facility (PDCF) effectively gives Wall Street's
primary government securities dealers, which includes all the large investment
banks, access to discount window borrowing. That means access to funding at the
bargain basement interest rate of 2.5 percent, and all that is asked is borrowers post
some form of investment grade collateral.
This arrangement constitutes a massive subsidy, which would be large in normal
times. However, it is especially large at a time of market uncertainty and liquidity
shortage. While other market participants are being forced to de-lever at fire-sale
prices, the Fed's friends are being given near-free government money to snap up
assets.
Wall Street has been quick to embrace the facility, and within four days borrowing
reached $29 billion. Erin Callan, Chief Financial Officer of Lehman Brothers,
enthusiastically declared the facility to be "incredibly attractive... Our ability to
access that form of financing to do more business for clients is incredibly interesting."
Morgan Stanley Chief Financial Officer Colm Kelleher described the facility as being
"there for normal business. It's not meant to be there as a last-recourse thing." A
Goldman Sachs spokesman declared "we think the Fed window provides a good
alternative to the secured funding markets and we welcome the initiative."
The new facility represents a complete break with the past. Previously, discount
window borrowing was restricted to regulated depository institutions, and access was
always described as "a privilege and not a right." That meant banks could only get
access to cover seasonal shortfalls of funds or dire emergency needs, and any
borrowing was subject to regulatory disapproval - so-called Federal Reserve "frown"
costs. Now, the Fed has apparently made the discount window available to Wall
Street as a source of ordinary business finance.
This means the Fed is providing risk capital to the likes of Goldman Sachs at paltry
interest rates that confer a significant subsidy. Moreover, the mere right of access
enables them to borrow more cheaply from other lenders because of the back-stop
reassurance provided by discount window access. It also establishes incentives for
future excessive risk-taking.
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These subsidies are a travesty. Goldman Sachs, Lehman Brothers, and Morgan
Stanley are extraordinarily profitable companies. They have also been the drivers of
the worst trends in the American economy over the past generation, pushing
excessive CEO pay that has spread like a cancer throughout corporate America, even
reaching into universities and non-profits. Additionally, they have pedaled the
shareholder value paradigm, that has pushed companies to emphasize short-term
gain over long-term investment, and contributed to ripping up America's social
contract. Meanwhile, their business model has promoted speculation that is behind
repeated asset and commodity price bubbles.
Subsidizing these firms is an insult to Main Street. Many families are losing their
homes as part of the mortgage crisis. If they had access to 2.5 percent financing that
would not be happening. Likewise, manufacturing firms are being forced to close
because of lack of affordable capital, which is destroying jobs and the economic
foundation of communities.
The Fed will claim it had to institute these measures to calm Wall Street. That is
nonsense. The fair and economically efficient way to deliver emergency liquidity to
Wall Street is through an auction facility that is open to all financial firms, and in
which participants supply good collateral. Those who need the funds most will bid the
highest. That way, taxpayers get properly paid for their support, and the funds go to
those who need them most.
Geologists say they learn the most from extreme events like earthquakes that reveal
the reality of the earth's crust. For the past twenty-five years, critics of the Fed have
been dismissed, and the Fed's high standing has blinded the reality of its revolving
door with Wall Street and its class-based conduct of policy. Now, the Fed's response
to Wall Street's panic has revealed the reality of its crony capitalist world. That
provides an opening for long-needed reform.
Thomas Palley is the founder of the Economics for Democratic & Open Societies
Project. Read more of his work at www.thomaspalley.com