How the Fed Opened Pandora’s Box

It was July 2019 when Representative Rashida Tlaib, a Michigan Democrat, asked Jerome H. Powell, the chair of the Federal Reserve, whether he would use the central bank’s powers to help state and local governments during the next recession.

“We don’t have authority, I don’t believe, to lend to state and local governments,” Mr. Powell replied. “I don’t think we want that authority.”

Yet nine months later, at the start of April 2020, the central bank announced that it would do effectively what Ms. Tlaib had asked. Fed officials set up a program to make sure that state and local governments could continue to borrow as credit markets dried up.

What had changed was the onset of the coronavirus pandemic. Roughly 15 of every 100 adults who wanted to work found themselves jobless that month, many of them suddenly. Stocks had plunged in value so precipitously that the nation’s households would lose 5.5 percent of their wealth in just the first three months of the year. Amid government-imposed shutdowns, with millions of people at home, there were real worries that Wall Street and small businesses alike would implode.

What hadn’t changed was the Fed’s enormous power. Whether central bankers were ready to embrace it in 2019 or not, the institution has long had sweeping authority to use its ability to create money out of thin air to save the financial system and economy in times of trouble.

And it could exercise that power expediently — and with considerable independence from the rest of the government — in no small part because a man named Marriner Eccles reluctantly took on the job of leading America’s central bank in 1934. That history is particularly useful for understanding what happened in 2020 — and what that might set in motion for the future. It is detailed in my new book “Limitless: The Federal Reserve Takes on a New Age of Crisis,” from which this article is adapted.

The Fed staged a no-holds-barred intervention during the pandemic to stabilize Wall Street and insulate the economy, slashing interest rates to rock bottom, buying trillions of dollars’ worth of government-backed bonds to keep critical markets functioning and promising trillions more in emergency programs that would keep loans flowing to municipal and corporate borrowers and midsize businesses.

It worked. The rescue was so successful that by the end of 2020 the Fed’s response effort was shutting down, rapidly fading from headline-grabbing news to mere historical artifact.

But the Fed’s actions quietly opened the monetary and financial policy equivalent of Pandora’s box: They made it clear to Fed officials themselves, to Congress and to financial market players exactly what the central bank is capable of doing and whom it is capable of saving. That makes it much more likely that the central bank will be called on to use its tools expansively again.

After seeing what the Fed could do during the 2008 financial meltdown, politicians asked: Why save Wall Street but not Detroit? After 2020, they may wonder: Why react to a pandemic crisis but not a climate crisis, or a military one?

In the meantime, the rapid inflation that took off in 2021 has spurred other questions about the Fed’s pandemic response. Specifically, is it partly to blame? It made money cheap when factories were shut and demand did not need such a big and lasting boost.

But even as critiques of the central bank’s 2020 response have largely focused on that inflation, some experts in central banking think the Fed’s broad use of its bond-buying and emergency lending powers also deserves a closer look.

Its actions could set a precedent for the next economic crisis, one in which Fed officials — insulated from voters by design — are left making sweeping decisions that shape which businesses, governments and economic sectors thrive and which ones struggle. Central bankers tried to avoid picking winners and losers in 2020, at times resisting partisan pressure to do so, but that often owed to the personalities in charge rather than to strict legal limitations.

“It’s starting to do things that we would expect our democratically responsive government bodies to do,” said Christina Parajon Skinner, who studies central banking at the University of Pennsylvania. The risk, she said, is that the Fed could be relied upon to do so much that it becomes less trusted at its core job: controlling the speed of the overall economy to keep inflation under wraps.

What Eccles set in motion

It was a blistering day in August 1934 when, during the middle of a conference at the White House, America’s Treasury secretary leaned over to Marriner Eccles and whispered that his name was in the running as the administration looked for someone to lead the nation’s central bank.

Mr. Eccles, a 43-year-old business magnate from Utah, was both surprised and unenthusiastic. The Federal Reserve had been created in 1913 to stabilize America’s banking system and keep money flowing around the country, so the stupendous stock market crash of 1929 and the painful depression that followed — one that a blundering response from a divided Fed exacerbated — were hardly a stellar example of its abilities.

Mr. Eccles himself was in Washington advising Franklin D. Roosevelt’s administration on how to lift the economy out of its deep malaise.

When the president repeated the offer personally a few weeks later, Mr. Eccles told him that he would do it only on one condition: He wanted to first reform what he saw as an “impotent” setup at the central bank. Much of its power to drive the speed of the economy was concentrated in the 12 quasi-private regional Fed banks that dotted the country. What authority it did wield out of Washington was partly as an extension of the White House, because the Treasury secretary and the comptroller of the currency held seats on the central bank’s board.

“The post would be an appealing one only if fundamental changes were made in the Federal Reserve System,” Mr. Eccles, a dark-eyed, sharp-tongued Mormon, told the president, according to his memoir.

