In defense of the Fed and its mission to ensure financial stability | Cumberland Comment
David R. Kotok
8 min read
David Kotok is chairman of the board and chief investment officer of Cumberland Advisors in Sarasota.
I’m extracting two thoughts from a newsletter that I receive every Saturday. The newsletter writer is a longtime friend.
· Item #1. “Cue the Churchill quote: ‘You can always count on the Americans to do the right thing after they have tried everything else.”’
·Item #2."But meanwhile, as we try everything else, things get worse. The Federal Reserve is a case in point. In 1913, after decades of severe banking and financial crises, it was decided we should have a central bank led by a panel of eminent, nonpolitical experts. That sentiment wasn’t wrong – giving control of the money supply to Congress would have had its own problems."
Let’s start with item #1 because it is fun. I invoked the quotation commonly attributed to Churchill many years ago and ended up in communication with the chief archivist of the Churchill Archives Centre, who told me that “Churchill never said it.” He explained that Churchill was very supportive of all that America did to assist Britain during the WWII period. He noted that Churchill was very sensitive to diplomacy and wouldn’t think of making such an utterance. It was one of the nicest admonishments I have ever received.
I have thoroughly searched for an attribution of this quote and cannot find an authenticated source. Churchill may have thought it, but he didn’t utter these words. Internet searches and generative AI will cite this quote repeatedly and attribute it to Churchill. They will be wrong. Just ask the Churchill Archives Centre if you wish to verify what I have just asserted.
Please note that Churchill did say something like, “Democracy is the worst system of government except for all the others,” but he didn’t originate the phrase. He rose in the House of Commons in 1947 to introduce this notion in a speech, and his exact words were, “It has been said that …” and then he recited “democracy is the worst system of government except for all those other forms that have been tried from time to time.” The written records of the House of Commons confirm the precise text. In my opinion, history, his writings and his speeches demonstrate that Winston Churchill was a precise orator and so, we must be respectfully and scrupulously careful about attributions.
Let’s move to item #2, the Federal Reserve System. Here I want to argue the positive case and write this essay in favor of the Fed, which is now 110 years old.
The Fed was formed after the banking crisis of 1907 and after a small group of New York bankers led by J.P. Morgan determined to avoid a repetition of the 1907 events. This history has been recounted many times and includes the secret meeting in Jekyll Island, Georgia, where a small group, not including Morgan but inspired by him, met to plan out the new central bank of the United States. The group later became known as the “First Name Club” because they used their first names to disguise their identities while traveling by train from New York to Georgia. They each traveled to the train separately, then departed from Hoboken, N.J.
Readers are encouraged to read this entire fascinating history for themselves. I will include some of it in my forthcoming book. A Google search of “First Name Club” and “Jekyll Island” will do the rest for you. In an ironic turn of history, John Pierpont Morgan Sr. died in 1913 and never saw the federal organization he had inspired when it came to fruition.
The Fed's patriotic history
The founders of the Fed were not motivated by inflation or the unemployment rate. They didn’t use “dot plots.” They paid no attention to things like GDP. They didn’t have the benefit of the system known as the National Income and Product Accounts.
These bankers were motivated by the issue of financial stability. They had had enough of various banking failures. They saw the hodgepodge of various state efforts in the banking arena. And they watched failure after failure. In my opinion, the state governments which asserted state rights over federalism have a wretched history of bank failures and financial misbehavior.
The Fed came into being because of the desire for a federal banking system and for financial stability. That remains crucial today.
Note also that the Federal Reserve has a strong patriotic history. In the World War I era, Benjamin Strong (one of the First Name Club members) used his Fed leadership position to sell war bonds. During the WWII era, the Fed maintained a very low interest rate for the entire war period even as the inflation rate exceeded 10% and even as the debt/GDP ratio climbed to 110%. If we look at history with a lens unencumbered by the constant throwing of political barbs, we see the Fed as an instrument of the United States that has continued to put the national interest above and beyond the partisan political nature of our system.
Also, note how the Fed continues to sponsor financial stability first and foremost.
When the twin towers fell on 9/11, there was a shock to the federal payments system. What happened? The Fed’s operational redundancy worked immediately. No payroll in Texas failed because of the systemic attack in New York. No real estate settlement in Florida was held up. No California merger was delayed. We watched the horror of an attack on the financial center of the world, but we may not have realized that some of the mechanics of our payments system lay destroyed in the rubble. The Fed met its responsibility under the most adverse circumstances.
