How Does Politics Affect Central Banking? Evidence from the Federal Reserve a Dissertation Submitted to the Department of Politi

HOW DOES POLITICS AFFECT CENTRAL BANKING? EVIDENCE FROM THE FEDERAL RESERVE

A DISSERTATION SUBMITTED TO THE DEPARTMENT OF POLITICAL SCIENCE AND THE COMMITTEE ON GRADUATE STUDIES OF STANFORD UNIVERSITY IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY

LUCAS PUENTE JULY 2015

This work is licensed under a Creative Commons Attribution- Noncommercial 3.0 United States License. http://creativecommons.org/licenses/by-nc/3.0/us/

This dissertation is online at: http://purl.stanford.edu/bb132pr2055

ii I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Stephen Haber, Primary Adviser

I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Jens Hainmueller

I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy.

Barry Weingast

Approved for the Stanford University Committee on Graduate Studies. Patricia J. Gumport, Vice Provost for Graduate Education

This signature page was generated electronically upon submission of this dissertation in electronic format. An original signed hard copy of the signature page is on file in University Archives.

iii Abstract

My dissertation investigates the ways in which political dynamics influence decision- making at central banks, particularly following financial crises. I focus on the panic of 1907, the Great Depression, and the recent global financial crisis. I address this question by looking at the different mechanisms through which political influence oc- curs. I devote a chapter to examining this topic in each of the following contexts: the (pre-WWII) evolution of the structure of the Federal Reserve, the preferences of monetary policymakers around elections (post-1988), and the Federal Reserve’s lending during the 2008 financial crisis. Through this series of chapters, I find that politicians designed the American central bank in such a way that political considerations are able to consistently affect monetary policymakers. However, stemming from the partial compromises inherent in its design, this influence is constrained in such a way to ensure its stability, as too much would lead to a new equilibrium in which the central bank is more apolitical.

iv Contents

Abstract iv

1 Introduction 1

2 The Politics Behind the Fed’s Structure 6 2.1 The Politics of Monetary Policy ...... 10 2.1.1 The Importance of Central Bank Structure ...... 11 2.2 The Federal Reserve Act of 1913 ...... 16 2.2.1 Republican Monetary Policy Reform Eﬀorts ...... 21 2.2.2 Democratic Reform & the Federal Reserve Act of 1913 . . . . 27 2.3 The Fed’s Adolescence ...... 34 2.3.1 World War I & the Start of Open Market Operations . . . . . 35 2.3.2 The Failure of Monetary Policy in the Great Depression . . . 38 2.3.3 First Steps Towards Reform ...... 42 2.4 The Banking Act of 1935 ...... 48 2.4.1 Proposals for Further Reform ...... 49 2.4.2 An Increasingly Supportive Political Climate ...... 55 2.4.3 Overcoming the Glass Veto Threat ...... 57 2.4.4 Bargaining in the Glass Subcommittee ...... 64 2.4.5 The Final Steps Towards Passage ...... 66 2.4.6 Counterfactual Analysis ...... 71 2.5 Conclusion ...... 81 2.6 Appendix ...... 84

3 The Fed as a Political Agent 88 3.1 The Fed: America’s Central Bank ...... 91 3.2 Do We Know if There is a Political Business Cycle in Monetary Policy? 98 3.3 Theory ...... 102 3.4 Data & Research Design ...... 107 3.4.1 Dependent Variable ...... 108 3.4.2 Econometric Model ...... 110

v 3.4.3 Independent Variables ...... 114 3.5 Results & Discussion ...... 119 3.6 Conclusion ...... 129 3.7 Appendix ...... 131

4 The Role of Politics in the Fed’s Lending 138 4.1 Background: What did the Fed do? ...... 140 4.2 Theory: What is the expected answer to this question? ...... 145 4.3 Data & Research Design ...... 148 4.3.1 Sample ...... 148 4.3.2 Dependent Variable ...... 149 4.3.3 Financial Controls ...... 150 4.3.4 Political Variables ...... 152 4.3.5 Econometric Model ...... 157 4.4 Results ...... 159 4.5 Conclusion ...... 167 4.6 Appendix ...... 169

5 Conclusion 186 5.1 Appendix ...... 192

vi List of Tables

2.1 House roll call vote 33, September 18, 1913 ...... 33 2.2 Senate roll call vote 184, December 19, 1913 ...... 33 2.3 Congressional Elections: 1926–1932∗ ...... 43 2.4 Results of the 1934 Midterm Election∗ ...... 56 2.5 House roll call vote 47, May 9, 1935 ...... 57 2.6 Membership & Preferences in the Glass Subcommittee ...... 62 2.7 Membership & Preferences in the Conference Committee ...... 67 2.8 Glass Subcommittee in 1933 ...... 78 2.9 Partisan Composition: 63rd and 74th Congresses∗ ...... 79 2.10 Comparison of Ideology: 63rd and 74th Congresses ...... 79 2.11 Partisan Preferences in 1913 ...... 84

3.1 Probability of Recommending a Rate Cut ...... 121 3.2 Tukey Multiple Comparisons of Means ...... 121 3.3 Generalized Ordered Logit Results ...... 123 3.4 Predictive Probabilities of Recommending a Cut in the Fed Funds Rate 124 3.5 Selected Regression Results for Republican Monetary Policymakers . 125 3.6 Predictive Margins: Republican Monetary Policymakers ...... 126 3.7 Predictive Margins: Republicans during Political Scandals ...... 129 3.8 List of Presidential Scandals ...... 132 3.9 Regression Results: Republicans vs. Democrats ...... 133 3.10 Regression Results: Republican Policymakers ...... 134 3.11 Regression Results: Republicans (With Person Fixed Eﬀects) . . . . . 135 3.12 Regression Results: Republicans vs. Democrats (Scandals) ...... 136

4.1 Summary Statistics of Financial Control Variables ...... 169 4.2 Summary Statistics of Political Variables ...... 169 4.3 Univariate Diﬀerences: TAF Participation ...... 170 4.4 Univariate Diﬀerences: DW Participation ...... 170 4.5 Correlation Matrix ...... 171 4.6 Logistic Regression Results: TAF Usage ...... 173

vii 4.7 Tobit Regression Results: Intensity of TAF Usage (In Days) . . . . . 174 4.8 Tobit Regression Results: Intensity of TAF Usage (Balance) . . . . . 175 4.9 Logistic Regression Results: Discount Window Usage ...... 176 4.10 Tobit Regression Results: Intensity of Discount Window Usage (Days) 177 4.11 Tobit Regression Results: Intensity of Discount Window Usage (Balance)178 4.12 Tobit Regression Results: Income Derived From TAF ...... 179 4.13 Tobit Regression Results: Income Derived From TAF (Placebo Test) 180 4.14 Tobit Regression Results: Income Derived From TAF (Interactions) . 181 4.15 Tobit Regression Results: Income Derived From TAF (Baseline Model) 183 4.16 Tobit Model Comparisons (DV: Income Derived From TAF) . . . . . 185

5.1 President Clinton’s Appointments to the the Fed’s Board of Governors 192

viii List of Figures

2.1 Efficiency Gains from Delegation ...... 12 2.2 Possibilites in Central Bank Structure ...... 14 2.3 Republican Preferences Over Central Bank Structure (1911) . . . . . 26 2.4 Democratic Preferences Over Central Bank Structure (1912) . . . . . 28 2.5 Democratic Preferences Over the Glass-Owen Bill (1913) ...... 31 2.6 Preferences Over the Glass-Owen Bill (All Groups) ...... 32 2.7 Federal Reserve Bank Credit ...... 37 2.8 Effect of the OMIC (left) & OMPC (right) ...... 38 2.9 Bargaining Process Between Glass & Eccles ...... 66 2.10 Preferences over the Final Bill ...... 71 2.11 Could the Banking Act of 1935 Have Passed In Previous Sessions of Congress? ...... 77 2.12 Histograms of Estimated Vote Outcomes: 70th – 74th Congresses . . . 85 2.13 Differences in Ideology: 63rd and 74th Congresses ...... 86 2.14 Could the Banking Act have Passed Had the Composition of Congress Not Changed Between 1913 and 1935? ...... 87

3.1 Boundaries of the Federal Reserve Districts ...... 92 3.2 Phillips Curve ...... 93 3.3 Frequency of Recommendations in the FOMC ...... 110 3.4 Using CFscores to Determine Reserve Bank Presidents’ Party IDs . . 131 3.5 Power Analysis: Democratic Elections’ Eﬀect on FOMC Republicans 137

4.1 Relationships Between Financial Covariates and Income Derived from TAF ...... 172 4.2 Lobbying’s Eﬀect on TAF Income, Conditional on Firm Type . . . . 182 4.3 Financial Covariates’ Marginal Eﬀects on Income Derived from TAF . 184

5.1 Presidential Appointments Serving on the Fed’s Board of Governors . 192 5.2 The Eﬀect of Quantitative Easing on the 2012 Presidential Election . 193

ix Chapter 1

Introduction

After being sworn-in as the Chairman of the Board of Governors for the Federal Reserve System (“Fed”) for the second time, Ben Bernanke reaﬃrmed the institution’s political independence:

The Federal Reserve has been granted, both in law and in political tradition, considerable independence and autonomy. That independence serves important public objectives. Critically, it allows the Federal Open Market Committee to make monetary policy in the longer-term economic interests of the American people, rather than in the service of short-term political imperatives. It also allows the Federal Reserve to make supervisory decisions based on the facts of each case and the need to preserve ﬁnancial stability, not on the basis of political considerations.1

The reason Bernanke took such a public stand defending the Fed’s independence is simple: central bank independence is widely seen as a necessary condition for the attainment of economic and ﬁnancial stability. Thus, Bernanke and central bankers

1Text of full statement is available at http://www.federalreserve.gov/newsevents/speech/ bernanke20100203a.htm.

1 CHAPTER 1. INTRODUCTION 2

everywhere have a substantial interest in promoting the idea that they are technocratic policymakers uninterested in domestic politics and unable to be influenced by external pressures. Without that reputation, they know that macroeconomic outcomes would be much more susceptible to harmful fluctuations. Given the ample evidence documenting this connection between central bank independence and fa- vorable economic policy outcomes, such as low rates of inflation, this is far from a unsubstantiated belief.2 However, just because a policymaker wants to cultivate the perception that they are of a certain type does not mean that they actually are of this type. In other words, how do we know that Chairman Bernanke was actually telling the truth in the above quote and not just engaging in “cheap talk”? Although the degree to Bernanke’s claims are true is a fundamentally empirically question, the extant literature does not provide a compelling answer to it. The existing studies with the most thorough investigations of central bank independence place an exclusive focus on the institution’s governing statutes and the insights made are only valid when making cross-national comparisons of central bank independence (e.g., Cukierman, Miller, and Neyapti 2002, Polillo and Guillen 2005, and Crowe and Meade 2008). Moreover, these typically consider only the rules pertaining to the conduct of monetary policy, thereby ignoring the crucial role that central banks play as lenders of last resort. Other studies have taken a more targeted approach in studying the impact of politics on policymaking at the Fed by asking whether or not monetary policy becomes

2For a review of the literature investigating this relationship, see Eijffinger and de Haan (1996). Bade and Parkin (1988), Alesina (1988), Grilli, Masciandaro and Tabellini (1991), Cukierman, Web and Neyapti (1992), Alesina and Summers (1993), Eijffinger, Van Rooij and Schaling (1996), Berger, De Haan and Eijffinger (2001), and Keefer and Stasavage (2003), among others, provide additional support. CHAPTER 1. INTRODUCTION 3

looser around elections.3 However, there has yet to be a consensus in this literature as to whether a so-called political business cycle exists in contemporary American monetary policy. The answers range from outright skepticism (Alesina, Roubini, and Cohen 1997 and Abrams and Iossifov 2006) to those claiming it readily exists, but only under Republican administrations (Clark and Arel-Bundock 2013) or always does, but only in one direction (Hellerstein 2007). A related question, though, has yet to even be answered. Despite the prominent role in plays as a lender of last resort, no scholarship yet exists on the degree to which firms’ political activities and connections affect its borrowing from the central bank during periods of liquidity constraints. This inattention combined with the lack of a consensus over the question of if the Fed alters monetary policy around elections makes it clear that we really do not know whether Chairman Bernanke was telling the truth when he claimed that the Fed was a politically impartial institution. My dissertation seeks to remedy this with a thorough examination of how politics affect central bankers at the Federal Reserve. Its main objective is to reveal the mechanisms through which political pressure and bias can influence central bankers. I start in Chapter 2 by describing why the firewall between the Fed and elected officials is intentionally thin. While not often a focus for scholars of monetary policy, a central bank’s structure – whether decentralized, centralized and controlled by bankers, or centralized and politically controlled – has important implications for policy outcomes. This is because interest groups, motivated by the distributive consequences of monetary policy, have divergent interests over not only these outcomes, but

3Put simply, the rationale for this monetary policy adjustment can provide a potent, if short-lived, stimulus to the economy may help improve voter perceptions of the incumbent party. CHAPTER 1. INTRODUCTION 4

also the underlying institutional structure. To provide a full account of the Fed’s pe- culiar structure, though, I go on to describe how the institutional design of Congress, with its multiple veto points, affects how these interests factor into the policymaking process. Finally, I show how economic shocks can shift these preferences and produce changes in the Fed’s design. In applying this theory to the politics of central banking from the dawn of the 20th century to today, I use qualitative evidence, spatial models, and econometric tests to provide substantiating evidence. With this multifaceted approach (a first of its kind in the literature), I describe how the panic of 1907 led to the creation of the Federal Reserve in 1913 as a decentralized institution. I argue this was the result of a repeated bargaining game in Congress and, more specifically, its Democratic caucus, then dominated by libertarian-like adherents to the real bills doctrine. I then explain how World War I and the Great Depression shifted preferences among pivotal voters, thereby catalyzing a substantial reform of the Fed’s structure in 1935 and producing a central bank only marginally protected from political influence. This change has had a profound impact on the institution by empowering those in favor of more accommodative monetary policy. Without these structural changes, it would have been much less likely that those in this group would have been able to make monetary policy outcomes in the United States in line with a populist agenda to the degree that they did. In the same way, this structural change paved the way for monetary policy becoming susceptible to electoral cycles, a topic explored in detail in Chapter 3. CHAPTER 1. INTRODUCTION 5

In that chapter, I use an originally constructed (and hand-collected) data set derived from meeting transcripts to show how members of the Fed’s primary policymaking body, the Federal Open Market Committee (FOMC), are influenced by electoral objectives. Specifically, officials with membership in the party of the president are more likely to recommend interest rate cuts around elections than they otherwise are. This is true for both members of the politically-appointed Board of Governors as well as the non-appointed presidents of the twelve reserve banks, but only when the chairman and the median member of the committee also share that common party identification. This tendency of copartisans at the Fed to recommend accommodative monetary policy (i.e. promote growth in the money supply) is also present in meetings held during political scandals, as coded by Nyhan (2014). By discovering the precise way in which elections impact contemporary monetary policy, this study improves our understanding of how political considerations can alter decisions in even our most apolitical institutions. Chapter 4 moves on to ask a novel question: how did political pressure affect the Fed’s lending during the financial crisis of 2007–2009, when the Fed played its biggest role in stabilizing the economy since the Great Depression. Using a new data set containing contract-level information on such lending, I find that more politically active and better-connected financial institutions did not receive more capital, once financial covariates have been accounted for. However, those more active in lobbying Congress and the Fed over issues pertaining to this lending program appear to have directly benefited from such actions, as multivariate tobit regressions report that such firms derived more profits by borrowing from the Fed than their less politically active counterparts. This finding provides additional evidence that the Fed’s ability CHAPTER 1. INTRODUCTION 6

to remain insulated from external political pressure is imperfect. I conclude in Chapter 5 by discussing the implications of my ﬁndings and mapping out some research projects that are natural extensions of this work. Chapter 2

The Politics Behind the Federal Reserve’s Structure

In this chapter, I ask: what explains the structure of the Federal Reserve? Though several authors offer explanations for some of the individual pieces within this broader puzzle, as far as I am aware, this is the first attempt to offer a comprehensive explanation of the structure of the American central bank. This relative scarcity of attention comes despite the importance of this question, as the design of the Fed has enormous implications for policy outcomes. This would not be true if central banking was a completely objective science. It is not, though. As Kenneth Rogoff (2014) put it, “no matter how much central banks may wish to present the level of inflation as a mere technocratic decision, it is ultimately a social choice.” Thus, just as in other elements of economic policy, different interest groups have contrasting preferences. On one end, labor groups and debtors favor an expansive monetary supply, while financiers and lenders prefer the opposite, desiring stable prices above all. A third group, today consisting mostly of libertarians, promotes

7 CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 8

a “hands off” approach to monetary policy in which the supply is not altered by policymakers, but rather via an automatic mechanism, such as the gold standard. Unlike fiscal policy, though, politicians do not try to directly manage monetary policy: delegating to an agency is simply far more efficient. As a result, the most direct mechanism through which interest groups can produce monetary policy outcomes in line with their interests is to put their allies in change of the agency. However, those in power at the time of the agency’s creation know that they will not retain their authority in perpetuity. Thus, to maximize their long-term impact on policy outcomes, they focus less on the first wave of (non-permanent) appointments to the agency and more on its structure. This is a rational decision since the initial structural setup limits potential changes in the distribution of power at the agency decision-making is delated to. In other words, it can “lock in” the degree of control of the enacting coalition for the long-term. As a result, the three different groups (introduced above) each have their own induced preferences over the central bank’s structure. Bankers, creditors, and other financiers tend to want the central bank to be highly centralized since that facilitates efficient decision-making and a greater ability to use monetary policy to limit fluctuations in the inflation rate. However, they want these decisions to be free from political influence since that is associated with increases in the money supply, an undesirable outcome for a group prioritizing price and financial stability. Labor groups and debtors have the opposite inclination, since a more robust supply of money is associated with lower unemployment and easier loan repayment. So while they also want a highly centralized central bank, they want its officials to be as responsive to the public as possible. In other words, they desire a politicized central bank. Finally, CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 9

what we now call libertarians have an entirely different set of goals, not wanting monetary policy to be used a tool to alter price levels and economic output. They therefore favor a weak central bank with only very limited powers, to the degree they want one at all. The distribution in the degree to which these groups are represented in the federal government during the legislative debate plays a key role in determining how the Fed is structured. Prior to the panic of 1907, few saw monetary policy as a discretionary art and thus a majority preferred that the US have no central bank. However, this economically painful event changed many minds regarding how to best conduct monetary policy and a consensus emerged that re-establishing a central bank would be beneficial.1 The question then became how centralized and politicized it should be. Once Democrats gained unified control of government in 1912, this decision came down to the division of power within the party. One group, inspired by William Jen- nings Bryan, favored creating a strong, yet politicized institution, while another, led by Carter Glass, maintained similar preferences from before the crisis and preferred creating a weak, decentralized institution. This latter group proved more powerful so the ultimate outcome, passed as the Federal Reserve Act of 1913, created a central bank in little more than name. That is, the Fed as initially constructed was highly decentralized and possessed limited policy authority. This distribution of preferences did not persist, though. To help meet the soaring financing demands of the US government and reduce the impact of declining growth in the supply of gold, both a direct result of World War I (i.e., an exogenous shock), the Fed began buying and selling Treasury securities. These so-called open market

1The Fed is the US’s third central bank. The First Bank of the United States was in operation between 1791 and 1811 and the Second Bank of the United States lasted from 1816 to 1836. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 10

operations, which had not been used until then, demonstrated how monetary policy could serve as a powerful economic policy lever. When the Fed failed to maximize this tool’s potential following the start of the Great Depression (when monetary policymakers maintained a “hands off” approach), many became convinced that structural change was needed. This was particularly true among Democrats, who gained unified control of government in 1932 thanks to the economic downturn also producing a severe anti- incumbency (i.e., Republican) bias. As a result of this frustration with the Fed’s lack of open market operations, many in the party had swung towards favoring a strong central bank with a high degree of political control. They figured that such a change would make the Fed less likely to repeat its mistakes in a future downturn. The only way reform could be stopped would be if the wing of the party maintaining a preference for a decentralized Fed, still led by Glass, retained a veto over change. However, following a further leftward shift in the composition of the Senate in the 1934 midterm elections, Glass came to be outnumbered in his own subcommittee and therefore lost his ability to prevent unwanted legislation. With that, the path towards change was cleared. When President Roosevelt signed the Banking Act of 1935 into law, the Fed became a centralized and fairly politicized institution. This result induced a structural equilibrium that persists today. This lack of subsequent change can be directly attributed to no shifts in the distribution of preferences having occurred since then that were big enough to induce structural revisions of the Fed. So while we have, of course, seen big changes in the composition of government since the New Deal, there have been few instances in which a majority of both houses of Congress may have favored a change in the structure of the Fed. In each of these, CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 11

however, reform was prevented by a veto player, whether in committee, at the agenda control level, or by the White House.2 That is not to say reform is never going to happen: the financial crisis of 2008 made monetary policy a prominent political issue once more and, if the industrial organization of Congress changes enough, further structural change could result. This chapter proceeds as follows. In section 2.1, I introduce the theoretical un- derpinnings behind the politics of monetary policy and central bank structure more specifically. In section 2.2, I apply this theory to explain why the Federal Reserve Act of 1913 ended up looking the way it did. Section 2.3 moves on to discuss how WWI combined with the Great Depression to stimulate changes in preferences over this issue. Section 2.4 then details how these changes caused the structural reforms made via the Banking Act of 1935. I conclude in Section 2.5 with a summary of my findings and discussion of the subsequent and potential future reform attempts.

2.1 The Politics of Monetary Policy

Although a casual observer may not view monetary policy as a controversial topic, it can be highly divisive. This is because there exists a persistent and inverse relationship between inflation and employment. As Irving Fisher discovered in 1926, prices tend to rise faster when unemployment is low and slower when it is high. Put differently, when inflation is high, unemployment is low and vice versa (see Figure 3.2 below). Given this reality, there is little agreement over how monetary policymakers should balance these two competing objectives.

2Since preferences are often common knowledge, explicit vetoes do not always have to be formally exercised. This is particularly true in the case of the president. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 12

On one end of the spectrum, the utility of labor groups is maximized under conditions of full employment so they prefer active growth in the supply of money since that helps produce their desired outcome. Debtors – such as homeowners, farmers, and students – exhibit similar preferences since a higher rate of inflation reduces their borrowing cost.3 Conversely, lenders and owners of capital prioritize price stability since low inflation is a necessary condition for their profitability. Hibbs (1977) sums up this division: “low and middle income and occupational status groups are more averse to unemployment than inflation, whereas, upper income and occupational status groups are more concerned about inflation than unemployment” (p. 1470).4 It is not surprising then that elected officials also exhibit divergent views over how to handle the distributional trade-offs inherent in monetary policy. Countries with right-wing governments tend to exhibit lower inflation than otherwise similar countries ruled by leftist politicians (Hibbs 1978). This is also true in the case of the US, where Democrats tend to have a higher inflation tolerance than their Republican counterparts (Samuelson and Hopkins 1977, p. 30–31).

2.1.1 The Importance of Central Bank Structure

Despite the amplitude (and temporal consistency) of these diﬀerences, monetary policy has never been a particularly active facet of the congressional portfolio. That is not because politicians have magnanimously decided to free this area from their partisan bickering. They have simply realized that, as is the case in certain other areas,

3Assuming this inﬂation is unexpected, as Faust (1996) points out. 4Using more blunt language, Johnson (1968) describes this divergence in monetary policy preferences as a prototypical case of class conﬂict between the bourgeoisie and the proletariat (p. 986). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 13

it is far less eﬃcient to make the day-to-day decisions of monetary policy via the legislative process than through an external body of specialists (Epstein and O’Halloran 1999). As Keefer and Stasavage (2003) point out, this delegation makes all better oﬀ (see Figure 2.1 below).

Figure 2.1: Eﬃciency Gains from Delegation

The question then becomes how to delegate this policy issue to the bureaucracy. Politicians’ goal here is to “stack the deck” to ensure that the agency to which policy is delegated (the Fed) brings about outcomes consistent with their interests and those of their constituents (McCubbins et al. 1987, p. 255). Legislators generally try to do so in two ways: impose formal rules and strict guidelines over administrative procedures to minimize bureaucratic discretion and / or sculpt the structure of the institution to empower those with similar interests. In the case of monetary policy, relying on the former can be both inefficient and ineffective so Congress has traditionally focused on the latter mechanism.5 The uncertainty inherent in monetary policy adds to the appeal of the latter since “political officials may not know what specific policy

5Recently, Congress has begun more seriously considering how rules could govern monetary policy. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 14

outcome they will want in the future, [but] they will know which interests [they want] to influence [the] decision” (McCubbins et al. 1987, p. 255). The bottom line: these structural choices over the design of the central bank – as is true elsewhere in the bureaucracy – “have important consequences for the content and direction of policy, and political actors know it” (Moe 1989, p. 268). In the case of the Fed, the debate over its structure can be distilled into two fundamental questions: how centralized should control be and should that control be in the hands of public or private actors (i.e., those politically appointed or not)? Importantly, however, this latter question of who possesses control of the institution only matters insofar as control exists at all. As Lauchlin Currie, an economist working on the Fed reforms in 1935, described “assuming, therefore, that it is desirable to have discretionary control, and that control must be centralized and exercised by a body which has both authority and responsibility, the issue becomes public versus private control” (2005, p. 271). This intuition is displayed in Figure 2.2 below: the area under the curve (shaded in light green) represents what is feasible. With low levels of centralization, a high degree of political influence is impossible. Under high levels of centralization, though, control can be highly politicized or not at all.6 Most individuals, with moderate simplification, can be classified into favoring a central bank structure resembling one of four possibilities, represented by points

Introduced by Bill Huizenga (R–MI), Vice Chairman of the Monetary Policy and Trade Subcommit- tee, and Scott Garrett (R–NJ), Chairman of the Capital Markets and Government Sponsored Enter- prises Subcommittee, H.R. 5018, the Federal Reserve Accountability and Transparency (FRAT) Act, attempts to move monetary policy towards a rules-based approach. Given the lack of Democratic support, though, the probability of this bill becoming law remains low, at least for now. 6In this chapter, I use the term “politicization” to connote high levels of public control. Put differently, as politicization (as I measure it) increases, policy outcomes become increasingly likely to reflect the interests of the median voter. Conversely, as it decreases, control shifts away from public officials and towards private bankers. Such a move would decrease the level of expected inflation. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 15

Figure 2.2: Possibilites in Central Bank Structure

A, B, C, and N on Figure 2.2. Debtors along with populists and those favoring higher employment tend to favor A. This is because high levels of political control are typically associated with a policy outcome they favor: higher inflation. Though this relationship has only been well documented empirically in the last thirty years (Bade and Parkin 1982; Alesina 1988, 1989; Grilli, Masciandaro, and Tabelline 1991), it has long been well known that, if able to, politicians will manipulate the money supply to serve their short-term interests, which usually leads to inflation. Exemplifying this, James Madison explained in his Federalist No. 44 that the Constitution’s Article I Section 10, prohibiting bills of credit and of laws impairing the obligation of contracts, was explicitly included to limit such practices. On the other hand, bankers and those favoring low levels of inflation typically prefer a highly centralized central bank they and their colleagues could control (option C in Figure 2.2). As Wall Street financier Paul Warburg put it, “central banking, like any other banking, is based on ‘sound credit,’ that the judging of credits is a matter of business which should be left in the hands of business men” (p. 175). It CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 16

is not surprising that he held this sentiment since empowering those with a similar background increases the probability that the decisions they make will be consistent with his own interests, chiefly a stable supply of money. In addition, centralizing the decision-making authority facilitates strong responses to financial instability, a role such individuals place high value on. Others prefer a third way (option B) in which centralization and politicization are both limited. Its supporters like this form of central bank structure since they see it as the best way to promote local economic constituencies and limit concentrated financial and political power (McCulley 1992, p. 272). The goal here is to make the monetary system elastic and therefore able to respond to the needs of the country’s small bankers and businesses (McCulley 1992, p. 274). Limiting power is also important, since such a decentralized structure facilitates self-regulation, which many in this group favor as a result of their adherence to the real bills doctrine. This theory regards government “interference” with the supply of money as unnecessary since the amount of credit automatically responds to the business cycle (Wicker 2005, p. 16, 95–96). Of course, there have been and surely always will be those reluctant to embrace any central bank. The reasons for supporting this option (N in Figure 2.2 above) are more diverse. Some simply reject the appeal of the need for a central bank, instead preferring an inelastic currency free from manipulation. Another rationale for this position is the concern that any central bank, no matter how its design, will eventually be captured by bankers and then used to promote those interests at the expense of all others. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 17

2.2 The Federal Reserve Act of 1913

Why was the Federal Reserve created in the first place? The US had gone many years without a central bank and, at the dawn of the twentieth century, there was little evidence that reform was forthcoming. The group favoring no central bank maintained significant power vis-à-visthe other groups and was thus able to easily prevent the few attempts at change. However, the panic of 1907 ended this equilibrium. Though the panic started with a loss of confidence in only a single enterprise, the United Copper Company, it quickly spread throughout the financial system as runs began on financial institutions that had lent to investors trading United’s shares. A week later, the Knickerbocker Trust Company, the third-largest trust in New York at the time, collapsed and many of its peer institutions followed suit within the month (Bruner and Carr 2008, p. 101). As a result of the panic of 1907, “the value of all listed stocks in the United States declined 37%, making it among the most damaging financial crashes of the 19th and 20th centuries, and affecting virtually every industrial sector” (Bruner and Carr 2007, p. 115). Despite the breadth and depth of its economic destruction, this event was seen as preventable. As Page and Page (1912) wrote, “crises occurred all over the world in 1907, but the distinction of a wasteful panic and its hideous consequences were reserved solely for the United States,” which was in the “conspicuous position” of lacking a central bank (p. 28). As Bordo (1985) puts it, when compared to Great Britain, France, Germany, Sweden and Canada, the US at the time was uniquely “susceptible to banking panics” (p. 6). Had there been a central bank serving as a lender of last resort, as there was, for example, in London with the Bank of England, the bank runs that had toppled so many of New York-based trusts, would have been CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 18

relatively easily addressed. That is, financial institutions could have met depositors’ demands for cash by tapping a credit line available at this “banker’s bank,” thereby restoring confidence in its financial status. Without one, though, private banks had a much more difficult time meeting these temporary liquidity constraints and, the many that could not meet the entirety of the demands on them were forced to shutdown. Realizing this and seeking to reduce the impact of future liquidity crises, policymakers abandoned the dominant paradigm of economic beliefs to that point, which had suggested that an inelastic currency was best for their constituents (West 1977, p. 53; Link 1954, p. 44). Put simply, the panic of 1907 represents the first cause of the Fed’s creation since without it, “it would have been impossible to overcome the inertia in Congress” surrounding financial reform (Willis 1923, p. 43). While the literature is largely in agreement that the panic of 1907 was a necessary condition for reform to the nation’s financial infrastructure, creating a central bank was not the only option available to policymakers interested in improving financial stability. An alternative approach would have been to instead focus on the underlying structure of the American banking system. In fact, moving away from the prevailing system of unit-banking may have been the most effective way to reduce the prevalence of banking panics in the first place (Bordo 1985, Calomiris and Haber 2014). The idea here is that allowing branch banking would greatly facilitate diversification among in banks’ balance sheets, thereby reducing firm-specific risk and, ultimately, stabilizing the overall system. The economic merits of branch banking were not necessarily controversial – after all, such a system had effectively prevented banking crises in Canada – but, politically, eliminating unit-banking was “infeasible” (Calomiris and Haber 2014, p. 184). Thus, Republican policymakers in power at the time had little CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 19

choice but to focus on the “next best” way to promote financial stability: dealing with the centrality of currency supplies and therefore turned their focus to the debate over the creation of a central bank (ibid, p. 185). Finally, there is the question of what was different about the panic of 1907 in comparison to its predecessors. After all, the US had numerous banking panics between 1836, when the country’s previous central bank, the Second Bank of the United States, had its charter expire, and 1907, but no monetary reform efforts succeeded following those other crises. The are two main distinctions between the panic of 1907 and those other crises. First, the “policy technology” of central banking was less developed prior to 1907. By this point, however, other developed countries’ central banks had refined their ability to serve as a lender of last resort in a way that began to differentiate their responses to panics. In particular, the Bank of England had succeeded in limiting the effects of a downturn in British financial markets in 1907 (Bordo 1985, p. 19). Second, though the depth of the panic of 1907 was not unprecedented, its breadth was. By originating in the systemically important New York-based trusts, this liquidity crisis spread throughout the economy, and more than any other time, affected a variety of industries and non-financial businesses. This degree of contagion has obvious political implications, as policymakers representing a variety of constituencies changed their views on the need for financial reform (Moen and Tallman 1999). Highlighting this, in his speech accepting the Republican nomination for president, William Howard Taft remarked, “This inadequacy of our present currency system, due to changed conditions and enormous expansion, is generally recognized.”7 In this reform-friendly environment, a second, more controversial question took

7Text of full statement is available at http://www.presidency.ucsb.edu/ws/?pid=76222. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 20

hold: how should a lender of last resort be structured? This was not an easy question for policymakers to agree on because serving as a successful lender of last resort also requires that the institution possess monopoly power over the supply of money. That is, for a central bank to be a true “banker’s bank,” it must be able to freely move surplus money to where it is needed and doing so without a uniform currency would be highly inefficient. Moreover, in certain circumstances, the amount of money needed to stabilize the financial system may not be offset by existing surpluses. Thus, the lender of last resort should also possess the ability to manipulate the supply of money since, with that authority, it can more easily address systemic liquidity constraints. Of course, however, this authority could be abused. For example, in the French Revolution, the National Assembly, a group of elected officials representing the bourgeoisie, tried to solve the country’s financial strains by issuing an abundance of assig- nats, its currency. This famously backfired, leading to hyperinflation that helped contribute to the fall of the government. The question for policymakers was how to balance these two concerns: an overly inelastic currency would continue to enable liquidity and banking crises, while an exceedingly elastic currency could provoke hyperinflation, which could be just as or even more economically harmful. As introduced above, different groups – and the policymakers representing them – had divergent preferences over the desired degree of currency elasticity. In addition, given the aforementioned need to delegate this monetary authority to an external agency, a debate emerged in Congress over how to structure this to-be-formed central bank. On this question, the literature is split over which groups achieved their desired outcomes. Some suggest it was merely the manifestation of private bankers’ interests (e.g., Kolko 1963). Correspondingly, Wicker (2005) suggests much of the credit for CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 21

the creation of the Fed should be given to Nelson Aldrich (R–RI), who served as an advocate for Wall Street on Capitol Hill and provided the initial suggestion for the re-establishment of an American central bank. Broz (1991) takes a similar if more nuanced approach in arguing the Fed came to be thanks to New York bankers, who wanted to increase their role (and the dollar’s) in international finance. However, these perspectives are in the minority; most instead suggest that the Fed was the result of legislative compromise amongst interested parties (Cushman 1941, Wiebe 1962, Clifford 1965, West 1974, Woolley 1984, White 1985, Kettl 1986, Greider 1987, Calomiris and Haber 2014). Jeong, Miller, and Sobel (2008) speak for much of the literature in arguing that the legislation was the “product of political compromise among disparate groups represented in the US Congress” (p. 473) and therefore represented “no party’s first choice” (p. 491). They acknowledge that this conclusion comes despite the Democrats’ possession of unified control of government. As they put it, “the final outcome was not the ideal point of the median of the majority party, [but] rather was in the ‘empty’ space close to the center of the Senate” (ibid). While I agree with this suggestion that that the bill represented a compromise, I disagree with the notion that it was approximately an even split between the two parties. Instead, I argue, using the theory grounded in the spatial model introduced above, the bill was a compromise amongst Democrats alone, a novel argument. The reason for our different interpretations is straightforward: their reliance on roll call votes leads to an assumption that all congressional Democrats preferred a decentralized institution yet were opposed to making it independent. While I do not argue against this specific conjecture (see Table 2.11 in the Appendix), it ignores the truism introduced above that a central bank cannot be simultaneously highly politicized and CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 22

decentralized. This explains the existence of an important split within the Democratic party, with some in the party prioritizing decentralization and others politicization. Thus, the outcome we observe – the Federal Reserve Act of 1913 – is not the result of a centrist olive branch to Republicans, as they suggest. Rather, it is the result of intraparty bargaining between the two groups of Democrats forced to bifurcate by the constraints inherent in designing a central bank’s structure. Moreover, that some Republicans voted for it is not an indication that Democrats sought out their support; those that did were simply expressing a preference for some central bank over none (see Figure 2.6). In the subsequent two subsections, I provide support for this argument. In the first, I focus on the failure of Republican efforts to establish a central bank. They were also divided over how to proceed with reform and, by the time the two sides could come to a mutually beneficial agreement, they lost control of government. The second subsection turns to focus on the Democrats. Following their takeover of Congress and the White House in 1912, they succeeded where their Republican counterparts had not: quickly coming up with an alternative both preferred to the status quo. With neither Democratic group interested in vetoing the bill, it easily passed in 1913. Though almost all of the literature discussing this original act stops at this point, significant reform of the Fed’s structure was still to come, points discussed in sections 2.3 and 2.4 of this chapter.

