Economist: "As A Shadow Government, The Fed Has Mirrored The Shadow Banking System"

In March, I wrote that we not only have a shadow banking system, but also a shadow government - specifically, the Fed and Treasury are spending trillions of dollars of our taxpayer money but refusing to answer Congress or the American people's questions about where the money is going.

Yesterday, well-known economist Robert Kuttner agreed:

The Federal Reserve is unique among America's governing institutions. Its combination of outsized power and lack of democratic accountability exceeds even that of the CIA, which at least reports directly to the president. The Fed's powerful regional banks are accountable to private boards made up mostly of bankers. When current Treasury Secretary Timothy Geithner was named president of the New York Fed in 2003, the search committee was chaired by private-equity mogul Peter G. Peterson and dominated by private financiers. The campaign to get Geithner the job was led by Robert Rubin of Citigroup.

All of this clubbiness was by design. In creating the Fed, Congress appropriated a radical idea from the populists for a more stable and resilient banking and currency system -- but put it in the safely conservative hands of private bankers. This insularity is troubling enough in ordinary times. It is downright scandalous in the aftermath of an economic crisis brought on by banking excesses that in turn were enabled and indulged by the Fed.

The economy was crashed by the activities of a shadow banking system -- mortgage companies, hedge funds, private-equity firms, buyers and sellers of credit-default swaps, and corrupted credit-rating agencies -- none of which were regulated by anyone and none of which troubled the Fed. The system's financiers were often bank holding companies whose activities were supposed to be supervised by the Fed but in practice were not.

As a shadow government, the Fed has mirrored the shadow banking system. Now the Fed has put its own balance sheet at risk, courting inflation down the road -- and inviting a long-overdue backlash.

... Critics across the spectrum are asking why the Federal Reserve should not be subject to the same kind of scrutiny as other agencies in its roles as regulator and emergency lender. Instead, these functions have become entangled in a fashion that defies accountability.

By creating massive liquidity that will eventually either find its way onto the national debt or be monetized as inflation, the Fed is now conducting fiscal as well as monetary policy. It is picking winners and losers, with no stated criteria. The Fed continues to waive regulatory scrutiny in the hopes of coaxing a wounded financial system back to life. It bails out institutions deemed "too big to fail," but in preventing the collapse of several banks, from Merrill Lynch to Bear Stearns to Wachovia to National City, its preferred strategy has been to orchestrate mergers to create even bigger banks, thus redoubling the too-big-to-fail problem.

The Fed has all but taken over the banking system ...

In late April, startling testimony by former Bank of America CEO Ken Lewis revealed that the Fed and Treasury had strong-armed him into purchasing Merrill Lynch even after it came to light that Merrill's losses were far larger than had been revealed. Legally, when there is a "material change" in the condition of a merger partner, the acquiring party may back out of the deal. But according to Lewis' testimony, confirmed both by Paulson and by official minutes of meetings, Paulson and Bernanke pressured Lewis into violating his own legal fiduciary duty to his shareholders, who had to approve the deal based on accurate information. Relying on no legal authority whatsoever, the Fed and Treasury threatened to remove the board and management of Bank of America if they refused to go forward and demanded that Lewis not divulge the conversation. Based on these revelations, Attorney General Andrew Cuomo of New York wrote a five-page letter to the SEC and key Congressional committee chairs, suggesting that the Fed and Treasury may have improperly interfered with Bank of America's legal duty to its shareholders...

According to The Washington Post, the latest Geithner-Bernanke plans were conceived and drafted by such leading investment houses as Goldman Sachs and Pimco, which of course stand to gain or lose many billions depending on what the government does...

Neither [the Congressional Oversight Panel] nor the inspector general has any authority over the Fed...

Where will the Treasury get the money? It will issue bonds, adding to the national debt. You could say that the Fed is essentially serving as a money laundry for eventual Treasury borrowing. Alternatively, the Fed could just create more credit, a process that risks inflation -- increasing unease among many of its senior officials.

Luckily, Kuttner thinks that the Fed's power will decrease, not increase:

However, the idea of giving the job [of systemic risk regulator] to the Fed is now all but dead because of its overreaching...

Greenspan has already fallen from grace, and Bernanke could be next. And though the Fed continues to play an outsized role in containing the crisis, its influence as a largely unaccountable shadow government has already peaked. The only question is how much further damage we will have to endure before both the financial system and its all-too-friendly central bank are rendered more accountable to a broad public interest.