Review: The Fed Unbound, by Lev Menand

Russ Allbery eagle at
Tue Nov 29 21:09:49 PST 2022

The Fed Unbound
by Lev Menand

Publisher: Columbia Global Reports
Copyright: 2022
ISBN:      1-7359137-1-5
Format:    Kindle
Pages:     156

The Fed Unbound is a short non-fiction exploration of US Federal
Reserve actions to reducing systemic risk caused by shadow banking. Its
particular focus is the role of the Fed from the 2008 financial crisis
to the present, including the COVID shock, but it includes a history of
what Menand calls the "American Monetary Settlement," the political
compromise that gave rise to the Federal Reserve.

In Menand's view, a central cause of instability in the US financial
system (and, given the influence of the dollar system, the world
financial system as well) is shadow banking: institutions that act as
banks without being insured like banks or subject to bank regulations.
A bank, in this definition, is an organization that takes deposits. I'm
simplifying somewhat, but what distinguishes a deposit from a security
or an investment is that deposits can be withdrawn at any time, or at
least on very short notice. When you want to spend the money in your
checking account, you don't have to wait for a three-month maturity
period or pay an early withdrawal penalty. You simply withdraw the
money, with immediate effect. This property is what makes deposits
"money," rather than something that you can (but possibly cannot) sell
for money, such as stocks or bonds.

Most people are familiar with the basic story of how banks work.
Essentially no bank simply takes people's money and puts it in a vault
until the person wants it again. If that were the case, you would need
to pay the bank to store your money. Instead, a bank takes in deposits
and then lend some portion of that money out to others. Those loans,
for things like cars or houses or credit card spending, come due over
time, with interest. The interest rate the bank charges on the loans is
much higher than the rate it has to pay on its deposits, and it pockets
the difference.

The problem with this model, of course, is that the bank doesn't have
your money, so if all the depositors go to the bank at the same time
and ask for their money, the bank won't be able to repay them and will
collapse. (See, for example, the movie It's a Wonderful Life, or Mary
Poppins, or any number of other movies or books.) Retail banks are
therefore subject to stringent regulations designed to promote public
trust and to ensure that traditional banking is a boring (if still
lucrative) business. Banks are also normally insured, which in the US
means that if they do experience a run, federal regulators will step
in, shut down the bank in an orderly fashion, and ensure every
depositor gets their money bank (at least up to the insurance limit).

Alas, if you thought people would settle for boring work that makes a
comfortable profit, you don't know the financial industry.
Highly-regulated insured deposits are less lucrative than acting like a
bank without all of those restrictions and rules and deposit insurance
payments. As Menand relates in his brief history of US banking,
financial institutions constantly invent new forms of deposits with
similar properties but without all the pesky rules: eurodollars (which
have nothing to do with the European currency), commercial paper, repo,
and many others. These forms of deposits are primarily used by large
institutions like corporations. The details vary, but they tend to be
prone to the same fundamental instability as bank deposits: if there's
a run on the market, there may not be enough liquidity for everyone to
withdraw their money at once. Unlike bank deposits, though, there is no
insurance, no federal regulator to step in and make depositors whole,
and much less regulation to ensure that runs are unlikely.

Instead, there's the Federal Reserve, which has increasingly become the
bulwark against liquidity crises among shadow banks. This happened in
2008 during the financial crisis (which Menand argues can be seen as a
shadow bank run sparked by losses on mortgage securities), and again at
a larger scale in 2020 during the initial COVID crisis.

Menand is clear that these interventions from the Federal Reserve were
necessary. The alternative would have been an uncontrolled collapse of
large sections of the financial system, with unknown consequences. But
the Fed was not intended to perform those types of interventions. It
has no regulatory authority to reform the underlying financial systems
to make them safer, remove executives who failed to maintain sufficient
liquidity for a crisis, or (as is standard for all traditional US
banks) prohibit combining banking and more speculative investment on
the same balance sheet. What the Federal Reserve can do, and did, is
function as a buyer of last resort, bailing out shadow banks by
purchasing assets with newly-created money. This works, in the sense
that it averts the immediate crisis, but it creates other distortions.
Most importantly, constant Fed intervention doesn't create an incentive
to avoid situations that require that intervention; if anything, it
encourages more dangerous risk-taking.

The above, plus an all-too-brief history of the politics of US banking,
is the meat of this book. It's a useful summary, as far as it goes, and
I learned a few new things. But I think The Fed Unbound is confused
about its audience.

This type of high-level summary and capsule history seems most useful
for people without an economics background and who haven't been
following macroeconomics closely. But Menand doesn't write for that
audience. He assumes definitions of words like "deposits" and "money"
that are going to be confusing or even incomprehensible to the lay

For example, Menand describes ordinary retail banks as creating money,
even saying that a bank loans money by simply incrementing the numbers
in a customer's deposit account. This is correct in the technical
economic definition of money (fractional reserve banking effectively
creates new money), but it's going to sound to someone not well-versed
in the terminology as if retail banks can create new dollars out of the
ether. That power is, of course, reserved for the Federal Reserve, and
indeed is largely the point of its existence. Much of this book that
relies on a very specific definition of money and money supply that
will only be familiar to those with economics training.

Similarly, the history of the Federal Reserve is interesting but
slight, and at no point does Menand explain clearly how the
record-keeping between it and retail banks works, or what the Fed's
"balance sheet" means in practice. I realize this book isn't trying to
be detailed description or history of the Federal Reserve system, but
the most obvious audience is likely to flounder at the level of detail
Menand provides.

Perhaps, therefore, this book is aimed at an audience already familiar
with macroeconomics? But, if so, I'm not sure it says anything new. I
follow macroeconomic policy moderately closely and found most of
Menand's observations obvious and not very novel. There were tidbits
here and there that I hadn't understood, but my time would probably
have been better invested in another book. Menand proposes some
reforms, but they mostly consist of "Congress should do its job and not
create situations where the Federal Reserve has to act without the
right infrastructure and political oversight," and, well, yes. It's
hard to disagree with that, and it's also hard to see how it will ever
happen. It's far too convenient to outsource such problems to central
banking, where they are hidden behind financial mechanics that are
incomprehensible to the average voter.

This is an important topic, but I don't think this is the book to read
about it. If you want a clearer and easier-to-understand role of the
Federal Reserve in shadow banking crises, read Crashed instead. If you
want to learn more about how retail bank regulation works, and hear a
strong case for why the same principles should be applied to shadow
banks, see Sheila Bair's Bull by the Horns. I'm still looking for a
great history and explainer of the Federal Reserve system as a whole,
but that is not this book.

Rating: 5 out of 10

Reviewed: 2022-11-29


Russ Allbery (eagle at             <>

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