2.2.1 Republican Monetary Policy Reform Eﬀorts

Following the shift in public opinion induced by the panic of 1907 described above, the Republican party leaders realized they needed to act to avoid losing control of CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 23

Congress in the upcoming 1908 elections (Wicker 2005, p. 42). The question was how to do so. While few desired a continuation of the status quo, the party, like the country more broadly, was split on how to proceed with longer-term policy change (Broz 1997, p. 172). At that point, the party’s primary dividing issue was over how currency should be issued, a question with important implications over the expansiveness of the money supply. Speaking for western and midwestern bankers, Charles Fowler, chairman of the House Committee of Banking and Currency, and his likeminded colleagues advocated giving their districts financial institutions monetary policy autonomy (Wicker 2005, p. 35, 42). Their ideal was to allow these commercial banks to issue currency backed by their own assets (Broz 1997, p. 168). The eastern wing in the party, however, had a different, more restrictive vision. Nelson Aldrich, chairman of the Senate Finance Committee, represented the interests of New York financiers by opposing such asset- based currency, instead preferring currency be issued on the basis of bonds (Wicker 2005, p. 42). Unable to resolve this difference during the 1908 congressional session, but still wanting to show voters they had done something, the two party’s two divisions ultimately compromised and passed the Aldrich-Vreeland Act on May 30, 1908 without any Democratic support.8 This was a stop gap measure, though, with the issue of institutional reform delegated to the National Monetary Commission, a study group created by the act (Shull 2005, p. 40; Wicker 2005, p. 43). This delegation decision was not trivial. It enabled the forum of debate to move away from Congress’s committee system, which the two groups had exploited to produce one-sided bills

8This was possible since Republicans controlled the House of Representatives, Senate, and White House. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 24

with little chance of making it through the other house. The idea was that without the glare of the public spotlight, the commission would enable interested actors to “coalesce around a unifying institutional program” that would form the basis of a bill “acceptable to the most active constituencies” (Broz 1997, p. 174). What they did not anticipate was that this process would take quite a while. Per congressional tradition, Aldrich, the sponsor of the bill creating the commission, was put in charge (Broz 1997, p. 173). However, distracted by congressional fights over the tariff and growing public apathy towards banking reform, he made little progress in the group’s first two-and-a-half years (Wicker 2005, p. 50). Fi- nally, in the fall of 1910, Henry Davison, a partner at New York-based JP Morgan & Company, persuaded Aldrich to convene a secret meeting on Jekyll Island, Georgia, where the group could finally hash out a proposal (Wicker 2005, p. 57). To maximize efficiency, these highly secretive meetings were only attended by a few individuals, all with backgrounds on Wall Street.9 This strategy worked well: after a week of meetings, the group had a clear proposal. Led by Warburg, a German-American immigrant who “strongly advocated” a European-style monetary system, the group called for the creation of a central bank (West 1977, p. 55; Broz 1997, p. 142).10 Their rationale was that the re-establishment of such an institution would eliminate the “perverse elasticity” and “short-term rigid- ity” inherent in the country’s money supply by facilitating transactions among institutions dealing in national bank notes (Broz 1999, p 43). This institution would also

9Besides Aldrich and Davison, only four others attended: Frank Vanderlip, vice president of National City, the largest bank in New York, Paul Warburg, partner at Kuhn, Loeb & Co., a Wall Street investment bank, A. Piatt Andrew, a PhD economist serving as the group’s research director, and Arthur Shelton, Aldrich’s personal secretary (Wicker 2005, p. 52). 10Demonstrating the apparent importance of the European example, Aldrich “became a convert to [this] viewpoint” after touring the continent and attributing the continent’s (relative) ﬁnancial stability to their central banks (Wicker 2005, p. x). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 25

mitigate liquidity pressures in the financial system by facilitating the smooth flow of capital from banking centers (primarily on the East Coast) to agricultural areas previously plagued by seasonal fluctuations in available currency (Calomiris and Haber 2014, p. 184). While another policy response likely could have addressed these same issues – for example, Canadian policymakers responded to the panic of 1907 by implementing new regulations over note issuances made in harvest season – opposition from rural interests would have challenged the political feasibility of such alternatives (ibid, p. 307). The objective of this proposed central bank – to be called the National Reserve Association – was clear: end the prevailing laissez-faire administration of money. It would not just do that, though: going further, the commission also proposed that the to-be-formed bank issue currency backed by both gold and commercial paper, thereby indicating that it preferred some discretion over the money supply (Eichengreen 2011, p. 25–26). With these two preconditions, the question was then where to align the proposal on the two-dimensional space introduced in Figure 2.2. The group on Jekyll Island approached this decision carefully. While the bankers participating all seem to have wanted a highly centralized, apolitical bank – something similar to C in Figure 2.2 – they knew that obtaining passage of a bank with such features would be particularly difficult (West 1977, p. 55).11 This difference between what the Aldrich group wanted and what was politically feasible grew much more when the Democrats won control of the House in the 1910 midterm elections just days before the secret meeting in Georgia (McCulley 1992, p. 261). Thus, Aldrich and his advisers had little choice but to deviate away from their ideal in hopes of

11As a reminder, I use apolitical to signify control by agents representing private instead of public interests. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 26

winning the support of their western and midwestern colleagues. This group, represented by the leadership of the American Bankers Association, had agreed to support a central bank if it would accept commercial paper as collateral (i.e., endorse asset currency) and avoid control by partisan or Wall Street interests (Wicker 2005, p. 69; Broz 1997, p. 178). This latter proposal reﬂected this by recommending that the central bank be highly decentralized. Under the Aldrich group’s plan, there would be ﬁfteen regional branches that collectively made decisions on the discount rate but otherwise possessed autonomy (Wicker 2005, p. 69).12 To further cement the informal agreement between the two groups of bankers, the plan was also quite clear in its vision to “get the government out of the banking business” (McCulley 1992, p. 235).13 In essence, Aldrich’s plan (AP), publicly proposed on January 16, 1911, was a compromise between his preferred central bank governance structure (C) and that of his progressive Republican colleagues (B), representing bankers outside of New York and the eastern seaboard. This measure succeeded in one sense: most Republicans, like the broad cross section of bankers they were representing, preferred it to the status quo of no central bank (Broz 1997, p. 184). This logic is illustrated in Fig- ure 2.3 below, where Aldrich and his fellow eastern and establishment Republicans

12This mechanism would not be entirely direct. The central bank was to have forty-five directors allocated across four classes. The first would be the representatives of each branch (15 directors), the second from commercial interests (15), the third selectees of the individual branches (9, but with weighted voting rights), the fourth would come from the federal government (6). This last group, a token to those favoring government participation, would be comprised of the secretary of the treasury, the secretary of commerce and labor, and the comptroller of the currency in addition to three governors to be selected by the president (Broz 1997, p. 181–182). 13To make the institution unambiguously private, the plan made the to-be-issued currency a liability of the bank alone (i.e., not the federal government) and, correspondingly, the stock to be held exclusively by member banks. As Aldrich put it, the National Reserve Association would serve as an “agency and tool” of the banks (McCulley 1992, p. 235). The only offering the Aldrich plan made towards those favoring politicization was to grant the president the authority to appoint six members of the thirty-nine member board (ibid). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 27

are notated by R1 and his progressive counterparts R2. The area shaded in light red represents the policy space that both groups prefer to the status quo.14 Aldrich’s compromise plan (AP) is easily within this set. Figure 2.3: Republican Preferences Over Central Bank Structure (1911)

The problem for Aldrich, however, was that Democrats were far less supportive. Having gained control of the House of Representatives, the Democrats possessed an effective veto over what could pass the Congress. Moreover, they made it clear that they were unwilling to engage in banking reform, at least until the 1912 presidential election (Shull 2005, p. 41). As the Wall Street Journal put it at the time, “the coming Democratic congress tends to reduce the chances for the establishment of the highly necessary central bank” (WSJ, Nov. 12, 1910). With firm control over the agenda, the party chose to instead focus its resources on investigating the money trust. The party’s leadership, newly installed Speaker Champ Clark and Majority Leader Oscar Underwood, figured this strategy would help them make further gains in the next election and they could then tackle this subject on their own terms (McCulley 1992, p. 261). That is almost exactly what they did.

14The area north of the possibilities frontier is not shaded since it represents a set of structural designs that cannot be achieved. Note also that both groups have strongly horizontal preference ellipses since they want to avoid politicization, even at the cost of moving away from their desired level of centralization (see Table 2.11). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 28

Following a recommendation of Representative Lindbergh (D–MN) to the House Rules Committee, Chairman Robert Lee Henry (D–TX), a staunch liberal, tasked Arsene Pujo (D-LA), chairman of the House Committee on Banking and Currency, to carry out an investigation of the “money trust.” Pujo’s hearings were immensely successful in achieving the objectives Clark and Underwood had hoped for. They “drove a wedge between New York and Chicago bankers... and by September [1912] small bankers were in open revolt” (Broz 1997, p. 192). By the time of the election, the Republicans had formally split into two parties with Theodore Roosevelt running under the Progressive label against his former co-partisan, William Taft.

2.2.2 Democratic Reform & the Federal Reserve Act of 1913

With all this momentum for the Democrats, the question then became how they would handle monetary reform. Like the Republicans, they ﬁrst had to overcome their internal division over central banking. William Jennings Bryan, whose “Cross of Gold” speech made monetary policy a lightning-rod issue in the 1896 election, led one side of the party. He appealed to voters in the agrarian west and south that strongly preferred the money supply be controlled by the government, not ﬁnancial interests (McCulley 1992, p. 268–269; Broz 1997, p. 198).15 Representative Carter Glass (D–VA) served as the leader of the other strand of the party that, like their conservative Democratic predecessor, Grover Cleveland, advocated minimum government intervention in monetary policy. Figure 2.4 illustrates this preference division in Democratic party. Glass and his

15As Bryan put it in a private conference with Wilson, “our party had been committed by Jeﬀerson and Jackson and by recent platforms to the doctrine that the issue of money is a function of government and should not be surrendered to banks” (As quoted in Link, 1956, p. 208). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 29

Figure 2.4: Democratic Preferences Over Central Bank Structure (1912)

followers (D1) had an ideal structure similar to B, with strongly vertically oriented preference ellipses since they would rather have control by Washington than control by Wall Street. Conversely, Bryan’s group (D2) favored a structure resembling A, with their preferences ellipses shaped horizontally to reflect their desire that political control exist to the highest degree possible. Had there been no restrictions on the “possibilities” in central bank structure, agreement would have been easy and the bank would have been simultaneously decentralized and politically controlled. Alas, that is an impossible combination since the latter can only be achieved with centralization, so coming to a mutually beneficial agreement would prove to be more difficult. Its exact nature, though, would depend on which side of the debate the party’s presidential nominee, Woodrow Wilson, positioned himself. For his part, Wilson campaigned actively, if vaguely, against the Aldrich plan in the run up to the election. While this reluctance to move from “principle to details” could be partially attributed to his ignorance of the details of central banking, his posturing was likely a deliberate attempt to keep both wings of the party united on this issue, at least until after the election (Link 1954, p. 45; McCulley 1992, p. 271). Following his election on November 5, 1912, Wilson no longer had this flexibility and CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 30

was forced to align himself more precisely so that his party could start work on their own reform plan. Wilson made the safe choice by siding with Glass, who, thanks to Pujo’s retire- ment, was to become chairman of the House Committee on Banking and Currency in the 63rd Congress. The Glass-led contingent was also more numerous, having pre- vailed over the Bryan-Henry coalition of more liberal members in a vote of 115 to 66 in the Democratic caucus earlier that year (McCulley 1992, p. 263). Still, Wil- son’s choice was not taken easily by Samuel Untermyer, counsel for the Congressional “money trust” investigation, and the liberal representatives, who were not pleased to hear that Glass had begun working with the new administration to craft a decentralized version of the Aldrich plan (Link 1954, p. 47; McCulley 1992, p. 276). By December 26, Glass had formed a complete proposal and presented it to Wilson. It called for the creation of up to twenty privately controlled reserve banks that would “provide for local or home control” of monetary policy (Willis 1923, p. 145). Glass had proposed a more decentralized central bank than the Aldrich plan, though both oﬀered little monetary policy authority to government actors.16 Liberals, led by Bryan, and Untermyer, were not happy with this proposal. They not only refused to support Glass’s plan in its current form, but also introduced a counterproposal drafted by Secretary William McAdoo to create a bank under his jurisdiction at the Department of the Treasury (Link 1954, p. 47). Though this alternative had little chance of success, it, in combination with their broader rhetoric against the Glass bill, served as an eﬀective signal that the Virginian would have to modify his proposal to gain their support. Doing so was crucial, since, though the

16The only such role Glass oﬀered was “very limited supervisory powers” for the comptroller of the currency (Broz 1997, p. 195). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 31

liberals were outnumbered, they still possessed an effective veto over what could pass through both chambers. This is because Majority Leader Underwood and Speaker Clark were only willing to let legislation get to a floor vote if said bills had first received a clear majority vote in the Democratic caucus. The liberals exercised this veto on July 25, when enough of them serving on the Committee on Banking and Currency refused to report Glass’s bill to the caucus (Link 1954, p. 49). Following this incident, Wilson realized this intraparty conflict had to be resolved, so he convened a series of meetings with Glass, Robert Owen, the chairman of the new Senate Committee on Banking and Currency, and McAdoo between June 17 and 19. There, he announced that the government would possess exclusive control of the Board and treat the system’s notes as its own obligations.17 In essence, this update, introduced as the Glass-Owen bill on June 26, 1913, maintained Glass’s vision of a decentralized central bank, but moved control, to the extent it existed, from Wall Street to Washington (Broz 1997, p. 198; Willis 1923, p. 250). This shift is represented in Figure 2.5 below as the move from B (Glass’s original plan and his ideal structure) to what came to be called the Glass-Owen bill, a compromise between the former and the structural setup preferred by the liberal wing of the party. Though this did not move as far in the northeast direction as the liberal group (D2) had wanted, they realized that continued opposition was unlikely to move the legislation further towards their ideal, even if they could continue bargaining indefinitely. They also understood that their leverage vis-à-visGlass and his followers (D1) was limited and that the Glass-Owen bill was still preferable than a continuation of the status quo of no central bank (N). Thus, with GO firmly in the

17In addition to trying to unite his party, Link (1954, p. 48) suggests Wilson decided to pursue this course of action after his informal advisor, Louis Brandeis, insisted that this was the right thing to do. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 32

policy space preferred by both to the status quo, the liberal Democrats pledged their support for the ﬁrst time.18 This support was formalized on August 28, when the Democratic caucus overwhelmingly voted in favor of the bill: 116 were in favor and only 9 opposed (Link 1954, p. 50). Figure 2.5: Democratic Preferences Over the Glass-Owen Bill (1913)

As the Democrats moved forward with the Glass-Owen bill, Republicans were faced with a take it or leave it offer. They could choose to vote for the legislation or against it, with failure implying a continuation of monetary policy without the guidance of a central bank. The progressive side of the party, represented by R2 in Figure 2.6 below, realized that Glass’s plan, though further from their ideal than when initially presented, would still offer them the same level of utility as the status quo. Put differently, many in this group, representing the interests of small, non- eastern bankers, were basically indifferent between the two available choices of GO 18Link (1954, p. 48) described the compromise as “the absolute minimum that would satisfy the Bryan element, who wanted governmental operation of the entire system, and the most that Glass would concede, but it sufficed.” My spatial model suggests there were more options that would have been acceptable to both groups (the area shaded in light blue in Figure 2.5 represents this range of options), but the precise position of the compromise reflected the two groups’s power relative to one another. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 33

and N. As Henry Moehlenpah, president of the Citizens Bank of Clinton, Wisconsin, testiﬁed to Congress, many community bankers were “willing to take [their] chances with the government” (as quoted in Broz 1997, p. 199). Thereafter, Moehlenpah’s representative, Henry Cooper, a Republican from Wisconsin’s ﬁrst district, supported the Glass-Owen bill.

On the other hand, establishment Republicans (R1) were staunchly opposed to what they saw as the “Bryanized Banking Bill” that would lead to unsound monetary policy (Broz 1997, p. 199). Despite their hostility, however, this group of Republicans had little power to inﬂuence the bill. That is because though they preferred the status quo to the Glass-Owen bill, a preference clear to all, for the ﬁrst time since the panic of 1907, no member of the Republican establishment (e.g. Aldrich and Wilson’s predecessor, William Howard Taft) possessed a veto. Thus, the large Democratic majorities in the 63rd Congress were ultimately able to move forward with the bill.

Figure 2.6: Preferences Over the Glass-Owen Bill (All Groups)

In summary, though the Glass-Owen bill (GO) represented no one’s ideal policy, just as Jeong, Miller, and Sobel (2008, p. 491) reported, it was not a compromise of all CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 34

in the legislature. Rather, this arrangement was determined exclusively by Democrats since it was one of the few available that could gain the support of both groups in the party and therefore the crucial support of the veto-possessing legislators, namely the Democratic members of the two relevant committees. With this pan-party support, the leadership allowed the bill to make it to the ﬂoor, where it had more than enough support to be voted through. On September 18, the House passed the bill with 287 aye votes and 85 nays (see Table 2.1). Three months later, the Senate followed suit, though with less bipartisan support owing to the scarcity of progressive Republicans in the upper chamber (see Table 2.2). In both cases, Democrats voted overwhelmingly in favor, with only 3 out of a total of 341 voting against the measure.19 Following a quick conference, both houses accepted the ﬁnal bill and Wilson signed it into law, establishing the Federal Reserve on December 23, 1913.

Table 2.1: House roll call vote 33, September 18, 1913

Paired Paired Not Party Yea Nay Yea Nay Voting Present Total Democratic 248 3 3 0 36 1 291 Republican 33 81 0 3 16 1 134 Independent 1 0 0 0 0 0 1 Progressive 5 1 0 0 3 0 9 Total 287 85 3 3 55 2 435

Table 2.2: Senate roll call vote 184, December 19, 1913

Paired Paired Not Party Yea Nay Yea Nay Voting Total Democratic 47 0 3 0 0 50 Republican 6 34 0 3 1 44 Progressive 1 0 0 0 0 1 Total 54 34 3 3 1 95

19This small group of midwesterners, led by Lindberg, opposed any sort of central bank. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 35

Since the role of Republicans on the formation of this legislation is a dividing issue between much of the literature and me, I devote one final paragraph to it. Of the 92 Republicans from midwestern or western states (in the House and Senate combined) that cast a vote on the bill, 39 of these voted in favor. This ratio – 42% – is consistent with this subset of congresspersons being indifferent between the bill and the status quo (p > 0.10 in a 2-sided binomial test). This (modest) Republican support has led many in the literature to conclude that the bill was explicitly designed to acquire bipartisan support. Again, however, I disagree, since their voting rates are consistent with the idea that the negotiated settlement between the two Democratic groups would produce the same utility for them as the status quo (see R2’s indifferent ellipse in Figure 2.6).

2.3 The Fed’s Adolescence

The Fed’s trajectory was significantly altered in its early years, particularly by an event it had no control over: World War I. The country’s entrance into that conflict led to the introduction of a new monetary technology: open market operations. Pol- icymakers at the Fed soon discovered that this new policy tool could help smooth economic fluctuations, though it would only be powerful if done in coordination. The start of the Great Depression, another exogenous shock, revealed the extent to which this is true. The Fed’s multiple veto points at the time prevented an adequate monetary policy response, a result that exacerbated the extent of the downturn. Unhappy with this policy outcome and wanting to prevent its repetition, many came to favor making the Fed more centralized. Most of those making this move were unwilling to CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 36

see this increase in control go to the private-led reserve banks, since that would do little to increase the probability that the Fed’s policy choices would produce what their constituents wanted, namely an expansionary supply of money. Instead, they wanted to pair this change with a corresponding increase in the degree of public control (i.e., increase its politicization). Put simply, this shift (and the subsequent change in structure) would not have occurred in absence of these two exogenous events, which are described in detail in the subsections below.

2.3.1 World War I & the Start of Open Market Operations

While certainly a landmark piece of legislation, the final version of the Federal Re- serve Act offered only a broad outline concerning the institution’s structure. Final decisions about these details were instead delegated to the Reserve Bank Organizing Committee (RBOC), who ultimately decided which cities would receive a Federal Re- serve bank and exactly how many there would be (they could choose between eight and twelve).20 Following the implementation of the RBOC’s recommendations, the Federal Reserve System became operational on November 16, 1914. Just as Glass and Fowler had wanted, individual reserve banks were largely left to their own devices in conducting monetary policy in a way that reflected their districts’s unique financial considerations. In the beginning, the only way they were doing so was by altering the rediscount rate, the rate at which they made loans to their member banks by discounting eligible paper (now called the discount rate; Meulendyke 1998, p. 19).

20There were three members of this committee: the Secretary of the Treasury, William McAdoo, the Secretary of Agriculture, David Houston, and the Comptroller of the Currency, John Skelton Williams. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 37

World War I had two big effects on monetary policy, both of which played a significant role in the evolution of the Fed. First, oceanic freight came to a near halt. This greatly reduced inflows of gold to the US and led to a fall in the prices of many commodities (Meltzer 2003, p. 82). This decline in the money supply also raised the value of the dollar, which hurt exporters. Second, the country’s dramatic uptick in military spending was not completely offset by increased revenues. The administration turned to debt to finance the difference, increasing the country’s national debt from less than $1 billion (as of 1913) to almost $27 billion (Eccles 1954, p. 167). Seeking to simultaneously address both of these issues, Treasury Secretary McAdoo turned to the newly created central bank. As the ex officio chairman of the Fed’s board, he got the reserve banks to facilitate the sale of his department’s new “Liberty Loans.” This became the Fed’s “main wartime activity,” with half of Treasury’s debt issues going through the new central bank (Meltzer 2003, p. 85). Realizing it could use this activity led to induce changes in the money supply (Meulendyke 1998, p. 20), the Fed gained an important new tool of monetary policy that it came to rely on more and more. As a result, Federal Reserve bank credit soared (see Figure 2.7) and the supply of money followed suit (Calomiris and Haber 2014, p. 187).21 Benjamin Strong, Governor of the Federal Reserve Bank of New York (FRBNY), realized this instrument could not just “offset undesired changes in gold holdings,” but also “stabilize economic activity” (Meulendyke 1998, p. 22). In other words, these open market operations (i.e., the buying and selling of Treasury securities) could be used as a counter-cyclical policy tool, but only if done in coordination. Meltzer (2003) put it this way: “A more activist policy required more and better information, new procedures, and a new framework for deciding on policy actions” (p. 140).

21Data in the ﬁgure come from Schwartz (1982). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 38

Figure 2.7: Federal Reserve Bank Credit

Data Source: Schwartz (1982)

As a result, working with (and under pressure from) the Treasury, Strong set out to centralize the Fed (Meltzer 2003, p. 143–146). To do so, he helped created the Governor’s Committee on Centralized Execution of Purchases and Sales of Govern- ment Securities in 1922 (West 1977, p. 224). That nascent body was replaced with the more formal Open Market Investment Committee (OMIC) following a board res- olution adopted in March 1923. The idea was that this group would “coordinate purchases and sales of government securities by the twelve district banks” (Patrick CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 39

1993, p. 6). Membership in this new body, though, was limited to the governors of the reserve banks of New York, Boston, Philadelphia, and Chicago (Eccles 1954, p. 169). Nevertheless, it was relatively successful. Led by Strong, the OMIC helped coordinate the use of open market operations to successfully combat the 1924 recession (Meulendyke 1998, p. 23).

2.3.2 The Failure of Monetary Policy in the Great Depres-

sion

Still, the tipping point for substantial change had yet to come and the Fed continued to conduct monetary policy so as to not disrupt the gold standard. So while the OMIC shifted the Fed away from the original setup as spelled out by the Glass-Owen bill (GO) towards a new, more centralized institution, Q*, it could not go too far since, thanks to this persistence of the gold standard, the central bank still lacked signiﬁcant policy autonomy. In addition, this institutional change, demonstrated in the left half of Figure 2.8, only increased centralization by empowering the FRBNY, so the relative authority of the politically appointed Board slightly declined.

Figure 2.8: Eﬀect of the OMIC (left) & OMPC (right) CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 40

Despite being only a modest change, support for this reform was not ubiquitous. Many at the Fed continued to hold views closely aligned with the real bills doctrine and only reluctantly accepted this move towards centralization and the open market operations it facilitated since they provided a way for the reserve banks to increase their earnings (Meltzer 2003, p. 201). They were not, however, going to tolerate robust purchases since they viewed such actions as inflationary. This divide came to a head shortly after the stock market dramatically collapsed following the series of steep declines culminating in “Black Tuesday” on October 29, 1929.22 At that point, George Harrison, who replaced Strong in New York after the latter’s death a year earlier, tried to get the Fed to employ a similar strategy. This time, however, the central bank was much less successful. Though Harrison was able to overcome significant resistance in persuading the Board to permit the FRBNY to cut its discount rate from 6% to 2.5% (as of August 1930), he was unable to do so in the realm of open market purchases (Friedman and Schwartz 1963, p. 367–368). Since, by then, the latter had eclipsed the former as the most influential tool of monetary policy, the Fed’s overall response to the initial downturn was rather limited (Meltzer 2003, p. 259). Harrison’s ability to get the Fed to engage in collective action was further limited by the institutional change that replaced the OMIC with the Open Market Policy Conference (OMPC) in May of 1929. Adolph Miller, one of the original members of the Federal Reserve Board, initiated this move with the help of his colleagues adhering to the real bills doctrine following Strong’s death in 1928. Their goal was to use this legal maneuver to dilute the authority of the FRBNY, which they felt had, under Strong’s leadership, increased the level of de facto centralization at the central bank

22At this point, stocks were 40% below their record highs from only a month before. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 41

(Meltzer 2003, p. 195). Put differently, Miller and his allies wanted to reverse the changes that had moved the Fed’s structure from GO to Q*. In that sense, they were relatively successful. The OMPC expanded the decision- making apparatus, giving each reserve bank a seat at the table, though implementation of the group’s policies was again left to the five reserve banks comprising the OMIC (Patrick 1993, p. 6; Eccles 1954, p. 169). Still, under the OMPC, the board was unable to determine system policies and the governors of the reserve banks were unwilling to engage in robust open market operations (Patrick 1993, p. 13). Thus, by increasing the autonomy of the reserve banks (and decreasing centralization), this institutional restructuring, shown via the dotted arrow featured in the right half of Figure 2.8 above, limited the Fed’s ability to engage in counter-cyclical monetary policy. In terms of creating conditions conducive to effective monetary policy, this modi- fication was much less successful. The reason for this is simple: the new institutional arrangement gave the governors based outside of New York a policy veto. This was exercised only a month into the new monetary regime, when the executive committee voted down Harrison’s recommendation for continuing purchases of government securities at the rate of $25 million per week (Friedman and Schwartz 1963, p. 369). His attempts to persuade his colleagues to expand this position failed since they were convinced that increasing the money supply further would not help end the recession, which they figured would soon end anyways.23 In other words, many of them were adherents to the real bill doctrine and viewed continued monetary expansion as ineffective in the short-run and inflationary in the long-run.

23See OMPC statement in January 1930 and speech by Hamlin in 1930 (via Irwin 2013, p. 57). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 42

For the next year, the “stalemate” between Harrison and his colleagues continued, with the result being policy inaction with that status quo producing “monetary tightness” (Friedman and Schwartz 1963, p. 375–376). At this time, what Bernanke (2004) refers to as the “financial accelerator” took hold. That is, banks suffered losses from these market declines and responded by reducing their lending, which then reduced investment and economic activity. This decline in macroeconomic conditions further reduced the banks’ lending, so this vicious cycle continued. Nevertheless, enough Fed officials maintained the belief that monetary policy was not the solution that the central bank did not engage in robust action. The FRBNY reclaimed significant monetary policymaking authority when Britain left the gold standard on September 19, 1931 since that bank has “always had primary responsibility for international monetary relations” (Friedman and Schwartz 1963, p. 380). However, this did not result in what Harrison had been previously advocating – an aggressive round of asset purchases. Rather, he became primarily concerned with helping the US maintain the gold standard. To prevent gold outflow, the FRBNY’s

1 1 board of directors raised the discount rate from 1 2 % to 2 2 % at its October 8 meeting 1 and then again to 3 2 % a week later. During this period, Harrison’s “concern about gold inhibited his desire to expand Federal Reserve credit” so asset purchases were fairly limited (ibid, p. 383). This gold-based constraint was relaxed in the spring of 1932, allowing the Fed to partially overcome its inertia and begin a round of asset purchases of up to $250 million in securities (Puente 2014). However, only four banks – New York, Philadelphia, Cleveland, and Kansas City – actually chose to participate. This lack of collective action became a binding constraint as the FRBNY decided it could no longer “go CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 43

at it alone” (Meltzer 2003, p. 365).24 The beneﬁts of this mostly unilateral action were too limited for Harrison to justify its maintenance to his directors. Thus, the Fed began tapering its purchases and the System’s assets “remained almost precisely constant” for the rest of the year (ibid). Overall, the Fed’s monetary policy following the crash was “almost entirely passive” and, correspondingly, highly ineﬀective (Friedman and Schwartz 1963, p. 420). Prices and exports declined dramatically, economic production collapsed, and hun- dreds of banks failed.

2.3.3 First Steps Towards Reform

This unprecedented poor economic climate led to a sea change in the country’s politics. Voters turned against the Republican incumbents that had possessed unified control of government between 1921 and 1930. In that November’s election, Democrats gained 49 seats (net) and cut the Republicans’ majority in the House to a majority of only two. However, the 72nd House did not convene for another 13 months and, during that period, 14 Representatives-elect died. When the session finally began on December 7, 1931, Democrats organized a 219 to 212 majority. As a result, the Republicans no longer held unified control of government. The anti-Republican fervor reached a fever pitch by the 1932 elections, leading to a resounding victory for Democrats. Franklin Roosevelt handily defeated Herbert Hoover, winning 42 of the 48 states. Democratic senatorial candidates were also very successful, defending all of their incumbent seats and picking up an additional 12 to gain control of the upper chamber. In the House, Democrats greatly expanded the

24The FRBNY made up to 80% of the system’s purchases during this period. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 44

narrow majority they had gained in the previous session, holding 313 of the chamber’s 435 seats. For the ﬁrst time since World War I, Democrats possessed uniﬁed control of government (see Table 2.3).

Table 2.3: Congressional Elections: 1926–1932∗

Election Number: Party in Chamber Date Democrats Republicans Other∗∗ Power 70th House Nov. 2, 1926 194 238 3 Republicans 70th Senate 46 48 1 Republicans 71st House Nov. 6, 1928 164 270 1 Republicans 71st Senate 39 56 1 Republicans 72nd House Nov. 4, 1930 216 218 1 Democrats† 72nd Senate 47 48 1 Republicans 73rd House Nov. 8, 1932 313 117 5 Democrats 73rd Senate 59 36 1 Democrats ∗Data source: oﬃcial House & Senate histories; totals are based on election day results. ∗∗In the 70th House, there was one Socialist; otherwise all were in the Farmer-Labor party. † See explanation above.