In fact, our national system works so well that we don’t even think about it. We transfer billions every day and take the system for granted. When I wire funds to Salt Lake City from a Florida bank account, does anyone really think about the fact that two different Federal Reserve System regional banks, in Atlanta and San Francisco, are involved in clearing that transaction and that they do it in seconds?
I continue to witness all kinds of crazy political proposals that attack or hammer the Fed. Florida passed a law to prohibit a central bank digital currency, even though such a currency doesn’t exist. Texas has a legal initiative to link a digital currency to gold. (See Bob Eisenbeis’s June 1 commentary, “Central Bank Digital Currency (Part 2)" The list of interventionist proposals is long. Imagine the madness: the Texas currency would be illegal in Florida if the law was national.
A long list of madness
One of the reasons the list of madness is long is that the perpetrators of political attacks on the Fed know that the laws they propose are not advancing, so they can say whatever they want and get away with it. They go unchallenged by others. And the Fed, meanwhile, goes on about its business and ignores them.
I’ll paraphrase what has been said to me, privately, several times by folks that are intimately familiar with the operations of our central bank: They [politicians] can say what they want because they know that we [the Fed] will intervene to clean up the mess they make after they make it.
Financial stability is the unspoken important part of the Fed’s agenda. It was true when the Fed was formed in the decade of WWI and of the Spanish Flu pandemic. It was so when the Fed and Treasury reached the accord after WWII. It was so when stock markets collapsed in 1987. It was true in 1999, in the run-up to the new millennium. I sat in two private advisory meetings about preparations for the change to the year 2000; the Fed was prepared so that there would be no bank failures or runs at the turn of the critical date.
Ben Bernanke led the Fed in the buffering the economy during the Great Financial Crisis in 2007–09. And Jerome Powell faced the enormity of a pandemic shock. By then, the Fed had studied epidemics and wanted to avoid a repeat of history. That, too, will be a discussion in my new book.
So, when we look at the central bank of the United States, let’s look with a full awareness of history. The Fed cannot be certain of tomorrow’s inflation rate or unemployment rate, no matter how much they model outcomes for the future. They try. We in the private sector try. Quietly, we compare notes and exchange data.
But financial stability keeps improving in the United States because of the Federal Reserve. Fed actions during the latest debt-ceiling political masquerade demonstrate it. We have written about that several times. You can read about it in my July 30 research paper, “The Cost of Debt Ceiling Crisis”. Imagine: three banks totaling $600 billion fail during the political debt ceiling charade and the Fed quietly preserves financial stability and avoids a financial contagion.
When the next crazy political proposal is mouthed by some politician, please remember that the Fed cannot defend itself. Politicians can attack the Fed with impunity. Private citizens can defend the Fed. In my opinion, it is in our mutual and national interest to understand that the system is asymmetrical. In my opinion, politicians are the problem, not the Fed.
And it is in our personal interest to encourage the financial stability; that is, what drives our financial markets and U.S. economy. Please remember that financial stability comes from the Fed, not from the politicians who are bashing the Fed.
A technical postscript
Serious readers please note that there is a difference between financial stability and price stability. The former involves the entire financial system and certainly the workings of the banking system as it is influenced by Fed policy. The systemic reach is to the entire U.S. economy and beyond it to globally important elements. Price stability is half of the mandated congressional portion, paired with full employment. The Congress has directed the Fed to focus on those two elements. What is necessary for the Fed to achieve full employment with price stability is that the whole system have financial stability.
We recommend serious readers explore this issue of financial stability in two important research papers available free from the Federal Reserve Bank of New York at Liberty Street Economics. These papers, both published in May, deal with the issues of financial stability and interest rates and specifically with the issue of policymaking and “real” interest rates. While the papers’ jargon is somewhat technical, the narrative is written well and therefore may give the reader some insight into this critical issue of financial stability:
“Financial Stability and Interest Rates” (libertystreeteconomics.newyorkfed.org/2023/05/financial-stability-and-interest-rates)
“Measuring the Financial Stability Real Interest Rate r**" (libertystreeteconomics.newyorkfed.org/2023/05/measuring-the-financial-stability-real-interest-rate-r)
David Kotok is chairman of the board and chief investment officer of Cumberland Advisors in Sarasota.
