Book Review: The Lords of Easy Money: How the Federal Reserve Broke the American Economyby Christopher Leonard (Simon & Schuster, 2022)

A book focused on the failures of American monetary policy in the post-GFC period would have a tiny readership, confined to academics and economic-policy wonks.

In any case, such a critique would face well-entrenched opposition, as the chief protagonists – US Federal Reserve Board Chair Ben Bernanke and Treasury Secretary Tim Geithner – have already written books recording what a good job they did in difficult circumstances. By and large, this positive view is maintained by other authors, such as Adam Tooze and by the Wall Street commentariat.

Thus to expound the failures of US monetary policy to a general audience, you need to use the voice of a tell-all insider, who articulates valid criticism and has been overruled, ignored, or even ostracised. This is the central element of Christopher Leonard’s Lords of Easy Money, with the key voice being that of Tom Hoenig, career central banker and a member of the Fed Board from 1991 to 2011.

The book’s “tick-tock” format is used to bring a dry political argument to life – the minute-by-minute telling of meetings between the main characters, conversations, inner thoughts, travels, back-stories and especially the adversarial interplay between opposing actors in the drama. Conflict always helps to sustain interest. Arcane economics becomes human drama.

What is the substance of this controversy?

Hoenig believed that the excessive central bank money sloshing around in the financial system would lower credit standards and threaten the integrity of the financial system.

Hoenig voted for the extreme measures taken by the Fed in 2008 to support the financial sector, when banks were teetering on the brink, the vital mortgage market had frozen and the money market funds “broke the buck”, with collapse imminent. Interest rates were slashed. The first tranche of Quantitative Easing (QE1) – to shore-up tottering banks and unfreeze the mortgage market – was unusual but conventional in the sense that it fitted the century-old Bagehot doctrine that the central bank should save the core of the financial sector by whatever means available.

Hoenig supported all of this. His dissent began in 2010 when the Fed, instead of winding back these extreme measures and beginning to restore normal interest rate settings, introduced a second massive round of Quantitative Easing (QE2) and then a third (QE3), far beyond anything Bagehot would have blessed. Interest rates were lowered even further, essentially to zero. Covid brought another round of generalised massive support for the financial sector.

Hoenig’s criticism goes much deeper than his first dissenting vote in 2010. He didn’t oppose the further rounds of QE because the “money creation” involved would set off inflation – a common criticism of QE at the time, especially from academic economists schooled in Milton Friedman’s view that “inflation was always and everywhere a monetary phenomenon”.

The key voice of Christopher Leonard’s Lords of Easy Money is that of Tom Hoenig, career central banker and a member of the Fed Board from 1991 to 2011 (pedrik/Flickr)

Instead, as a former bank supervisor, Hoenig believed that the excessive central bank money sloshing around in the financial system would lower credit standards and threaten the integrity of the financial system. The combination of persistently low interest rates and excessive liquidity would undermine lending standards, encourage risky financial innovation and impose misleading price signals on borrowing and lending. While it didn’t bid up consumer goods inflation, it had a substantial effect on asset prices, with adverse consequences for wealth distribution and social cohesion.

Moreover, the repeated rescues of over-extended finance institutions fundamentally changed the mindset of the sector. Going back to the first “Greenspan put” during the 1987 share market rout, the Fed had saved those who took excessive risk. As a result, incentives in the financial sector have become seriously skewed.

Bernanke’s defence would be that, with fiscal policy in harsh austerity mode after 2010 through political ineptitude in Washington, he had to use the instruments available to him (including some he invented) to put as much stimulus as possible into the lacklustre post-2010 recovery.

A dissenter is not a team player. Dissent undermines the authoritative aura and political legitimacy that comes with unanimity.

After more than a decade of near-zero interest rates and a shock-and-awe expansion of the Fed’s balance sheet through its QE operations, the jury is still out on adjudicating the different views of Hoenig and Bernanke. But what seems irrefutable is that the Fed’s flood of QE liquidity promoted an over-expanded financial sector, so fragile that it requires rescue every decade or so. This rescue service isn’t provided to other sectors of the economy. To make this more controversial still, this rescue is provided by an institution whose much-vaunted independence bypasses the usual democratic processes.

There are also lessons here about institutional decision-making. A dissenter is not a team player. Dissent undermines the authoritative aura and political legitimacy that comes with unanimity. To stand alone against this pressure to conform to the majority view, consistently over time, takes grit. Bernanke called his own book The Courage to Act: Hoenig shows just as much courage in arguing for less action.

For the rest of the non-US world (including Australia), we have all had to adopt “low-for-long” near-zero interest rates for fear that the differential between domestic and US interest rates would strengthen our exchange rates, with the loss of international competitiveness. Emerging economies have received an overflow of lending funds from the United States, creating potential debt problems in the longer term as interest rates rise.

The central debate Hoenig promoted is still unresolved. The financial sector, for all its dramas, has not collapsed (so far, at least). But the story of the 2008 GFC is unfinished, still unfolding.

What happens when interest rates return to normality? As Hoenig says: “Do you think it’s costless? Do you think that no one will suffer? Do you think there won’t be winners and losers? No way.” Watch this space.