In additional to these sweeping changes in the partisan composition of Congress, the Fed’s monetary failure had important implications for the real bills doctrine. Prior to the Great Depression, many Democrats (and some progressive Republicans or those in R2) had used the real bills doctrine doctrine to justify their support for a decentralized monetary system and opposition to increased lending by the reserve banks. Since World War I, this group had seen the possibilities oﬀered by counter- cyclical monetary policy – particularly during the responses to the recessions of 1924 and 1927 – but its absence was even more powerful. The dearth of open market operations following the 1929 stock market crash had been exactly what the theory recommended, but obviously had disastrous results (Friedman and Schwartz 1963). Put simply, the economic events between 1929 and CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 45

1933 “exposed the fallacies” behind the theory that had, until then, provided a primary theoretical justification for this decentralized monetary system (Patrick 1993, p. 10). Thus, most turned against it, instead preferring a more activist monetary policy. As Faust (1996) described, “the desirability of the gold standard anchor was widely questioned, and many key players came to view monetary policy as a discretionary art” (p. 272). Responding to this “national consensus [against] an automatic monetary policy regime,” President Roosevelt took the country off the gold standard shortly after his inauguration on March 4, 1933 (Laughlin 2004, p. 271).25 Without the constraint of the gold standard, Fed officials were free to pursue policy as they saw fit. How- ever, the system’s would only be able to maximize its recently increased potential to serve a counter-cyclical economic policy tool if its members could agree to engage in coordinated action. As before, though, this remained elusive. As the Fed continued its pattern of policy inaction, the political context around it, like the country more broadly, was undergoing a significant shift. The decline of the real bills doctrine combined with the ending of the gold standard resulted in more becoming in favor of an activist approach at the Fed in which open market operations were expanded and the supply of money increased. Realizing the Fed’s structure was an institutional burden to such action, calls for reform to the central bank began. Many who had previously favored a diffuse division of power at the Fed came to instead prefer making the central bank more centralized and politicized. Using the language from the preference figures above, most Democrats had come to prefer A

(politicized Fed) to B (decentralized Fed) so, for the ﬁrst time, D2 contained more

25Though the causes of this action are not a focus of this chapter, that Britain had already done so may have also contributed to this decision by increasing its political feasibility. For those interested in why that country decided to take itself oﬀ the gold standard, see Morrison (2013). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 46

members than D1. That is not to say all underwent this evolution. Carter Glass (D–VA), now a senator, maintained his prior beliefs, continuing to prefer decentralization. Despite becoming a minority in his own party on this issue, he retained power thanks to his appointment as the chairman of the Senate Banking and Currency subcommittee, a position he had held since December 1930. With his party having gained agenda control in both chambers, he could ﬁnally pursue the overhaul in banking regulation that he had been working on since assuming that position, though he knew any such legislation would still fail without the support of the resurgent liberal wing of the party. Working with economist H. Parker Willis, who, like Glass, did not stray from his strong views in line with the real bills doctrine, Glass crafted legislation that he hoped would reduce concentrated ﬁnancial power and speculation, his chief culprits for the country’s economic malaise (Meltzer 2003, p. 429). With this goal in mind, Glass spent much of his energy on legislation requiring the separation of commercial and investment banks. While, as described above, much of his party had shifted away from Glass’s monetary policy views, the liberal wing of the party could still agree with this move meant to tame New York banks. For its part, the latter group, led by Henry Steagall (D–AL), the chairman of the House Committee on Banking and Currency and a populist champion of small banks, focused on establishing deposit insurance (Patrick 1993, p. 17; Calomiris and Haber, p. 190). This was a politically popular measure, with many depositors viewing it as a way to recoup the losses they had incurred from the countless bank closures (Meltzer 2003, p. 432).26 Glass had “opposed deposit insurance for years” but eventually

26Meltzer (2003) argues that had the Fed performed admirably as a lender of resort between 1931 CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 47

came to back a compromise proposal that authorized $2,500 of insurance to ensure the broader bill’s success (Meltzer 2003, p. 433). With this agreement, the two groups created the Federal Deposit Insurance Corporation (FDIC) as part of the Banking Act of 1933. The last measure the two sides worked to address was that of the Federal Re- serve’s structure. Blaming the FRBNY for exacerbating speculation via its purchases of Treasury securities, Glass sought to diminish its role in the system and limit open market operations more broadly. Other members of the party leadership, such as Steagall, accepted the ﬁrst part of Glass’s goal, but wanted to pair this change with an expanded role for the Board in D.C. Thus, the compromise the two sides reached mandated that reserve banks could only participate in open market operations if explicitly permitted to do so under board regulations (Krooss 1969, vol. 4, p. 2724-69). The board also gained authority in regulating banks, with the legislation permit- ting them to investigate any banks (not just members of the Federal Reserve System) under the same corporate umbrella as a member bank. It came to possess the right to limit the interest rate member banks could pay on time deposits as well (Patrick 1993, p. 16). In addition, the board was put in charge of relations between central bankers within and outside the system, taking the place the FRBNY had informally held until then (Patrick 1993, p. 188). This was combined with a move to modestly reduce political control over that group by increasing the tenure of board members from ten to twelve years, though, thanks to Woodin, Roosevelt’s ﬁrst Secretary of the Treasury, Glass was unable to remove the Treasury Secretary’s seat on the board (Patrick 1993, p. 188–189). and 1933, far fewer banks would have closed and thus the “political pressure for deposit insurance would have remained weak” (p. 433). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 48

To facilitate the implementation of these changes, the legislation replaced the OMPC with the Federal Open Market Committee (FOMC). While this new body represented “a step away from the idea of semiautonomous reserve banks, it did not abandon local operation” (Meltzer 2003, p. 430). For one, the reserve banks could refuse to participate in open market operations (Kennedy 1973, p. 210). Second, all twelve reserve banks possessed membership in the FOMC and chose an executive committee consisting of the same five members – Boston, New York, Philadelphia, Cleveland, and Chicago – and chairman, Harrison, as had been the case under the OMPC (Meltzer 2003, p. 436). Perhaps most importantly, the board lacked a voice on this new committee and could only approve or disapprove of its decisions after they had been made (Eccles 1954, p. 170). Though it provided what Glass wanted in the short-run by reducing the power of Harrison and the FRBNY, this was also true across the system, as all the reserve banks lost a degree of autonomy to the board (Meltzer 2003, p. 430). Thus, the creation of the FOMC in 1933 had an important unintended consequence, at least for Glass. For the first time, the political appointees on the board would play a non-trivial role in the conduct of monetary policy. However, few would be happy with this hybrid system in which neither the board nor the reserve banks possessed unbridled control and each side could veto the other. Needless to say, this “crippling” decision-making apparatus did not represent a sustainable equilibrium and it would soon be the target of a more robust reform effort (Patrick 1993, p. 16). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 49

2.4 The Banking Act of 1935

The changes brought about by this reform were only short-lived. Two years later, Congress passed and Roosevelt signed legislation overhauling the Fed’s design. Why did this occur? As first discussed in the previous section, the proximate causes were two exogenous events. First, World War I stimulated the invention of a new policy technology, open market operations, which monetary policymakers discovered could be used to reduce macroeconomic fluctuations. Relatedly, when the Fed’s structure prevented it from engaging in effective counter-cyclical monetary policy following the start of the Great Depression, an impetus for reform emerged. By exposing the fallacies of the real bills doctrine, this second economic shock (the Depression) strengthened the reform movement in another way: many moved towards a preference for a politicized and centralized central bank for the first time. While necessary, these stimuli were not sufficient to drive the resulting structural change in-and-of-themselves. This is because not everyone became amenable to making the Fed more politicized. This is particularly true among Republicans, who held control in Congress and the White House at the start of the Great Depression. For the Fed to be reformed, two additional conditions would have to be met. First, those unhappy with the status quo would have to replace those content with it (or at least outnumber them). Thanks to the widespread dissatisfaction with incumbent politicians produced by the Great Depression, this condition was quickly met. Democrats gained large enough majorities in the 1932 elections to possess unified control of government (see Table 2.3 above). The second condition – the removal of veto power from those opposed to the change – would come two years later, after Senate Democrats gained even more seats. This eliminated Carter Glass’s ability to CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 50

stop monetary reform legislation in the upper chamber. In the subsections that follow, I oﬀer a narrative account of the legislative process that culminated in the Banking Act of 1935, the legislation that reformed the Fed. To further establish the causality of the factors that I argue are behind this structural revision, I conclude this section with a set of counterfactual analyses. These reveal that without these factors, the change either would not have happened or at least not have been as profound. An additional counterfactual exercise suggests that what much of the listerature (e.g., Patrick 1993) attributes as a primary cause of the reform – the policy entrepreneurship of Roosevelt’s representative at the Fed, Marriner Eccles – was really just a reaction to the political environment at the time. So while it certainly helped ease the legislation’s passage, it is unlikely that the legislation would have failed without it.

2.4.1 Proposals for Further Reform

Following the passage of the Glass-Steagall bill in 1933, there was initially little interest from the administration in initiating reform, much less a robust one. Patrick (1993) put it this way: “if the system had been on trial during 1933 and early 1934, Roosevelt must have acquitted the defendant [since ...] after devaluation he told [Fed oﬃcials] Black and Harrison the reserve banks had acted satisfactorily and that he would do nothing to decrease the system’s inﬂuence or its power” (p. 233). This was not the case in Congress, though. A plan created by a group of economists at the University of Chicago (the “Chicago Plan”) calling for the Fed to be replaced by a to-be-created government-run “Federal Monetary Authority” was gaining trac- tion (Palmer 2010, p. 268). Alan Goldsborough and Bronson Cutting, members of CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 51

the House and Senate banking committees, respectively, introduced this plan as legislation in the second session of the 73rd Congress and gained support from several liberal Democrats and progressive Republicans (Phillips 1994, p. 558–559). Though this coalition comprised a minority of Congress, it still prompted the administration to begin considering how to improve the conduct of monetary policy, even before Eccles became involved. Morgenthau convened a group of experts in ﬁnance and banking to consider if and how to reform the nature of monetary policy in the country. This group, which became known as the “Freshmen Brain Trust,” spoke enthusiastically of the Federal Monetary Authority in the report they submitted to Morgenthau in September 1934 (Phillips 1994, p. 559). However, by that time, the Treasury Secretary had already become more invested in another committee he started, the Interdepartmental Loan Committee, that would focus more broadly on an omnibus banking bill. Aware of this interest in reform, oﬃcials at the Fed established their own group, the System Committee for Legislative Suggestions, in the summer of 1934 to prepare for what they saw as an approaching legislative debate on their institution. Harrison (from the FRBNY) served as chair of a reserve bank-heavy committee and only one member came from the board, Vice Governor J.J. Thomas (Meltzer 2003, p. 469). However, quite unlike the others interested in the subject, they wanted any subsequent legislative reform of their institution to preserve their operational autonomy. As this debate began to unfold, Marriner S. Eccles, a prominent banker in Utah, had started to gain a reputation as an outspoken advocate of counter-cyclical economic policy. Shortly before Roosevelt’s inauguration in 1933, he met with Stuart Chase, a “Roosevelt administration brain truster,” during the latter’s trip to Salt CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 52

Lake City (Kettl 1986, p. 47). Chase was enthusiastic about Eccles’s potential as a valuable ally for the incoming administration and recommended that Eccles meet with Rexford Tugwell during an upcoming trip to the East Coast. That meeting went quite well and by February 24, Eccles was in Washington testifying in favor of aggressive government spending in front of the Senate Committee on Finance (Patrick 1993, p. 252). Subsequent to this successful trip, Henry Morgenthau, Jr., Roosevelt’s second Secretary of the Treasury, asked Eccles to join him at 1500 Pennsylvania Avenue as a full-time advisor. For the next year-and-a-half, Eccles worked closely with the administration’s top economic officials on the National Housing Act, Reconstruction Finance Corporation, and various other New Deal programs (Patrick 1993, p. 252). Eccles was also an active administration surrogate at the legislative branch, working, for example, with the conference committee deliberating over the FDIC Act of 1934 in the waning days of the 73rd Congress (Patrick 1993, p. 200.57). Then, in the summer of 1934, Roosevelt began looking for a new chair of the Federal Reserve. His previous chairman, Eugene Black, had agreed in 1933 to take over temporarily, but was eager to return to his old (higher paying) job as governor of the Atlanta Fed. That September, Roosevelt interviewed Eccles for the job. Though eager to make his mark on monetary policy, the Utahan was not willing to accept any offer to take over the central bank unless the president would commit to substantive reforms of the central bank, highlighted by consolidating power in the board and, more specifically, the chairman.27 Roosevelt asked for more details about precisely what Eccles wanted to see change

27Eccles’s recollection of this back-and-forth with President Roosevelt is available at http: //fraser.stlouisfed.org/docs/historical/eccles/046_17_0003.pdf. Patrick (1993, p. 252) and Meltzer (2003, p. 467) also discuss it. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 53

and, on November 4, 1934, Eccles presented the president with a memo on the topic (Eccles 1951, p. 173). In it, he argued that as it stood now, the Fed’s “diffusion of power” made “inertia and indecision [inevitable]” (Eccles 1934, p. 2). He also pointed out how the actors with the most formal decision-making authority – the twelve reserve bank governors on the FOMC – “cannot help” but make monetary policy decisions with narrow banking interests, rather than broader social welfare in mind (ibid). Eccles’s solution can be boiled down to a single recommendation: power should be consolidated at the reserve board in D.C., with this group having “complete control over the timing, character, and volume of open market operations” (Eccles 1934, p. 1). He also argued that the reserve bank governors should not just be junior partners of the board in policy implementation, but also formally subordinate to them: he advocated giving the board the right to veto the appointment of any governor. Eccles was clear about his motivation for these structural reforms. If these changes could be implemented, monetary policy would finally be made to benefit the public’s interest. In other words, greater centralization and politicization of the Fed’s structure would facilitate effective counter-cyclical monetary policy and the use of monetary policy to expand economic activity (Egbert 1967, p. 72). Put differently, these reforms would help prevent the monetary inaction that exacerbated the depths of the Great Depression, a point Eccles’s advisor, Lauchlin Currie, had just made in the academic literature (Currie 1934). In addition to these long-term benefits, Eccles also pointed out that this reform would be of more immediate help to Roosevelt. He explained to the president how empowering the board would facilitate the $4 billion relief package the White House CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 54

was preparing to request from Congress. As Eccles (1954) describes, under the system created by the Banking Act of 1933, “a group of private individuals in the reserve banks had the latent power to block [this] program by damming needed funds by withholding the sort of action in Federal Reserve operations that could maximize” the program’s benefits (p. 187). Had Eccles not insisted on the importance of these changes, Roosevelt may not have come to have supported them as quickly as he did, but he was always likely to do so in the long-run. Eccles’s vision lined up nicely with his administration’s broader economic agenda and Roosevelt agreed to support Eccles in both his confirmation and reform efforts. He nominated Eccles to the board’s chairmanship less than a week later. Eccles formally took office on November 15, 1934, serving initially in a recess appointment since Congress adjourned months earlier. Per Roosevelt’s promise to Eccles, the administration quickly began planning comprehensive banking legislation. On November 26, 1934, Morgenthau announced his Interdepartmental Loan Committee, staffed with representatives from all bureaucratic agencies involved in banking, would be submitting a new omnibus banking bill in the new year. By January, the committee delivered on its promise and quickly gained Roosevelt’s endorsement. The specific (and primary) changes it made regarding the Fed’s structure – meant to bring it in line with Eccles’s ideal of a powerful central bank with limited private bank influence – are as follows:28

• Make reserve bank governors’ appointments subject to the approval of the Fed’s board.

• Limit the tenure of members of reserve banks’ boards of directors to six years. 28See fraser.stlouisfed.org/eccles/record.php?id=7801 for a digitized version of this document, “Outline of Proposed Federal Reserve Legislation.” CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 55

• Replace the board’s geographical quotas with educational requirements.29

• Enable the president to replace a member of the board whenever desired.

• Amend Section 12A of the Federal Reserve Act to limit membership in the FOMC to ﬁve members: the chair and two other members of the board along with two governors elected annually by their colleagues.

• Expand the deﬁnition of collateral eligible for discount at a reserve bank to include any member bank’s “sound assets.”30

• Allow purchases of any Treasury security, regardless of maturity.

• Repeal the requirement that the Fed hold collateral for outstanding Federal Reserve notes (i.e., circulating American currency).

• Give the board the discretion to adjust reserve requirements at all member banks.

Similar to those in the Aldrich plan proposed in 1910, this set of recommendations was not as sweeping as Eccles seemingly would have liked, but still close enough to his ideal and likely sufficiently moderate to appeal to the whole party.31 To ensure that this was the case, the administration decided to combine these structural proposals with two other popular measures. The first, to become Title I of the combined bill, involved an extension to the newly formed FDIC, while the other, Title III, focused on technical adjustments to the Office of the Comptroller (OCC).

29Theretofore, the board has to approximate a geographical cross-section of the country. The motivation for that rule was to promote decentralization. 30This was done to catalyze credit-based increases in the money supply. 31The obvious diﬀerence between the two being the former’s targeted Republicans instead of Democrats. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 56

The choice posed to Congress, then, would be a clear one: should these reforms – including strengthening the board – be passed or should the Fed maintain its theretofore structure and the country revert to a banking system without deposit insurance? There were costs and benefits associated with this approach. The risk was that by taking a hardline on the non-excludability of this “sandwich” legislation, the administration would not get its other banking reforms passed if Congress could not be persuaded that they needed to increase the politicization and centralization of the Fed. But that was more than offset by the benefits of doing so: combining all three aspects into one bill changed legislators’ decision-making calculus. Members of

Congress still preferring decentralization (those in the now-smaller D1) would only be inclined to vote against the banking bill if the changes to the Fed’s structure would reduce their utility more than the other two highly supported measures would add to it.32

2.4.2 An Increasingly Supportive Political Climate

Fortunately for Eccles, he had both the administration’s lobbying apparatus and the broader political wind at his back. In that November’s midterm elections, voters again expressed strong support for the New Deal. In the Senate, Democrats gained another 10 seats, pushing the total number of seats held to 69. They also expanded their majority in the House, with 321 of the 435 being Democrats (see Table 2.4). Despite the Democrats’ expanded majorities in the legislature and Roosevelt’s ever-growing political capital, there was still uncertainty about the probability of success for Eccles’s proposal. After all, not every Democrat wanted he did; the

32The degree to which this proved decisive in getting the legislation passed is discussed in greater detail below. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 57

Table 2.4: Results of the 1934 Midterm Election∗

Election Number: Party in Chamber Date Democrats Republicans Farmer-Labor Progressives Power 74th House Nov. 8, 321 104 3 7 Democrats 74th Senate 1932 69 25 1 1 Democrats ∗Data source: official House & Senate histories; totals are based on election day results. intra-party split over the ideal structure of the Fed continued into the 74th Congress. This divide was not particularly salient, though, in the House. The leadership in the lower chamber was united in favor of the legislation and the few of the party’s 300-plus rank-and-file members expressed a reluctance to support it. In addition, the bill’s pathway through committee was facilitated by the public endorsement of its chairman, Henry Steagall, and second-ranking leader, Alan Goldsborough (D–MD) (Egbert 1967, p. 110). This process even resulted in the bill becoming more slightly liberal. The committee added a mandate that the Fed pursue economic stability and expanded the power of the board by increasing the ratio of board members to governors from 3:2 to 8:5 (Egbert 1967, p. 111). These changes resulted in the submission of a new, otherwise similar bill, H.R. 7617. For their part, the bill’s opponents, led by committee ranking member John Hollis- ter (R–OH) and Everett Dirksen (R–IL), repeatedly tried to stop the bill in committee or at least alter it, but lacked the ability to do so. When it came time for the committee to approve the legislation, the 17 Democrats on it all voted in favor, while the 7 Republicans did the opposite (Egbert 1967, p. 111–112). From there, the bill went to the floor of the House, where Hollister continued his efforts to weaken Title II, provision-by-provision. His efforts were again in vain, however. Each of his four amendments were soundly voted down, as was his motion to recommit the bill (by a vote of 117-260). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 58

Following this, it was ﬁnally time for a full House vote on H.R. 7617. The legislation easily passed, with a largely party-line vote of 271 in favor to only 110 opposed and 2 voting “present” (see Table 2.5).

Table 2.5: House roll call vote 47, May 9, 1935

Paired Paired Not Party Yea Nay Yea Nay Voting Present Total Democratic 262 11 10 0 34 2 319 Republican 3 96 0 4 0 0 103 Progressive 4 2 0 0 0 0 6 Farmer-Labor 2 1 0 0 0 0 3 Total 271 110 10 4 34 2 431

2.4.3 Overcoming the Glass Veto Threat

The situation was much diﬀerent in the Senate, where Carter Glass, who continued – as he had since drafting the legislation creating the Fed in 1912 – to prefer decentralization. Having played such an important role in the system’s creation, Glass “regarded the system as his personal property” and was reluctant to see it change (Patrick 1993, p. 17). Moreover, any move away from the Fed’s extant structure would decrease his utility, a point he eagerly made to demonstrate his unambiguous opposition to the administration’s banking bill. This was not an idle threat either. Though he had chosen to chair the Senate Appropriations committee instead of the Currency and Banking one following the Democrats’ takeover in the Senate in 1933, in matters of banking he maintained de facto control in the upper chamber thanks to his colleagues deference to him (Meltzer 2003, p. 429; Patrick 1993, p. 167). As Senator Couzens put it, “most of us [senators] rely upon Senator Glass [in this policy area since he] knows that subject better than CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 59

any of us” (as quoted in Patrick 1993, p. 17). Thus, the bill’s passage hinged on ensuring this pattern of Glass dominating banking and monetary regulation in the upper chamber did not persist; if it did, the reforms would surely fail. As a first move, Glass set out to test the administration’s commitment to an omnibus bill. Like the rest of the committee, he supported the measures in the bill not pertaining to the Fed – Titles I and III – and figured, if he could introduce them on their own, he could avoid Eccles’s reforms to the institution he had helped create (Egbert 1967, p. 130). However, this initial effort failed: Morgenthau realized Glass’s strategy and had Roosevelt send the full bill to Congress, where the two relevant committee chairmen – Steagall in the House and Duncan U. Fletcher (D–FL) – formally introduced them as H.R. 5357 and S. 1715 before Glass could introduce his alternative legislation (Patrick 1993, p. 256). From here, the question became which body would gain jurisdiction over the newly introduced bill. Reflecting tradition, the Senate banking committee voted unanimously to give jurisdiction over the administration’s banking bill and Eccles’s confirmation to the Subcommittee on Monetary Policy, Banking, and Deposit Insur- ance that Glass chaired.33 While not unexpected, this move expanded his de jure authority and ability to veto the legislation he was so against. With this recently solidified leverage, Glass began his campaign to defeat the bill by defeating Eccles himself – that is, sink his confirmation. Though his opposition stemmed from strong differences of opinion over the ideal structure of the Fed, Glass focused the confirmation hearings on Eccles’s eligibility. He insinuated that Eccles was ineligible due to alleged ties with his former banks in Utah, though he lacked

33Meltzer (2003) reports that, since 1933, “all legislation aﬀecting banking and the Federal Reserve went through his subcommittee” (p. 429). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 60

evidence to substantiate his claims (Meltzer, p. 479.133; Hyman 1976, p. 174-175). Still, this may not have mattered had the hearings been held by the same body in the previous Congress. Glass’s subcommittee was then composed of two Democrats (Glass and McAdoo) and two Republicans (Townsend and Walcott) opposed to Ec- cles’s proposed reforms, while only one member, Robert J. Bulkley (D–OH), supported them (and him). Following the 1934 election, however, the subcommittee came to have more supporters than opponents. Three Republicans members of the broader banking committee in the 73rd Congress gave up their seats following the 1934 midterm elections. Hamilton Kean (NJ), Fred- eric Walcott (CT), and Phillip Lee Goldsborough (MD) all were strong proponents of eastern banking interests and would have opposed Eccles and his proposed reforms, but lost their seats to Democrats.34 The liberal Democrats elected to the seats previously held by the latter two – Francis Maloney and George Radcliff, respectively – replaced their predecessors on the banking committee as well. Kean’s seat on the committee was filled by a Republican, albeit a progressive one: Senator Bronson Cut- ting (NM). He held views quite unlike those of his predecessor, going as far as calling for the nationalization of the Federal Reserve system (Phillips 1994).35 Fletcher then used this shift in the overall composition of the committee (i.e., going from 12 to 14 Democrats and 8 to 6 Republicans) to justify changes in Glass’s subcommittee. Per Glass’s request, Walcott’s spot was filled by Senator James Couzens (R–MI), who had already served as a member of the overall committee and seems to have gained Glass’s respect there thanks to his expressions of similar views. For instance, Couzens criticized the Federal Reserve as early as 1927 for encouraging “a

34Goldsborough retired so he did not run. 35A. Harry Moore, who defeated Kean in November, chose to pursue a seat on the Interstate Commerce committee instead of the banking one. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 61

great orgy of speculation” (Barnard 2002, p. 193). However, he refused to promise to Glass that he would oppose Eccles upon being added. When the time came to make a decision, he did not seek Glass’s advice, turning instead to Charles L. McNary (R– OR), the liberal Republican leader of the Senate, who advised him to vote for Eccles (Weldin 2000, p. 63). Importantly, this was not the only change Fletcher, a staunch administration ally and reliable partner in financial reform efforts, made (Eccles 1954, p. 200-222; Egbert 1967, p. 144). On February 5, 1935, he announced the addition of three more additions to Glass’s subcommittee, all of whom were strong supporters of the New Deal: Cutting, James F. Byrnes (D–SC) and John H. Bankhead (D–AL). Done “without Senator Glass’s approval, and, it was said, without his knowledge,” this was a deliberate attempt to reduce the Virginian’s power on the subcommittee.36 This compositional shift ultimately played a critical role in preventing Glass from vetoing Eccles’s confirmation. It flipped the subcommittee’s alignment and supporters came to outnumber the opponents by a tally of five to three when that ratio had previously been one to four (see Table 2.6).37 This group thus looked past the paltry evidence Glass presented in opposition of Eccles and sided with the administration over Glass in this confirmation fight. On April 23, the subcommittee cleared Eccles by a vote of four in favor to three opposed, including Glass, the chairman. Acknowledging defeat, Glass then gave up on Eccles’s confirmation, showing up to neither the full committee meeting, where Eccles was approved unanimously, nor the floor debate over the confirmation. As a result, Eccles was easily confirmed by the overall Senate

36See The New York Times’s story from February 6, 1935, titled “Bank Bill Heads Into Warm Fight.” 37For more, see St. Petersburg Times, Feb 6, 1935, p. 1–2. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 62

the next day.38 To be clear, this was only possible because of the 1934 senatorial elections. Had the Senate’s Democratic to (conservative) Republican ratio not shifted, Cutting would have stayed off the Banking committee altogether and Byrnes and Bankhead would not have been added to the Glass subcommittee. Put differently, Eccles’s confirmation was only possible thanks to the 1934 election that further reduced the power of eastern Republicans and empowered in their place progressives and liberal Democrats. Though necessary, this compositional change was not sufficient in-and-of-itself to get Eccles through the subcommittee. Had a majority of the Republicans on it not supported him, he would never have been confirmed. In that sense, the partial splintering of the Republican party following the 1932 election was just as necessary in ensuring his confirmation. Specifically, three of the Republicans on the subcommittee Couzens, Cutting, and Norbeck were part of a group of “senatorial insurgents from [the west] [who] made common cause with the Roosevelt administration” (Morris 1960, p. 2). This progressive bloc, led by Norbeck, the committee’s chairman prior to Fletcher and Republican ranking member in the 74th Congress, did so since much of the New Deal “extended governmental powers to solve economic problems” (Fite 1948, p. 2; Horowitz 1997, p. 13). Eccles helped ensure that this was also true in the realm of monetary policy by submitting a supplemental report to Couzens and the rest of the subcommittee detailing how the Fed would have acted differently (and more successfully) had its structure in 1929 resembled the one he was proposing. This documented helped assuage any concerns of these senators and consolidated their support for his plan (Nelson 2012, p. 298). Glass’s next attempt at breaking up the bill leveraged time. On July 1, the

38As The New York Times put it, “senatorial opposition collapsed unexpected.” CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 63

Table 2.6: Membership & Preferences in the Glass Subcommittee

Date Date Reason Member Party State Added Removed for Change Supportive? Carter Glass D VA 5/29/30 No Sam Bratton D NM 5/29/30 1/19/31 Switched committees Peter Norbeck∗ R SD 5/29/30 Yes John G. Townsend R DE 5/29/30 No Frederic C. Walcott R CT 5/29/30 3/9/35 Lost seat in 1934 election Robert J. Bulkley D OH 12/14/31 Replaced Bratton Yes William Gibbs McAdoo D CA 3/9/33 Elected in 1932 No James Couzens R MI 1/3/35 Replaced Walcott Yes James F. Byrnes D SC 1/3/35 Appointed by Fletcher Yes John H. Bankhead D AL 1/3/35 Appointed by Fletcher Yes Bronson Cutting R NM 1/3/35 5/6/35† Appointed by Fletcher Yes ∗ Ex officio member without subcommittee voting rights. † Died in a plane crash during a visit to his home state of New Mexico. nature of coverage offered by the FDIC, as established two years earlier, would change drastically, and executive officers of national banks with outstanding debts to their institutions would be severely penalized. Few wanted either of these to occur and would both be solved by the other parts of the omnibus banking bill. Glass thought that if he could delay action on Title II (Eccles’s proposed reforms) and pass the popular Titles I and III, he would be able to defeat the reforms when they came up for a vote on their own later (Meltzer 2003, p. 479). While Glass was able to postpone hearings on Eccles’s full confirmation or the banking bill for a while, his plan was never destined to succeed.39 For Glass’s plan to work, we would have to not only gain the support of the rest of the Senate, but also the House of Representatives and President Roosevelt, who would have to sign Titles I and III on their own. Eccles and his supporters in the White House made it clear that they would not go along with it, standing resolute behind the omnibus package. “Confronted by a direct Presidential request, and backed by

39He rationalized this delay by saying he was focusing on a $4.8 billion relief measure that was part of his responsibility as Chairman of the Senate Appropriations Committee. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 64

a strong-minded Goldsborough, Steagall did [the same]” (Eccles 1954, p. 219). The Senate quickly followed suit and both houses passed resolutions postponing the dates of the unwanted changes by sixty days (Meltzer 2003, p. 483; Patrick, p. 264). Glass’s final move was to convince his colleagues on this subcommittee that Ec- cles’s proposal was counterproductive to economic growth. As Kress (1935) put it, Glass “challenged the validity of the philosophy apparently underlying Title II of the bill, and in this connection solicited the views of a number of leading economists and bankers.” Bankers from James Warburg of the Bank of Manhattan to Elwyn Evans of the clearing houses in Wilmington, Delaware railed against Title II’s attempts at centralization of monetary policy power (Egbert 1967, p. 128). Support for this view was offered by a bevy of academic economists, such as Edwin W. Kemmerer of Prince- ton, Oliver M.W. Sprague, and H. Parker Willis of Columbia, who testified against what they saw as the dangers of a politicization of monetary policy. The Economists’ National Committee on Monetary Policy, a group composed of 59 leading economists, also publicly came out against Eccles’s vision with their “Memorandum in Opposition to Title II of the Banking Bill of 1935.” These warnings failed to achieve their desired result, though, and momentum towards passage persisted. This was in no doubt due in large part to the continued public support of Roo- sevelt and Morgenthau. In fact, Roosevelt got Morgenthau to suggest to Glass’s subcommittee that the bill could push further towards politicization, going as far as saying he was personally in favor of at least partial government ownership of reserve bank stock (Patrick 1993, p. 280).40 The goal in doing so was to get Glass to realize that, though it may be difficult, the administration could likely get reform passed without his support, in which case it would be even extreme, so he would be best

40This was a resuscitation of earlier eﬀorts by liberal Democrat Oliver Cross in the House. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 65

served by starting to work with them. In essence, the administration was oﬀering to reduce the changes produced by the bill in order to expedite its passage.

2.4.4 Bargaining in the Glass Subcommittee

Faced with this string of defeats, Glass agreed to this trade, realizing that if he could not beat the coalition in favor, it would best for him to join them. By doing so, he could reduce the degree to which the bill would deviate from his ideal and therefore mitigate the decrease in his utility its passage would produce. Thus, we should not interpret Glass’s work on the bill as an approval of the changes and a “puzzling” change of heart from his theretofore support of decentralization, as Calomiris (2010, p. 551) does. Rather, he was simply acting as a rational actor seeking to maximize his utility in a constrained context. To do so, he worked with his subcommittee to amend the bill (S. 1715), which they finished on June 21 and submitted it to the full committee on July 1. This process brought forth several changes to the bill meant to reduce the politicization brought about by Title II. The first and most noticeable change was to replace the two ex officio members of the board with one new board member. Put different, the Secretary of the Treasury and the Comptroller of the Currency would no longer have a formal role at the Fed and the board would be comprised solely of seven members each appointed by the President. This move also affected the recommended ratio of board members to governors on the FOMC, reducing it to 7:5 from 8:5 in the House version (Egbert 1967, p. 130–131). This potential impact of this change was greatly expanded by an added provision CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 66

preventing more than four of these board members from being of the same party. The combination of these two modifications could catalyze the formation of a majority block on the FOMC with interests not aligned to the president’s. That is, the five reserve bank governors could partner with the three members of the board from the opposite party of the president to form a coalition of eight that could not be counterbalanced by the four co-partisans of the president. The subcommittee implemented other changes to the bill to further decrease potential politicization. It extended the terms of board members to 14 years and implemented a one-term limit. Glass’s revised bill also changed the frequency of the chair’s reappointment. In both the original plan and the House plan, that position would be filled yearly; in his, this would happen every four years and would not be altered by the presidential electoral calendar (Eccles 1935). The subcommittee made two other changes meant to reduce the expansionary effect on the money supply that the House bill would have. It removed the provision allowing Federal Reserve banks to discount on any sound assets. It also raised the threshold the board needed to alter reserve requirements by mandating that any such action would have to be supported by 5 of the 7 (Egbert 1967, p. 131). With the aforementioned partisan identification quotas, this would further constrain the president’s influence on monetary policy. Needless to say, Eccles, the administration, and their allies in Congress would have preferred that these changes not been made. Still, they represented an unambiguous improvement from the status quo of a decentralized Fed. For Glass and fellow Democrats still advocating an adherence to the real bills theory, the new bill was a clear improvement over the House version. Their utility would be considerably lower CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 67

in absence of these changes, though this revised bill was still a noticeable departure from their ideal of a decentralized central bank. Figure 2.9 below represents these changes, with the subcommittee’s markup represented as GA, Eccles’s ideal as A, and Glass’s as B. Figure 2.9: Bargaining Process Between Glass & Eccles

Both sides knew they would have to iron out their diﬀerences in the conference committee and were eager for this process to start. Thus, Fletcher and his liberal colleagues in the broader Currency and Banking Committee unanimously accepted Glass’s updates to the bill and sent it to the ﬂoor. Once there, the bill passed with such “scant opposition” that no roll call vote was taken (Patrick 1993, p. 266). Immediately following this vote on July 26, the Senate named six conferees: Fletcher, Glass, Bulkley, McAdoo, Townsend, and Norbeck.

2.4.5 The Final Steps Towards Passage

Upon receiving the Senate’s version of the banking bill, the House voted against accepting it as is since the Senate compromise was still too far from where they CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 68

knew they could get the bill to be. The legislation then entered the ﬁnal step in the process towards passage when the House named three members of its own – Steagall, Goldsborough, and Hollister – to the committee. In total, that body had ﬁve supporters, four Democrats and one progressive Republican, Norbeck, along with four opponents, half of whom were Democrats and half Republicans (see Table 2.7).

