The Federal Reserve Bank is typically thought of as an institution with domestic concerns. When the Fed is in the news, it’s usually about interest rates and how policy changes may affect U.S. growth and employment. But behind such closely watched pronouncements, the Fed quietly exercises enormous influence on U.S. international financial policy. One eye-popping example: During the financial crisis the Fed had swapped currencies with various countries worth $583 billion.
David Zaring, a Wharton professor of legal studies and business ethics, notes that the Fed was able to essentially influence foreign affairs without oversight by Congress or the executive branch. While independence is a central pillar of the Fed’s existence, a question nevertheless arises: To what extent should the Fed disclose its intentions when considering such decisions?
Tackling the issue are Zaring and fellow Wharton professor Peter Conti-Brown, also a professor of legal studies and business ethics, in their issue brief “Shining a Light on the Federal Reserve’s Foreign Affairs,” written for the Wharton Public Policy Initiative. In this Knowledge at Wharton interview, Zaring shares some of their key points. (Listen to the full podcast above.)
An edited transcript of the conversation appears below.
Knowledge at Wharton: Please tell us about what your research has found, such as around the idea of policy coordination.
David Zaring: People think of the Fed as a domestic institution, and it is. And in important ways, the research work I have done with Peter Conti-Brown has focused on one of the ways in which the Fed is really interested in its domestic pursuits, sometimes to some inconsistency with the way it deals with its foreign counterparts.
But the core of our research is this insight: The Fed is increasingly engaged in relationships with other central banks and banking regulators, and that a lot of its foreign policy and domestic policy initiatives are compounded by the fact that it’s interacting with them. We also found, when we took a look at the history of the Fed, which is a relatively young central bank — it was founded in 1913 — that this interest in foreign affairs and foreign policy was right there at the founding.
One of the reasons to create an American central bank was to take on the Bank of England, which had its own global currency of last resort. It was something that American policymakers very much were interested in maybe displacing. One way they tried to do that was to create a strong or somewhat strong American central bank, which since then has increasingly found itself enmeshed in these foreign relationships.
Knowledge at Wharton: We know that during the financial crisis there were lots of problems, especially in North America and Europe, and that the Fed coordinated closely with foreign central banks and financial officials to basically bail out the world economy. That was an emergency and, looking back, some now are asking, “Is our central bank too intertwined with some of these foreign regulators or foreign banks, to the possible detriment of domestic affairs?”
“The Fed is an institution that’s really neither accountable to Congress nor the president — it’s self-funded. It was created by Congress, but it acts on its own.”
Zaring: That’s right. When we think about who makes foreign policy in the United States, some people put the leadership of that process at the executive branch, with the president. And Congress certainly has a role to play. It declares war. It has to ratify treaties. It’s supposed to regulate commerce with foreign nations. One interesting aspect of our constitutional history has been the tug-of-war between these two parties — Congress and the executive branch — for control over foreign affairs. What we saw in the financial crisis, as Peter and I document, is that the Fed is an institution that’s really neither accountable to Congress nor the president — it’s self-funded. It was created by Congress, but it acts on its own. The president is not supposed to intervene.
… It’s got a degree of independence from the political branches, which is remarkable. It never gets reviewed in court. The president is not supposed to mess with it. And the current president has been critical of it in a way that has resulted in some pushback from Fed officials. And it shows up to testify to Congress, but Congress doesn’t hold the purse strings.
So during the financial crisis, what you had was this really independent institution making sure that there were enough dollars out there so that other banks would have access to dollars — the currency of last resort — during the financial crisis. It did this through a pretty tricky maneuver. It extended swap lines that ultimately amounted to hundreds of billions of dollars to foreign central banks, which basically guaranteed them access to dollars and at a rate that was predictable and fixed.
Then those central banks distributed those dollars to the banks that they regulated, and it was a way to get dollars in the hands of struggling financial institutions. In many ways, it looked like good policy. The thing that is interesting about it — and we don’t want to quibble too much after the fact — is that it was good policy that was justified on something of a legal technicality, in that it was never authorized by Congress or explicitly supported by the president. Instead, the Fed went out there and spent hundreds of billions of its own dollars on these swap lines, and it did it of its own accord. So that’s why we think it increasingly looks like the Fed has its own foreign policy priorities that may be different from those of Congress and the president.
