Central Banking’s Hogwarts Syndrome

Central banks—the US Federal Reserve is one—come with the mystique of Oz. While the Fed fiercely denies that it is powerful enough to cure recessions with a click of the heels, there are those who believe it’s true. If, however, you look behind the velvet curtains and columned lobbies, you will find good men, but bad wizards. In mid-December, the bank’s Open Market committee pledged $85 billion a month until unemployment drops below 6.5 percent. Such policies are a long way from Kansas and prudent finance.

Around the world central banks have become convenient instruments of public and private bailouts, accommodating lenders when citizens reject tax hikes and governments need a few trillion to bail out Greece or prop up the housing market. It helps that they are shrouded in mystery and give the impression that they hold their meetings at Hogwarts, perhaps with Albus Dumbledore presiding.

The reason that the Federal Reserve, like many of its European counterparts, looks like a failing credit union is that its balance sheet numbers don’t add up. On November 12, 2012, the Fed showed a assets of $2.9 trillion against equity of $69 billion. In other words, the bank’s leverage is 42 times its capital. At its peak, Lehman was geared 36 times; a prudent limit might be eight times. At this time next year, its assets (which would more properly be considered, liabilities) will be $4 trillion.

$1.6 trillion on the Fed’s book is held in US Treasury securities, although, I can assure you that money has been spent, perhaps on that swell new $3.4 billion “campus” for the Department of Homeland Security.

Before 2008, the Fed’s balance sheet was less than $900 billion, and assets were short-term interbank loans and Treasury securities. Now the balance sheet is $2.9 trillion, and mixed in with the gold at Fort Knox is $886 billion in mortgage-backed securities, making the Federal Reserve the nation’s Savings & Loan. (Imagine the toasters given away to build up such a loan book.)

One reason that the Fed’s balance sheet is not available for a congressional audit is that it might scare world markets to death to discover that the US central bank is awash with non-performing assets, not British gilts or J.P. Morgan’s gold bars. As lenders of last resort, many central banks now have vaults that are crammed with junk bonds, subprime exposure, unwound credit default swaps, out-of-the-money options, and sovereign debt issued by governments that have long since vanished.

Take the European Central Bank. After the 2008 crisis it encouraged banking groups to load up on sovereign credits, hoping that this would prevent further collapse and stimulate local economies.

The same practice of offloading substandard loans to the Federal Reserve governed the stimulus programs of the Bush and Obama administrations, which “stimulated” the economy by moving bad loans off Wall Street and into the Fed.

Another definition for quantitative easing (QE3 in its last rendition) might be “government payday loans.” Together, the central banks of the United States and Europe are holding more than $6 trillion as “assets” on their balance sheets, which if they were accurate might read: “Advances against street demonstrations.”

How did we get to these diminishing returns? In their modern incarnation, central banks replaced market makers and robber barons that got tired of business cycles and having to bail out commercial banks and stock jobbers that had hit the skids.

In the US, the panic of 1907 (which J.P. Morgan mitigated, although to his own ends) pushed the country to later enact legislation creating the Federal Reserve System that, in the future, would provide liquidity during periods of recession; its current dual mandate is to fight inflation and maximize employment.

Given that economics was deemed a science of predictions, the presence of strong central banks in North America and Europe was supposed to mean the end of sharp volatility, even though it has been convincingly argued that the Federal Reserve has made little difference in the many recessions since 1913, notably in the Great Depression, when it restricted the money supply.

In his history of central banking, Lords of Finance: The Bankers Who Broke the World, Liaquat Ahamed makes the point that the leading central banks in and after World War I—those of England, France, the United States, and Germany—routinely made bad decisions when it came to issuing currency, propping up the money supply, or regulating the amounts of credit and bonds in various banking systems.

The biggest problem with central banks is that they are mortgaged to the political classes and have become the funding arm of various get-elected-quick schemes rather than sticking to their job of fiddling with the money supply. The Fed’s evolution into a casino cashier window started sometime after 1996 and continued into the administration of George W. Bush, when the equity in American homes became just another chip for Wall Street croupiers to sweep into their aprons.

Under patriotic banners proclaiming that home ownership was a democratic rite of passage, both Congress and the Fed made it easy for banks to grant mortgages based on little, if any, collateral (remember “liar loans?” I bet Alan Greenspan does). They also looked the other way when the administration decided to pay for its wars and tax cuts by using home equity to keep consumer markets irrationally exuberant. Why? Prosperity has a lot to do with reelecting incumbents, and it was those officials who regulated the regulators. Furthermore, member commercial banks, not the US government, own the Fed, even if the US President appoints the chairman.

What might hasten a reckoning of these wobbly accounts is that central bankers are finding it harder to agree that their temples of finance are ministries of magic. A few, like the German and Swiss central banks, dread inflation and take a dim view of speculators. Those attitudes find little sympathy in Italy, Spain, or Greece—should we add California?—which need to kite checks to pay state pensions.

The US isn’t sufficiently flush to help bail out the European Union. Alas, not even the Fed has deep enough pockets to fund trillion dollar annual deficits. Nor should anyone think that the US government is a likely candidate to bail out the Fed, as right now it is the Fed that is bailing out America.

Flickr photo by Lance McCord: Federal Reserve Bank of Atlanta Eagle: Eagle sitting atop a decorative (though once-structural) column outside the Federal Reserve Bank of Atlanta on Peachtree Street; it dates from an earlier incarnation of the Atlanta Fed’s home.

Matthew Stevenson, a contributing editor of Harper’s Magazine, is the author of Remembering the Twentieth Century Limited, a collection of historical travel essays. His next book is Whistle-Stopping America.