Table 2.7: Membership & Preferences in the Conference Committee

Member Party State Chamber Supportive? Duncan Fletcher D FL Senate Yes Carter Glass D VA Senate No William Gibbs McAdoo D CA Senate No Robert J. Bulkley D OH Senate Yes Peter Norbeck R SD Senate Yes John G. Townsend R DE Senate No Henry Steagall D AL House Yes Alan Goldsborough D MD House Yes John Hollister R OH House No

From the beginning there was conflict between the two sides. Goldsborough, Steagall, and the others in favor of Eccles’s reforms fought to protect the increased power of the board, while Glass and the opponents continued to work against them. In remarks delivered on the House floor, Goldsborough described this divide as one between those favoring control of the money supply by the people versus those favoring control by bankers.41 Following the negotiations, Glass claimed the final bill closely followed his vision. The conference committee’s decision regarding membership on the board, which they renamed the Board of Governors of the Federal Reserve System, would mostly follow the provisions included in the Senate plan. The Secretary of the Treasury and

41See Congressional Record, v. 79, pt. 13: p. 13711. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 69

Comptroller of the Currency would be removed as ex officio members, though an additional political appointee would be added, bringing the total to seven. Also per the Senate version, these members’ non-renewable terms would be raised from 12 to 14 years, with the chairman and vice-chairman appointed to those leadership positions every four years. Glass scored another win by keeping the geographic qualifications for board membership in place, thereby promoting decentralization. In aggregate, these changes helped reduce the increases in politicization made by the House bill, thereby making it more in line with Glass’s vision. Glass also claimed to have won on the composition of the FOMC. The conference committee decided this policymaking body would be composed of all seven board members along with representatives from five of the twelve reserve banks (Patrick 1993, p. 268). Though this reflects the revisions he made during the subcommittee markup process, it would be incorrect to conclude that this was a change he desired. After all, this new setup eliminated the monopoly the reserve banks had held on the Fed’s primary decision-making body.42 Following the bill’s passage, the reserve banks would be outnumbered by the Board. More importantly, the FOMC would no longer be distinguished by its complex web of veto possibilities that promoted decision-making paralysis following the Banking Act of 1933. Specifically, reserve banks lost their autonomy: they would now be obligated to participate in all open market operations, as decided upon by the FOMC.43 Such operations would also be expanded by the committee making “permanent the authority to use government securities as collateral for reserve notes” (Patrick 1993, p. 268). The same would

42Under the previous institutional design, the twelve members of the FOMC were the twelve reserve banks. See Meltzer 2003, p. 84. 43As Egbert (1967) put it, “all open market activities would be initiated, controlled, and executed by the FOMC only (p. 151). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 70

be true for the use of the discount window since the final bill broadened the use of eligible collateral for such loans, which were also to become subject to board approval (Meltzer 2003, p. 485). The claim that the legislation implemented Glass’s objectives becomes even more specious once one fully accounts for the biggest change induced by the bill: the empowerment of the Board. In addition to gaining control of a more authoritative FOMC, the board could now also unilaterally set reserve requirements, which, until recently, was a primary tool of monetary policy. As the House version had dictated, this could occur with a simple majority vote of the board (4 of the 7). Glass had thus failed in his effort to raise this threshold to 5 of the 7, which was itself still a significant deviation from his ideal of keeping such power in the hands of the reserve banks themselves. The Board also gained veto power over who was to lead the reserve banks. Once the district bank’s directors had appointed a new president (the new name for these positions, previously called governors), that individual could not start his five-year term until approved by the Board of Governors. Glass had tried to counteract this move towards centralization by taking an aggressive stance towards the president’s ability to control the board. This also failed. The provision he added in the subcommittee’s revisions restricting membership on the board to no more than four members of the same political party was stripped out, as was another he inserted mandating at least two members come from the private banking community.44 Even the main provision he had managed to keep to reduce politicization (i.e., the 14-year nonrenewable terms) lacked full bite thanks to a large loophole. That is, board members first appointed to fill an unexpired term could then

44See Congressional Record, v. 79, pt. 13: p. 13702. The latter provision had been included in the Federal Reserve Act of 1913, but was removed in 1922 (Meltzer 2003, p. 74). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 71

be appointed to a full 14-year term. This enabled Eccles to be eligible to serve until 1958 and another Roosevelt supporter on the board – Matt S. Szymczak – to remain there until 1961. The four-year cycles for chair also did not do much to reduce the ties between the administration and Eccles as the latter was reappointed as chair in each of Roosevelt’s three re-election years: 1936, 1940, and 1944. Once the conference committee had finalized this set of agreements on Friday, August 16, they referred the bill back to their two chambers, both of which promptly accepted the final bill, though no votes were recorded. The next Monday, President Roosevelt signed it into law. Though the final legislation may not have gone as far as Eccles and the administration had hoped, it still greatly increased the degree of centralization and politicization at the Fed. It also went much further in this direction than Glass had desired. As Figure 2.10 below demonstrates, the final version of the bill (FB) is unambiguously closer to Eccles’s ideal (A) than what Glass’s subcommittee had proposed (GA). As Nelson (2012) put it, “nearly all of the fundamental changes that Eccles wished to make in the System were achieved to one extent or another” (p. 313).45 The difference between the initial proposal and the what was actually passed can be attributed mostly to the work of Carter Glass, though it would be a mistake to overstate his role. That is, this set of reforms actually decreased his utility since it moved the structure of the Fed away from his ideal of a central bank in which decision-making authority is highly diffuse. Similarly, his public credit claiming for the bill (see Nelson 2012, p. 312) should instead be viewed as an attempt to maintain his

45Schlesinger (2003) echoes this sentiment: “the Banking Act of 1935 was, in every essential respect, Eccles’s original idea.... Whatever was lost in detail, Eccles’s basic philosophy of monetary control, his determination to transfer control of the money market from New York to Washington, survived intact. With the new law, the national government acquired indispensable powers for the management of the economy” (p. 301). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 72

Figure 2.10: Preferences over the Final Bill

political capital in the realm of ﬁnancial and monetary policy. Had he acknowledged the truth – the bill was actually counter to his preferences and was passed despite his continuous opposition – his reputation amongst the public would have been damaged so he chose to instead engage in subterfuge, a reality some in the press eventually caught on to (Eccles 1954, p. 230–231).

2.4.6 Counterfactual Analysis

In the subsections above, I discussed the process through which the Fed’s structural reform unfolded in 1935. In this subsection, I elaborate on how we know which factors were necessary for the change to occur and which were not. To do this, I rely on counterfactual hypothesis testing. With this approach, I estimate the outcome of interest – the Fed’s design – had the factors of interest not occurred. As Fearon (1991) points out, if the outcome we observe could have plausibly occurred in absence of these factors, then we cannot say it played a causal role. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 73

I apply this approach to test three hypotheses regarding the role of Marriner Ec- cles, the compositional changes in Congress, and the exogenous events (WWI and the Great Depression). I suggest the first factor – what the literature calls Eccles’s policy entrepreneurship – was not a necessary condition for the reform since Congress had already begun debating this issue on its own since a majority had become amenable to structural reform. Thus, while Eccles’s leadership and the administration’s support helped facilitate the legislation’s passage, we cannot definitively say that it would not have passed without it.46 The second test concerns the importance of the ideological and partisan composition of Congress. For the first several years of the Depression, Congress was controlled by Republicans, whose utilities would not be improved by these structural revisions. Thus, the change in government following the 1932 election was a necessary condition, though so was the further leftward shift in 1934 since that eliminated the veto power of Glass, a key opponent. Finally, I show how there is no reason to believe that Congress in 1935 was measurably more liberal than it was in 1913. Thus, the divergence in policy outcome regarding the Fed’s structure cannot be attributed to the composition of Congress alone. The factor that did change between these two Congresses (the 63rd in 1913 and the 74th in 1935) was preferences over central bank structure, which can be reasonably attributed to the creation of open market operations in WWI and the decline of the real bills doctrine after the start of the Great Depression.

46Of course, the bill likely would have failed without the administration’s approval of it, but that is a diﬀerent consideration. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 74

Marriner Eccles’s Leadership

I start with the role of Marriner Eccles. The question here is had Eccles not introduced his reform, would the Fed’s structure today be different? One way in which we can establish that he played a causal role as a policy entrepreneur is if there is evidence that further reform of the Fed’s structure would not have occurred without him and his proposal. As discussed above, there was already momentum for reform when Eccles became chairman. Thus, we can reasonably conclude that, with or without Eccles in a position of authority, the subject of the ideal structure of Federal Reserve would have been on the 74th Congress’s agenda. The next question then is whether the precise nature of the reform – represented as FB in Figure 2.10 above – would have been different without Eccles. On the surface, the answer appears to be an easy one. Since few had publicly endorsed what he proposed at the time he did, we are tempted to say that this was indeed the case. However, that ignores the reality that the two sides building momentum on this issue were on either side of him. The Chicago plan proposed a slightly more extreme version on what Eccles did, while the Fed’s System Committee for Legislative Sug- gestions countered with a plan to minimize politicization and maintain reserve bank autonomy. Thus, we cannot rule out that Eccles’s plan was not exogenous, but rather the result of shrewd political calculus. The final element to consider here then is whether Eccles played a vital role in tipping the scales in favor of the proposal he did propose. In this sense, Eccles also appears to have played an important role in getting the legislation through Congress. Exemplifying this, Eccles’s aforementioned memo to Senators Couzens helped convince the progressive from Michigan and his like-minded Republican colleagues that CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 75

his reform would lead to policy outcomes in line with their constituents’ interests. Again, however, the question that ultimately matters is whether he was the only one who could have ameliorated the doubts of these initial skeptics. We cannot defi- nitely conclude that to be the case. After all, even before Eccles, there was a group of administration officials and advisors who supported the idea of counter-cyclical fiscal policy and, correspondingly, reforming the Fed’s structure (Meltzer 2003, p. 420). This group was composed of Lauchlin Currie, a member of Morgenthau’s Freshmen Brain Trust, Harold Ickes, the Secretary of the Interior, and Harry Hopkins, Roo- sevelt’s federal relief administrator (Palmer 2010, p. 273). This group’s policy ideas had already been implemented in the first wave of the New Deal so it would be remiss to ignore their potential contributions had Eccles not been present. Overall, given Eccles’s central role in getting the Banking Act of 1935 passed, many are inclined to conclude the bill would not have passed without him. Raymond Clapper articulated this view in the Review of Reviews following the bill’s passage: had the weather been more cooperative during Roosevelt advisor Stuart Chase’s visit to Utah, Eccles would not have had the opportunity to deliver an impromptu speech about economic policy in front of him, an event that led to Eccles making his way to Washington and starting the process that led to the reform of the Fed. Thus, “a lot of important people in the East” that opposed the legislation wished Chase had gone the other direction and Eccles never made that speech (as quoted in Eccles 1954, p. 230). Palmer (2010) reaches a similar conclusion, arguing that this outcome was driven by Eccles’s apparently exogenous “supply” of this policy and would not have occurred without it (p. 291–296). However, as I have discussed in the paragraphs above, had Eccles never come to CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 76

Washington (i.e., those “eastern” opponents gotten their wish), the banking reform would still likely have unfolded in much the same manner. Contrary to what Palmer (2010) claims, this “supply” cannot have caused the outcome since it was itself a response to the economic and political climate at the time. In other words, Eccles’s alleged policy entrepreneurship was an endogenous phenomenon lacking truly causal importance.

Shifts in the Partisan Composition of Congress

That there was momentum for reform building even before Eccles and the administration formally proposed it was not random. As discussed in sections 2.3.3 and 2.4.2 above, there was sweeping changes in the partisan makeup of Congress. Prior to the convening of the 72nd Congress on December 7, 1931, Republicans had possessed unified control of government since 1921. And when the Democrats won majorities in both houses as well as the White House in 1932, it was the first time they had unified control since 1918. The Democrats then expanded their majorities in Congress two years later. While these elections clearly had an impact on the composition of Congress, that still does not prove that this was a necessary condition for the reform to pass. To determine if this was indeed the case, I test a simple counterfactual, asking whether the reform could have passed had the composition of Congress not changed. In other words, could Eccles’s proposal have passed in a previous session of Congress? To answer this question, I use a no parametric bootstrap procedure. I first sample with replacement from the population of the members of the House that voted on the bill. I then fit a logistic regression of the House vote based on the participating CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 77

legislators’s two-dimensional DW-nominate scores (Poole and Rosenthal 1997).

p ln( ) = β + β DW + β DW + (2.1) 1 − p 0 1 1 2 2 i

Third, using the predict function in R, I obtained the probability that each legislator

th th present at the start of the 70 –74 Congresses would also have voted yes (pi). With these individual probabilities, I calculated the compound probability that the bill would have passed the House and Senate during each of these sessions. The formula for doing so is as follows,47

N N Y X j ((1 − pˆi) +p ˆix) = qjx (2.2) i=1 j=0 where the quantity of interest is:48

N X qj (2.3) N j= 2 +1

This quantity is then stored and the entire process repeated 5,000 times. The results of this simulation (mean and 95% conﬁdence intervals) are presented below in Figure 2.11, with additional histograms shown in Figure 2.12 of the Appendix. The conclusion here is clear: prior to 1933, the bill would have failed since at least one house would have voted it down. Following the 1932 elections, though, Congress as a whole became suﬃciently liberal (the start of the 73rd Congress) to have passed

47N equals the total number of legislators voting (395). 48In the case of the Senate during the 73rd and 74th Congress, the Vice President was also a Democrat, so, in the case of a tie, Democratic-sponsored legislation, such as the banking bill, would N N pass. Thus, j just equals 2 in these two instances. In all cases, 2 is rounded up to the nearest integer. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 78

Figure 2.11: Could the Banking Act of 1935 Have Passed In Previous Sessions of Congress?

the bill had Eccles and the administration presented it. Still, though the bill could have passed a ﬂoor vote in 1933, it would never have made it there. As I detail in section 2.4.3 above (and display in Table 2.6), the composition of the Senate Subcommittee on Monetary Policy, Banking, and Deposit Insurance that Glass chaired was not amenable to passage until the 74th Congress. That is, in the prior Congressional session, Glass represented the majority of the members on his subcommittee in opposing a move towards centralization and the politicization in the Fed’s structure (see Table 2.8). Thus, if and, given tradition, more likely when, he gained jurisdiction over the legislation, the bill’s supporters would have been unable to prevent Glass from turning his opposition into a veto of the legislation. The subcommittee would not have even had to hold a formal vote to kill it; it could CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 79

condemn it by simply doing nothing.49

Table 2.8: Glass Subcommittee in 1933

Member Party State Supportive? Carter Glass D VA No Peter Norbeck∗ R SD Yes John G. Townsend R DE No Frederic C. Walcott R CT No Robert J. Bulkley D OH Yes William Gibbs McAdoo D CA No ∗ Ex oﬃcio member without subcommittee voting rights.

Once Couzens replaced Walcott and Fletcher added three new members to the subcommittee, this constraint against the bill’s passage was removed. With the path cleared, the bill could make its way to the ﬂoor where it was eagerly received and quickly passed. Had these compositional changes not occurred, the outcome we ob- served clearly would not have occurred. Thus, we can conclude these changes in the partisan makeup of Congress were necessary conditions for the bill’s passage and, in that sense, helped cause its success.

The Impact of WWI & the Great Depression

While necessary, the shifts in the partisan composition of Congress was not the only reason the reform occurred. After all, Democrats also possessed uniﬁed control of Congress in 1913 when the initial debate of the Fed’s structure was unfolding and they obviously came to a very diﬀerent outcome. In this subsection, I discuss the sim- ilarities in the two eras in both the partisan and ideological composition of Congress. As Table 2.9 (above) reveals, there were more Democrats in both the House and

49Unlike in the House where a discharge petition can be used to force a bill out of committee by a majority vote, discharges in the Senate require unanimous consent and thus would have been inapplicable in this instance, as they generally are (Gold 2013). CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 80

Table 2.9: Partisan Composition: 63rd and 74th Congresses∗

Election Number: Party in Chamber Date Democrats Republicans Farmer-Labor Progressives Power 63rd House Nov. 5, 291 134 1† 9 Democrats 63rd Senate 1912 51 44 0 1 Democrats 74th House Nov. 8, 321 104 3 7 Democrats 74th Senate 1932 69 25 1 1 Democrats ∗Data source: oﬃcial House & Senate histories; totals are based on election day results. †This representative switched from being a progressive Republican to an Independent in the 63rd Congress.

Senate during the 74th Congress than in the 63rd. However, once we account for policymakers’ underlying ideology, as measured by Poole and Rosenthal (1997), the data tell a slightly different story. According to the these scores, the average member in the House in 1913 was marginally more liberal on the (general) economic (first) dimension than in 1935 (p < 0.10; see Table 2.10). This is also true when looking just at Democrats. The median member of the Democratic caucus in 1913 has a DW- nominate first-dimension score of -0.334, while his counterpart in 1935 is estimated to have a -0.158 (see Figure 2.13 in the Appendix for a visualization of this). This pattern is even more apparent when focusing on Poole and Rosenthal’s (1997) second dimension. In both cases, the average member (and median Democrat) are estimated to have been more racially progressive, an unsurprising finding since the party had less of a presence in the south prior to the New Deal.

Table 2.10: Comparison of Ideology: 63rd and 74th Congresses

House Senate (Group Mean) t p- 95% CI (Group Mean) t p- 95% CI Measure 1913 1935 stat value of diﬀerences 1913 1935 stat value of diﬀerences DW1 -0.096 -0.058 -1.690 0.091 -0.082 0.006 -0.006 0.007 -0.298 0.766 -0.098 0.007 DW2 0.007 0.072 -1.820 0.069 -0.136 0.005 -0.221 0.044 -3.849 0.000 -0.400 -0.129

Given these ﬁndings, it is not surprising then that, using the same no parametric bootstrap method as above, I ﬁnd that the Banking Act would have almost just CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 81

as easily passed had the composition not changed at all between 1913 and 1935. Figure 2.14 in the Appendix below demonstrates this: the estimated number of “yea” votes in both houses is well above the minimum threshold needed for the bill to pass. Thus, we can reasonably conclude that a change in the general ideological composition of Congress did not drive this significant change in policy outcome. That difference must have instead been driven by another factor that changed in the 21.5 years that passed between the passage of the two bills. The candidates here are the obvious ones: World War I and the Great Depression. As discussed in detail above, the former demonstrated how open market operations and an activist approach to monetary policy more broadly could help smooth macroeconomic fluctuations. The latter then showed how damaging a lack of such action could be and thus provided the impetus for this sweeping reform.

Summary of the Causal Factors Behind the 1935 Bill

Why was the Fed’s structure reformed? As tempting as it is to say it stemmed from Eccles’s work, this was not causal. He was simply exploiting an opportunity created by the political context at the time. Partially as a result of the incomplete reform passed in 1933, reform of the Fed’s structure remained on the political agenda through 1934 and promised to be a focus of the 74th Congress. With the changes in the partisan composition of government induced by the 1932 election, reform of the nature that was passed became a proﬁtable opportunity since it would raise utility for much of the legislature. Still, had Glass’s veto power as the chairman of the relevant subcommittee in the Senate not been eroded by changes in committee membership produced by further CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 82

Democratic gains in the 1934 election, the bill would never had made it to a floor vote in the upper chamber. Although Glass ultimately became an active member of the “winning coalition,” it would be a mistake to view him as anything but opposed this reform. He only chose to negotiate in good faith since he wanted to limit the bill’s movement away from his ideal of a decentralized central bank. The final factor behind the bill’s success, and perhaps the most nuanced is the learning of monetary policymakers and their Congressional observers in the interwar period. Following World War I, many came to believe in the ability of open market operations to reduce the downside associated with the cyclicality of economic production. This trend only intensified as the Great Depression began. Had this learning not occurred, the events of 1913 would likely have been repeated and decentralization of the central bank continued. I can say this with confidence because, using the same econometric method described in the previous section, I estimated whether Congress could have passed the Banking Act of 1935 had the composition been identical to what it was in 1913. The answer, displayed in Figure 2.14 in the Appendix, is a resounding yes. Both houses have a predicted number of ‘yea’ votes well above the required threshold to pass.

2.5 Conclusion

Since the dawn of the 20th century, we have seen two major overhauls in the nature of central banking in the United States. First, in response to the panic of 1907, Congress set out to create the country’s third central bank. The legislation that body ultimately passed, the Federal Reserve Act of 1913, was the result of bargaining between two divisions within the Democratic party that held divergent preferences CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 83

over the central bank’s design. With more numbers and greater formal authority as chairs, the side favoring a decentralizing institution won out and the institution created mostly resembled their ideal structure. This changed, however, in 1935, when exogenous events induced changes in preferences and the side of the Democratic party in favor of making the Fed more centralized and politicized became more powerful. This switch in the balance of power within the party resulted in a corresponding change in the legislative outcome. Thus, the Fed’s institutional design came to empower the wing of the Democratic party in favor of making monetary policy more in line with populists interests, a structure that persists today. Had this not occurred, economic policy during the 20th century would have been quite different. Liberal interests would have played a less salient role in determining monetary policy and the potency of such policy would have been limited by an inability to coordinate across Reserve districts, as was the case prior to the structural reform produced via the 1935 legislation. So why have these changes not yet been undone or materially altered? The short answer is that there just has not been an opportunity to change it again. Though preferences evolved significantly during the early interwar period, following the bill’s passage in 1935, they stayed fairly constant, particularly while Democrats retained control of government during the Roosevelt and Truman administrations. When Republicans eventually won it back in the 1952 elections, they only had it for a single Congressional session and altering the structure of the Fed was not at the top of their legislative agenda. Republicans did not have unified control again until 2003 and, by that point, the long boom following World War II had mitigated interest in institutional reform of monetary policy. This is less true following the United States’s CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 84

2008 ﬁnancial crisis and subsequent Great Recession, so a continued persistence of the Fed’s structure is not guaranteed. That is particularly true if Republicans gain control of the White House and retain control of Congress following the 2016 elections, as they would have the most to gain by engaging in a third structural reform of the American central bank. CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 85

2.6 Appendix

Table 2.11: Partisan Preferences in 1913

Group Leader Constituency Ideal Orientation Rationale D1 Carter antifederalists B Vertical To the extent possible, Glass & RBD adherents Democrats would rather have D2 William populists A Horizontal control by Washington than Jennings & liberal control by Wall Street Bryan Dems R1 Nelson Wall Street C Horizontal Republicans want to avoid Aldrich bankers politicization, even at the R2 Edward non-eastern B Horizontal cost of moving away from their Vreeland bankers desired level of centralization Key: A = politicized central bank B = decentralized, private bank with autonomous branches C = centralized bank controlled by Wall Street CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 86

Figure 2.12: Histograms of Estimated Vote Outcomes: 70th – 74th Congresses CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 87

Figure 2.13: Diﬀerences in Ideology: 63rd and 74th Congresses CHAPTER 2. THE POLITICS BEHIND THE FED’S STRUCTURE 88

Figure 2.14: Could the Banking Act have Passed Had the Composition of Congress Not Changed Between 1913 and 1935? Chapter 3

The Fed as a Political Agent: How Partisan Central Bankers Allow Elections to Impact Monetary Policy

As the central bank for the United States, the Federal Reserve plays a vital role in the functioning of the American economy. For it to best achieve its goals of minimal unemployment and stable prices, scholars agree that the central bank must minimize the degree of political influence. That is, central bank independence is widely seen as being a necessary condition for low inflation and macroeconomic stability (for a review of the economic benefits of central bank independence, see De Haan and Eijffinger 2006).1 However, Nordhaus (1975) also points out that policymakers may abandon

1Since both of these economic outcomes are sought by policymakers from across the political spectrum, politicians generally agree with this point made by economists.

89 CHAPTER 3. THE FED AS A POLITICAL AGENT 90

these longer-term economic objectives by pursuing a strategy that instead prioritizes near-term growth since such a strategy may help achieve their political goals. In the realm of monetary policy, this entails becoming more likely to cut interest rates (or less likely to raise them) just before an election to provide a short-lived stimulus to economic growth. By helping to improve perceptions of the incumbent president, this approach to monetary policy may help the president (or his party) maintain control of the White House. Subsequent work has debated the presence of what Nordhaus (1975) refers to as the “political business cycle” in monetary policy, with evidence pointing towards its presence prior to de jure and de facto reforms enacted during Paul Volcker’s tenure as chairman of the Federal Reserve (1979–1987). Following this period, though, the literature is more mixed and, as of now, no consensus exists on the extent to which monetary policy is subject to political manipulation in the contemporary (i.e., post-1980s) era. In this chapter, I fill that void by testing the presence and uniformity of an electoral effect on monetary policy between 1989 and 2008. To do so, I hand-collect data on monetary policy recommendations from the transcripts of the Federal Open Market Committee (FOMC), the main policymaking body of the Federal Reserve. I then employ a multifaceted coding strategy to determine the partisan identities of each member serving on this committee during the twenty years of my sample. With these data, I test whether FOMC officials issue different recommendations shortly prior to elections than they do otherwise. These tests, which control for a variety of economic covariates available at the time of the meeting as well as official Fed projects of future economic performance, reveal a unique contribution. As an institution, the FOMC conditions, but does not eliminate, the impact of CHAPTER 3. THE FED AS A POLITICAL AGENT 91

partisan preferences on monetary policy. Put differently, although partisan actors are considered to desire the re-election of the incumbent president whenever the two are of the same political party, those preferences are not always expressed. This is because making a recommendation in the FOMC inconsistent with that of the median – and then getting rolled – is costly. Therefore, I only expect monetary policy recommendations to be explicitly made to help the president (or his party) win re-election only when the member issuing that recommendation shares a party affiliation with the president, the Board’s chair, and a majority of the committee. A pattern matching this hypothesis is then uncovered in the data. Statistical tests reveal the extent of a strong, but not uniform electoral effect on monetary policy. Specifically, I find that FOMC officials allow electoral interests to influence their recommendations when their party affiliation is the same as the president, the Board’s chair, and the median committee member. When these conditions hold for a majority of the FOMC – as they did in 1992, 2004, and 2008 – the result is a clear political business cycle in monetary policy. This effect is also apparent when comparing meetings held during political scandals, as coded by Nyhan (2014), to otherwise similar meetings held in politically calmer waters. These findings demonstrate how political biases change the manner in which policy is made at a supposedly apolitical institution, ultimately leading to what all can agree are economically suboptimal outcomes. This chapter proceeds as follows: in the second section, I introduce how monetary policy is made at the Fed. I next review the literature debating the presence of a political business cycle in monetary policy. In the fourth section, I offer my own theoretical framework of how elections affect monetary policy decisions, and, in the CHAPTER 3. THE FED AS A POLITICAL AGENT 92

ﬁfth, elaborate on my empirical approach to answering this question. I then present my econometric results and conclude with a discussion of the implications of these ﬁndings.

3.1 The Fed: America’s Central Bank

All national banks in the United States are required to be members of the Federal Reserve System.2 These financial institutions are then assigned to one of twelve regional Reserve banks, based on where they are headquartered (see Figure 3.1).3 As a condition of membership, these institutions must deposit 3 percent of their capital (i.e., the net worth of the bank, as calculated by subtracting its total liabilities from its assets) in their respective regional Reserve bank. The twelve of these then pool their resources and work together to provide value to their members banks – essentially their shareholders – by maximizing aggregate financial and macroeconomic stability in the US.4 This system is then overseen by a public body, the Board of Governors, which is composed of seven political appointees, including one chairman.5 To manage the system’s goals effectively, the Fed engages in three highly related activities. The first of these – regulating financial institutions – is designed to ensure that the system’s member banks are limiting their exposure to risk and are otherwise operating safely. Without such regulation, banks would be less likely to avoid

2State-charted banks may request to join as well. In total, there are approximately 2,900 member institutions. 3The geographic boundaries of the system were established by the Reserve Bank Organizing Committee in 1914 – shortly after the system was signed into law by President Wilson – and have never been altered. 4In addition to this set of public goods, the Reserve banks offer a more direct benefit to member banks by providing a yearly dividend of 6% of the paid-in capital stock. 5To be clear, all seven of these individuals are nominated by the president and confirmed by the Senate. CHAPTER 3. THE FED AS A POLITICAL AGENT 93

Figure 3.1: Boundaries of the Federal Reserve Districts

insolvency and more likely to fail, an outcome inconsistent with system stability. Of course, even if banks are fundamentally sound, the fractional reserve system in banking in which a bank has far less cash-on-hand than deposits creates the possibility of temporary cash constraints (e.g., the seminal scene from Frank Capra’s 1946 film, It’s a Wonderful Life). To alleviate such issues of illiquidity, the Fed acts as a lender of last resort, or the “bankers’s bank.” With the reserves it has collected from all its member banks (more on this below), it can provide loans to banks facing short-term cash shortages. Such action prevents needless and easily avoidable bank failures. The Fed’s last activity is to manage American monetary policy. Its objective in this capacity is to facilitate the operation of a uniform currency in the US in a way that smoothes macroeconomic fluctuations. The precise way to do so, though, is not always universally accepted. This is because the Fed is statutorily obligated to conduct monetary policy in a way that keeps both inflation and unemployment low, CHAPTER 3. THE FED AS A POLITICAL AGENT 94

though these two macroeconomic goals cannot be simultaneously attained. As first discovered by Fisher (1926), prices tend to rise faster when unemployment is low and slower when it is high. Put differently, when inflation is high, unemployment is low and vice versa (this pattern is now referred to as the Phillips Curve; Figure 3.2).

Figure 3.2: Phillips Curve

Making this trade-off decision more difficult is that the Fed is not required to prioritize one indicator over the other nor does it have to pursue specific targets in outcomes. In other words, the FOMC is free to decide exactly how much inflation is too much and what level of unemployment is too high.6 By not imposing strict inflation and unemployment goals on itself, that body ultimately leaves this decision up to each of its members, who independently decide how to handle this tradeoff. In essence, these officials are left to decide for themselves which is higher than desired – inflation or unemployment – and therefore whether the supply of money should 6This is not the case at all other central banks, as many have formal inflation goals that they must strive for. For example, the European Central Bank has a formal (and time-invariant) target of 1% inflation. CHAPTER 3. THE FED AS A POLITICAL AGENT 95

be lowered (if inflation is more pressing), increased (if unemployment is the larger concern), or maintained. To carry out this function (i.e., altering the supply of money in the economy), the Fed has traditionally had three available tools at its disposal. First, it can change the reserve ratio. That is, the Fed has the authority to alter the amount of funds a bank keeps as either cash-on-hand (i.e., “vault cash”) or in deposits at the district Reserve bank. Raising reserves will limit the amount of loans a bank can make, thereby taming inflation but also reducing economic growth and employment levels, while lowering reserve requirements has the opposite effect.7 However, since adjusting this ratio – usually around 10% – has substantial consequences for a bank’s operational budget and is a relatively coarse way to adjust the money supply, it is rarely changed. The second way in which the Fed conducts monetary policy is via the discount rate. This is the interest rate the Fed charges to banks wishing to borrow from Reserve banks.8 By directly providing cash to liquidity-constrained institutions, this tool has the advantage of enabling the Fed to simultaneously serve as a lender of last resort and adjust the money supply.9 For example, lowering the rate can simultaneously ease liquidity concerns among member institutions and lower a bank’s cost of capital, thereby promoting more lending and ultimately helping address concerns about weak economic growth.10 While certainly an important part of the Fed’s toolkit, the discount window has traditionally not served as the primary mechanism through which

7Since 2008, there has been a secondary dimension associated with this policy tool: the Reserve banks are now able to pay (variable) interest on these deposits. This adoption has helped the Fed keep the target and effective Fed Funds Rate close together. 8The riskiness of these loans is diminished by the fact that they are backed by collateral with a market value equal to or above the principal of the loan. 9In response to the recent financial crisis, the Fed greatly expanded the scope of the discount window by adding several new versions of it between 2007 and 2010. Chapter 4 focuses on this topic. 10The Fed will increase the discount rate if it is more concerned about inflation than growth and serving as a lender of last resort. CHAPTER 3. THE FED AS A POLITICAL AGENT 96

the Fed adjusts the money supply. That designation instead lies with the fed funds rate, which has been the Fed’s preferred method of conducting monetary policy for many years. In fact, lending through this mechanism has typically been ten times that of the discount window. Moreover, the fed funds rate – what one financial institution charges another to borrow (overnight) its Reserve bank balances – is traditionally lower than the discount rate since it eliminates the Fed’s role as a lending middleman. Despite these differences, policy decisions are motivated by the same reasoning: if inflation is too high, the Fed will recommend raising interest rates, but will recommend lowering them if it is unemployment that is too high. And, if neither is too high, then they will suggest maintaining the fed funds rate at the current level. Put differently, the fed funds rate is correlated with the state of the economy: decreases tend to occur during macroeconomic contractions and raises during expansions. Or as former Fed chairman, William McChesney Martin, liked to put it, monetary policy “leans against the wind” since the overall supply is inversely related to the business cycle. Demonstrating this, as the economy heated up in the early-to-mid 2000s, the fed funds rate increased to keep prices stable and interest rates moderate; it then fell drastically as the economy entered the “Great Recession” and unemployment rose dramatically. Importantly, the Fed does not possess direct control over the fed fund rates, unlike its two other monetary policy mechanisms. Instead, it sets a target rate and then directs a group of traders (managing the “System Open Market Account”) at the Federal Reserve Bank of New York to conduct open market operations – the buying and selling of US Treasury securities – to hit this target. If it wants the fed funds rate to fall, these traders will buy securities from “primary dealers,” which then deposit CHAPTER 3. THE FED AS A POLITICAL AGENT 97

the proceeds from these sales in the Fed’s member banks, ultimately expanding the latter group’s reserves. From here, basic economic principles take over: with more reserves (supply) in the system, the fed funds rate (prices) fall. The opposite is also true: the Fed can increase the fed funds rate (prices) by selling securities since that will lower the amount of reserves (supply) in the system. This last monetary policy mechanism is also set apart by being the only one of the three in which policy decisions are jointly made by the Reserve banks and the Board of Governors. The latter has exclusive control over setting reserve requirements and final say over the discount rate.11 In the case of the fed funds rate, though, policy is made in the FOMC, which includes officials from both groups. All seven political appointees serving on the Board of Governors are included on the FOMC. The body’s other five members come from the presidents of the twelve Reserve banks.12 The president of the Federal Reserve Bank of New York is always among these five (it has a permanent seat on the FOMC), while the other 11 presidents rotate into the committee every other or every third year.13 Given these inherent constituency-level differences, it is unsurprising that several scholars have found a link between officials’ “type” and the recommendations that

11Reserve bank directors set the discount rate every two weeks, but their decisions must be approved by the Board of Governors. 12The presidents are charged with running their respective Reserve bank and are selected by a 9-member Board of Directors. Six of these directors are elected by the Reserve bank’s member institutions, while the other three, including the board’s chair and deputy chair, are appointed by the Board of Governors. The Board of Governors also possesses a veto over the Board of Director’s selection for president and though one has apparently never been formally (or at least publicly) exercised, its presence does implicitly constrain the latter body as it makes its choice. 13The presidents of the Federal Reserve Bank of Cleveland and Chicago share one seat between themselves, so they rotate in and out of the committee yearly. The other three seats are each split between three Federal Reserve banks apiece: the presidents of Philadelphia, Richmond, and Boston rotate in one, Minneapolis, San Francisco, and Kansas City in another, and Dallas, Atlanta, and St. Louis in the third. CHAPTER 3. THE FED AS A POLITICAL AGENT 98

they offer. That is, as is reported in many other instances of policy delegation, presidents (or bankers) appoint individuals who will evaluate the tradeoff between unemployment and inflation in a manner similar to themselves (Chang 2003, p. 140). For Democratic presidents, who depend on voters, such as from laborers and borrowers, with a clear preference for higher inflation and lower unemployment,14 that means appointing those who are relatively more likely to suggest reducing interest rates. Conversely, Republican presidents are answering to business groups, high-earners, and savers who prefer a more balanced approach and a modest rate of inflation.15 This leads to a greater likelihood of supporting interest rate increases. However, the group most likely to do so is the Reserve bank presidents who are answering directly to bankers, whose profitability is generally maximized under conditions of low inflation. Evidence for this pattern comes from several sources. Samuelson (1977) shows that Democrats tend to have a higher inflation tolerance than Republicans (p. 30–31). Tufte (1978) demonstrates how the two parties’s platforms have consistently differed in terms of which issue they emphasize as needing improvement – unemployment and inflation – and generally enact policies to address these concerns. Similarly, Hibbs (1987) finds that Democratic voters tend to evaluate incumbent politicians based more on unemployment than inflation, while the opposite is true for Republicans (p. 177). Finally, Chappell, Havrilesky, and McGregor (1993), McGregor (1996),

14This preference is highly rational since, as Wolff (1979) reported, “inflation [can act] like a progressive tax, leading to a greater equality in the distribution of wealth” (p. 207). Moreover, as Minarik (1980) points out, “many if not most low-income households are protected [from price increases] by explicit or implicit indexing of their incomes”; as a result, they suffer relatively little from inflation, but may gain significantly from increased employment opportunities (p. 226–227). Similarly, cost of living adjustments help prevent social security recipients’ incomes from being adversely affected by inflation (ibid, p. 229). 15These groups are also correctly mapping policy decisions to utility outcomes since inflation erodes the wealth of those with accumulated savings (Minarik 1980, p. 229) and investments in capital and capital goods (Greider 1987, p. 40). CHAPTER 3. THE FED AS A POLITICAL AGENT 99

Falaschetti (2002) and Adolph (2013) all examine votes in the FOMC and assert that Democratic governors prefer lower rates than Republican governors. However, all of these analyses rely heavily, though not exclusively, on data from before the Volcker tenure. This is problematic since the Fed’s level of politicization is seen to have evolved since then (more on this below).