Knowledge at Wharton: One figure in your paper caught my eye — at one point the Fed had swapped currencies worth $583 billion. Not only is that huge, but you point out by way of comparison that the entire Foreign Development Assistance budget for USAID is only $22 billion.
Zaring: Yes, the Fed is an enormous player in international financial relations and dwarfs all the other financial support by other American regulators. At some point, something like a quarter of the Fed’s balance sheet was devoted to supporting these swap lines, and that meant that the Fed itself was holding all this foreign currency against which it had promised dollars.
Knowledge at Wharton: Today, everyone would pretty much agree that that more or less saved the world economy — or at least Europe and North America — from pretty much tanking.
Zaring: It certainly helped. One thing the financial crisis revealed to us is the importance of the so-called Eurodollar market, which are basically dollars held by anyone, but financial institutions in particular, offshore.
The problem with the Eurodollar market is that the Fed produces dollars and the supply of dollars, but it can’t control what’s happening to dollars that aren’t held in the United States. … So banks suddenly had a run on their dollar reserves, and they needed dollars to support their positions in the Eurodollar market, and that’s one of the things that the Fed decided to give to them through these swap lines.
Knowledge at Wharton: Critics might say, “Well, there was a cost to that, and what are we doing bailing out these foreign banks?” And the retort is obviously, “Well, if they go down, that’s going to really severely affect our own financial systems.” But your paper noted that it worked out this time, but maybe we need to have something more orderly set up so that we can make proper decisions in the future.
Zaring: Yes, in some ways the swap line gambit is something like a gamble — a big bet — that the Fed took. And it turned out that the bet was the correct one. But one of the things you worry about is whether these sorts of big, one-sided, unhedged bets are going to turn out the right way every time the Fed makes them. So that’s one of the reasons why you think about oversight.
Also Peter and I are sympathetic to the idea that the Fed had a role to play in stabilizing the global financial system. It could be that most people agree with us on this, but it’s certainly the case that Congress never authorized this kind of big bailout of foreign banks with dollars — that wanted access to dollars. So there are some real accountability questions that are raised by the Fed’s decision here.
“It increasingly looks like the Fed has its own foreign policy priorities that may be different from those of Congress and the president.”
The Fed is a really cosmopolitan entity. It views the global financial system and economy as extremely interlinked. Therefore, instabilities in one part of the financial system can show up in one country or series of countries and then affect financial institutions all over the world. This sort of cosmopolitan view of how financing works affects the Fed’s view of financial regulation, which it thinks should be done on a global level and makes it willing to participate in sort of a global regulatory approach to financial stability that once again is, I think, defensible and in many cases a good idea. But not everyone in this country would agree that that’s the sort of thing that our central bank ought to take on.
Knowledge at Wharton: You argue that there is some line beyond which the Fed needs to be reviewed more closely. So what would that look like? Your paper considers a twice yearly Congressional review.
Zaring: That’s right. One of the conclusions we have in this paper is that this is a difficult problem to solve, because on the one hand, one thing that we’ve cherished in this country is the idea that the central bank is independent from political meddling.
We think that central bank independence is a worthy goal, and everybody at Wharton thinks that central bank independence is important to different degrees, though we would say that the decision about what to do with monetary policy and foreign relations — these decisions are, in some ways, political to some degree. They are going to affect the way we experience the government’s control and oversight of all kinds of things that businesses want to do.
We want the Fed to make decisions for technocratic, smart reasons. We think that that’s most likely to keep inflation under control, which is one thing that a central bank wants to do. But we also want the world and the United States and in particular Congress to have a sense of what the Fed thinks about in its international initiatives, and what it thinks is going to happen with those initiatives.
That’s why Peter and I have a recommendation, a way to maybe bring the Fed’s central policy out into the light from the hidden shadows in which it has operated in in the past. Our proposal is supposed to be modest and incremental and achievable.
We think that Congress could responsibly ask the Fed’s vice chair for supervision. The current vice chair is the head of an international organization that involves financial regulators from all over the world. He should come and testify twice a year to Congress about what the Fed plans to do in the next six months. This kind of disclosure and sunshine will solve some of the accountability problems that the Fed faces by making the decisions that it has made in the past in a somewhat more hidden — I don’t want to talk conspiratorially — but unobserved way.
