Robert Kuttner: Federal Reserve Has Become Slush Fund

From the Huffington Post:

Even more alarmingly, the administration is now using the Federal Reserve as an unlegislated, all-purpose slush fund. Because the Fed's operations are largely beyond the reach of Congressional appropriations or scrutiny, the Fed can do whatever it wishes with its money. The Geithner plan was negotiated behind closed doors, the main players being the Fed, the FDIC, the Treasury, and power-brokers on Wall Street.

What we have is something perilously close to a dictatorship of the Fed and the Treasury, acting in the interests of Wall Street. The contrasts with the first hundred days of the Roosevelt administration are striking. Like Roosevelt, Obama faces an economic emergency. Like Roosevelt, he faces an angry public, which has been bilked by excesses on Wall Street. And like Roosevelt, Obama has a supportive Democratic Congress that is willing to substantially defer to the White House on an emergency recovery plan.

But unlike Roosevelt, who used the public's indignation and Congress's support to constrain the barons of private finance, Obama's economic team is using government funds to put the most abusive players on Wall Street back in the saddle. And Geithner and Summers, working with the Fed, are assembling their plan with no public scrutiny.

In the course of a week, the administration's own rhetoric on the A.I.G. bonuses has shifted from "We were bound by contracts" to "This is an outrage" to "Never mind." Wall Street was out for favor for just days. Meanwhile, Geithner is out with a new proposal to give the Federal Reserve even more sweeping powers to be a "systemic risk regulator."

All of this invites a couple of hard questions.

First, was this the only way to proceed? I have addressed this in a previous column arguing that a superior approach would be a new Reconstruction Finance Corporation.

For details of a well articulated rationale for a new RFC, see the recent speech by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, whose jurisdiction covers eleven Midwestern states. (PDF)

Second, where is Congress? Basically, the key Democratic Committee chairman, whatever their private reservations, have been persuaded that they need to support their president and that the Geithner plan is worth a try. But at the very least, they should be asking harder questions and demanding more transparency. For instance, the Treasury needs to define tactics to game the bailout that will be be prohibited. Congress needs to know which Wall Street moguls the Treasury team met with, and exactly what they were promised. And the whole plan needs to be legislated, rather than made up on the fly by Summers, Geithner, and Bernanke.

At the very least, Congress should act now to cap the kind of windfall profits that hedge funds and private equity companies are likely to make with government bearing nearly all of the risk. There is a good precedent for this. During and after World War II, ending only in the early 1970s, there was a government agency called the Renegotiation Board. Defense Contractors had to agree to a contractual provision allowing a post-audit, after the contract was finished. If their profit exceed the stipulated amount, the government got a refund. By the same token, hedge fund and private equity bets made with government guarantees should have limits on their upside.

And before the Fed is turned into an even more potent all-purpose regulator, Congress should turn it into a true public institution--a reform project that has been deferred since Roosevelt's day.

At a recent conference of the New America Foundation, economist and Obama adviser Laura Tyson, an in exchange with me, defended the administration's approach on the premise that there was no way that Congress would legislate the one to two trillion dollars in public funds that will be needed to make this rescue work. So, in Tyson's view, there was no alternative other than having Treasury contrive its own plan, using the Fed as an all purpose source of unlegislated financing.

I think this is exactly backwards. The administration has, in fact, put $750 billion into its current budget for bank-bailout funds to be tapped later. And if the White House had proposed a more progressive approach to the whole financial rescue--taking failed banks into receivership, involving Congress in the program design, doing comprehensive government audits of bank balance sheets before rather than after the fact, and forcing bank shareholders and bondholders rather than taxpayers to take more of the hit--Congress might well have provided at least some of the funds, leaving the Fed to provide the rest.

Under the present arrangement, the Fed provides nearly all of the funds, an approach that carries no transparency and huge risks of its own. Until last September, the Fed bought and sold mainly Treasury bonds, the safest securities there are. And it did so for one purpose only--to conduct monetary policy. Now, the Fed is buying trillions of dollars of junk assets, and it will be under tremendous pressure to keep these on its own books, compromising its capacity to run the nation's monetary policy.

It's possible that the Geithner plan will "work" in the sense of re-starting the Wall Street bubble machine, this time with a limitless line of direct credit from the Federal Reserve. If that happens, it will defer an even more serious day of reckoning, as the cost of the Fed's immense credit creation comes due. But the greater likelihood is that the plan will merely enrich some speculators, but neither bring zombie banks back to life, nor get a normal banking and credit system operating again. And then the administration will need to come back to Congress, this time with less credibility, with the economy in even worse shape, having burned through more than a trillion dollars.

We were promised unprecedented openness. In the most momentous area of policy for getting the economy functioning again for ordinary Americans, we have instead unprecedented secrecy, designed by and for Wall Street. We expected better of Obama.