3.2 Do We Know if There is a Political Business

Cycle in Monetary Policy?

Most studies assessing the presence of a political business cycle in monetary policy have decided against pursuing this more fine-grained, individual-level analysis and focused instead on observable outcomes. For many years, this choice was inconse- quential since the evidence in favor of a political business cycle at the Fed was so strong. That is, many came to agree with Nordhaus’s (1975) claim that partisan actors want their party to maintain control of the White House and those working at the Fed are just as likely to use policy to try to attain this objective as their counterparts in other bureaucratic agencies. In the same sense, few contested Tufte’s (1978) assertion that the Fed acted to facilitate the president’s (or his party’s) re-election chances. Highlighting this, it was widely believed that President Nixon had strong- armed Arthur Burns into pursuing a highly expansionary monetary policy shortly before the 1972 presidential election (Rogoff 1990). This led to a bout of inflation that was not contained until President Carter appointed Paul Volcker to be chairman of the Board of Governors. Prior to that, Volcker had served as the President of the Federal Reserve Bank of New York and established CHAPTER 3. THE FED AS A POLITICAL AGENT 100

a reputation as a fierce opponent of inflation. Highlighting this, he had voted against the recommendation of his predecessor, George William Miller, to maintain the status quo in the spring of 1979, despite surging inflation. Moreover, when approached by the Carter administration about taking the reins of the Fed, Volcker was clear that he would only do so if Carter would commit to preserving the Fed’s independence and not interfere in any way with its decisions.16 When Carter agreed, Volcker accepted the job. Under his watch, the Fed quickly increased interest rates, which initiated a painful recession, but finally ended stagflation. This economic situation contributed to a swift defeat for Carter in the 1980 election, though “to his credit, President Carter honored his pledge not to pressure Volcker” (Meltzer 2010b, p. 1011). In addition to allowing Volcker to operate free of political inference (i.e., increase the Fed’s de facto independence), President Carter also signed two bills into that law that were designed to raise the Fed’s de jure independence by mandating that monetary policy follow clear long-term objectives. The Federal Reserve Reform Act of 1977 made price stability the Fed’s primary objective for the first time, while the Full Employment and Balanced Growth Act of 1978 introduced the aforementioned dual- mandate for the Fed of low inflation (i.e., stable prices) and maximum employment. Put together, these changes were seen as being a strong move towards full political independence for the Fed. As Waller (2011) puts it, “the Federal Reserve System is a well-designed institution, created by Congress, that keeps the government from relying on the printing press to finance public spending. It is independent, credible, accountable, and transparent” (p. 300). Following these changes, clear evidence of a political business cycle seemed to

16Volcker himself reports that he was “mainly concerned that the president not be under misun- derstanding about my own concern about the importance of an independent central bank and the need for tighter money – tighter than Bill [Miller] had wanted” (Volcker and Gyohten 1992, p. 164). CHAPTER 3. THE FED AS A POLITICAL AGENT 101

evaporate. Alesina, Roubini, and Cohen (1997) find strong support of a political business cycle in interest rates and monetary aggregates before the 1972 election, but no evidence thereafter. Abrams and Iossifov (2006) produce corroborating evidence. Following an analysis of monetary policy between 1957 and 2004, they argue that the Fed becomes more expansionary in the 7 quarters preceding an election, but acknowledge that this effect basically disappears during the Greenspan era (p. 257).17 In a follow-up study using the same data, Tempelman (2007) agrees with this, displaying null results when removing pre-Volcker data from the sample. Faust and Irons (1999) are also skeptical of the persistence of such an effect. Still, there are those that insist a political business cycle in monetary policy remains. Clark and Arel-Bundock (2013) contend that this effect is uniform in the entire sample between 1954 and 2008, though only under Republican administrations. That is, they suggest “the Federal Funds Rate declines as elections approach when Republicans control the White House, but rises before elections when the sitting President is a Democrat” (p. 1). Hellerstein (2007) reaches a different conclusion, suggesting that the Fed embraces inaction around elections and neglects to raise interest rates even when it should. Thus, the central bank is providing a short-lived implicit stimulus to the economy. This builds on earlier work done by Beck (1991) and Drazen (2001) pointing to a political business cycle generated by active fiscal policy and accommodated by passive monetary policy. While these outcome-based analyses have yielded relatively weak evidence in support of a political business cycle in monetary policy, two recent studies have taken a different approach by accounting for individual-level variation (Chappell et al. 2005;

17Their study also indicates that the presence of a political business cycle in monetary policy appears to be condition on the president and chair sharing the same party. I expand on this below. CHAPTER 3. THE FED AS A POLITICAL AGENT 102

Adolph 2013). This is a preferable approach for understanding how elections affect monetary policy since using the fed funds rate as the dependent variable is question- able, as “the FOMC cannot totally control the federal funds rate” (Chang 2003, p. 87). Interestingly, both studies present stronger results. In other words, they argue that “in-party” governors (what I call copartisans) on the FOMC are generally more “dovish” (i.e., likely to recommend easing interest rates) and become even more so around elections. However, several factors lead us to question the validity of these findings. First, they assume any electoral effect is uniform across parties. If Clark and Arel-Bundock (2013) are correct in asserting that the Fed only reacts to electoral pressure under Republican administrations, then their broad conclusion may be an overgeneraliza- tion. This could also be true if Abrams and Iossifov (2006) are right in their claim that there is only an effect when the president and the chair are members of the same party since Chappell et al. (2005) and Adolph (2013) do not account for the role of the party identification chair and the median FOMC member. In addition, these analyses assume the Reserve bank presidents are not partisan actors and therefore treated as a monolithic block. This misses a point raised by Tootell (1996): members of this group can be distinguished from one another on the basis of their partisan background.18 Finally, and perhaps most importantly, the data analyses in both Chappell et al. (2005) and Adolph (2013) rely heavily on data from the pre-Volcker era. Thus, their conclusion that there is an electoral effect on copartisans’ monetary

18While innovative, Tootell (1996) uses a very coarse measure of partisan backgrounds by simply looking at when presidents were appointed. The rationale is that since the Board of Governors can veto their appointments the presidents should share a political party with the chair. This ignores the point that this veto authority has never actually been exercised as well as the heterogeneity on the board in terms of partisan backgrounds. As discussed in much greater detail below, I improve on this. CHAPTER 3. THE FED AS A POLITICAL AGENT 103

policy recommendations may be being driven by the well-known pressure on the Fed prior to the Volcker era. Given these shortcomings, one can safely say the extent and presence of an electoral eﬀect on monetary policy preferences in the contemporary era (i.e., post-Volcker) has yet to be determined. However, by assessing this very question in the sections to come, I determine the exact conditions under which elections aﬀect monetary policy.

3.3 Theory

To derive an original testable hypothesis regarding how elections aﬀect monetary policy recommendations, I build oﬀ of a robust literature on economic voting that considers voters to be retrospective and economically minded when evaluating the president (Cohen and Noll 1991; Duch and Stevenson 2006; Fiorina 1978; Lewis-Beck and Paldam 2000). Moreover, following recent developments in this literature, I assume the incumbent president or his party are primarily evaluated on the basis of economic performance immediately preceding an election (< 12 months), rather than the full duration of his term (Achen and Bartels 2004).19

19This assumption treats voters as not fully rational; if they were, then they would evaluate the president based on the economic performance “over [his] entire term of office, with little or no backward time discounting” (Hibbs 2004, p. 7). However, as Achen and Bartels (2004) report, “the clear consensus in the literature is that recent economic performance is much more relevant at election time than what happened earlier” (p. 16). Uchitelle (2004) uses blunter language: “If the economy is flourishing in the final weeks of a campaign, when the music stops, the incumbent is likely to be re-elected.” Experimental studies have illustrated the psychological micro-foundations behind this phenomenon. Huber, Hill, and Lenz (2012) show that participants tasked with evaluating randomized computer “allocators” place significantly more weight on the payments most recently received. This short-term bias leads them to not choose allocators that offer greater total payments, but rather those with payments peaking at the end of the cycle. Similarly, Healy and Lenz (2014) use a set of survey experiments to demonstrate that voters choose to rely on recent outcome measures instead of evenly weighting those from the full time horizon since the former are seen as easier to rely upon. CHAPTER 3. THE FED AS A POLITICAL AGENT 104

This myopia among voters provides an opportunity for the Fed to use monetary policy to provide a short-term boost to the economy.20 The intuition here is straightforward: by lowering the fed funds rate, the Fed can increase the supply of money and credit in the economy, which together work to stimulate economic production and employment. To voters focusing on the short-term, these improvements signal that the incumbent president is succeeding in managing the economy and therefore make them more likely to support his re-election campaign or, if he is term-limited, that of his party. Not surprisingly, however, a stimulative approach to monetary policy when not justified by economic expectations at the time is not costless. In a macroeconomic sense, lowering interest rates when economic observables do not support doing so (e.g., with modest levels of unemployment) – or failing to raise them when rising inflation concerns suggest raising them – will produce higher-than-desired inflation in the long-run. There are also implications for institutional legitimacy: a central bank perceived to be helping the incumbent win elections will be less able to achieve its long-run objectives of full employment and stable prices. As Richard Fisher (2010), the president of the Federal Reserve Bank of Dallas, stated, a country cannot achieve “sustainable non-inflationary growth if its central bank is governed by a politicized monetary authority.” This long-term cost to the central bank of pursuing electoral goals presents monetary policymakers with a clear trade-off: should they help the incumbent president and sacrifice its long-term goals or stay the course on monetary policy and neglect to help the incumbent president (or his party) maintain control of

20While convenient, the assumption of voters as myopic is not a necessary condition for monetary policymakers to be incentivized to be more accommodative around elections. Lohmann (1998) shows how policymakers can become “trapped into manipulating the money supply before the election because the voter (rationally) expects her to do so” (p. 7). CHAPTER 3. THE FED AS A POLITICAL AGENT 105

the White House? Not surprisingly, not all officials serving on the FOMC handle this calculation in the same way. We know this because the structure of the institution makes heterogeneity in partisan background almost inevitable. As introduced above, seven of the twelve on the committee (the Governors) are politically appointed and therefore have a clear party affiliation. With fourteen-year terms, these appointments (by design) do not overlap neatly with a president’s term and, in absence of one party controlling the White House (and appointments to the Fed) for an extended period, both parties will have representation on the Board of Governors. The five Reserve bank presidents serving on the FOMC present another potential source of partisan heterogeneity. Although they are not formally selected by the president, there is no reason to expect them to lack a partisan identity altogether.21 Thus, although we may not easily observe their political party affiliations, we still must account for them since their susceptibility to partisan bias around elections depends on this factor. Obviously, some in this group will be unaffiliated with either party, just as many members of the general public are. There is little reason to expect those individuals to try to help the incumbent. After all, we cannot expect someone to be willing to accept a substantial long-term cost to help a politician to which he is (at least publicly) indifferent. Put differently, for these political independents, the costs of manipulating the money supply around elections is simply not offset by a sufficient benefit. In the same way, the Reserve bank presidents and Governors with ties to the opposite party of the president are not expected to try to help the incumbent. In fact,

21There are no statutory requirements – in the Federal Reserve Act or elsewhere – concerning these individuals’ memberships in political parties. CHAPTER 3. THE FED AS A POLITICAL AGENT 106

for this group of officials, there may even be an incentive to instead pursue restrictive monetary policy since raising interest rates will have the opposite effect on the economy in the short-term: reducing production and employment, both of which hurt the incumbent. However, the benefits of this “contrarian” policy may not always exceed the expected costs. If such an approach to monetary policy is implemented, but unsuccessful, thereby allowing the opposite party to maintain control of the White House, the Fed may be subject to political attacks, such as audits and other attempts to decrease its cherished autonomy. This may also be true if officials at the Fed are subject to loss aversion. That is, if monetary policymakers prefer avoiding losses to acquiring gains, they will be likely to help an incumbent president of the same party, but unlikely to try to hurt one of an opposite party (Kahneman and Tversky 1979). That monetary policy is not guaranteed to sway election outcomes (i.e., there is inherent uncertainty in this relationship) increases the likelihood of these policymakers being loss averse. For these two reasons, I am reluctant to put forth a strong theoretical expectation on whether elections in which the incumbent president is of the opposite party will result in these out-of-power monetary policymakers exhibiting no change or becoming more restrictive. There is much less theoretical ambiguity, however, for those sharing a partisan affiliation with the president. This subset of monetary policymakers has a clear reason to change their monetary policy recommendations around elections. Like partisan actors everywhere, they have an unambiguous preference for a fellow member of their party to control the White House (Nordhaus 1975). Thus, as long as the expected reputational costs do not exceed the anticipated benefits associated with this political outcome (re-election of their party), they will be willing to use monetary policy to CHAPTER 3. THE FED AS A POLITICAL AGENT 107

help achieve this political outcome. In other words, I consider this subset of officials at the Fed to be prone to advocating “policies with immediate, highly visible benefits and deferred, hidden costs – myopic policies for myopic voters” (Tufte 1978, p. 143).22 Still, there is one reason why copartisans of the president would not make monetary policy recommendations designed to help the incumbent president. Central bankers will not want to develop a reputation as an overt political agent of the president if that personal cost is not sufficiently offset by a tangible benefit. In this context, that means they should not be expected to recommend unjustified increases in the money supply around elections unless they can be confident that enough fellow members of the FOMC will also do so. That is, unless at least half of the FOMC voting members share the party identification of the president, any attempts to use monetary policy to sway the presidential election will be unable to generate the desired policy outcome. Since such attempts will still produce reputational costs, but without yielding compensatory benefits, policymakers will avoid them as long as they are not expected to succeed. In a similar way, changing the course of monetary policy around elections likely requires the consent of the chairman. This is because, despite having little de jure authority, the chairman of the FOMC has traditionally been highly influential. Much of this power comes from the chair’s agenda setting power. Meade (2005) describes how this works: “After a staff presentation on policy options, Greenspan [the chair] provided an extended discussion of his views before making a policy recommendation. Other participants followed in no fixed order” (p. 94). Following this round of

22This “opportunistic” political business cycle is distinct from Hibbs’ s(1977) “partisan” political business cycle. In that model, monetary policymakers may instead decrease the money supply shortly before elections so as to stabilize prices, if the party in power represents a constituency that is more concerned with inﬂation. CHAPTER 3. THE FED AS A POLITICAL AGENT 108

discussion, his initial proposal would be put to a vote, which was approved by the voting members in all 154 meetings of his tenure.23 In fact, the last time the Fed chair did not get his desired outcome was in 1986, when Paul Volcker, a Democrat, was outvoted on the discount rate level after four Republicans joined the Board after being appointed by President Reagan.24 However, Volcker was able to consolidate his power after this episode by threatening to resign if the dissenters did not come to agree with him, a strategy that succeeded relatively quickly (Irwin 2013). More generally, though, it could just be the case that the chair is being strategic and advocating the median’s policy recommendation to ensure that he is not rolled (i.e. defeated by the majority). While I leave a full exploration into that question to a separate study, for now we can say that having the support of both the median and chairman is conducive to changing the course of monetary policy around elections. Put together, this set of theoretical beliefs leads us to a single testable hypothesis: monetary policymakers will be more likely to recommend cutting interest rates when the incumbent president is of their same party and that party also possesses control of the FOMC.25

3.4 Data & Research Design

To determine how monetary policymakers change their recommendations around elections (if at all), I analyze data on the individual-meeting level. I look at each monetary policymakers’ recommendations for the 165 (∼8 / year) FOMC meetings held between

23He served as chair from August 11, 1987 to January 31, 2006. 24As mentioned above, decisions regarding the discount rate are solely decided by the Board of Governors and do not take place in the FOMC. 25To be clear, by control, I mean that the chairman is of this party, as is the median member of the committee. CHAPTER 3. THE FED AS A POLITICAL AGENT 109

1989 and 2008.26 For each meeting, I obtain every participant’s verbal recommendation as well as their formal vote. I then compare the policy recommendations made in meetings held within twelve months of a presidential election to a clear benchmark: those made in non-election meetings by members of the same political party. Finally, I account for the partisan composition of both the White House and the FOMC – as well as the contiguity between the two – to see if my theory matches up with the patterns in the data. To do so, I measure the partisanship of both the political appointees as well as those selected by private bankers.

3.4.1 Dependent Variable

To measure the preferences expressed by Fed oﬃcials, I take a comprehensive approach. First, using the FOMC’s oﬃcial minutes, released three weeks after the meeting and published on the Fed’s website, I document each member of the FOMC’s vote. These minutes indicate the direction of the policy change – maintain, lower, or raise – and whether each member voted in support of the change. In the case of a dissent, the minutes describe the member’s preferred alternative (maintain, lower, or raise). Thus, determining the direction of a policymaker’s vote from the minutes is fairly straight-forward. My data set begins with 1989 since, prior to that, the Fed had relied on a mone- tarist approach to monetary policy in which it targeted the money supply and borrowed reserves instead of the fed funds rate (Meade 2005). Shortly after the start of the Greenspan era, the FOMC began targeting the fed funds rate and this continued until December of 2008, when the fed funds rate had reached zero, prompting the Fed

26In most years, there are eight FOMC meetings, though there were 10 in both 1998 and 2001, and 13 in 2003. CHAPTER 3. THE FED AS A POLITICAL AGENT 110

to pursue alternative policy tools from that point forward.27 Thus, making comparisons about the determinants of monetary policy recommendations for these twenty years is most reasonable; expanding the data set into more years could produce comparisons of “apples-and-oranges.” Incorporating more recent data, even if desirable, is not possible, though, since the Fed only releases the transcripts after a lag of five years. The 2009 meetings will not be released until January of 2015. Overall, the minutes from the 165 meetings held in these 20 years give us 1,790 observations (∼12 officials/meeting ∗ ∼8 meetings/year * 20 years = 1,790 observations). Of these, 338 (18.88%) represented a recommendation for lowering the fed funds rate, while 368 (20.56%) were for increasing the rate. The other 1,084 (60.55%) were in favor of keeping it constant (for a summary, see the right half of Figure 3.3). In addition to the votes, I examine the verbal recommendations, as provided by the official FOMC transcripts. In this pursuit, I follow Meade (2005), who uses the transcripts of the 72 FOMC meetings from 1989 to 1997 to describe each member’s verbal recommendation for the change to the fed funds rate (in basis points) and how that compares to both the chair’s initial recommendation and their ultimate vote. With a similar set of explicit coding rules, my research assistant and I then hand-collected data from the 93 FOMC meetings held between 1989 to 2008. In total, these transcripts offer 2,920 observations (16–19 officials/meeting ∗ ∼8 meetings/year * 20 years = 2,920 observations). By providing recommendations made in basis points instead of directional arrows (as the votes do), these data offer a more precise estimate of the recommendations made by the FOMC participants. In addition, these may better reflect the internal posturing that goes on during FOMC meetings (Meade 2005). As a result, prior

27For this reason, the meeting held in December 2008 is not part of the sample. CHAPTER 3. THE FED AS A POLITICAL AGENT 111

studies emphasize this speciﬁcation of the dependent variable, so I will also do so.28 The frequencies for the recommended basis point changes are as follows (see also Figure 3.3): +100 once (0.01%), +75 16 times (0.56%), +50 121 times (4.21%), +25 500 times (17.39%), 0 1,702 times (59.18%), -25 285 times (9.91%), -50 227 times (7.89%), and -75 24 times (0.83%). In comparison, in the 165 meetings in the sample, the frequencies of the policy change ultimately implemented are – in basis points: +75 once (0.61% of the time), +50 three times (1.82%), +25 twenty-ﬁve times (15.15%), -25 nineteen times (11.52%), -50 thirteen times (7.88%), and -75 twice (1.21%). In the other 101 meetings (61.82%), there was no change to the fed funds rate.

Figure 3.3: Frequency of Recommendations in the FOMC

3.4.2 Econometric Model

These data (described in Figure 3.3) present three possible speciﬁcations of the dependent variable. The most precise would be to use the verbal recommendations in basis points (see the left half of Figure 3.3). A frequently used econometric approach

28As a note in Section 3.5, though, this speciﬁcation choice does not change our substantive conclusions at all. This is not surprising given the relatively high correlation between the votes and verbal recommendations. CHAPTER 3. THE FED AS A POLITICAL AGENT 112

with non-dichotomous panel data is to employ an ordinary least squares (OLS) regression. However, my data are not continuous. Rather, the recommendations are made in increments of 25 basis points. If these recommendations were instead made a true continuum, we could rely on the OLS technique. Since they clearly are not, though, estimates derived from OLS may be unreliable (Williams 2006). To deal with this lack of continuity, we could instead treat each distinct recommendation as one unit in an eight-point scale. That is, divide each recommendation by 25, and then code it as a value on a simple ordinal scale, ranging from -3 to +4.29 With this set of ordinal outcomes, one could potentially use an ordered logistic regression or an ordered probit. For us to be sure that this is the right model, we need to check that the assumptions inherent in it are met in this instance. Specifically, we need to check that the relationship between each pair of outcome groups is identical. This is because this particular model constrains the coefficients for each independent variable to be the same, regardless of whether it is comparing the lowest possible outcome (-3) to all higher ones (-2 through +4), or the second lowest (-2) to the ones above it (-1 through +4). Fortunately, this assumption, known as the proportional odds or the parallel lines assumption, is testable. To address this question, I run a Wald test. If the proportional odds assumption is upheld in the data, then the test statistic in the Wald test will be insignificant. In my case, it is not. The χ2 value on 15 degrees of freedom is 189.16, which corresponds to a p-value of 0.00. This is not particularly surprising, though, since I am asking a lot out of relatively sparse data, particularly in the tails. In other words, the variation in the independent variables is not sufficiently offset by a similar level of variation in the dependent variable since

29 −75 −50 −25 0 The results from this exercise produce the following results: -3 ( 25 ), -2 ( 25 ), -1 ( 25 ), 0 ( 25 ), 25 50 75 100 +1 ( 25 ), +2 ( 25 ), +3 ( 25 ), or +4 ( 25 ). CHAPTER 3. THE FED AS A POLITICAL AGENT 113

the ordinal dependent variable is so thinly spread, as the left half of Figure 3.3 shows us. To help address this issue, then, I collapse the recommendations into a trichotomy of lower (-1), maintain (0), or raise (+1) interest rates. Though this partially helps address the previous problem, a subsequent Wald test also fails (χ2 = 24.00 and p = 0.03). A second test of this assumption, the Brant Test of Parallel Regression Assumption, confirms that the assumption is violated. As a result, we have to pursue an alternative econometric model that does not require all the coefficients to be fixed.30 One way to do this would be the multinomial logit. Just as before, we must ensure that this model’s assumptions are met. In this instance, the main assumption is the independence of irrelevant alternatives (IIA). For this assumption to hold in the context of explaining monetary policy recommendations, if an official on the FOMC is indifferent between an increase and a decrease (i.e., 50% chance of choosing either), then they would have to maintain that probability ratio if a third alternative – maintaining interest rates – is available. Although there are suggested ways to test this assumption, such as the Hausman-McFadden test (1984) and the Small-Hsiao test (1985), simulations performed by Fry and Harris (1996, 1998) and Cheng and Long (2006) demonstrate their unreliability. As a result, we must use theory to instead guide our judgement on this issue and, in that sense, we cannot reasonably conclude that the addition of an alternative monetary policy would not change the recommendations ultimately issued. Since this model’s ignorance of the ordinal nature of the dependent variable further limits its attractiveness, we must continue to seek alternative approaches.

30Since the ordered probit also requires this assumption, we cannot rely on it instead. CHAPTER 3. THE FED AS A POLITICAL AGENT 114

The one we ultimately come to rely on is the generalized ordered logit. This is almost identical to the more commonly used generalized ordered logit model, but it relaxes the proportional odds or the parallel lines assumption where necessary. In other words, it imposes partial proportional odds by allowing the coefficients to differ if (and only if) they do not pass a Wald test of parallel lines. It does so by running a series of binary logistic regressions. So, with three possible outcomes (-1, 0, and +1), this model would run a regression comparing recommendations in favor of lowering (-1) to anything else (0 or +1) and then a separate one contrasting raising (+1) to maintaining or lowering (0 or -1). After these regressions are completed, a Wald tests is automatically performed for each and only those “variables which pass the tests (i.e., variables whose effects do not significantly differ across equations) have proportionality constraints imposed” (Williams 2014). Equation 3.1 presents the formal notation behind this approach:

exp(αj = Xi,tβj) P (Yi,t > j) = g(Xβj) = (3.1) 1 + exp(αj = Xi,tβj)

where, as described above, j = −1 or 0, βj is the set of coefficients associated with outcome j, and Xi,t is a vector of explanatory variables associated with observation i made in time t. Since existing literature indicates that members of different parties may have different cost-benefit calculations over how to conduct monetary policy, we want to use this model to focus on explaining intra-party temporal variation. This is particularly true since our theory indicates that a policymaker’s benefits from manipulating monetary policy depends entirely on their partisan identity. Thus, the econometric tests should compare the recommendations made by members of one party to those CHAPTER 3. THE FED AS A POLITICAL AGENT 115

made by members of the same party during non-election years. This will enable us to estimate the effect of elections on monetary policy for each party separately, thereby eliminating concerns that any findings are plagued by issues of uncontrolled cross- sectional heterogeneity. To do so most conservatively, I use a divided sample instead of dummy variables. With this approach, I allow members of the two parties to have different coefficients for the entire set of right-hand-side variables (descriptions to follow), such as inflation and unemployment, not just the one interaction variable of election∗copartisan. Also, to account for potential collinearity of the dependent variable within the groups in a given meeting, I cluster the standard errors for each of 165 dates.

3.4.3 Independent Variables

To test my hypothesis most appropriately,31 I need to differentiate recommendations made during elections years by copartisans of the White House to those made by those in the same party during non-election years. So, with a sample of fellow members of the party, the estimate of interest is an interaction term between copartisan and election year. Coming up with the first half of this variable requires first establishing monetary policymakers’ political party affiliations. To do this most effectively, I use several data sources. For the political appointees, this process is rather straightforward. In almost every instance since the Fed’s inception, the governors appointed by the president are also members in his political party.32 I confirmed this contiguity in

31As a refresher, the hypothesis is that monetary policymakers will be more likely to recommend cutting interest rates when the incumbent president is of their same party and that party also possesses control of the FOMC. 32In my sample, there are two exceptions. In 1988, President Reagan appointed John P. LaWare, whom I code as an independent. In 2001, President George W. Bush, re-appointed Roger W. Ferguson, Jr., a Democrat who ﬁrst joined the Board in 1999. CHAPTER 3. THE FED AS A POLITICAL AGENT 116

partisan identity by using information from press reports at the time of the nomination as well as other sources on governors’ partisan identities from McGregor (1996) and Nixon (2005). Not surprisingly, establishing the partisan identities for the non-appointed Reserve bank presidents is more of a challenge. To my knowledge, there have been no systematic attempts at establishing their identities, or at least none that generated a public database of this information. For the most part, these officials’ partisan identities are also not disclosed in the press or in the announcements concerning their selection. There are a few, though, for whom this is not the case. For example, Richard W. Fisher, the President of the Federal Reserve Bank of Dallas, ran as the Democratic party’s choice for one of Texas’ US Senate seats. Likewise, William Poole became the President of the Federal Reserve Bank of St. Louis immediately after serving at the White House in the Reagan Administration as a member of the Council of Economic Advisors. For such individuals – three Republicans and this one Democrat – we can reasonably treat them as members of one party or the other. To establish the party memberships for other officials (i.e., those lacking a clear connection to one party, as indicated by their curriculum vitae or press reports), I examine other sources. First, I search for any voter registration information pertaining to the officials. To do so, I rely on a national voter file published by Catalist, a political data provider.33 These registration data indicate that four are Democrats, another four are Independents, and five are Republicans. The remaining 15 are not able to be identified, since they either are (or were) not a registered voter or are not included in the Catalist voter file that I have access to through my university’s subscription.34

33Other studies using Catalist for data on voter registrations include Ansolabehere and Hersh (2012), Hersh and Nall (2013), and Peterson (2014). 34The subscription is for only a subset of the entire Catalist national voter ﬁle. CHAPTER 3. THE FED AS A POLITICAL AGENT 117

As a supplementary source, I follow Bonica et. al (2012) by deriving these individuals’ ideal points from their campaign contributions. Specifically, using the Database on Ideology, Money in Politics, and Elections (Bonica 2013), I collected data on each monetary policymakers’ campaign contributions between 1979 and 2012. This included when, how much, and to whom they gave. With these data and the methodology established by Bonica (2014), I then derived an estimate of their ideology known as their CFscore. This is a numerical, unidimensional estimate of how liberal or conservative each official is based on which candidates and group they donate to. Giving exclusively to liberal Democrats will generate a score far below zero, while donating to conservative Republicans will lead to a highly positive CFscore. To determine if they can be treated as a Democrat or Republican, I compare their CFscores to the universe of political candidates in state and federal elections. If their CFscore is closer to the median of Democratic politicians (-0.691) than it is to zero (the score of one who is perfectly independent), I code the official as a Democrat. Likewise, if their scores are greater than 0.425, (i.e., half of the median score of the Republican candidates of 0.850), then I code them as a Republican. For those without any campaign contributions or a CFscore closer to zero, I code them as having no party identification.35 This exercise offers evidence that five of the presidents are Democrats and 10 Republicans, while the other 21 are either considered independents or unable to be classified (see also Figure 3.4 in the Appendix). I then put these data together and look for inconsistencies. In other words, if one data source indicates the Fed official is of another party, but another source shows

35I also exclude donations to purely social causes. This takes out the two donations made by Jeﬀrey Lacker, the former president of the Federal Reserve Bank of Richmond, since they were both made to the Human Rights Campaign National Marriage Fund. These two donations are the only indication of his political identity, so I am unwilling to declare him to be a member of either party. CHAPTER 3. THE FED AS A POLITICAL AGENT 118

them to not be in this category, then I code them as having no party affiliation. For example, Edward Gerald Corrigan, a former President of the Federal Reserve Bank of New York, had, at one point, registered to vote as a member of the Democratic party, but has given substantial campaign donations to politicians in both parties. As a result, I code him as having no partisan affiliation and therefore never being a copartisan of the president.36 Overall, this coding strategy produces the following results: five are Democrats and twelve are Republicans, while nineteen cannot be safely classified as being in either party. Following much of the previous literature on the existence of a political business cycle in monetary policy, I use a simple binary variable to code each meeting as either being a one or a zero, based on whether it is within twelve months of a presidential election. This cutoff point makes the most sense since this is when the potency of a monetary boost to the economy is maximized, particularly given what we know about how voters retrospectively evaluate the incumbent president (or his party). Using a different window may produce a Type II error by finding no effect. Cutting interest rates (or not deciding against raising them) in meetings held over a year away will lead to economic growth well before the election, but is also likely to produce increases in inflation before that event. Thus, the benefits of manipulating the money supply so far in advance are limited. Likewise, if the window was smaller, say six months, the benefits would be less likely to be fully realized prior to the election, thereby limiting the incentives to change recommendations just prior to the election. As a robustness check, I also look to see if monetary policymakers change their recommendations in other politically salient meetings. Specifically, I look to see if

36Similarly, Richard Francis Syron, who served in the Treasury Department during the Carter administration, was also a frequent donor to candidates on both sides of the aisle, so I do not code him as a Democrat. CHAPTER 3. THE FED AS A POLITICAL AGENT 119

recommendations are altered during political scandals affecting the president. This measure comes from Nyhan (2014), who classifies 28 scandals based on extensive coverage by The Washington Post between 1978 and 2008.37 A meeting is coded as a one if there is at least one front-page story in the The Washington Post about a political scandal affecting the president during the week of the FOMC meeting and a zero otherwise. The intuition here is that if monetary policymakers are trying to help their party keep control of the White House, they may also be willing to help their copartisan when his political capital has been partially eroded by a scandal. On the other hand, if Fed officials are not influenced by political concerns, then they should issue the same types of recommendations during scandals as they do otherwise. Of course, to fully account for the determinants of each FOMC participants’ monetary policy recommendations, we must account for relevant economic variables. Af- ter all, Fed officials should be acting in line with the Fed’s guiding legislation, the Full Employment and Balanced Growth Act of 1978, which mandates that the Fed “promote full employment and production, increased real income, balanced growth, a balanced Federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance ... and reasonable price stability.” To most appropriately model the decisions of the FOMC officials, I rely heavily on the Fed’s Greenbook forecasts, the internal set of economic reporting and forecasting that monetary policymakers have access to at the time of their decisions. The importance of using these real-time data instead of ex post revised data is well documented by Orphanides (2001). The bulk of the data from the Greenbook that I use measure the Fed’s projections for real, quarter-over-quarter growth in the following areas: real GDP (Real

37For the full list, see Table 3.8 in the Appendix. CHAPTER 3. THE FED AS A POLITICAL AGENT 120

GDP), core CPI (Core CPI ), headline CPI (Headline CPI ), personal consumption expenditures (Consumption), real business fixed investment (Business Investment), and federal government consumption and gross investment (Federal Expenditures). I also employ projections from the Greenbook regarding the overall unemployment rate (Unemployment), the number of housing starts in millions (Housing Starts), and quarterly growth in the industrial production index (Production). All of these measures were the most recent projections available to the policymakers as of the FOMC meeting. To this data set, I also add a trade-weighted measure of the US dollar (Dollar Value Change), obtained from the Federal Reserve Bank of St. Louis’ FRED economic database, as well as a measure of the S&P 500 (S&P Change). In both instances, these were measured on the percentage change in value over the last 90-days, as measured on the day before the FOMC meeting, an approach consistent with both the dependent variable and other independent variables. Finally, I add a control for the current US government operating budget (Budget Deficit), also accessed via the Federal Reserve Bank of St. Louis’ FRED economic database, and the fed funds rate at the time of the meeting (Prior FFR). To ensure that all of these controls were useful additions to the econometric model, I ran several tests of collinearity. By finding the variance-inflation factors to be at acceptable levels, these tests confirmed that none of the control variables is a linear function of others.

