December 11, 2011

The further we get from 2008, when the American economy flirted with another Great Depression, the more people forget what happened and create stories that satisfy some political, ideological or journalistic urge. Among the biggest losers in this revisionism is the Federal Reserve. Although it helped save the economy from a deeper collapse, it is increasingly portrayed as the epicenter of an unspoken conspiracy to use government money to benefit Wall Street at everyone else’s expense.

If this view prevails — and it’s common among the tea party, the Occupy Wall Street movement, political figures on both left and right, and some members of the media — we may all be losers. Congress created the Fed in 1913 to act as a lender of last resort for the nation’s banking system. The legislation stemmed from the Panic of 1907, when the absence of a lender of last resort aggravated a severe slump.

We know what happened when the Fed shunned this role: the Great Depression. From 1929 to 1933, 43 percent of the 24,970 U.S. banks failed or were merged out of existence. Economic historians still argue over why the Fed abdicated its responsibilities, but the consequences were dire. The collapse of money and credit deepened the Depression. Unemployment in the 1930s averaged 14 percent. Criticism that the Fed was too active in 2008 may induce it to be too passive in another crisis.

The latest anti-Fed salvo is a long story from Bloomberg, the news agency. It asserts that the Fed “committed” $7.77 trillion to saving the financial system and that it engaged in many “secret” deals to rescue major banks. The allegations and $7.77 trillion figure got wide Internet circulation.

It’s mostly sensationalism. For starters, the $7.77 trillion figure is bogus. Any reasonable person reading the story would conclude that the Fed lent banks and others $7.77 trillion. Not so. This was the amount, Bloomberg later explained, that the Fed might have lent. The Fed’s lending never topped $1.5 trillion, which of course is a lot but still pales next to a financial sector worth in excess of $20 trillion. Virtually all the loans have been repaid with interest, says the Fed.

Economist James Hamilton of the University of California at San Diego meticulously examined how the $7.77 trillion figure was constructed. The number involved calculations that are “nonsensical,” he concluded. Suggesting that the Fed lent all that money to banks is “outrageously inaccurate” and ultimately “a lie.” Economics columnist David Wessel of the Wall Street Journal wrote that the notion that the Fed lent banks $7.77 trillion simply “isn’t true.

Nor did the Fed keep the loans a “secret.” The Fed’s Web site always contained voluminous information on the amount of lending and the collateral offered in return for loans. True, the names of the borrowers weren’t disclosed. But there was a good reason: In a financial panic, disclosing the identity of borrowing banks might further undermine confidence in them. This practice has been standard for decades in the United States and elsewhere.

After Lehman Brothers’ failure in September 2008, American credit markets began shutting down. Banks wouldn’t lend to banks. Investors balked at buying commercial paper — a type of short-term loan — and many “securitized” bonds. Fearing they’d lose credit, businesses dramatically cut spending. Layoffs exploded: 6.3 million jobs vanished between that September and June 2009. Firms canceled investment projects in plants and equipment. In the first quarter of 2009, business investment spending fell at a 31 percent annual rate.

The Fed’s lending programs provided alternative sources of credit and aimed to restore confidence. Banks and others could borrow from the Fed. If it hadn’t intervened, the outcome would have been far worse. Says economist Mark Zandi of Moody’s Analytics:

“The banking and financial system would have collapsed and taken the real economy with it. We’d have been in a depression. I remember getting a call from the CEO of a major retailer, saying his suppliers couldn’t get credit and couldn’t deliver goods to shelves. The commercial paper market had frozen. It’s the lifeblood of many corporations. They use it to make payroll. The layoffs would have been massive compared to what we got.”

The Fed is nominally “independent” for a reason. It is to do unpopular things necessary for the country’s long-term health. The Bloomberg story and other critiques suggest that the Fed and Treasury should have split up big banks as the price for lending them money. But attempting this in the midst of crisis would have compounded uncertainty and fear. Some banks would have taken their chances without the Fed loans. The panic would have intensified.

Fed bashing is old hat, but rarely has a major media organization participated by rewriting history. If the Fed is stigmatized for succeeding, we may find that next time it won’t be there.