McTeer Reviews The Fed
Financial Times
July 2, 2001

Comment & Analysis—Marvelling at the magician's art—The Federal Reserve has won hero-status under Alan Greenspan. Bob McTeer praises a book that says it must now change.

My Fed career took a turn toward the unknown in 1980 when, after 12 years in economic research and related jobs at the Richmond Federal Reserve, I was put in charge of its Baltimore branch—an operations job. I looked for something to read but soon learned that operations people don't write about what they do and how they do it.

Then I discovered Martin Mayer's The Bankers, with excellent, detailed chapters on operations. Amazingly, the author wasn't a banker. Mayer has continued to impress with some exceptional books and articles.

That The Fed is good, therefore, is no surprise. I didn't realize we needed another book on the U.S. central bank or Alan Greenspan, its chairman, but if we did, who better to write it? The book does remind me, though, of a line I read a while back: "I believe everything I read in the newspapers except for those few things about which I have some personal knowledge." For all that, my quibbles are only minor.

The Fed is about how the U.S. central bank got to be what it is, why it does what it does, and why it must become something else. To most Fed-watchers, all that matters are interest rates and monetary policy. Mayer's view is broader—and that is his contribution. "Avoiding Catastrophe," the title of the book's third part, sums it up.

One potential catastrophe avoided was Long-Term Capital Management, which Mayer implies was bailed out by the Fed. Not exactly. LTCM's principals were not made whole, its creditors had to put more money at risk to cut their losses, and the taxpayer never had a dog in that fight. Rather, Bill McDonough, president of the New York Fed, did as the host of U.S. television's Saturday Night Live "Coffee Talk" segment does when she gives her guests a topic and asks them to talk among themselves.

I never understood why everyone seemed so eager for LTCM to end in a big, messy, potentially systemic failure. I understand moral hazard, but the outcome hardly encourages anyone to follow in the footsteps of LTCM or its creditors. The desire for blood on the floor probably reflected a view that LTCM had got too big for its breeches.

Mayer goes on to evaluate the Fed's day job as a participant in, and supervisor of, the payments system. He takes the Fed to task for not pushing harder for an all-electronic payments system. I am afraid I have another minor quibble here.

The evolution toward more electronics and less paper will probably accelerate someday. However, the current evolving structure reflects user preferences reacting to the real costs of the alternatives. It would be the height of arrogance for the Fed to overrule the market and public preferences and decide what is best for everyone.

Monetary experts and others have long urged greater transparency on central banks, a call which the Fed has heeded. Rather than wait for markets to decipher our moves, we now announce them shortly after the meetings conclude. Mayer now calls that theatre and a sign of weakness.

He notes that the policy toolkit is diminished compared with the old days, including the demise of interest-rate ceilings. True, but this spreads the impact of policy more evenly across the economy rather than concentrating it on housing—on balance, I would say, a net benefit.

The main theme of the book is that we live in a state of transition between two eras: the one of the past, when commercial banks had the lion's share of credit provision; and the one of the future, when financial markets will provide most of the credit. We will have to adapt.

I used to lament this shifting paradigm since I believed—and still do—that banks were losing market share unfairly because of more burdensome laws and regulations. However, the east Asian crisis showed the downside of having few alternatives to banks, and the recent bursting of the technology stock bubble did not bring banks down precisely because tech was financed by equity.

Mayer marvels at the ability of our chairman—the Magician—to pull rabbits out of his hat and have such a large impact with such a small change in short-term interest rates. He notes that sometimes it works well and sometimes it works less well. It is magic because it cannot be explained satisfactorily by economic theory. Maybe it is snake oil or voodoo but it seems to work, at least for the moment. That is why central banking is still an art rather than a science.

The Fed is an especially good read for those who know or think they know a lot about central banking. Unlike most Fed critics, Mayer can step on our toes without messing up our shine. He tells more than most people want to know about the Fed and central banking, but if you really do want to explore the subject, The Fed is for you.

About the Author McTeer is president and CEO at the Federal Reserve Bank of Dallas.