3.5 Results & Discussion

The ﬁrst step in my empirical analysis is to examine the basic diﬀerences between verbal recommendations made by monetary policymakers around elections to those CHAPTER 3. THE FED AS A POLITICAL AGENT 121

made in non-election meetings. As an illustrative first step, I use a 1-sample propor- tions test to derive a confidence interval around a mean representing the probability of recommending a reduction of the fed funds rate.38 As a follow up, I employ Tukey’s Honest Significance Test to generate a set of confidence intervals on the within-party differences of the mean of recommending a rate cut based solely on the type of election upcoming: none, Republican, or Democratic. The results from these two exercises, displayed in Tables 3.1 and 3.2, suggest that, on average, Republicans were most likely to recommend a rate cut during meetings held within 12 months of an election in which the incumbent was also a Republican.39 This group of Republican monetary policymakers also appears slightly less likely to be in favor of reducing the fed funds rate during a Democratic presidential election year than they are otherwise. However, the difference between the mean likelihood in the no election group and the Democratic election group is not statistically significant (see the bottom row of the left side of Table 3.2). Among the Democratic monetary policymakers, the distinctions are more modest. These analyses offer no evidence that there is a difference between the likelihood of a rate cut recommendation around elections with a Republican incumbent and one with no election upcoming. However, the Tukey’s Honest Significance Test suggests that Democrats on the FOMC are significantly less likely to recommend a reduction in the

38The results from this exercise – though not displayed – would be similar, but flipped if the dependent variable was instead measured as the probability of recommending an increase in the fed funds rate. Note also that this test is run without a continuity correction since doing so would lead to an overcorrection raising the probability of a Type II error (Stefanescu, Berger and Hershberger 2005). 39For added robustness, I also ran a Welch Two Sample t-test comparing Republicans’ proclivities for recommending a rate cut in meetings held around Republican elections to a baseline of meetings with no election proximate. This difference between the two is, again, highly statistically significant (t statistic = -3.147 on 263 degrees of freedom; p-value = 0.002). Moreover, an ANOVA F-Test suggests that we can reject the null hypothesis that all three groups have identical means (p < 0.001). CHAPTER 3. THE FED AS A POLITICAL AGENT 122

fed funds rate in meetings within 12 months of an election in which the incumbent is Democratic than they are in either of the two other types of meetings. Despite the curiousness of this last ﬁnding, one should not overemphasize its implications since, as with all of the results from these univariate exercises, they are, at best, only suggestive evidence of an interesting pattern. To make meaningful inferences, we must account for the state of the economy at the time to ensure that any diﬀerences between recommendations made in meetings held in election versus non-election years are not attributed to other factors.

Table 3.1: Probability of Recommending a Rate Cut

Republicans Democrats Election Lower Point Upper Lower Point Upper N N Type: Bound Estimate Bound Bound Estimate Bound No 0.164 0.186 0.210 1077 0.183 0.220 0.262 423 Election Republican 0.235 0.293 0.358 205 0.182 0.279 0.402 61 Incumbent Democratic 0.071 0.113 0.176 141 0.026 0.075 0.199 40 Incumbent

Table 3.2: Tukey Multiple Comparisons of Means

Republicans Democrats Election Type Lower Upper Lower Point Upper Diﬀerence P (adj) P (adj) Comparison Bound Bound Bound Estimate Bound Democratic- -0.179 -0.280 -0.078 0.000 -0.195 -0.361 -0.030 0.016 Republican None - -0.107 -0.177 -0.037 0.001 -0.059 -0.189 0.071 0.538 Republican None- 0.072 -0.010 0.155 0.100 0.137 0.015 0.258 0.023 Democratic

As described in Subsection 3.4.2 above, I rely on a generalized ordered logit model CHAPTER 3. THE FED AS A POLITICAL AGENT 123

to fully account for potentially confounding variables. Although the transcripts theo- retically enable us to analyze a wider range of the dependent variable (i.e., an ordinal scale from -3 to +4), the tails on both ends are simply too thin to run a successful test. Thus, we must rely instead on the trichotomous measure introduced in Subsec- tion 3.4.1, where the dependent variable is coded as -1 if the policymaker advocates a reduction in the fed funds rate, 0 if she prefers the status quo, and +1 if she would prefer to raise the rate. Table 3.3 displays the results for the coefficients of interest. Among Republican monetary policymakers, there is a statistically significant and negative effect around elections in which the incumbent president is a Republican. More specifically, the coefficient of interest is estimated to have a value of -1.882, with a p-value less than 0.001. Thus, we can safely reject the null hypothesis that elections with a Republican incumbent have no effect on Republican monetary policymakers. Rather, it appears that Republican monetary policymakers have a clear pattern of lowering their interest rate recommendations around Republican elections.40 The same cannot be said, however, for Republicans around Democratic elections or Democrats around any election. Those coefficients are all statistically indistinguishable from zero (see Table 3.9 in the Appendix for full regression results). To make these results more easily interpretable, I convert the coefficients to predictive margins (see Table 3.4). This exercise allows us to derive the predicted probability of an interest rate cut if all the economic control variables are held at their sample means.41 This indicates that if no election was forthcoming, a Republican monetary

40This is also true if we use votes instead of verbal recommendations. With that alternative dependent variable, the coeﬃcient for the Republican election year variable is -2.226, with a standard error of 0.606 and a p-value < 0.001. 41Since the coeﬃcients of interest consistently pass the Wald test of parallel lines, the generalized CHAPTER 3. THE FED AS A POLITICAL AGENT 124

Table 3.3: Generalized Ordered Logit Results

Republicans Democrats Std. P- Symmetric Std. P- Symmetric Variable Coef. Coef. Error value Effect? Error value Effect? Republican -1.882 0.518 0.000 Yes -0.835 0.954 0.381 Yes Election Democratic 0.109 0.605 0.856 Yes -0.695 0.764 0.363 Yes Election policymaker would have a probability of recommending a rate cut of 16.7%. However, this rises to 39.1% if a Republican (or his party) is up for re-election within twelve months. Reflecting the potency of this effect, the upper bound of the probability of a Republican advocating for an increase in a non-election meeting is 20.6%, lower than the lower bound of the probability of doing so during a meeting around a Republican election. Although Republicans appear to be slightly less likely to recommend a rate cut around Democratic re-election campaigns (15.8% vs. 16.7%), this difference is not statistically significant.42 For the Democrats, all three point estimates are within 320 basis points of one another, consistent with the lack of statistical significance in the coefficients produced by the generalized ordered logits. To add further confidence that the results presented here are not being driven by some unobserved variable, I run an additional regression for Republicans that adds person fixed effects. By focusing on within person variation, this version of the econometric model will account for any time-invariant idiosyncrasies that affect one’s monetary policy judgements. As a result, this specification of the regression reduces ordered logit constrains them to be symmetric. As a result, from this exercise, we can infer that Republicans are not only more likely to recommend cutting interest rates around elections, but also less likely to raise them around elections. 42This could perhaps be attributed to a limited sample (N=141) not detecting a modest effect (a Type II error), though there are also theoretical explanations for this lack of a finding. I elaborate more on this below. CHAPTER 3. THE FED AS A POLITICAL AGENT 125

Table 3.4: Predictive Probabilities of Recommending a Cut in the Fed Funds Rate Republicans Democrats Election Lower Point Upper Lower Point Upper Type Bound Estimate Bound Bound Estimate Bound No 0.129 0.167 0.206 0.139 0.179 0.219 Election Republican 0.255 0.391 0.528 0.121 0.218 0.314 Election Democratic 0.060 0.158 0.256 0.137 0.211 0.285 Election the risk of bias, though doing so at the expense of increased variance and diminished power. Nevertheless, the estimated effect of a Republican election year on Republicans’ recommended changes to the fed funds rate is again negative and statistically significant. In fact, the magnitude of the coefficient (-2.275) is larger than without person fixed effects (-1.882; see Table 3.11 for the full regression report). As before, the coefficients of interest (Rep Election Year and Dem Election Year pass the Wald test of parallel lines and are therefore identical regardless of the model’s choice of outcome level (i.e., the value of j in equation 3.1 above). Thus, these results add further confidence to the conclusion that Republicans become both more likely to recommend reducing the fed funds rate and less likely to recommend raising it in meetings around elections in which their party was attempting to retain control of the White House. Next, to determine the source of the strong result we observe – on Republican monetary policymakers around Republican elections – I then divide the sample further into one for Republican governors and another for Republican reserve bank presidents (i.e., political appointees versus those selected by bankers). The results here CHAPTER 3. THE FED AS A POLITICAL AGENT 126

(highlighted in Table 3.5) show that both groups issue statistically lower (i.e., more accommodative) recommendations in meetings held within a year of an election in which the incumbent is a Republican (see Table 3.10 in the Appendix for a full summary of these regressions). When converted to predictive margins (again, with all

Table 3.5: Selected Regression Results for Republican Monetary Policymakers Governors Reserve Bank Presidents Std. P- Std. P- Variable Coef. N Coef. N Error value Error value Republican -2.275 0.606 0.000 686 -1.523 0.531 0.004 737 Election control variables held at their sample means), we see how much more likely both groups of Republicans are to recommend lowering interest rates around Republican elections – or less likely to recommend a rate increase (see Table 3.6). Although the magnitude of the effect is greater for the politically appointed governors, the reserve bank presidents also exhibit different (i.e., more accommodative) behavior around elections. The appearance of a strong finding for both suggests that individual members of the Fed are not attempting to manipulate the money supply to advantage the president merely because of their personal attachments to that politician or their own career concerns as partisan appointees, but also do so because of their strong preferences regarding control of the executive branch. If this effect is so robust, one may ask why there are no other significant results. Although perhaps surprising on the surface, in reality, the asymmetry in these findings is not inconsistent with expectations. First, as initially discussed in Section 3.3 (“Theory”), there is reason to view the costs and benefits of manipulating the money CHAPTER 3. THE FED AS A POLITICAL AGENT 127

Table 3.6: Predictive Margins: Republican Monetary Policymakers Governors Reserve Bank Presidents Election Lower Point Upper Lower Point Upper Type Bound Estimate Bound Bound Estimate Bound No 0.129 0.171 0.212 0.127 0.168 0.209 Election Republican 0.266 0.410 0.554 0.218 0.340 0.462 Election supply around elections as not uniformly distributed. Although using monetary policy to try to keep one’s party in control of the White House is likely to induce benefits that exceed costs (at least in the short-term), in the inverse scenario – tightening the supply of money to hurt a president of the opposite party – the costs will likely be greater than the benefits. This is because implementing an exceptionally restrictive course of monetary policy could jeopardize the Fed’s cherished autonomy. Raising interest rates when not called for based on economic fundamentals would not only be particularly unpopular with the president of the opposite party, but also the general public. Put together, these two phenomena could lead to the Fed becoming more constrained in the future than it otherwise would be, a highly undesirable outcome for monetary policymakers. This null finding among Republican central bankers during Democratic election years could also be explained by these officials engaging in loss aversion. This would mean that they prefer avoiding losses to acquiring gains. Either (or both) can explain Republican monetary policymakers’ pattern of being willing to help a copartisan but no such pattern when it comes to hurting a non-copartisan. Still, it is worth acknowledging that a small, but real negative effect may be present. With a limited sample size, it is possible, though unlikely, that we could possibly be making a Type II error by finding no effect when there is in fact one. CHAPTER 3. THE FED AS A POLITICAL AGENT 128

Figure 3.5 illustrates this point by conducting a power analysis. This exercise shows that under the current sample size of 1,218, the probability of concluding an effect is present given that there actually is one is less than 5%, once controls are included. However, even if the sample was expanded to 10,000 observations, that probability would only rise to just over 10%. The lack of a demonstrable effect among Democrats is also unsurprising. This is not because this group of monetary policymakers is inherently more benevolent (or less Machiavellian) than their Republican counterparts. Rather, they simply never had a chance to, as a group, dictate the course of monetary policy around elections. Highlighting this, the chairman for the entire duration of the sample was a Republican. Alan Greenspan served from August 11, 1987 to January 31, 2006 and his successor, Ben Bernanke, served from February 1, 2006 to February 3, 2014. Both were first appointed by Republican presidents and their membership in the Republican party is well known. In addition, in the sixteen possible meetings in which monetary policy could have been used to help the Democrats keep control of the White House (8 in 1996 and another 8 in 2000), there were never more than four Democratic members on the FOMC. In fact, not only did the Democrats not have a majority in these sixteen meetings, Republicans actually outnumbered them in all of these instances.43 The exact opposite is true, however, for the meetings held around presidential elections with a Republican incumbent. In each of those 25 instances (8 in 1992, 7 in 2004, and 10 in 2008), the chairman was a Republican and a majority of the members serving on the FOMC were Republicans. Furthermore, in the 8 meetings held within twelve months of the Democratic election, there were no Democrats serving on the

43This is not the case for every meeting, just those held within twelve months of a presidential election with a Democratic incumbent. Democrats actually had six members in seven meetings of the sample (all in 1998), just none during electorally salient times. CHAPTER 3. THE FED AS A POLITICAL AGENT 129

committee. Likewise, there were only four Democrats on the FOMC in each of the 7 meetings held around the 2004 election, and 2 in the 10 around the 2008 election. Thus, they had no real ability to prevent (or veto) the Republicans from changing the course of monetary policy to help the incumbent president (or his party). This finding that elections only affect monetary policy among Republican monetary policymakers around Republican elections is consistent with the theoretical expectations since that party controlled both the White House and the FOMC, as indicated by the partisanship of the median voter and the chairman. A final set of evidence supporting the conclusion that Republicans at the Fed are changing their monetary policy recommendations around elections with a Republican incumbent comes from a comparison of meetings held during political scandals affecting the president to those made otherwise (including during election years).44 Out of the 165 meetings held total during my sample, 27 were held during political scandals affecting the presidents.45 To complete this test, I use an identical econometric model, but with the indicator variable for election year switched to one signifying that a political scandal is ongoing at the time. The results from this exercise further demonstrate the robustness of this finding. As before, we see a statistically significant result, but only among Republican monetary policymakers. The coefficient for the dummy Republican Scandal variable is -1.364 and its standard error is only 0.429, making it distinguishable from zero at con- ventional levels (see Table 3.12 for full regression results). In terms of the predictive

44This variable is described at the end of Subsection 3.4.3 and in Table 3.8 in the Appendix. 45Since Nyhan (2014) codes a scandal as lasting as long as it is being featured on the front page of The Washington Post, durations often exceed one week. So, although there were only ﬁve political scandals during the George H.W. Bush administration, fourteen of the meetings held during his four years a president are coded as having taken place during a political scandal. In the same way, the ﬁve political scandals of the George W. Bush administration spanned thirteen FOMC meetings. CHAPTER 3. THE FED AS A POLITICAL AGENT 130

margins (see Table 3.7), having a meeting during a Republican presidential scandal takes the probability of an interest rate increase from 18.3% to 32.7%, when holding all control variables at their sample means. The structural conditions hypothesized to be necessary – that the same party control both the White House and the FOMC – are again present. These conditions are never there for the Democrats, though, hence yet another statistically insigniﬁcant result for this group (see the right side of Table 3.12).

Table 3.7: Predictive Margins: Republicans during Political Scandals

Meeting Lower Point Upper Type Bound Estimate Bound No 0.148 0.183 0.218 Scandal Republican 0.225 0.327 0.429 Scandal

3.6 Conclusion

In this chapter, I have presented clear empirical evidence that partisan actors at the Federal Reserve are willing to sacriﬁce their long-run macroeconomic objectives to achieve political gains. However, I also show how their willingness to do so is conditional on the partisan composition of the institution in which they are operating. Since expressing electorally inﬂuenced recommendations while in the (partisan) minority is costly, monetary policymakers are only willing to do so when their party is in control of the committee. This explains why we only observe Republicans acting as partisan actors: in each of the three elections in which the incumbent was a Republican, the FOMC had a Republican chair and more than 50% of its members CHAPTER 3. THE FED AS A POLITICAL AGENT 131

were Republicans. On the other hand, these structural conditions were never present during Democratic election years, making the null effect for that group of monetary policymakers unsurprising. More broadly, these findings offer further evidence of how partisan interests can influence the making of public policy in the bureaucracy. For any governmental agency with policy discretion – many fit this bill, especially the Fed – there may be an opportunity to use policy to accomplish partisan electoral goals. Nevertheless, such “political policy cycles” are often counter to long-term objectives so there are many that may be interested in reducing or eliminating these patterns, particularly via an adjustment to the institutional design. In general, expanding the number of veto points or preventing the ability of one set of partisan actors from controlling these veto points may help. One particular idea comes to mind from the legislative history of the Fed. During the congressional debate over the Banking Act of 1935, Senator Carter Glass (D–VA) inserted a provision into the bill that would have restricted membership on the FOMC to no more than four members of the same political party. However, this element of the bill was taken out by the Conference Committee just prior to its final passage and so never actually went into law. Although there have been myriad attempts at reforming the structure of the Fed since this bill, none have succeeded in initiating changes in the composition of the FOMC so the party quotas are still no more than an idea. There may be other reasons for Congress to avoid implementing this rule, a topic beyond the score of this chapter, but for those interested in helping prevent the Fed from implementing accomodative monetary policy around elections, this may be a solution. CHAPTER 3. THE FED AS A POLITICAL AGENT 132

3.7 Appendix

Figure 3.4: Using CFscores to Determine Reserve Bank Presidents’ Party IDs CHAPTER 3. THE FED AS A POLITICAL AGENT 133

Table 3.8: List of Presidential Scandals

Scandal Administration Onset Date S&L failures/bailout G.H.W. Bush May 15, 1989 HUD corruption G.H.W. Bush July 8, 1989 FDA generic drugs G.H.W. Bush September 1, 1989 Banca Nazionale del Lavoro G.H.W. Bush March 22, 1992 Tailhook controversy G.H.W. Bush June 27, 1992 Whitewater Clinton July 1, 1994 Travel Office firings Clinton January 5, 1996 Dick Morris Clinton August 30, 1996 Filegate Clinton October 26, 1996 Foreign contributions Clinton December 21, 1996 1996 fundraising Clinton February 13, 1997 Military sexual harassment Clinton May 31, 1997 Links to Carey/Teamsters Clinton October 6, 1997 Lewinsky affair Clinton January 24, 1998 China spying/Los Alamos Clinton March 14, 1999 Valerie Plame G.W. Bush October 5, 2003 Abu Ghraib G.W. Bush May 6, 2004 Prisoner treatment G.W. Bush January 7, 2005 Safavian convicted G.W. Bush June 21, 2006 US attorneys G.W. Bush March 21, 2007 Source: Nyhan (2014) CHAPTER 3. THE FED AS A POLITICAL AGENT 134

Table 3.9: Regression Results: Republicans vs. Democrats

Republicans Democrats Outcome Level -1 0 -1 0 Rep Election Year -1.882*** -1.882*** -0.835 -0.835 (0.518) (0.518) (0.954) (0.954) Dem Election Year 0.110 0.110 -0.695 -0.695 (0.605) (0.605) (0.765) (0.765) Prior FFR -0.507*** -0.507*** -0.642* -0.642* (0.197) (0.197) (0.361) (0.361) Budget Deﬁcit -0.000411 -0.000411 -0.00424 -0.00424 (0.00263) (0.00263) (0.00292) (0.00292) Unemployment -0.100 -0.100 1.236 -0.879 (0.289) (0.289) (0.809) (0.636) Real GDP -0.0424 -0.0424 0.181 0.181 (0.263) (0.263) (0.507) (0.507) Headline CPI 0.102 0.102 0.667*** 0.667*** (0.127) (0.127) (0.210) (0.210) Core CPI 1.192*** 1.192*** 1.346** 1.346** (0.440) (0.440) (0.640) (0.640) Consumption 0.300* 0.300* 0.615** 0.615** (0.179) (0.179) (0.269) (0.269) Business Investment -0.0255 0.101** -0.00961 -0.00961 (0.0389) (0.0437) (0.0618) (0.0618) Federal Expenditures 0.0209 0.0209 0.0851 -0.0447 (0.0360) (0.0360) (0.0566) (0.0628) Housing Starts 0.637 4.228*** 2.925* 2.925* (1.479) (1.196) (1.574) (1.574) Production 0.476*** 0.476*** 1.032*** 0.276** (0.0961) (0.0961) (0.264) (0.134) Dollar Value Change 13.39*** 13.39*** 49.52*** 6.945 (4.855) (4.855) (12.76) (7.541) S&P Change 6.949*** 6.949*** 15.94*** 2.638 (2.391) (2.391) (4.929) (3.550) Constant -0.998 -12.16*** -13.61** -7.180 (3.253) (3.188) (6.135) (5.482) Observations 1,423 1,423 556 556 Wald χ2 157.2 157.2 88.89 88.89 Log Likelihood -848.1 -848.1 -271.3 -271.3 Pseudo R2 0.366 0.366 0.521 0.521 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 3. THE FED AS A POLITICAL AGENT 135

Table 3.10: Regression Results: Republican Policymakers

Republican Governors Republican RBPs Outcome Level -1 0 -1 0 Rep Election Year -2.275*** -2.275*** -1.523*** -1.523*** (0.606) (0.606) (0.531) (0.531) Dem Election Year -0.203 -0.203 -0.00210 -0.00210 (0.868) (0.868) (0.585) (0.585) Prior FFR -0.877*** -0.877*** -0.254 -0.254 (0.250) (0.250) (0.198) (0.198) Budget Deﬁcit 0.00259 0.00259 -0.00741*** -0.000729 (0.00297) (0.00297) (0.00271) (0.00318) Unemployment -0.185 -0.185 -0.119 -0.119 (0.349) (0.349) (0.312) (0.312) Real GDP 0.145 0.145 -0.217 -0.217 (0.324) (0.324) (0.285) (0.285) Headline CPI 0.0778 0.0778 0.154 0.154 (0.143) (0.143) (0.140) (0.140) Core CPI 1.836*** 1.836*** 0.863** 0.863** (0.602) (0.602) (0.393) (0.393) Consumption 0.271 0.271 0.277 0.277 (0.211) (0.211) (0.174) (0.174) Business Investment -0.0333 0.107* -0.0305 0.0957** (0.0492) (0.0561) (0.0412) (0.0447) Federal Expenditures 0.0263 0.0263 0.0125 0.0125 (0.0448) (0.0448) (0.0338) (0.0338) Housing Starts 0.182 5.335*** 3.001** 3.001** (1.641) (1.432) (1.248) (1.248) Production 0.573*** 0.573*** 0.478*** 0.478*** (0.124) (0.124) (0.0992) (0.0992) Dollar Value Change 16.12** 16.12** 12.86*** 12.86*** (6.321) (6.321) (4.646) (4.646) S&P Change 6.050** 6.050** 11.54*** 2.456 (3.047) (3.047) (3.024) (3.323) Constant 0.0279 -14.80*** -4.578 -9.517*** (3.446) (3.856) (3.342) (3.487) Observations 686 686 737 737 Wald χ2 131.5 131.5 118.7 118.7 Log Likelihood -337 -337 -476.5 -476.5 Pseudo R2 0.472 0.472 0.320 0.320 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 3. THE FED AS A POLITICAL AGENT 136

Table 3.11: Regression Results: Republicans (With Person Fixed Eﬀects)

Outcome Level -1 0 Rep Election Year -2.018*** -2.018*** (0.540) (0.540) Dem Election Year 0.0252 0.0252 (0.591) (0.591) Prior FFR -0.550*** -0.550*** (0.199) (0.199) Budget Deﬁcit -0.00164 -0.00164 (0.00270) (0.00270) Unemployment -0.274 -0.274 (0.306) (0.306) Real GDP -0.0160 -0.0160 (0.283) (0.283) Headline CPI 0.117 0.117 (0.143) (0.143) Core CPI 1.176*** 1.176*** (0.439) (0.439) Consumption 0.303 0.303 (0.187) (0.187) Business Investment -0.0200 0.110** (0.0444) (0.0486) Federal Expenditures 0.0602 -0.0522 (0.0471) (0.0526) Housing Starts -0.574 5.090*** (1.562) (1.354) Production 0.498*** 0.498*** (0.100) (0.100) Dollar Value Change 13.52*** 13.52*** (5.206) (5.206) S&P Change 9.835*** 0.534 (3.002) (3.731) Constant 3.008 -11.38*** (3.675) (3.511) Person Fixed Eﬀects Yes Yes Observations 1,423 1,423 Wald χ2 6719 6719 Log Likelihood -789.3 -789.3 Pseudo R2 0.410 0.410 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 3. THE FED AS A POLITICAL AGENT 137

Table 3.12: Regression Results: Republicans vs. Democrats (Scandals)

Republicans Democrats Outcome Level -1 0 -1 0 Republican Scandal -1.365*** -1.365*** -0.450 -0.450 (0.429) (0.429) (0.747) (0.747) Democratic Scandal -0.137 -0.137 -0.465 -0.465 (0.490) (0.490) (0.536) (0.536) Prior FFR -0.314* -0.314* -0.457 -0.457 (0.185) (0.185) (0.299) (0.299) Budget Deﬁcit 0.000363 0.000363 -0.00419 -0.00419 (0.00261) (0.00261) (0.00281) (0.00281) Unemployment 0.0835 0.0835 1.226* -0.643 (0.291) (0.291) (0.744) (0.583) Real GDP -0.0908 -0.0908 0.0122 0.0122 (0.236) (0.236) (0.453) (0.453) Headline CPI 0.0765 0.0765 0.624*** 0.624*** (0.136) (0.136) (0.201) (0.201) Core CPI 1.279*** 1.279*** 1.345** 1.345** (0.440) (0.440) (0.660) (0.660) Consumption 0.247 0.247 0.631** 0.631** (0.195) (0.195) (0.269) (0.269) Business Investment 0.0414 0.0414 -0.0171 -0.0171 (0.0392) (0.0392) (0.0590) (0.0590) Federal Expenditures 0.0680 -0.0579 0.107** -0.0400 (0.0418) (0.0443) (0.0528) (0.0566) Housing Starts 2.292* 6.160*** 3.999*** 3.999*** (1.235) (1.201) (1.382) (1.382) Production 0.430*** 0.430*** 1.027*** 0.270** (0.0904) (0.0904) (0.249) (0.130) Dollar Value Change 16.38*** 16.38*** 47.23*** 6.827 (4.892) (4.892) (11.79) (7.656) S&P Change 6.107** 6.107** 15.26*** 3.203 (2.749) (2.749) (4.509) (3.770) Constant -5.476** -16.05*** -15.68*** -10.31** (2.728) (3.010) (5.645) (4.746) Observations 1,423 1,423 556 556 Wald χ2 160.6 160.6 101.6 101.6 Log Likelihood -854 -854 -272.3 -272.3 Pseudo R2 0.362 0.362 0.519 0.519 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 3. THE FED AS A POLITICAL AGENT 138

Figure 3.5: Power Analysis: Democratic Elections’ Eﬀect on FOMC Republicans Chapter 4

The Role of Politics in the Federal Reserve’s Lending during the Financial Crisis

As the US financial crisis of 2007–2009 unfolded, financial institutions became increasingly unable to sell their assets (particularly those tied to the housing market) and generate the capital needed to fund their lending activities. In response to these severe liquidity constraints, the Federal Reserve engaged in an unprecedented level of lending to the private financial industry. One substantial concern associated with this lending is that it could potentially be gamed by rent-seeking financial institutions. In other words, private banks may have attempted to use political levers to influence the Fed’s administration of these lending programs in a way that would benefit their bottom line. This chapters addresses whether or not such strategies were successful. Specifically it asks, did more politically active financial institutions receive more money or benefit

139 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 140

more from the Federal Reserve’s lending during the financial crisis? Despite the policy salience of this question (billions of dollars were at stake), there have been no prior attempts to answer it, at least to the best of my knowledge. This study addresses that hole, thereby taking a growing literature investigating the impact of political influence on government lending into a new forum and ultimately provides a mixed answer to this important set of questions. On one hand, my analysis of data only recently made available suggests that financial institutions’ lobbying efforts targeting the Federal Reserve were unsuccessful. That is, multivariate regressions report that such expenditures are not associated with an increase in the probability of receiving funding from the Fed during the financial crisis, after controlling for a host of firm-level covariates. On the other hand, though, lobbying does seem to have been effective for healthier firms. Among this set of financial institutions, greater lobbying expenditures are robustly correlated with higher levels of income derived via funds borrowed from the Fed. This suggests that many firms were engaging in rational political behavior, even if the Fed seems to have succeeded in partially limiting the influence of external actors on the administration of its lending programs during the financial crisis. This nuanced conclusion contributes to a literature that until now had provided mostly binary conclusions about the effect of politics on the administration of governmental lending programs during the financial crisis. While some recent literature investigating the impact of firms’ political activities find only strong, positive effects (e.g., Duchin and Sosyura 2012), others find no such effects (e.g., Fisman et al. 2006). Here, however, I document how the virtually universal approved standard of central bank independence does not appear to have been fully realized during the Fed’s most CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 141

important moment since the Great Depression. This provides even more reason to be concerned about the state of the Fed’s political firewall, particularly when combined with the evidence described in the previous chapter. This chapter proceeds as follows: I first detail the Fed’s actions during the financial crisis and describe the lending programs it created. Second, I elaborate on the existing literature and the theoretical expectations it provides about the answer to this question. Third, I explain the data and methodology I employ to answer this question and, fourth, discuss the results from my quantitative analyses. I then conclude with a discussion of the implications of these findings.f

4.1 Background: What did the Fed do?

In 2007, as economic growth halted and problems in the housing market emerged, ﬁnancial institutions started feeling liquidity pressures and, as a result, increased their borrowing from the Fed. At ﬁrst, much of this borrowing was done through the Fed’s discount window, the traditional mechanism through which the Fed acts as a lender to banks. Chairman Bernanke and the Board of Governors used this tool aggressively, slashing all three of the discount window’s rates, with the primary credit rate dropping from 5.75% in August of 2007 to 0.5% by December 2008.1 In addition to beginning to lower the rates that August, the Fed extended the maximum term on primary credit loans to 30 days and then to 90 days in March 2008 (Federal Reserve Bank 2011). Financial institutions responded to these policy changes by

1The Fed charges financial institutions one of three rates to borrow through the discount window: the primary credit rate, which provides the cheapest capital to the healthiest firms in exchange for higher quality capital, the secondary credit rate, which is higher and extended to firms that do not qualify for the primary rate, and the seasonal credit rate, which is charged for loans lasting as long as 9 months. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 142

borrowing in record numbers, with the value of discount window loans outstanding averaging $30 billion per day during the financial crisis.2 This represents a jump of 17,547.06% from the daily average between 2003 and 2006, when the comparable amount was $170 million (Berger et al. 2014). As the subprime financial crisis became increasingly severe, investors became much less willing to lend to financial institutions, prompting these institutions to have significant liquidity pressures. To address this, Fed leaders decided a more innovative and robust effort was needed, particularly to stimulate term funding markets. As a result, on December 12, 2007, the Fed used its discount window authority to establish the Term Auction Facility (TAF), through which the Fed “auctioned longer-term funds to depository institutions in exchange for discount window collateral” (Inspec- tor General 2010, p. 17).3 During the 28 months TAF was operating (the program ended on April 8, 2010), $3.82 trillion was lent out through some 4,200 transactions. Daily TAF usage averaged approximately $191 billion during the crisis (Berger, Black, Bouwman and Dlugosz 2014). Despite the robust nature of the TAF program, pressure on the term funding markets continued. Thus, the Fed decided that its Open Market Trading Desk would engage in a series of term repurchase transactions. To borrow through this mechanism, formally referred to as single-tranche open market operations (ST OMO), the twenty eligible institutions were required to make bids indicating the interest rate they were willing to pay to receive the given amount of Fed capital. The results of the auctions yielded capital being borrowed at rates as low as 0.01% in December, even when

2The amount of outstanding borrowing from the discount window peaked at $111 billion on October 29, 2008. 3Note that any ﬁnancial institution operating in the US, including American branches of banks based abroad, were eligible for TAF, as long as they held deposits subject to reserve requirements. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 143

the Fed was charging 0.5% for financial institutions to borrow through its traditional discount window (Wachtel 2011; Ivry 2011). Ultimately, the Fed used ST OMO to make a series of 28-day loans to eleven financial institutions from March 7, 2008 to December of that year.4 However, even with this innovative combination of lending through the discount window, the TAF, and ST OMO, the Fed again decided that more action was needed to “avoid systemic financial failure within the US economy” (Inspector General 2010, 17). Thus, using the “usual and exigent circumstances” authority of section 13(3) of the Federal Reserve Act, the Fed’s Board created and implemented a variety of extraordinary and specially targeted lending measures to act as a lender of last resort to a variety of corporations and financial institutions. Between March and November 2008, six such programs were introduced: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CCFF), the Primary Dealer Credit Facility (PDCF), the Term Securities Lending Facility (TSLF), the Term Asset-Backed Securities Loan Facility (TALF), and the Money Market Investor Funding Facility (MMIFF).5 The first of these new extraordinary programs, the TSLF, was created on March 11, 2008, and offered additional assistance to primary dealers facing term funding pressures.6 Through this program, the Fed “loaned relatively liquid Treasury securities for a fee to primary dealers for one month in exchange for eligible collateral

4The following ﬁnancial institutions borrowed from ST OMO: Credit Suisse ($45 billion) Goldman Sachs ($30 billion), RBS ($30 billion), Deutsche Bank ($20 billion), Barclays ($20 billion), UBS ($15 billion), Morgan Stanley ($12 billion), BNP Paribas ($10 billion), Citigroup ($2.8 billion), JPMorgan Chase ($1 billion), and Merrill Lynch ($4.7 billion). The peak amount outstanding was approximately $80 billion (Ivry 2011). 5These last two programs are excluded from my analysis since the Fed used these to lend to investors rather than ﬁnancial institutions. 6Primary dealers are the broker-dealers that facilitate the Fed’s open market operations and, correspondingly, help provide liquidity in the market for US Treasury securities. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 144

consisting of other, less liquid securities” (Federal Reserve System 2012d). Between March 27, 2008, when the Fed held the first auction to allocate the loans via the TSLF, and February 1, 2010, when the last auctions closed, financial institutions borrowed over $2 trillion via 558 transactions. Like its predecessors, the implementation of this new program did not alleviate all of the primary dealers’ stressors. Another challenge for this group came from the triparty repurchase agreement market. To alleviate the pressure on this front, the Fed created the PDCF on March 16, 2008. Through the PDCF, the Fed made overnight loans to primary dealers, just as it does with depository institutions via its discount window. The Fed started making loans via the PDCF the day after the announcement of its creation and continued doing so through May 12, 2009, ultimately extending $8.95 trillion to the participating financial institutions (Federal Reserve System 2012c). Next, on September 19, 2008, only three days after the Lehman Brothers’ collapse had triggered the collapse of the $62.5 Reserve Primary Fund and a more general run on money market funds, the Fed announced that it was establishing the AMLF. Through the AMLF, the Fed was able to “help money market mutual funds (MMMFs) that held asset-backed commercial paper (ABCP) meet investors’ demands for redemptions, and to foster liquidity in the ABCP market and money markets more generally” (Federal Reserve System 2012a).7 To do this, the Fed offered non-recourse loans to financial institutions that then used this capital to purchase ABCP from the participating MMMFs. The program was successful in this mission: the market for

7Put more technically, the AMLF was used to “extend non-recourse loans at the primary credit rate to US depository institutions and bank holding companies to ﬁnance their purchase of high- quality asset-backed commercial paper from money market mutual funds” (Federal Reserve System 2008). CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 145

asset-backed commercial paper, which turns receivables into notes used to provide short-term financing (i.e., liquidity) for a variety of companies, continued to function, and no other money market mutual funds collapsed as result of not being able to meet their redemptions. From September 22, 2008, when the program officially came online, to February 1, 2010, when it was terminated, the AMLF had been used by financial institutions to borrow $217 billion.8 Despite this robust effort in shoring up the ABCP market, the Fed decided that the spiking interest rates and declining volume of notes outstanding in the broader commercial paper market warranted further action. The organization announced on October 7, 2008 that it would serve as a buyer in this market if need be. To begin the program, the Fed created an entirely new private subsidiary, the CPFF LLC. This new limited liability company received funding from the Federal Reserve Bank of New York (FRBNY) via three-month loans. The proceeds of these loans were then used to “purchase commercial paper directly from eligible issuers (Federal Reserve System 2012b). To remediate the risk of holding these notes, CPFF LLC charged issuers fees, collecting a total of $849 million (ibid). Ultimately, between October 27, 2008, when it made its first purchases, and August 30, 2010, when the CPFF LLC was dissolved, the FRBNY loaned over $739 billion to the CPFF LLC and that organization purchased a near identical amount of commercial paper. The full set of these transactions were not disclosed to the public until Bloomberg LP filed and won a federal Freedom of Information Act (FOIA) lawsuit granting their full release.9 Bloomberg News subsequently organized the data from the more than 29,000 pages of official Fed records into Microsoft Excel spreadsheets available for

8For more, see Condon (2011) and the data provided by the Federal Reserve System (2012a). 9The Fed had previously released records on December 1, 2010, March 31, 2011, and July 6, 2011 to comply with the 2010 Dodd-Frank Act as well as various FOIA requests (Kuntz and Ivry 2011). CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 146

download by the public. With these records, we can now systematically examine the approximately 50,000 transactions made throughout the ﬁnancial crisis (Kuntz and Ivry 2011).