“One of the things you worry about is whether these sorts of big, one-sided, unhedged bets are going to turn out the right way every time the Fed makes them.”
Knowledge at Wharton: So what happens when Congress doesn’t like what the Fed has to say in that hearing?
Zaring: Our proposal depends on the value of disclosure, which of course comes with some threat that the Congress or the president will respond in some way. But we think that so far Fed independence has been a principle that has been strong enough. It’s especially hard to pass legislation these days. And so the idea that Congress could legislate to reverse some Fed policy in some ways — we think that that would only be something that would likely to happen when there is a wide agreement that what the Fed’s doing is bad in some way.
And if there is that kind of wide agreement by political actors that’s bipartisan and something that both houses of Congress can pass, and the president can sign, then maybe there should be some sort of response. At least the Fed should be aware that there could be some sort of response and that it has to think about the more politically accountable branches when it acts.
This is where we rely on some of those maxims that are associated with, I think, Louis Brandeis, who said, “Sunlight is the best disinfectant.” Disclosure is a good way to regulate — especially when it comes to things like capital markets.
Our approach is to look to the advantages of sunlight, disclosure, and communication. We think that if the Fed goes down that road, then it’s much less likely that there will be some sort of outraged, after-the-fact reaction to some decision it has made about international relations that really don’t enjoy the support of a broad array of elected officials.
Knowledge at Wharton: Is there interest in Congress?
Zaring: Congress has recognized that our financial regulators, not just the Fed, play an important role when they enter into agreements with foreign regulators — that that’s a real source of policy-making. Congress has expressed some interest in doing something about that. So a couple of bills introduced in the last two years have asked federal regulators to come and report to Congress — either before they enter into these international negotiations, or during the course of those negotiations. Aspects of that are exactly the kind of thing that we’re proposing in our paper.
Knowledge at Wharton: The paper cites alternatives you believe are not good ideas.
Zaring: We are looking for a Goldilocks solution — something that gets the Fed more public about what it wants to do with its foreign affairs policy, but not something that takes away its independence, which we value, along with everyone else.
You could imagine some less attractive outcomes that would maybe harm the central bank’s independence. An example would be an equivalent to the United States trade representative. The U.S. financial representative could be a Cabinet-level office, appointed by the president, confirmed by the Senate, who would enter into these foreign negotiations. That is a straight-forward way to ensure that the president basically has his foreign affairs negotiators all reporting to him. He’s got the Department of State, the USTR, and now the U.S. financial representative all singing from the same songbook. And the president himself can sort of set up what he wants that songbook to look like.
We worry that might make the president too important — or might give the president too much control over what the Fed is up to. This means that the president might want lots of swap lines when it looks like the economy is at risk, and direct his financial regulator to do it. And that, in turn, might affect monetary policy, where the Fed is most interested in staying the course and staying independent.
“The current vice chair … should come and testify twice a year to Congress about what the Fed plans to do in the next six months.”
We can imagine doing nothing, and that would leave the problems that Peter and I have identified out there, somewhat hidden, with the rest of America and the legislative and executive branches not really knowing what the Fed is up to. Or we could imagine that some of these proposed legislation could go too far: requirements that the Fed or other financial regulators set forth their foreign policy in advance before Congress, take comments from any interested party, present its negotiating position to the House Financial Services Committee and the Senate Banking Committee.
This has appeared in some draft legislation that hasn’t gone anywhere in some other contexts. That really would make it hard for the United States to have any sort of give-and-take between its financial regulators and foreign allies or potential allies.
Instead, it would have to present every international effort as a fait accompli. “Here’s what we agreed to at home — take it or leave it.” We think that that doesn’t give the Fed the flexibility it might need to take on a financial crisis or something like it in the future.
Knowledge at Wharton: So that brings you back to the twice yearly Congressional reviews?
Zaring: Peter and I worried when we said, “You’re calling for more Congressional testimony? Is that an exciting solution to the problem of accountability?” We in some ways think it’s the worst solution except for all the others. It gives you disclosure without taking away flexibility, and without giving the president or Congress too much control over the foreign affairs of the financial regulators.