Opinion: Columnists

Sunday Reflection: From the Fed to Dodd-Frank, a legacy of corporate liberalism

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The Dodd-Frank law passed with the idea of preventing the next big financial collapse and bailout of banks deemed "too big to fail." Instead, it is concentrating power in those same banks and probably just setting us up for the next banking catastrophe.

This is what happened after the first great campaign against big banks -- the one that produced the original Federal Reserve Act of 1913. Woodrow Wilson had campaigned in 1912 against a Wall Street "money trust" that he claimed abetted other trusts. Louis D. Brandeis was the star witness at congressional hearings that year. He emphasized the idea that big banks buffeted monopolies by refusing credit to small competitors. He published his findings in a book, "Other People's Money and How the Bankers Use It."

His general point -- that money power was concentrated in New York -- was fanciful. In fact, New York's share of the national money market had fallen from 23 percent to 18 percent in the previous decade, and the city had little influence in the national money market. Big national banks grew slowly in number after 1890, and smaller state banks began to outnumber them. It was the large national banks that sought national banking reform, for relief from the proliferation of state bank competitors.

Brandeis provided scant evidence for his argument that banks starved small business of credit. Despite his reputed mania for "facts," he often relied more on moral earnestness and assertion than on data. William Howard Taft, though depicted as far behind Brandeis in economic acumen, was closer to the mark when he noted that "The country is somewhat more independent of Wall Street than it used to be."

Congress had established a National Monetary Commission after the Panic of 1907 to study the issue of monetary reform -- principally to provide a more "elastic" money supply and avoid periodic panics. Southerners and Westerners hoped that elasticity would make credit more easily available in their regions, heretofore ignored or subject to usurious interest rates by Wall Street. The commission proposed a reserve bank, owned and operated by private banks. The bank notes in the system would be secured not only by U.S. bonds (as under the National Banking Act) but also by the bank's short-term loans, or commercial paper.

Wilson turned to Brandeis for advice, and he counseled the president to insist on a presidentially appointed Federal Reserve Board and making its notes obligations of the federal government. These provisions were worked into the bill. The bill provoked outrage among the populist wing of the party, which believed it would "legalize the money trust." While the "money trust" was a populist fantasy, it is true that the bill strengthened the power of large banks.

The Federal Reserve Act did not create a genuine, government-controlled "central bank," but it was certainly a step in that direction. It made political manipulation of money and credit (especially inflation) easier. Although it ultimately gained tremendous influence in the American economy, it was years before its potential power was realized.

And bankers soon learned how to manipulate this agency themselves. The Fed is a good example of what political scientists call "regulatory capture," where the industry that is supposed to be regulated ends up dominating the regulating agency and using it for its own ends. New York banks regained their dominance in the national money market by the time of the Great Depression, which in turn brought about the next phase of federal regulation.

The Fed bears a large share of the blame for aggravating that depression, but the only consequence of its ineptitude was that Congress gave it more power. As usual in politics, nothing succeeds like failure. It illustrates what economist Deepak Lal calls the "dirigiste dogma" -- government intervention aggravates the problem that the intervention was meant to alleviate, and this aggravated condition becomes the justification for further government intervention.

Many historians have advanced the view that progressives like Wilson were really "corporate liberals," claiming to be defending "the people" against big "interests" while actually advancing the agenda of those interests. The Federal Reserve Act supports this view. While it's almost certain that this was not their intent, their animus against economic institutions they did not understand often produced perverse policy outcomes. Politicians are no different today, so it will come as no surprise if history is repeating itself.

Paul Moreno is the Grewcock Chair in Constitutional History at Hillsdale College.

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