The 2007 financial crisis revealed the notion of an “independent” Federal Reserve or central bank is a complete myth.

At a minimum, the Fed has been captured by the very banks it is suppose to regulate.  This was demonstrated in its choice of how to respond to the financial crisis.  The Fed advocated for bailing out the banks (see Bernanke’s testimony before Congress as part of getting authorization for TARP).  In doing so, it effectively pushed the policymakers to the Japanese Model for crisis response.  Under this model, banks and banker bonuses are protected at all costs and the burden of the excess debt in the global financial system is placed on the real economy.

In addition, the Fed’s monetary policy during an economic expansion is captured to the extent the Fed is worried about political pushback if it removes the punchbowl too soon and slows economic growth.  This pushback occurs because it is very hard to explain why interest rates have to be raised to slow down the economy when no economic problems are apparent.

The Fed’s monetary policy during a financial crisis is also captured.  Under the Japanese Model, saving the banks at all costs includes reducing interest rates (the banks’ cost of doing business) so the banks can generate more income (of which about 50% gets paid out as bonuses).  While this is very good for bankers, the losers are anyone who invests in short or intermediate term bonds.  The return on their investment is artificially held down.  A way of looking at it is the bankers who captured the Fed pick up in bonuses a sizable percentage of the earnings pension funds, insurers and individuals are deprived of by the Fed’s monetary policy.

In Transparency Games, I discuss how transparency ends the banks’ capture of the Fed.