Fed's Expanded Market Role Fuels Fierce Debate

For 95 years, the Federal Reserve has been the nation's lender of last resort. Now it's becoming the lender of first resort.

Since the onset of the financial crisis, the Fed has used new, unconventional programs to indirectly make hundreds of billions of dollars available to people buying a house or a car or using a credit card, and to businesses large and small. The central bank, for instance, has pledged to make half a trillion dollars available for mortgages by buying packages of loans known as mortgage-backed securities.

To Fed Chairman Ben S. Bernanke and the economists who embrace his strategy, the central bank is using creative approaches to try to contain the worst financial crisis in generations, exercising its authority to restart lending in a world in which private markets have all but shut down. Central banks around the world are starting to mimic the approach.

But the Fed is also now deciding how vast amounts of capital are deployed in the economy. Its actions so far have favored home buyers and consumers while doing much less prop up lending for businesses seeking to make long-term investments. Even analysts who support the Fed's actions say they have distorted investment decisions and emboldened elected officials to pressure the central bank in ways that undermine its independence.

"The Fed is socializing the capital markets," said Ethan Harris, an economist at Barclays Capital, who nonetheless said he believes the Fed's steps have been necessary. "You're creating a new class of welfare recipients. That's why it's extremely important that there be rules around transparency and lobbying, because the potential for abuse is high. And they have to exit out of this as quickly as markets allow them to."

Deciding how to allocate capital is one of the most important functions in the economy. In modern capitalist societies, it happens as investors and lenders try to find businesses and loans that offer the highest possible returns relative to their risks.

These markets make mistakes sometimes -- take, for example, the vast overinvestment in housing in the middle of this decade. But they have generally proven better at deploying capital toward useful purposes than any other system. The fall of the Soviet Union had a lot to do with the government's failure to deploy capital efficiently, as did the economic stagnation of post-World War II Britain, when the government played an outsize role in business investment decisions.

The U.S. government is nowhere near taking such a massive role. In the view of Bernanke and his allies, private markets are failing to do their job, so policymakers are essentially propping them up until they repair themselves. For centuries, central banks have bolstered banks during financial crises, these policymakers argue, adding that in an era when banks account for only a modest portion of all lending, it makes sense for the Fed to update its role as the lender of last resort.

Critics, however, point out that the government is now deciding to help certain sectors and firms but not others. Stanford economist John B. Taylor, in a recent paper, argued that the Fed's strategy amounts to a form of "industrial policy."

"If we are to have an extensive industrial policy, it should be approved by the Congress with the purposes stated and debated transparently," Taylor wrote in the paper, presented at the American Economic Association's annual meeting. "Will such interventions only take place in recessions, or will Fed officials use them in the future to try to make economic expansions stronger or to assist certain sectors and industries for other reasons?"

"The Fed has sacrificed its independence, and I think it's a disaster," said Allan H. Meltzer, an economist at Carnegie Mellon University and a leading historian of the central bank. "It is creating a system of credit allocation, and if the government is going to do that, it should be done through fiscal policy, not as part of monetary policy."

Other economists vehemently disagree. The Fed's independence would be far more threatened if it were to stand by while the economy entered the worst downturn in 80 years, they argue. Moreover, the Fed is pushing more money into broad categories of lending, not deciding exactly how much cash goes to individual industries, let alone companies or individuals.