4.2 Theory: What is the expected answer to this

question?

Should we expect more politically active firms to participate and benefit more from the Fed’s lending than their less political counterparts? Basing one’s answer to this question solely on the extant literature leads to contradictory conclusions. On one hand, there is much scholarship arguing that political connections do truly matter. This finding is most convincing when investigating the subject of political connections and influence in contexts – usually developing countries – in which political institutions are unable to prevent nepotism and corruption (Krueger 1974). Fisman (2001) and Khwaja and Mian (2005) provide robust empirical support for this conclusion in their studies on the impact of political connections in Indonesia and Pakistan, respectively. Branching out into a large, cross-national study, Faccio, Masulis and McConnell (2006) find that politically connected firms are systematically more likely to receive government bailouts, in both developed and developing economies. They also contend that this tendency affects private lending behavior, as creditors believe the firm that they are lending to will not be allowed to go bankrupt and thus offer loans at lower rates. Within the US, several scholars have contended that the bureaucracy can be easily influenced by external political forces (Wood and Waterman 1994; Carpenter 2004). CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 147

Building off of this idea, others have recently found that politics affected the federal government’s behavior in the recent financial crisis. Acemoglu et al. (2013) argue that investors perceived that firms that had personal connections to Secretary of the Treasury Timothy Geithner would benefit from their relationship during the government’s bailout efforts. Similarly, Duchin and Sosyura (2012) argue that measures of financial institutions’ political influence, such as personal connections to high-level government officials, campaign contributions, and lobbying efforts, are robustly associated with receiving funds in the Treasury-administered Capital Purchase Program (CPP), a part of the broader Troubled Assets Relief Program (TARP). Veronesi and Zingales (2010), Li (2010), and Helmond (2010) provide corroborating evidence in their own studies of the CPP and TARP. Perhaps financial institutions themselves believe that political activities can affect their treatment by regulators and propen- sity to be bailed out, since lenders lobbying more are more prone to engage in riskier lending (Igan, Mishra and Tressel 2011). However, these claims that political connections and influence matter in the US are far from universally accepted. Exemplifying the strand of scholarship suggesting that connections and influence do not matter, Fisman et al. (2006, p. 1) conclude,“U.S. institutions are effective in controlling rent-seeking through personal ties with high- level government officials.” Even when political relationships do appear to have an effect in the US, their substantive effect is relatively minor. For example, Jayachan- dran (2006) finds that firms’ campaign contribution do not impact their market value following a natural experiment (the switching of parties by Senator Jim Jeffords that tipped control of the Senate into Democratic hands), once accounting for industry fixed effects in an econometric model. Similarly, Roberts (1990) acknowledges a lack CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 148

of “systematic evidence” of a relationship between legislators’ seniority in Congress and the “distribution of federal benefits” (p. 31). Addressing the idea that government lending to private enterprises is affected by politics, Cortésand Lerner (2011) show that political connections do not affect grants made by the Community Development Financial Institution. In a similar context, Puente and Wilson (2013) find that the community banks’ campaign contributions are not systematic predictors of funding received from the Treasury’s Community De- velopment Capital Initiative. In addition, Puente (2012) reports that more politically active and better-connected financial institutions did not receive preferential terms from the Department of the Treasury when exiting TARP. This ambiguity is compounded by the fact that there is little work specifically investigating the firm-level determinants of the Fed’s lending decisions. The scholarship that does exist focuses exclusively on the financial covariates associated with firm borrowing. Berger et al. (2014) finds evidence that, among large banks, healthier institutions borrowed more, a finding inconsistent with the Lender of Last Resort theory that central bank funding is usually tapped by weaker institutions. However, studying the same question with only a slightly different sample, the analysis conducted by Boyson, Helwege and Jindra (2014) generates the opposite conclusion: weaker banks borrowed more from the Fed. In the only other work focusing on the potential impact of political considerations on Fed lending during the financial crisis, Broz (2014) suggests that the Fed “discriminated” in its administration of central bank swap lines by targeting jurisdictions with higher levels of importance to US commercial banks. The question of what explains firm-level variation in borrowing is not explored in that paper, though. Thus, with no previous studies addressing the politically important CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 149

question of if firms’ political activities affected their borrowing from the central bank during the financial crisis, there is an opportunity for an original contribution to be made.

4.3 Data & Research Design

4.3.1 Sample

The Fed’s responses to the financial crisis of 2007–2009 ranged widely in terms of their target constituency. Many of the programs, such as the TSLF, were designed to ease pressures faced by primary dealers, while others, like ST OMO, were only used by a few systemically important institutions. To maximize the breadth of the sample without sacrificing a high-level of consistency of comparisons across these different programs, like Boyson, Helwege and Jindra (2014) and Berger et al. (2014), I focus on the two designed to benefit commercial banks operating in the United States: TAF and the discount window. There were 7,219 commercial banks operating at the start of the financial crisis (the fourth quarter of 2007), though the vast majority of these were small, locally operated banks. Such institutions generally lack the economies of scale to engage in autonomous political activities on the federal level and rarely turn to the Fed to address their long-term liquidity constraints. Large commercial banks, on the other hand, are known to do both. Thus, as Boyson, Helwege and Jindra (2014) do, I restrict my sample to the bank holding companies of commercial banks with total assets over $1 billion that operated for at least one quarter in the financial crisis.10

10This avoids survivorship bias since any ﬁrm that was acquired or failed during the crisis (e.g., Wachovia) is still included in the sample. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 150

Unlike Boyson, Helwege and Jindra (2014), however, I do not restrict the sample to only include publicly traded companies since that introduces a potentially artificial differentiation among firms over this size threshold and thus may induce bias into the results. This leaves us with a sample of 442 distinct financial institutions in the sample (from 27 different countries),11 121 of which borrowed from the TAF (27.38% of the sample) and 93 of which borrowed from the discount window (21.04%). From a temporal perspective, data are collected for the period widely seen as the duration of the financial crisis: the fourth quarter of 2007 through the fourth quarter of 2009. Thus, the unit of analysis is the bank-quarter, with nine observations (at most) per bank.12

4.3.2 Dependent Variable

From the Bloomberg LP data, we can derive several measures of ﬁnancial institutions’ borrowing from the Fed in each quarter of the sample (Q42007–Q4 2009). The simplest measure we can derive is a binary indicator variable, marked as one if the institution borrowed at all from the Fed and as zero otherwise. To better understand the mechanisms behind any patterns we observe, though, we want to disaggregate this lending by the program source. Thus, I look at borrowing banks received from the TAF and the discount window separately. We can add even more precision to this by incorporating the number of days each institution borrowed from the Fed’s TAF or its discount window. We can also measure the average daily outstanding balance of each institutions’ debt from these two sources. 11Note that the multivariate regressions include an indicator variable for ﬁrms based outside of the United States. 12Banks that were not operating for all nine of these quarters will have fewer observations. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 151

Finally, for a subset of the institutions in the sample, we can also derive an approximate measure of how much income each firm derived from borrowing from the Fed. To do this, I employ the tax-adjusted net interest margin calculated by Bloomberg. This is “the difference between what [banks] earn on loans and investments and what they pay in borrowing expenses” (Kuntz and Ivry 2011). I convert this interest margin into a quarterly percentage and then multiple it by the financial institution’s average outstanding balance in Fed loans in that quarter. The final step of that calculation is to multiply that value by the length of the quarter (∼ 90 days; see equation 4.1).

NetInterestMargin ( 100 ) ∗ (AverageDailyOutstandingF edBalance)∗ 365 (4.1) (ReportingP eriodLength)

Unfortunately, this Bloomberg-provided measure of the tax-adjusted net interest margin is only available for 114 of the financial institutions in the sample. This is because only some of the institutions provided the inputs needed to calculate this estimate of interest margin in their public financial disclosures. Moreover, since Bloomberg only focuses on firms that actually borrowed from the Fed, none of these 114 are “never takers.” That is, they all borrowed at least once in the sample.

4.3.3 Financial Controls

To explain variation in firm-level borrowing from the Fed, there is an obvious need to control for firms’ financial characteristics, as reported on their balance sheets, income statements, and regulatory disclosures. Most saliently, bigger financial institutions are likely to borrow more from the Fed. Thus, we need to account for firm size, which I measure with total book assets. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 152

Regulators and central bankers considering applications requesting liquidity provisions are also likely to consider the institution’s capital adequacy. That is because they will want to consider whether a bank has sufficient capital to withstand an economic downturn or any other event inducing unexpected weakness into the balance sheet. I measure this concept with the most common way to do so, the Risk-Adjusted Tier 1 Capital Ratio. Banks’ asset quality is also likely to be considered when they are seeking lending. This measure is relevant since it offers additional information about a bank’s health during a crisis by accounting for how easily a bank can handle losses stemming from nonperforming loans. Following standard conventions, I measure this as the ratio of loan and lease allowance to total loans. To ease interpretation, I follow Duchin and Sosyura (2012) in inverting the sign of this ratio “so that greater values of this proxy reflect higher asset quality” or an easier ability to absorb losses (p. 45). To measure earnings I use each banks’ return on assets, calculated by dividing the income earned in a quarter by their total book assets. This is an important control since central bankers are seemingly unlikely to treat more profitable firms exactly the same as their less profitable counterparts. Boyson, Helwege and Jindra (2014) suggest that “firms with high short-term debt and low deposits are more likely to access the Fed programs” (p. 9). Thus, I control for both concepts, measuring the former as debt in current liabilities divided by total book assets and the latter as total deposits over total book assets. Finally, I control for leverage to account for a financial institution’s risk level. I measure this as total debt divided by total book assets, as is typically done. These CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 153

data were all collected from the COMPUSTAT Bank Fundamentals database, published by Standard & Poors Capital IQ and accessed via Wharton Research Data Services. In all but a few cases, the variables are measured on a quarterly basis.13 With bank-quarter as the unit of analysis, each entry for the dependent variable is associated with the latest available financial covariates at the time that quarter started. For example, when examining the borrowing that occurred in the fourth quarter of 2007, I use the financial control variables available as of September 30, 2007 (i.e., the end of the third quarter of that year). Summary statistics for these financial covariates are available in Table 4.1 of the Appendix.

4.3.4 Political Variables

I employ a multi-faceted approach to investigate how firms’ political activities may have affected their participation in the Fed’s lending programs during the financial crisis. The most direct way for firms to do so is to engage in lobbying. By hiring a third-party, private enterprise with expertise in dealing with government agencies and policymakers, financial institutions – like any lobbying client – can become more likely to achieve desired outcomes. In this case, that means acquiring funding from the Fed. Even if firm-specific lobbying does not result in the Fed changing its decisions over the bank’s unique applications (perhaps an overly strict standard for lobbying success), it still may result in legislators or policymakers changing the rules governing these lending programs just enough to change the course of their attempts at receiving funding.

13For those with semi-annual or annual data, appropriate adjustments were made to ensure consistency. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 154

To investigate the effectiveness of lobbying, I rely on data from the Center for Re- sponsive Politics’ OpenSecrets.org (accessed via the Sunlight Foundation’s Influence Explorer API). To ensure that the data obtained is relevant to the domain of interest (i.e., Fed lending), I only include records in which the House of Representatives, Senate, or the Fed itself are among the agencies targeted. I add a second filter to exclude any lobbying on issues other than banking, finance, or bankruptcy.14 Finally, I calculate each firm’s total expenditures from this set of “relevant” lobbying efforts made between the current quarter and that quarter in the previous year, inclusive. While only a relatively small percentage of firms participated in lobbying, those that did spent over a million dollars a year doing so, on average (see Table 4.2 in the Appendix for summary statistics of lobbying expenditures from the full bank-quarter panel data set). To account for another possible mechanism through which financial institutions may have sought to influence the Fed’s lending decisions and program guidelines, I also measure each firms’ campaign contributions in the 2006 & 2008 election cycles. The potential link here is relatively straightforward: firms use campaign contributions to consolidate relationships with elected officials.15 These policymakers could then (potentially) use their de jure and de factor authority to influence the Fed in its administration of its emergency lending during the financial crisis. As with lobbying, though, a firm could be very active in making campaign contributions, but this is unlikely to affect the Fed if these donations are made to elected

14Each lobbying record indicates which policy issue it is addressing. This third issue category is an important one since some lobbying ﬁrms consider emergency lending to pertain to “bankruptcy,” apparently since its absence would be associated with that outcome. 15Note that I am agnostic about the direction of causality here and do not take a stance about whether campaign contributions generate “friendships” or “friendships” generate contributions. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 155

officials expending their legislative resources on issues unrelated to these lending programs.16 Thus, I focus on contributions made to members of relevant committees that have a clearly established interest – not to mention a statutory mandate – in oversight of the Fed. During the period of interest, the two committees that played by far the biggest (public) roles in oversight of the Fed are the Financial Services Committee in the House of Representatives and the Banking, Housing, and Urban Affairs Committee in the Senate.17 73 representatives served on the former in the 110th and 111th Congresses and 31 senators (from 28 states) on the latter.18 While these committees served as the primary forums for public legislative oversight of the Fed, there are others in Congress who seek to influence the Fed via private correspondence. Typically, this information would not be revealed and therefore could not be incorporated into a study such as this one. However, I was able to overcome this barrier by submitting a successful Freedom of Information Act (FOIA) request to the Fed’s Board of Governors to uncover all previously confidential correspondence (i.e., letters) issued between the board and Congress pertaining to the Fed’s emergency lending during the financial crisis.19 The over 3,300 pages that were released included 69 letters from congresspersons

16This point is even more true if the campaign contributions are made to politicians that are never even elected to office. After all, a firm can make a campaign contribution for many reasons, not just to try to influence the Fed’s lending. 17While some, such as Duchin and Sosyura (2012), focus on one or two subcommittees within this larger body in studying the administration of other government lending programs, in this particular case, no such sub-entity possessed sole oversight powers. That is, in this context, the broader committee had a much higher level of salience. 18Interestingly, there was no turnover during this period on the House Financial Services Commit- tee, while 9 of the 31 serving on the Senate Banking Committee only did so in the 111th Congress (i.e., they joined in 2009). Data on committee membership was provided by Stewart III and Woon (2009). 19I also submitted FOIA requests to the twelve Federal Reserve districts, but none of the twelve had engaged in such correspondence. The official at the Board handling my FOIA request, the Deputy Secretary of the Board, also noted that most of the incoming formal correspondence to the Board of Governors was through letters, hence my focus on this medium. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 156

as well as 251 from officials at the Board of Governors (primarily the chair at the time, Ben Bernanke). Since the latter group primarily consists of letters responding to the ones first sent by members of Congress and periodic (and statutorily obligated) transparency disclosures, I focus on the former group for the purposes of my analysis. Unsurprisingly, letters originating from a heterogenous set of congresspersons also tend to express a variety of messages. A majority (45 of the 69) expressed enthusiasm for the lending program in some capacity, though never with overt encouragement to make loans to specific institutions. Another 19 letters struck a more neutral tone in the questions expressed or information requested. Only five of the letters from congresspersons were outright critical of the Fed’s lending. With this information, I created a new subset of congresspersons composed of members that had written a sole-authored letter to the Board of Governors on the topic of the Fed’s lending during the financial crisis with either a neutral or positive tone. I ignored those only listed on co-authored letters because including one’s name on a mass-signed (the mean number of signatories in a co-authored letter in this data set is 7.9) letter is relatively costless. Therefore, this “uncostly” signal is unlikely to change the Fed’s decisions regarding the set of institutions with which those congresspersons have relationships. Similarly, it seems implausible that the Fed would respond to a letter from a congressperson that expresses disdain for the lending in general by increasing said lending to firms that they may have relationships with. Put simply, if the Fed is influenced at all by private correspondence from members of Congress, it is only likely to when letters are written on their own expressing in- dividualistic preferences consistent with an expansion in lending, hence the focus on sole-authored letters with a positive or neutral tone towards the Fed’s lending. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 157

In total, this set of congresspersons includes 22 representatives and 12 senators (from 11 states). Some of these were not surprising at all; for example, Representative Barney Frank (D–MA), the chairman of the House Financial Services Committee, and Senator Chris Dodd (D–CT), the chairman of the Senate Banking Committee, were both frequent letter writers. 11 of the representatives writing such letters also served on the House Financial Services Committee, while 4 of the senators doing so were members of the Senate Banking Committee. Others in the group were less obvious, though not entirely surprising candidates to engage in private correspondence with the Fed. Among this latter group were Iowa’s two senators, Tom Harkin (D-IA), the chairman of the Health, Education, Labor, and Pensions Committee, and Chuck Grassley (R-IA), the ranking member of the Senate Finance Committee. Another committee somewhat well represented among the Senate letter writers is the Small Business and Entrepreneurship Committee. In the House, some prominent leaders from outside the Financial Services Committee also wrote letters, including Representative Carolyn B. Maloney (D-NY), Chair of the Joint Economic Committee, and Representative Darrell Issa (R-CA), Chair of the Committee on Oversight and Government Reform. Of course, however, there were also those writing letters from outside the two main committees and without any notable leadership positions, such as Mike McIntyre (D-NC).20 Of the 442 ﬁnancial institutions in the sample, 68 made campaign contributions in either the 2006 or the 2008 election cycle to at least one member of the House Financial Services Committee, 106 to (a) member(s) of the Senate Banking Com- mittee, and 57 to (a) congressperson(s) writing at least one sole-authored letter to

20McIntyre’s most salient appointment at the time of his letter was to the Majority Leader’s Advisory Council. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 158

the Fed. The average donated from each financial institution making at least one donation to members of the House Financial Services Committee is $15,340. The comparable figure among members of the Senate Banking Committee is $21,030 and $11,980 when looking at the group of congresspersons writing letters. Table 4.2 in the Appendix lists full summary statistics for the campaign contributions variables in the full bank-quarter panel data set. Of course, financial institutions can also develop relationships with congresspersons by simply being headquartered in that individual’s district. That is, if a bank is based in the congressional district of a representative or the state of a senator, the policymaker will have a clear interest in promoting policies that will benefit the financial institution. After all, if the banks based in their district or state are more profitable, then those institutions will be able to employ more individuals and extend more credit to the homeowners, consumers, and small businesses that are a core part of their constituency. Moreover, a legislator’s ability to achieve positive policy outcomes for banks in their district is likely to be enhanced when she is willing to spend more resources on relevant policy domains and overseeing pertinent agencies, such as the Fed. As before, I consider three proxies that get at a legislators’ interest in helping banks with which they have relationships: membership in either the House Financial Services Commit- tee or the Senate Banking Committee or evidence of having written a sole-authored letter to the Fed regarding its lending program. Of the 442 banks in the sample, only 24 were headquartered in the district of a member of the House Financial Services Committee, though 229 were in one of the 28 states represented by a member of the Senate Banking Committee in either the 110th or 111th Congresses. 86 banks were CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 159

in either a congressional district or state represented by a congressperson writing a letter to the Fed (see Table 4.2).

4.3.5 Econometric Model

My baseline econometric model is a logistic regression that analyzes whether or not a financial institution received funding from the Fed’s TAF or, separately, its discount window. The financial covariates described above are included as are the political variables of interest, though I analyze each potential mechanism separately. That is, I look at the possible impact that the strength of a financial institution’s relationships with a) members of the House Financial Services Committee b) members of the Senate Banking Committee and c) members of Congress that wrote sole-authored letters to Congress has on its borrowing from the Fed.21 To limit the potential for Type I errors and account for the possibility that the error terms may be correlated within banks, like Berger et al. (2014), I cluster the standard errors for all regressions by bank and include quarter fixed effects to focus on explaining variation within each of the nine time periods of the sample. Equation 4.2 describes this model more formally,

p(x) log( ) = β + (X ∗ β) + (4.2) 1 − p(x) 0 i

where X is a column vector composed of the independent variables (X1,,Xn), β is a row vector of coeﬃcients (β1,,βn) for these variables, i represents the clustered standard errors for each bank, and n is the number of covariates in the model. As described in subsection 4.3.2 above, though, there is additional precision we

21Since we cannot know for sure whether or not a ﬁnancial institution applied for funding from the Fed, our inferences about how a bank’s partnerships in Congress aﬀect how it is treated by the Fed are limited. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 160

can add to these coefficient estimates by using other specifications of the dependent variable that better reflect the intensity of a bank’s usage. These include the number of days a bank had outstanding debt from the TAF or the discount window in the quarter of interest, the average daily outstanding balance of their debts (logged to reflect non-linearities),22 and the income derived from borrowing at low rates from the Fed’s two sources (also logged). In all of these regressions, there will still be a high number of zeroes, but the upper bound of the dependent variable will no longer be one. Thus, just as Berger et al. (2014) do, I employ a tobit regression model (Equation 4.3), with the following simplistic notation:

∗ yi,t = h(Campaign Contributionsi, Lobbying Expendituresi,t,

HQ In Districti, T ier 1 Ratioi,t, Asset Qualityi,t,

Return On Assetsi,t, Liquidityi,t, Leveragei,t, (4.3)

Short T erm Debti,t, Deposits T o Assetsi,t,

T otal Assetsi,t, F oreign Institutioni, Quarter Dummyt, i)

where yi,t is deﬁned according to Equation 4.4.

  ∗ ∗ yi,t if yi,t > 0 yi,t = (4.4)  ∗ 0 if yi,t = 0

22All amounts in the regressions – including campaign contributions, lobbying expenditures, and total assets – are logged for this same reason. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 161

4.4 Results

Prior to implementing these multivariate models, I first analyze the bivariate relationships between the primary independent variables of interest and participation in the Fed’s two lending programs offered to commercial banks during the financial crisis: the TAF and the discount window. The differences that emerge offers evidence in favor of the hypothesis that the most politically active institutions were more likely to receive funding from the Fed. T tests show that the firms offering more campaign contributions to congresspersons expressing an interest in the Fed’s lending and spending more on lobbying salient policymakers consistently received more funding from the TAF and the discount window. However, this pattern appears to be limited to the variables measuring political expenditures. The univariate differences mostly disappear when comparing borrowing from banks headquartered in districts represented by relevant congresspersons to those with headquarters elsewhere. The one exception is that there is limited evidence suggesting that banks represented in the House by members of the Financial Services Committee were more likely to receive funding from the TAF. The opposite is true for those represented by congresspersons writing letters to the Fed: those based in these districts were far less likely to participate in TAF and somewhat less likely to borrow from the discount window. This suggests that legislators’ letters may have been a reaction to suboptimal lending outcomes – or expectations of such outcomes – (i.e., a dearth of borrowing among the financial institutions they have developed relationships with) instead of attempts to prevent deviations from positive outcomes. Similarly, the t tests present modest evidence that firms based in states with senators serving on the Banking Committee borrowed CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 162

less from the discount window, on average, than those without such representation. Tables 4.3 and 4.4 in the Appendix offer more details on the results of these univariate differences. Of course, however, these simple analyses may provide misleading conclusions since the political variables of interest are not randomly assigned across firms.23 Thus, we must account for the financial covariates before making more definitive conclusions about the impact that firms’ political activities had on their borrowing from the Fed. While the logit and tobit models (described in subsection 4.3.2 above) do not completely overcome the lack of a random “treatment,” they do substantially reduce the potential of bias when compared to the estimates produced by the t tests presented in Tables 4.3 and 4.4. Highlighting this, once firm-level covariates are controlled for, campaign contributions no longer appear to be statistically significant predictors of TAF borrowing, regardless of how that is defined. When analyzing variation in a dependent variable that simply indicates whether or not the bank received funding from TAF, logistic regressions report that a bank’s campaign contributions to each of the three groups of interests have no discernible effects (see Table 4.6). This set of results does not change when modifying the dependent variable to capture the intensity with which a bank borrowed from TAF in a given quarter, as reported by the tobit regression summaries found in Tables 4.7 and 4.8. In addition, there is only mild evidence of any robust relationship between relevant lobbying expenditures and TAF borrowing. Although all of the coefficients on lobbying possess the expected sign (Tables 4.6–4.8), only one is distinguishable from

23This is particularly true since we see non-zero correlations between some of the political variables and the ﬁnancial controls, as reported in Table 4.5 of the Appendix. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 163

zero. This sole statistically significant result is produced by the logistic regression analyzing the dichotomous TAF borrowing variable when controlling for relationships with congressperson writing letters to the Fed’s Board of Governors on the topic of direct lending during the financial crisis. On the issue of congressional representation, though, the pattern is contrary to the theoretical expectations: firms whose headquarters resided in the district of the House Financial Services Committee or the district or state of a congressional letter writer were actually less likely to receive TAF funding. There is one small exception here, though: banks headquartered in states with senators serving on the Senate Banking Committee were no less likely to borrow from TAF. Additional evidence suggesting that political activities may be attempts to reverse unsuccessful relationships with the Fed comes when analyzing variation in borrowing from the discount window (Tables 4.9–4.11). Once again, firms located in the district of a congressperson serving on a relevant committee or expressing interest in Fed lending appear less likely to borrow from the Fed’s discount window.24 As introduced above, this pattern suggests congresspersons focusing on oversight of the Fed may be more motivated by acquiring gains for the banks in their district than avoiding losses. In other words, it could be the case that policymakers are expending their resources (through the seeking of relevant committee assignments or by directly generating correspondence to central bankers) to attempt to help firms struggling in their interactions with central bankers at the Fed. However, it appears such efforts were not successful in changing the nature of lending during the financial crisis, hence the negative correlations on the district coefficients reported by the

24Banks with physical ties to members of the Senate Banking Committee are no longer excluded from this pattern as they too have a negative and signiﬁcant result. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 164

regressions in Tables 4.9–4.11. This second set of regressions also show a robust negative correlation between lobbying expenditures and the degree to which financial institutions borrow from the discount window. The implication of this pattern is substantively consistent with the previous point: firms are lobbying Congress and the Fed in a seemingly unsuccessful effort to generate more lending for themselves. Moreover, that these findings from analyzing borrowing from this permanent source – the discount window – are stronger than when looking solely at the transitory TAF makes sense. Firms and their congressional allies would be most rational to more heavily weight their participation (or lack thereof) in the discount window when deciding how to allocate their political resources targeting the Fed since, unlike TAF, it is a permanent source of funding. Regardless of the roots behind the negative correlations between this set of political variables and borrowing activities, the Fed does not appear to have been foolproof in insulating itself from external influence during the administration of its lending during the financial crisis. As Table 4.12 shows, there is a persistent correlation between relevant lobbying expenditures and income derived from TAF borrowing. As first explained in Subsection 4.3.2, this specification of the dependent variable can only be calculated for the subset of firms in the sample that actually borrowed from TAF. Thus, this finding suggests that conditional on applying and being selected for TAF funding at least once, lobbying is a highly profitable strategy. In terms of magnitude, the coefficients produced by the tobit regressions suggests that a 100% change in relevant lobbying expenditures will generate between a 50.4 and 79.6% increase in the amount of income derived from TAF borrowing.25 Since the

25Since, in this case, both the independent and dependent variable are logged, these ﬁgures are CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 165

amount of relevant lobbying expenditures for each firm in the sample fall far behind the amount of income generated by borrowing at the below-market-rates offered by TAF, this represents a very profitable arbitrage opportunity. Highlighting this, the mean amount lobbied in a given year (conditional on lobbying at all) is $1,014,901, while the mean income derived is $751,630.4 per quarter.26 We can be more confident of the profitability of this lobbying strategy among this subset of participating firms by comparing the results displayed in Table 4.12 to those in Table 4.13. The only difference between these two regression specifications is that the latter replaces “relevant” lobbying expenditures (defined in Subsection 4.3.4 above) with “irrelevant” lobbying expenditures. While the former solely includes lobbying transactions pertaining to bankruptcy, banking, and finance, and targeting Congress or the Fed, the latter only includes transactions in which the issue area and / or the agency targeted was unrelated to the Fed’s lending program. As Table 4.13 shows, banks more actively engaging in this form of “placebo” lobbying derived no more profits, on average, than their otherwise comparable counterparts (hence the statistically insignificant coefficients on the lobbying expenditures variable in this set of tobit regressions). To further investigate the scope conditions under which lobbying is associated with higher levels of income derived from TAF, I ran a set of regressions that add in an interaction effect between lobbying and firm type. The goal here is to see if the effect of lobbying is conditional on the firm’s underlying health. To do this, I classified each firm-quarter observation as one of three types: “healthy,” “illiquid,” or calculated by multiplying the coefficient estimates for lobbying expenditures (from Table 4.12) by 100. 26By not excluding zeros, the average amount lobbied by a bank in the previous year in this sample falls to only $6.83. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 166

“unhealthy.” These are all relative classifications based upon the two main financial factors influencing firm profits from TAF: liquidity and asset quality (see the regression results reported in Tables 4.12 and 4.15).27 Those deemed healthy were at least in the 25th percentile in both liquidity and asset quality. I classified firms as illiquid if they were below the 25th percentile in liquidity but above that threshold for asset quality. Finally, firms below the 25th percentile in asset quality were classified as unhealthy. With these coding guidelines, I classified 348 bank-quarter observations as healthy, 136 as illiquid, and 162 as unhealthy. I then ran a series of regressions investigating how the effect of lobbying differed across these three types of firms. These regressions, reported in Table 4.14, suggest that lobbying is an effective use of a firm’s resources only when they are healthy. The marginal effects plots displayed in Figure 4.2 demonstrate this with greater clarity: there is only a positive relationship between lobbying expenditures and income derived from TAF when the firm engaging in that lobbying is above the 25th percentile in both its liquidity and asset quality (i.e., in the healthy category). This finding further illustrates how, for the firms most likely to qualify for borrowing from the Fed, lobbying was a profitable use of their resources. For those with even temporarily weaker balance sheets, however, lobbying appears to have been an exercise in futility. That is, spending more on this activity is not associated with an increase in profits derived from TAF for the firms classified as either illiquid or unhealthy, hence the flat slopes seen in Figure 4.2 for these groups. The financial variables offer their own interesting conclusions.28 As expected,

27This classification scheme also reflects the well-known Bagehot rule regarding central bank lending: lend freely to firms that have solid underlying assets but face temporary liquidity constraints, but not to those without good collateral (Bagehot 1888). 28As Figure 4.1 illustrates, there are no obvious non-linear relationships between these financial CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 167

bigger firms received more funding from the Fed via both the TAF and its discount window. They do not, however, make more money off of these loans, as demonstrated by the statistically insignificant coefficients for the Total Assets variable in Table 4.12. More profitable firms – those with a higher return on assets – did not receive more funding nor did they make more money from such loans. Similarly, a firm’s capitalization does not seem to have affected its borrowing from the Fed during the crisis, as evidenced by the lack of a robust correlation between the Tier 1 Ratio variable and the various specifications of the dependent variable. Those with high quality assets borrowed less actively from the discount window, but benefited more by borrowing from the TAF. The former result is consistent with that of Boyson, Helwege and Jindra (2014), as is the finding that less liquid firms, those with more short-term debt, and banks with fewer deposits (a stable source of liabilities) to assets borrowed less. Put simply, banks with more short-term funding needs do seem to have borrowed more, contrary to what Berger et al. (2014) claim. Finally, consistent with expectations, foreign institutions borrowed less, though their nationality did not affect their ability to profit from such lending. When regressing only financial covariates against income derived from TAF, these same conclusions hold. As shown in Table 4.15 and in the marginal effects plots shown in Figure 4.3, firms with higher quality assets profited more from this extraordinary lending program, as did those with less liquid balance sheets and more short-term debt on their books. This is also a robust negative correlation between firms’ ratios of deposits to assets to the income derived from TAF. This regression with only financial covariates also reveals that adding political covariates and the primary outcome of interest: income derived from the TAF. Thus, transformations of these variables do not improve model fits. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 168

variables to the equation adds relatively little in explanatory power. As Table 4.16 shows, this baseline model is more parsimonious, but not very different in terms of how well it fits the data when compared to regression specifications with the full set of political variables as well as those adding in interaction effects. This corroborates the conclusion made above that politics seem to have played a minor role in the administration of the Fed’s lending during the financial crisis. That does not mean that political influence attempts were never successful, though. It is just that only relatively healthy financial institutions benefitted from lobbying, while firms suffering from liquidity constraints and lower asset qualities do no appear to have profited from lobbying or having relationships with members of Congress.

