The Fed Unbound

The Fed Unbound is a short non-fiction exploration of US Federal Reserve actions to reducing systemic risk caused by shadow banking. Its particular focus is the role of the Fed from the 2008 financial crisis to the present, including the COVID shock, but it includes a history of what Menand calls the "American Monetary Settlement," the political compromise that gave rise to the Federal Reserve.

In Menand's view, a central cause of instability in the US financial system (and, given the influence of the dollar system, the world financial system as well) is shadow banking: institutions that act as banks without being insured like banks or subject to bank regulations. A bank, in this definition, is an organization that takes deposits. I'm simplifying somewhat, but what distinguishes a deposit from a security or an investment is that deposits can be withdrawn at any time, or at least on very short notice. When you want to spend the money in your checking account, you don't have to wait for a three-month maturity period or pay an early withdrawal penalty. You simply withdraw the money, with immediate effect. This property is what makes deposits "money," rather than something that you can (but possibly cannot) sell for money, such as stocks or bonds.

Most people are familiar with the basic story of how banks work. Essentially no bank simply takes people's money and puts it in a vault until the person wants it again. If that were the case, you would need to pay the bank to store your money. Instead, a bank takes in deposits and then lends some portion of that money out to others. Those loans, for things like cars or houses or credit card spending, come due over time, with interest. The interest rate the bank charges on the loans is much higher than the rate it has to pay on its deposits, and it pockets the difference.

The problem with this model, of course, is that the bank doesn't have your money, so if all the depositors go to the bank at the same time and ask for their money, the bank won't be able to repay them and will collapse. (See, for example, the movie It's a Wonderful Life, or Mary Poppins, or any number of other movies or books.) Retail banks are therefore subject to stringent regulations designed to promote public trust and to ensure that traditional banking is a boring (if still lucrative) business. Banks are also normally insured, which in the US means that if they do experience a run, federal regulators will step in, shut down the bank in an orderly fashion, and ensure every depositor gets their money back (at least up to the insurance limit).

Alas, if you thought people would settle for boring work that makes a comfortable profit, you don't know the financial industry. Highly-regulated insured deposits are less lucrative than acting like a bank without all of those restrictions and rules and deposit insurance payments. As Menand relates in his brief history of US banking, financial institutions constantly invent new forms of deposits with similar properties but without all the pesky rules: eurodollars (which have nothing to do with the European currency), commercial paper, repo, and many others. These forms of deposits are primarily used by large institutions like corporations. The details vary, but they tend to be prone to the same fundamental instability as bank deposits: if there's a run on the market, there may not be enough liquidity for everyone to withdraw their money at once. Unlike bank deposits, though, there is no insurance, no federal regulator to step in and make depositors whole, and much less regulation to ensure that runs are unlikely.

Instead, there's the Federal Reserve, which has increasingly become the bulwark against liquidity crises among shadow banks. This happened in 2008 during the financial crisis (which Menand argues can be seen as a shadow bank run sparked by losses on mortgage securities), and again at a larger scale in 2020 during the initial COVID crisis.

Menand is clear that these interventions from the Federal Reserve were necessary. The alternative would have been an uncontrolled collapse of large sections of the financial system, with unknown consequences. But the Fed was not intended to perform those types of interventions. It has no regulatory authority to reform the underlying financial systems to make them safer, remove executives who failed to maintain sufficient liquidity for a crisis, or (as is standard for all traditional US banks) prohibit combining banking and more speculative investment on the same balance sheet. What the Federal Reserve can do, and did, is function as a buyer of last resort, bailing out shadow banks by purchasing assets with newly-created money. This works, in the sense that it averts the immediate crisis, but it creates other distortions. Most importantly, constant Fed intervention doesn't create an incentive to avoid situations that require that intervention; if anything, it encourages more dangerous risk-taking.

The above, plus an all-too-brief history of the politics of US banking, is the meat of this book. It's a useful summary, as far as it goes, and I learned a few new things. But I think The Fed Unbound is confused about its audience.

This type of high-level summary and capsule history seems most useful for people without an economics background and who haven't been following macroeconomics closely. But Menand doesn't write for that audience. He assumes definitions of words like "deposits" and "money" that are going to be confusing or even incomprehensible to the lay reader.

For example, Menand describes ordinary retail banks as creating money, even saying that a bank loans money by simply incrementing the numbers in a customer's deposit account. This is correct in the technical economic definition of money (fractional reserve banking effectively creates new money), but it's going to sound to someone not well-versed in the terminology as if retail banks can create new dollars out of the ether. That power is, of course, reserved for the Federal Reserve, and indeed is largely the point of its existence. Much of this book relies on a very specific definition of money and money supply that will only be familiar to those with economics training.

Similarly, the history of the Federal Reserve is interesting but slight, and at no point does Menand explain clearly how the record-keeping between it and retail banks works, or what the Fed's "balance sheet" means in practice. I realize this book isn't trying to give a detailed description or history of the Federal Reserve system, but the most obvious audience is likely to flounder at the level of detail Menand provides.

Perhaps, therefore, this book is aimed at an audience already familiar with macroeconomics? But, if so, I'm not sure it says anything new. I follow macroeconomic policy moderately closely and found most of Menand's observations obvious and not very novel. There were tidbits here and there that I hadn't understood, but my time would probably have been better invested in another book. Menand proposes some reforms, but they mostly consist of "Congress should do its job and not create situations where the Federal Reserve has to act without the right infrastructure and political oversight," and, well, yes. It's hard to disagree with that, and it's also hard to see how it will ever happen. It's far too convenient to outsource such problems to central banking, where they are hidden behind financial mechanics that are incomprehensible to the average voter.

This is an important topic, but I don't think this is the book to read about it. If you want a clearer and easier-to-understand role of the Federal Reserve in shadow banking crises, read Crashed instead. If you want to learn more about how retail bank regulation works, and hear a strong case for why the same principles should be applied to shadow banks, see Sheila Bair's Bull by the Horns. I'm still looking for a great history and explainer of the Federal Reserve system as a whole, but that is not this book.

Rating: 5 out of 10

Reviewed: 2022-11-29