And with that, Mr. Eccles set America’s central bank on a one-way track from impotence to omnipotence.

The Banking Act of 1935, which he helped to shape, would result in a major shift of power toward the central bank’s board in Washington. Board members had just had their ability to stage emergency financial rescues expanded drastically during the Great Depression. Now, they would also hold seven of 12 votes on interest rate and bond-buying policies aimed at controlling the speed of economic growth. The regional reserve banks, which more closely represented private business interests, would have just five.

The board’s empowerment would elevate the central bank’s chair. And by concentrating the Fed’s authority, the changes would make it a more nimble policymaker in times of crisis.

Mr. Eccles also helped to insulate the Fed from politics. The 1935 reform removed administration officials from the Fed’s seven-person Board of Governors. Mr. Eccles would go on to play a key role in cementing the central bank’s independence from the Treasury and the White House in a 1951 agreement that gave the Fed freedom to pursue its economic goals without political interference.

Yet the long-ago Fed chair and his contemporaries mostly believed that the Fed’s vast power should be used in a limited way. During the years of relative market calm that stretched from the 1950s to the early 2000s, officials focused on keeping the economy humming and on controlling inflation.

The Fed was mighty, but it wasn’t flexing.

The financial implosion of 2008 changed that. As a meltdown on Wall Street helped to drive the most painful recession since the Great Depression, the Fed stepped up to prevent unmitigated disaster.

Ben S. Bernanke, the Fed chair during the crisis, was a scholar of the 1930s. He and the central bank’s lawyers understood what the Fed was capable of, and they leveraged its vast abilities to pull the economy back from a terrifying abyss. The central bank bought bonds in mass quantities. It rolled out emergency market rescues that bailed out banks and entire financial markets.

And as the Bernanke Fed took those actions, it set out a playbook that would be repeated and built upon in 2020.

Pandora’s box of 2020

When disaster struck again, this time caused by a virus, the Fed took sweeping action even more quickly — and more expansively — than it did during the global financial crisis.

The Treasury market was melting down, so the central bank bought government debt in previously unheard-of sums. Then the market where corporations issue bonds to raise money was looking wobbly, so within weeks the central bank established emergency lending programs to fix it. Next came rescues for midsize businesses and, finally, for municipal bonds.

The emergency buying programs were set up alongside the Treasury, per a legal requirement, and Congress provided a layer of security funding to cover any losses: $454 billion. That gave the programs an element of democratic buy-in. But the Fed’s ability to take those dollars from Congress and supplement them with its own limitless balance sheet meant that America could pledge vastly more relief to the financial system — the Fed could have lent trillions of dollars to flailing borrowers.

The sheer scope of that promise meant that markets calmed and little lending was required.

“It think it was the Fed at its best,” said Richard Clarida, who was vice chair of the Fed at the time and is now a professor at Columbia University. “It was an unusual circumstance, and being able to move boldly and with principle and design served the country well.”

Yet between the Fed’s huge bond purchases — which made it easier for the whole government to borrow — and the backstops the central bank provided to key financial markets, it also became clear just how far the central bank’s powers could reach.

The scope underscored that often when the Fed says it cannot take a certain action — as Mr. Powell did in 2019 — it means that it does not want to. Its legal abilities can be vastly and creatively interpreted. And the speed of the response illustrated how efficiently the streamlined institution could act to avert disaster.

That could give rise to temptation in the future. It takes Congress time to come to thorny agreements, so the Fed could be seen as a quicker option for channeling out aid amid crisis. And what constitutes a crisis is not particularly well defined.

“There will inevitably be those whose plans are grand and whose patience with democratic accountability low,” Randal K. Quarles, who was the Fed’s vice chair for supervision in 2020 — and who is the husband of one of Mr. Eccles’s great-nieces — said during one of his final official speeches.

People, he warned, “will begin to ask why the Fed can’t fund repairs of the country’s aging infrastructure, or finance the building of a border wall, or purchase trillions of dollars of green energy bonds, or underwrite the colonization of Mars.”

That’s why some Fed watchers, like Ms. Parajon Skinner, think it is worth reflecting on whether the guardrails guiding the central bank’s abilities are sufficient. It is also where Mr. Eccles comes in again.

He thought it was critical for the Fed to be powerful enough to safeguard troubled markets and protect against inflation. It was essential for it to be independent from partisan politics, so that it could enact painful economic policies when they were needed for long-run stability. But he also believed central bankers and the public needed to understand the critical — and limited — place the Fed ought to hold in American policy.

“If it is to succeed in its mission,” he wrote at the conclusion of his memoir, “it will need great internal strength in its composition, great courage in its action, and a sustained public and congressional understanding of the role it should play in our society of democratic capitalism.”