4.5 Conclusion

The analysis presented above and documented in the Appendix offers two related conclusions. First, it appears that, for many firms, attempting to influence the Fed and change the way in which it was administering its lending during the financial crisis was unsuccessful. It would be a stretch to infer that lobbying or attempting to cultivate partnerships in Congress is counterproductive (i.e., that it causes firms’ borrowing usage and intensity to decrease). Nevertheless, these findings do suggest that much of the political behavior surrounding the Fed during the financial crisis were attempts to generate gains that did not achieve the desired outcomes.29 On the other hand, there does appear to be evidence that, among firms that sought and qualified for funding from the Fed, lobbying was a profitable endeavor. For this

29I want to be careful to not overstate the generalizability of this conclusion, though, by claiming that this evidence provides conclusive proof that legislators and ﬁrms are generally motivated primarily by gain acquisition in their political behavior. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 169

group, there is a reasonably robust relationship between the amount of money spent on “relevant” lobbying and the income derived from TAF borrowing. Confidence that this is not a spurious correlation is further increased by the lack of a significant findings when the lobbying variable is adjusted to include only lobbying expenditures on issues unrelated to oversight or administration of the Fed’s lending programs. This set of findings only partially corroborates Chairman Bernanke’s claim that “an institution that was eligible to participate could do so if it chose without the need for ‘influence,’ while an institution that was not eligible would not have been able to participate without regard to any efforts at influence.”30 The second part of this claim seems to hold up upon closer inspection, but the first is much more specious. While the pattern uncovered here does not definitively prove that lobbying caused the Fed to offer more funding to firms engaging in such activity, this finding should nonetheless be concerning since even the perception of a central bank that can be influenced by external political pressure is damaging to its ability to pursue its mandate of financial stability. Given this practical importance and the absence of other scholarship on the topic, I invite additional work to provide further clarity on the contexts in which lobbying (and similar initiatives) can successfully influence the Fed.

30This quote comes from a letter sent to Senator Bernie Sanders (I–VT) that was part of the correspondence acquired from the Board of Governors following my successful FOIA request. CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 170

4.6 Appendix

Table 4.1: Summary Statistics of Financial Control Variables

Statistic Mean St. Dev. Pctl(25) Median Pctl(75) Tier 1 Capital Ratio 10.408 2.906 8.680 10.025 11.818 Asset Quality −0.017 0.010 −0.019 −0.014 −0.011 Return on Assets −0.001 0.008 −0.0003 0.001 0.002 Short Term Debt 0.059 0.063 0.011 0.041 0.089 Leverage 0.910 0.038 0.894 0.913 0.932 Deposits to Assets 0.697 0.124 0.644 0.719 0.779 Assets ($millions) 103,514.900 394,585.900 1,592.122 3,202.455 12,390.140

Table 4.2: Summary Statistics of Political Variables

Statistic Mean St. Dev. Pctl(25) Median Pctl(75) Lobbying (Indicator) 0.054 0.227 0 0 0 Lobbying Expenditures (Amount) 1,014.901 1,896.002 60.000 255.000 1,100.000 Contributions to HFS Member (Indicator) 0.162 0.368 0 0 0 Contributions to HFS Member (Amount) 15.412 48.152 0.500 2.300 9.200 District of HFS Member (Indicator) 0.054 0.227 0 0 0 Contributions to SBC Member (Indicator) 0.250 0.433 0 0 1 Contributions to SBC Member (Amount) 21.222 68.332 1.000 2.000 10.000 District of SBC Member (Indicator) 0.512 0.500 0 1 1 Contributions to Letter Writer (Indicator) 0.132 0.338 0 0 0 Contributions to Letter Writers (Amount) 12.306 29.214 1.000 2.100 5.150 District / State of Letter Writer (Indicator) 0.198 0.399 0 0 0 Amounts are listed in thousands of dollars, with zeros excluded (here only). CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 171

Table 4.3: Univariate Diﬀerences: TAF Participation

Group Means: No Yes Yes minus No t-Statistic HFS Contributions 1, 670.807 7, 640.960 5, 970.153 -3.353 SBC Contributions 3, 549.970 16, 329.530 12, 779.560 -4.407 Letter Writer Contributions 1, 073.892 5, 048.198 3, 974.306 -4.227 Lobbying Expenditures 27, 025.810 231, 951.800 204, 926.000 -4.403 Represented by HFS Member 0.051 0.077 0.026 -2.124 Represented by SBC Member 0.515 0.491 -0.023 0.992 Represented by Letter Writer 0.208 0.137 -0.071 4.251

Table 4.4: Univariate Diﬀerences: DW Participation

Group Means: No Yes Yes minus No t-Statistic HFS Contributions 2, 188.555 6, 296.493 4, 107.938 -1.890 SBC Contributions 4, 610.343 14, 047.510 9, 437.171 -2.507 Letter Writer Contributions 1, 391.516 4, 489.543 3, 098.027 -2.500 Lobbying Expenditures 51, 769.190 99, 080.920 47, 311.730 -1.297 Represented by HFS Member 0.054 0.064 0.011 -0.698 Represented by SBC Member 0.516 0.454 -0.063 2.022 Represented by Letter Writer 0.201 0.157 -0.044 1.933 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 172

Table 4.5: Correlation Matrix

TAF DW HFS HFS Tier 1 Return Short Deposits Total Lobbying Asset Participation Borrowing Contributions District Capital on Term Leverage to Assets Amount Quality (Indicator) (Indicator) Amount Dummy Ratio Assets Debt Assets ($millions) TAF Participation 1 0.336 0.142 0.102 0.040 -0.059 -0.040 -0.002 0.122 0.041 -0.183 0.233 (Indicator) DW Borrowing 0.336 1 0.025 0.053 0.012 -0.083 -0.022 -0.014 0.115 0.036 -0.098 0.108 (Indicator) Lobbying 0.142 0.025 1 0.263 0.247 -0.016 -0.092 -0.012 0.128 0.010 -0.147 0.341 Amount HFS Contributions 0.102 0.053 0.263 1 0.191 -0.035 -0.018 -0.096 0.040 0.026 -0.073 0.158 Amount HFS District 0.040 0.012 0.247 0.191 1 0.005 -0.079 -0.036 0.046 -0.004 -0.026 0.072 Dummy Tier 1 Capital -0.059 -0.083 -0.016 -0.035 0.005 1 0.172 0.268 0.003 -0.560 -0.040 -0.093 Ratio Asset -0.040 -0.022 -0.092 -0.018 -0.079 0.172 1 0.360 0.018 -0.180 0.035 -0.002 Quality Return on -0.002 -0.014 -0.012 -0.096 -0.036 0.268 0.360 1 0.089 -0.204 -0.137 0.043 Assets Short- Term 0.122 0.115 0.128 0.040 0.046 0.003 0.018 0.089 1 0.082 -0.288 0.045 Debt Leverage 0.041 0.036 0.010 0.026 -0.004 -0.560 -0.180 -0.204 0.082 1 0.041 0.274 Deposits to -0.183 -0.098 -0.147 -0.073 -0.026 -0.040 0.035 -0.137 -0.288 0.041 1 -0.453 Assets Total Assets 0.233 0.108 0.341 0.158 0.072 -0.093 -0.002 0.043 0.045 0.274 -0.453 1 ($millions) CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 173

Figure 4.1: Relationships Between Financial Covariates and Income Derived from TAF CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 174

Table 4.6: Logistic Regression Results: TAF Usage

Dependent Variable: TAF Borrowing (Y/N) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.013 0.018 −0.031 (0.022) (0.019) (0.025) Lobbying Expenditures 0.029 0.027 0.036∗ (0.020) (0.020) (0.020) HQ in District −0.552∗ 0.0005 −0.631∗∗∗ (0.297) (0.135) (0.179) Tier 1 Ratio −0.022 −0.029 −0.022 (0.028) (0.028) (0.029) Asset Quality 4.646 6.665 10.257 (8.148) (7.994) (8.140) Return on Assets 9.129 8.880 10.047 (9.834) (9.854) (10.056) Liquidity −6.066∗∗∗ −5.915∗∗∗ −6.081∗∗∗ (1.202) (1.211) (1.231) Leverage −2.528 −2.911 −2.522 (2.330) (2.308) (2.381) Short Term Debt 4.061∗∗∗ 4.019∗∗∗ 4.170∗∗∗ (0.940) (0.940) (0.945) Deposits to Assets −1.980∗∗∗ −2.029∗∗∗ −2.096∗∗∗ (0.673) (0.677) (0.674) Total Assets 0.537∗∗∗ 0.506∗∗∗ 0.573∗∗∗ (0.054) (0.056) (0.057) Foreign Institution? −1.384∗∗∗ −1.225∗∗∗ −1.637∗∗∗ (0.343) (0.345) (0.346) Constant −12.902∗∗∗ −11.867∗∗∗ −13.565∗∗∗ (3.051) (3.059) (3.157) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -869.903 -871.371 -863.047 Akaike Inf. Crit. 1,781.806 1,784.742 1,768.094 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 175

Table 4.7: Tobit Regression Results: Intensity of TAF Usage (In Days)

Dependent Variable: Number of Days With TAF Debt Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.502 0.772 −1.712 (1.998) (1.770) (2.145) Lobbying Expenditures 0.711 0.533 0.971 (1.570) (1.534) (1.429) HQ in District −22.702 −1.362 −29.853∗ (28.276) (12.471) (16.718) Tier 1 Ratio −0.526 −0.817 −0.404 (2.270) (2.287) (2.295) Asset Quality 232.384 343.614 465.179 (628.935) (630.203) (661.498) Return on Assets 394.620 371.859 406.242 (472.178) (483.410) (489.888) Liquidity −295.189∗∗∗ −289.661∗∗∗ −300.319∗∗∗ (105.126) (107.814) (108.533) Leverage −79.383 −101.213 −74.959 (185.669) (183.439) (185.677) Short Term Debt 228.323∗∗ 226.635∗∗ 239.173∗∗∗ (92.379) (91.290) (91.952) Deposits to Assets −113.322∗∗ −112.997∗∗ −119.685∗∗ (56.058) (56.126) (57.089) Total Assets 25.989∗∗∗ 24.854∗∗∗ 27.669∗∗∗ (4.223) (4.688) (4.519) Foreign Institution? −66.897∗∗ −60.942∗∗ −78.228∗∗∗ (27.411) (28.783) (27.314) Constant −670.271∗∗∗ −624.184∗∗∗ −702.514∗∗∗ (229.316) (234.322) (232.204) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -2,875.7 -2,877 -2,867.9 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 176

Table 4.8: Tobit Regression Results: Intensity of TAF Usage (Balance)

Dependent Variable: Average Daily Outstanding Balance, TAF (Logged $) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.100 0.246 −0.392 (0.502) (0.454) (0.534) Lobbying Expenditures 0.274 0.202 0.316 (0.401) (0.397) (0.368) HQ in District −6.476 −0.158 −8.064∗ (7.055) (3.156) (4.231) Tier 1 Ratio −0.236 −0.329 −0.225 (0.584) (0.592) (0.593) Asset Quality 62.798 91.878 123.490 (159.077) (159.890) (167.469) Return on Assets 106.425 100.662 111.022 (124.683) (127.712) (129.661) Liquidity −76.234∗∗∗ −74.503∗∗∗ −77.279∗∗∗ (25.966) (26.813) (26.729) Leverage −20.133 −26.977 −20.643 (47.171) (46.932) (47.265) Short Term Debt 55.379∗∗ 54.813∗∗ 58.059∗∗ (23.534) (23.259) (23.441) Deposits to Assets −27.620∗ −27.501∗ −29.100∗∗ (14.195) (14.249) (14.407) Total Assets 7.051∗∗∗ 6.664∗∗∗ 7.413∗∗∗ (1.073) (1.187) (1.133) Foreign Institution? −18.419∗∗∗ −16.335∗∗ −21.094∗∗∗ (6.956) (7.294) (6.908) Constant −178.078∗∗∗ −163.303∗∗∗ −183.212∗∗∗ (58.644) (60.231) (59.190) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -2,351.7 -2,353.1 -2,343.8 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 177

Table 4.9: Logistic Regression Results: Discount Window Usage

Dependent Variable: DW Borrowing (Y/N) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions −0.012 0.044∗ 0.028 (0.029) (0.024) (0.032) Lobbying Expenditures −0.050∗ −0.070∗∗ −0.071∗∗ (0.028) (0.027) (0.028) HQ in District −1.079∗∗∗ −0.659∗∗∗ −0.611∗∗∗ (0.406) (0.166) (0.223) Tier 1 Ratio −0.038 −0.053 −0.050 (0.036) (0.037) (0.037) Asset Quality −26.756∗∗∗ −18.622∗ −21.841∗∗ (9.945) (9.649) (9.711) Return on Assets 3.348 1.746 2.810 (10.401) (10.289) (10.508) Liquidity −8.585∗∗∗ −8.738∗∗∗ −8.989∗∗∗ (2.568) (2.533) (2.616) Leverage 1.432 −0.488 0.238 (3.134) (3.116) (3.163) Short Term Debt 3.737∗∗∗ 4.277∗∗∗ 3.936∗∗∗ (1.071) (1.101) (1.091) Deposits to Assets −2.077∗∗ −2.203∗∗ −2.090∗∗ (0.859) (0.865) (0.866) Total Assets 0.335∗∗∗ 0.255∗∗∗ 0.283∗∗∗ (0.067) (0.068) (0.069) Foreign Institution? −1.939∗∗∗ −1.871∗∗∗ −1.778∗∗∗ (0.506) (0.508) (0.505) Constant −10.256∗∗∗ −6.391∗ −7.972∗∗ (3.883) (3.827) (3.948) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -618.649 -614.518 -619.112 Akaike Inf. Crit. 1,279.299 1,271.037 1,280.224 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 178

Table 4.10: Tobit Regression Results: Intensity of Discount Window Usage (Days)

Dependent Variable: Number of Days With DW Debt Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions −0.310 0.752 0.732 (1.248) (1.054) (1.330) Lobbying Expenditures −1.220 −1.678∗ −1.801∗∗ (0.906) (0.869) (0.913) HQ in District −22.622∗ −14.928∗∗ −14.539∗ (13.080) (7.028) (8.242) Tier 1 Ratio −1.040 −1.317 −1.234 (1.248) (1.275) (1.276) Asset Quality −498.920∗ −372.807 −439.285 (297.833) (321.693) (305.425) Return on Assets −152.967 −170.208 −152.317 (263.245) (261.862) (267.507) Liquidity −217.850∗∗ −226.940∗∗∗ −228.393∗∗ (88.101) (87.250) (91.229) Leverage 36.934 −8.795 12.655 (100.702) (95.896) (101.712) Short Term Debt 95.164∗∗ 105.470∗∗ 100.082∗∗ (43.532) (43.631) (44.721) Deposits to Assets −62.757∗ −64.961∗∗ −61.947∗ (32.742) (31.321) (32.938) Total Assets 6.641∗∗ 5.368∗∗ 5.653∗∗ (2.581) (2.710) (2.741) Foreign Institution? −44.007∗∗∗ −42.749∗∗∗ −40.768∗∗ (16.058) (16.428) (16.508) Constant −212.770∗ −136.208 −169.396 (128.256) (130.115) (131.004) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -1,437.4 -1,433.4 -1,436.8 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 179

Table 4.11: Tobit Regression Results: Intensity of Discount Window Usage (Balance)

Dependent Variable: Average Daily Outstanding Balance, DW (Logged $) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions −0.116 0.526 0.419 (0.660) (0.540) (0.699) Lobbying Expenditures −0.598 −0.861∗ −0.893∗ (0.472) (0.444) (0.466) HQ in District −12.065 −8.181∗∗ −7.604∗ (7.357) (3.431) (4.205) Tier 1 Ratio −0.577 −0.747 −0.686 (0.675) (0.685) (0.692) Asset Quality −285.187∗ −213.254 −250.544 (167.025) (177.671) (175.539) Return on Assets 7.006 −2.008 9.976 (132.576) (131.595) (136.062) Liquidity −106.938∗∗∗ −111.298∗∗∗ −111.796∗∗∗ (40.400) (39.578) (42.142) Leverage 16.833 −9.065 3.874 (54.711) (52.848) (55.948) Short Term Debt 52.498∗∗ 57.641∗∗∗ 54.807∗∗ (21.540) (21.136) (21.816) Deposits to Assets −27.609 −28.963∗ −27.032 (17.083) (16.398) (17.214) Total Assets 4.223∗∗∗ 3.420∗∗ 3.686∗∗∗ (1.297) (1.364) (1.374) Foreign Institution? −24.997∗∗∗ −23.970∗∗∗ −23.237∗∗∗ (8.244) (8.526) (8.532) Constant −128.387∗ −82.934 −104.947 (67.701) (67.915) (69.484) Quarter dummies? Yes Yes Yes Observations 2,401 2,401 2,401 Log Likelihood -1,328.5 -1,323.5 -1,328 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 180

Table 4.12: Tobit Regression Results: Income Derived From TAF

Dependent Variable: Income Derived From TAF Borrowing (Logged $) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.441 −0.553 −0.504 (0.509) (0.404) (0.498) Lobbying Expenditures 0.504 0.796∗∗ 0.724∗∗ (0.337) (0.327) (0.335) HQ in District −2.836 2.253 1.387 (4.352) (2.412) (3.609) Tier 1 Ratio 0.217 0.428 0.472 (0.661) (0.701) (0.704) Asset Quality 288.931∗ 334.082∗ 344.096∗∗ (170.846) (170.999) (166.640) Return on Assets 131.209 108.636 96.694 (126.897) (126.181) (129.729) Liquidity −81.174∗∗∗ −82.066∗∗∗ −84.008∗∗∗ (24.701) (26.024) (26.516) Leverage 5.081 24.550 32.478 (57.866) (56.940) (59.072) Short Term Debt 72.498∗∗∗ 72.277∗∗∗ 70.779∗∗∗ (20.621) (20.379) (20.470) Deposits to Assets −21.526 −18.361 −20.595 (13.546) (13.665) (14.090) Total Assets −0.115 0.939 0.689 (1.172) (1.238) (1.138) Foreign Institution? 1.131 −2.663 −1.866 (6.833) (6.679) (6.431) Constant −12.964 −55.434 −56.262 (72.516) (73.669) (74.778) Quarter dummies? Yes Yes Yes Observations 646 646 646 Log Likelihood -1,830.8 -1,829.1 -1,830.7 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 181

Table 4.13: Tobit Regression Results: Income Derived From TAF (Placebo Test)

Dependent Variable: Income Derived From TAF Borrowing (Logged $) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.632 −0.335 −0.180 (0.480) (0.380) (0.493) Lobbying Expenditures 0.547 0.642 0.544 (Placebo) (0.411) (0.441) (0.442) HQ in District −3.321 2.195 0.599 (4.261) (2.473) (3.803) Tier 1 Ratio 0.382 0.682 0.626 (0.683) (0.726) (0.711) Asset Quality 292.214∗ 346.132∗∗ 337.717∗∗ (170.851) (174.844) (169.309) Return on Assets 86.514 41.070 45.474 (127.364) (128.577) (127.846) Liquidity −79.817∗∗∗ −77.635∗∗∗ −78.520∗∗∗ (25.923) (27.479) (27.503) Leverage 10.820 33.392 33.209 (58.492) (59.048) (60.233) Short Term Debt 70.612∗∗∗ 67.332∗∗∗ 67.182∗∗∗ (20.847) (20.262) (20.515) Deposits to Assets −23.729∗ −21.565 −22.577 (13.244) (13.339) (14.030) Total Assets 0.085 1.471 1.098 (1.227) (1.267) (1.185) Foreign Institution? −0.206 −5.803 −4.565 (7.232) (7.310) (6.892) Constant −23.892 −77.654 −68.131 (74.717) (76.896) (77.309) Quarter dummies? Yes Yes Yes Observations 646 646 646 Log Likelihood -1,831.5 -1,832.5 -1,833.9 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 182

Table 4.14: Tobit Regression Results: Income Derived From TAF (Interactions)

Dependent Variable: Income Derived From TAF Borrowing (Logged $) Political House Senate Letter Entity: Fnl Svc Banking Writers Campaign Contributions 0.397 -0.554 -0.537 (0.492) (0.401) (0.498) Lobbing Expenditures 1.030** 1.313*** 1.286*** (0.410) (0.390) (0.401) HQ in District -1.480 1.853 1.291 (4.638) (2.816) (3.496) Status = Illiquid -3.858* -3.316 -3.757 (2.341) (2.245) (2.356) Status = Unhealthy 3.876 3.714 3.831 (4.216) (4.326) (4.299) Illiquid*Lobbing -1.083** -1.192*** -1.339*** (0.439) (0.453) (0.455) Unhealthy*Lobbing -0.948* -0.987** -0.944** (0.485) (0.459) (0.472) Tier 1 Ratio 0.217 0.498 0.461 (0.656) (0.688) (0.693) Asset Quality 355.0 369.8 408.7* (232.8) (231.9) (229.4) Return on Assets 183.2 158.3 150.6 (124.5) (125.6) (131.0) Liquidity -97.95*** -99.33*** -101.6*** (25.17) (26.02) (26.94) Leverage 6.373 41.03 32.80 (58.14) (59.60) (58.65) Short Term Debt 70.24*** 70.81*** 69.72*** (20.79) (20.78) (20.64) Deposits to Assets -23.44 -19.87 -22.88 (14.58) (14.59) (14.70) Total Assets -0.315 0.696 0.461 (1.198) (1.232) (1.156) Foreign Institution? 1.140 -2.609 -1.793 (6.872) (6.827) (6.425) Constant -4.990 -62.30 -46.36 (72.70) (77.80) (73.96) Quarter dummies? Yes Yes Yes Observations 646 646 646 Log Likelihood -1824.9 -1823.4 -1824.4 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 183

Figure 4.2: Lobbying’s Eﬀect on TAF Income, Conditional on Firm Type

(a) Political Entity: House Financial Services

(b) Political Entity: Senate Banking Committee

Table 4.15: Tobit Regression Results: Income Derived From TAF (Baseline Model)

Dependent Variable: Income Derived From TAF Borrowing (Logged $) Tier 1 Ratio 0.496 (0.666) Asset Quality 301.082∗ (168.712) Return on Assets 77.346 (127.256) Liquidity −75.305∗∗∗ (25.919) Leverage 24.014 (55.517) Short Term Debt 68.665∗∗∗ (20.041) Deposits to Assets −22.123∗ (13.133) Total Assets 1.274 (0.942) Foreign Institution? −5.765 (6.172) Constant −64.485 (67.197) Quarter dummies? Yes Observations 646 Log Likelihood -1835.5 Note: ∗p<0.1; ∗∗p<0.05; ∗∗∗p<0.01 CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 185

Figure 4.3: Financial Covariates’ Marginal Eﬀects on Income Derived from TAF CHAPTER 4. THE ROLE OF POLITICS IN THE FED’S LENDING 186 Financial + Political +HFS Interactions 646-1909.984-1824.9293649.858(620) SBC -1909.984 3646.849(620)170.110(24) -1823.425 646 3648.747(620) 0 173.119(24) -1909.984 0.045 -1824.374 0.031 Letter 171.220(24) Writers 0.2320.232 646 0.0450.269 0 0.032532.127 0.235389.056 0.2365.73 0.045 0.2733701.858 532.163 0.031 -362.038 386.789 0 0.233 -14.811 3698.849 0.233 3811.628 531.593 5.726 0.27 -365.0463699.858 388.323 -17.819 3700.747 3808.619 -363.148 3696.849 5.729 3810.517 -15.921 3698.747 Financial + Political HFS646-1909.984-1830.8143661.628(624) SBC -1909.984 3658.708(624)158.340(20) -1829.354 646 3661.485(624) 0 161.260(20) -1909.984 0.041 -1830.743 0.03 Letter 158.482(20) Writers 0.2170.218 646 0.0420.254 0532.914 0.031 0.221397.686 0.2225.736 0.041 0.2593705.628 533.506-376.151 395.513 0.03 0 0.218 -28.924 3702.708 0.218 5.7323803.985 532.604 0.253 -379.0713705.628 397.71 -31.844 3705.485 3801.065 -376.294 3702.708 5.736 3803.843 -29.066 3705.485 Financial None 646 -1909.984 -1835.549 3671.097(627) 148.870(17) 0 0.039 0.029 0.206 0.206 0.242 534.42 404.934 5.742 3709.097 -386.094 -38.867 3794.042 3709.097 Table 4.16: Tobit Model Comparisons (DV: Income Derived From TAF) LR > Covariates Included: Political Entity: N: Log-Lik Intercept Only Log-Lik Full Model D LR Prob McFadden’s R2 McFadden’s Adj R2 ML (Cox-Snell) R2 Cragg-Uhler(Nagelkerke) R2 McKelvey & Zavoina’s R2 Variance of y* Variance of error AIC AIC*n BIC BIC’ BIC used by Stata AIC used by Stata Chapter 5

Conclusion

With my dissertation, I focus on understanding how political institutions and pressures affect policy implementation at the Federal Reserve. Although the Fed is often seen as a largely politically insulated institution that makes decisions free from external influence and without regard to political biases, my dissertation suggests that this perception is not entirely accurate. Despite the popularity of that conception, this result really is not surprising given the intent of the framers of the modern Federal Reserve. As documented in Chapter 2, the architects of the institution’s restructuring in 1935 designed the institution to allow partial political influence, but not so much that politics would dominate the institution. In this way, we should interpret the results from the other chapters as evidence that this vision succeeded. That elections can impact monetary policymakers when one party controls the FOMC is only possible thanks to the structural reforms produced by the Banking Act of 1935; without that reform, no party would have such an ability. The benefits of lobbying we see in Chapter 4 are also only present because of that reform. This is for two reasons: first, prior to the 1935 reform, Congress had far less oversight over what was then a

187 CHAPTER 5. CONCLUSION 188

decentralized institution, and second, that institution lacked the ability to generate the robust level of lending that modern financial institutions have benefitted from. Although this dissertation maintains a specific focus on determining the various ways in which politics affects the policies made by the American central bank, its conclusions should not construed as myopic. Perhaps most obviously, once differences in institutional design have been accounted for, its lessons can be used to help better understand the impact of political dynamics on other central banks. This is particularly true in the case of financial institutions using external influence to affect central banks in their role of lender of last resort. The conclusions from this dissertation also inform us about the difficulty of eliminating electoral cycles from public policy. After all, if a political business cycle can manifest at the Fed, arguably the most politically insulated institution in American government, then it will be quite the challenge to prevent electoral cycles in settings in which the policymakers are more closely connected to voters. Finally, the chapter on the politics behind the Fed’s restructuring illustrates the importance that the veto points inherent in the industrial organization of Congress can have on attempts at policy change as well as how exogenous shocks can induce shifts in preferences that ultimately generate changes in policy. An additional benefit to the work presented in this dissertation is that it has many natural extensions. For example, my chapter on the structure of the Federal Reserve describes the politics behind the creation of the Fed in 1913 and its reform in 1935, but focuses less on the lack of reform in the subsequent 90 years. This lack of change comes despite the introduction of many proposals in Congress to further reform the structure of the Fed, including some by prominent policymakers. For example, in 1975, Senator Hubert Humphrey (D–MN) introduced S. 2540, CHAPTER 5. CONCLUSION 189

which would have removed the Reserve bank presidents from the FOMC, reduced the terms of appointees from fourteen to seven years, and added two members to the committee from the cabinet. However, this proposal never made it out of committee.1 While this outcome was fairly predictable given a lack of unified Democratic control of government at the time it was introduced, it is more surprising that Representative Barney Frank’s (D–MA) was not able usher in an almost identical structural reform. He tried to do so with his H.R. 1512 in the 111th Congress, but only after his party had lost control of the House of Representatives. Had he been more proactive when he chaired the House Financial Services Committee, he surely would have gotten closer to getting the bill passed. Of course, even then nothing is guaranteed. As Krehbiel, Meirowitz and Wiseman (2015) point out, the minority party and moderates in the governing coalition can still effectively limit moving policy to the extreme – as Frank’s proposal would have done. The question that remains, though, is what precisely was different in 2010, and other years in which one party controlled government, when compared to 1935? Was the cost needed to generate structural reform in this recent example not sufficiently offset by the benefit of such change or is another factor to blame? Further investigating this could further improve our understanding of when and why legislative adjustments are made to agency design and other policies already on the books. The investigation into the impact that elections have on the recommendations of monetary policymakers serving on the FOMC presented in Chapter 3 somewhat abstracts away from the potential role of strategy in these meetings. While personal, in-person interviews with former Fed officials provide further confidence that

1There have also been plenty of unsuccessful proposals from Republican policymakers designed to move the Fed in the opposite direction by, for example, making all twelve Reserve bank presidents permanent members of the FOMC (see S. 238 H.R. 1174 from the 113th Congress). CHAPTER 5. CONCLUSION 190

such strategic considerations play relatively little role in the roundtable conversations (hence my focus on the transcripts instead of the votes), it could be the case that the chair is more considerate of others’ opinions since she does not want to be rolled. The question here is as follows: is the chair simply reflecting the position of the median voter on the committee, making her own recommendation independently of the others, or doing some combination of the two? This question has yet to be explored in depth by the scholarship pertaining to central bank decision-making and is thus an area ripe for new research. Another question that arises from this research on the politics behind monetary policy decisions pertains to the appointment procedure. Each of the last four presidential administrations has had at least two vacancies on the Board of Governors simultaneously open for a period of over six months. Figure 5.1 illustrates this point; the white space representing an unfilled seat is readily apparent to the eye. Table 5.1 offers more details on this puzzle within the Clinton presidency, showing the precise appointment lags associated with each vacancy on the Board during that administration. Needless to say, in each of these four White Houses, the puzzle is apparent: given the substantial impact that monetary policy can have on the economy – and, as I suggest, elections – why do appointments to the FOMC take so long?2 While I focused on the impact that myopic voters may have on monetary policymakers, there is still much to be learned about the inverse relationship. While there is evidence that citizens incorporate short-term fluctuations in the macro-economy when voting, we know less about the precise transmission of this information. More specifically, very little has been written about how quickly monetary policy can affect

2I am not alone in pointing this out. Journalist Matthew Yglesias (2014) called the failure to ﬁll two seats on the Board of Governors President Obama’s “biggest economic policy mistake.” CHAPTER 5. CONCLUSION 191

voters. Preliminary evidence from the 2012 election suggests that the third round of quantitative easing, a classic case of monetary expansion (labelled QE3 in Figure 5.2), resulted in a spike in the probability of President Obama’s re-election probability as quantified by Intrade, a prediction market.3 Additional analyses of this question could improve our understanding of voter behavior and therefore clarify the micro-foundations underpinning the political business cycle in monetary policy. Finally, the evidence from the previous chapter (4) analyzing the sources behind firm-level variation in borrowing from the Fed suggests that some policymakers may be expending their legislative resources in a way that reflects a desire to acquire gains rather than prevent losses. If generalizable, this would be an important contribution to the field of legislative behavior, particularly since it is inconsistent with the predictions from prospect theory (Kahneman and Tversky 1979). In addition, the negative correlation between relevant committee appointments and some of the borrowing measures suggests that some legislators may be targeting committee appointments that could help out businesses (and presumably constituents too) that are struggling in their interactions with governmental agencies.4 Again, with more data across more policy contexts,5 we could determine how widely that strategy is being applied as well as at how seniority combines with committee membership to generate desired gains. I look forward to working with my colleagues to pursue such research and thereby continuing to push the frontiers of our understanding of how politics impacts public

3The subsequent dip in that probability is likely unrelated since it immediately follows the 2nd presidential debate in which President Obama is widely seen to have faltered. 4It is reasonable to reject the possibility that this correlation stems from reverse causation since it seems highly unlikely that the Fed is discriminating against ﬁnancial institutions in districts represented by individuals on these committees. 5Of course, care must be taken to account for the possibility of heterogenous eﬀects across policy dimensions. CHAPTER 5. CONCLUSION 192

policy. CHAPTER 5. CONCLUSION 193

5.1 Appendix

Figure 5.1: Presidential Appointments Serving on the Fed’s Board of Governors

Table 5.1: President Clinton’s Appointments to the the Fed’s Board of Governors

Person Term Member Previously Date: Opening Date of Seat Other Persons Nomination Date of Date of Position Appointed Type Holding Seat Announced Opening Considered Number Nomination Confirmation Alan S. Blinder Member Unexpired David W. Mullins, Jr. 02/02/1994 02/14/1994 George Perry PN1321 04/22/1994 06/24/1994 Alan S. Blinder Vice Chair New David W. Mullins, Jr. 02/02/1994 02/14/1994 George Perry PN1322 04/22/1994 06/24/1994 Janet L. Yellen Member New Wayne D. Angell n/a 02/09/1994 Unknown PN1476 04/22/1994 08/11/1994 Alan Greenspan Chair New Alan Greenspan n/a 03/02/1996 Unknown PN951 02/22/1996 06/20/1996 Laurence Meyer Member Unexpired John P. LaWare 03/28/1995 05/01/1995 Unknown PN952 02/22/1996 06/20/1996 Alice M. Rivlin Member New Alan S. Blinder 01/17/1996 02/01/1996 Felix G. Rohatyn PN953 02/22/1996 06/20/1996 Alice M. Rivlin Vice New Alan S. Blinder 01/17/1996 02/01/1996 Felix G. Rohatyn PN954 02/22/1996 06/20/1996 Edward M. Gramlich Member Unexpired Janet L. Yellen 12/20/1996 02/18/1997 Unknown PN451 07/10/1997 10/30/1997 Roger W. Ferguson Member Unexpired Lawrence B. Lindsey 01/10/1997 02/06/1997 Unknown PN452 07/10/1997 10/30/1997 Carol J. Parry Member Unexpired Susan M. Phillips 05/05/1998 06/30/1998 Unknown PN480 08/05/1999 Not confirmed Roger W. Ferguson Vice New Alice M. Rivlin 06/03/1999 07/16/1999 Unknown PN531 08/06/1999 09/29/1999 Roger W. Ferguson Member New Roger W. Ferguson n/a 02/01/2000 Unknown PN532 08/06/1999 Not confirmed Alan Greenspan Chair New Alan Greenspan n/a 06/20/2000 Unknown PN729 01/04/2000 02/03/2000 CHAPTER 5. CONCLUSION 194

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