What We Learn About Corporate Ethical Lapses Disasters, Vulnerability, and Governmental Response Hawala: How Terrorists Move Funds Globally The president was mostly right: The Fed is an independent outfit ... a number of outfits, it turns out. The of America was among the last of the industrialized nations to create an official central bank in 1912 (known as the Federal Reserve System) after the banking cre- ated a groundswell of sup- port at both the "grasstops" and "grassroots" levels for federal government inter- vention in the nation's often chaotic banking affairs. (The banking scare of 1907 op quiz: What is the Federal was preceded by the , which Reserve System? Oh yes, it is the was preceded by the panic of 1884, which was preceded by the 1873 banking crash, organization that sets key bank etc. Bank "crashes" occurred about every ten interest rates, "controls" inflation, and has years after the American Civil War. The something to do with regulation of the Federal Reserve System was adopted to pre- United States banking industry . . . right? vent and/or deal with recurring future crises In March 2006, at one of his public press in the banking system.) conferences, President George W. Bush suf- fered a senior moment (that all of us have When the Federal Reserve System was experienced one time or another) when he established, the nation's economy was quite failed to recall the name of "the Fed" in different from that of the current econ- answering a question from the audience, say- omy. Agriculture and manufacturing were ing only that it wasn't his Administration the mainstays of the national economy. but an "independent organization" that sets Regional banks that reflected the influ- ence of their respective regions were estab- interest rates that in turn decide outcomes lished in capital cities. There is one bank on home mortgage rates. (He couldn't recall in St. Louis and another not so far away the name of the Federal Reserve Bank for in Kansas City—these reflect the impor- a brief moment.) tance of early-20th-century trading and The minor flub was good for a laugh at capital outposts for agriculture. Others President Bush's expense, but there is a similarly situated were the Minneapolis point to this: Many Americans don't under- and Chicago banks. Today, these four mid- stand what the Federal Reserve System ("the west banks have broadened their per- Fed") is all about . . . and what short- and spectives to include the information long-term effects the "bank" has on their economy and high-tech America, but all professional, business, and personal lives. remain strongly anchored in agri-busi- The Fed is much more than the keeper of ness. Each regional bank serves as an the prime rate or overnight bank-lending important "sentinel" for its regional eco- discount rate. The Fed's policy tools include nomic activities and as a "canary in the coal "open market" operations, setting the bank mine" for bringing important views and per- discount rate, and establishing banking spectives to national deliberations of the reserve requirements. system.

Hank Boerner is managing director of the New York office of Rowan & Blewitt, a management consulting company. A former head of communications for the New York Stock Exchange, he is a corporate governance, accountability, and responsibility con- sultant and advisor to corporations. The views presented are his own. Hank welcomes emails at [email protected]. Even as we near the 100th anniversary of quently by input from leading academics, the venerable institution, the Fed can be a economists, monetary technicians, and cap- mystery to many Americans, even at times ital markets experts who participate in Fed- to those who daily toil in corporate finance eral-Reserve-sponsored or -conducted and the capital markets. workshops, seminars, and symposia. The fre- For some of us it can be like one of the quent speeches by various Federal Reserve mysterious beasts of mythology that breaks Bank CEOs and presidents also provide into view every now and then — through philosophical and practical frameworks — such sightings as reported in headlines like and send signals — for anticipating Fed the following: "The Federal Reserve Bank policies and action steps. Today Cranked Up Interest Rates for the Fifth Time in a Year ..." Federal Open Market Committee At the system level, one of the most visi- The visible chairman—Alan Greenspan ble effects of the Federal Reserve is the The almost mythical status achieved by the decision making of the FOMC, which sets recently retired chairman of the system — target levels for interest rates. A number of the honorable Alan Greenspan — coincided regional bank CEOs and presidents sit on with the emergence of several all-finan- this committee and provide advice and cial-news-all-the-time programs on Amer- counsel from their respective regions, ican cable television systems (delivered by reflecting the fact that the United States is MSNBC, CNNfn, CNBC, Fox News, not a single economy but is made up of sev- Bloomberg Television, and other net- eral regional economies. works). The broadcasters reveled in The FOMC consists of seven governors footage of the chairman over the of the national board, the president of the course of his eighteen years of service, Federal Reserve Bank of New York, and four usually pictured toting his briefcase of the eleven remaining regional bank pres- to the scheduled Federal Open Mar- idents (serving on a rotating basis). All ket Committee (FOMC) meetings twelve regional bank heads attend every where key interest rates would be set. meeting, contribute to the discussion, and The heft of the totem briefcase became provide forecasts that are then summarized a signal for confidence or anxiety on Chair- in congressional testimony. "FOMC fore- man Greenspan's part as he strode the walk- casts" are the summary of forecasts col- way to the "temple" that is the Fed's lected from this body and include input Washington, DC headquarters. from nonvoting regional bank heads. The followers were even said to be watching the practice of providing February and July briefcase very carefully to know what direc- forecasts to the US Congress began in the tion to start trading debt or equity! Such year of 1979. is the mystical power of the Fed. But what As William Gavin, vice president and about the system's real powers? economist of the St. Louis Federal Reserve What does the Federal Reserve really Bank, explained in May 2003, the FOMC do—and why should financial executives can be reluctant to commit publicly to an in any professional pursuit care about the inflation target because there can be a wide "bank"? To begin our exploration of the range of differences of opinion among the Fed, note that there are actually twelve FOMC members.2 On his watch, Chairman independent Federal Reserve Banks in addi- Greenspan is credited with moving the Fed tion to the system's headquarters located toward greater transparency about both in the nation's capital.1 Each regional bank decision making and background infor- operates somewhat independently, even as mation that influenced FOMC decisions. the Federal Reserve System itself attempts The key rate that is set—targeted—by the to operate independently of government. FOMC is the market rate paid for balances Among the most important activities of held at the Fed by banks and other insti- the various banks are the research efforts tutions when those balances are traded; of economists and others employed by the these balances are part of the banking sys- twelve regional banks, supplemented fre- tem's reserves and are used to effect pay- ments and meet statutory reserve require- economic recessions and weathered a series ments. As Daniel Thornton of the Federal of storms. Reserve Bank of St. Louis pointed out in August 2003, the Fed has used the open market rate since the 1980s to achieve objec- The Greenspan legacy tives mainly by buying and selling gov- Two important legacies were established ernment securities, increasing and by Chairman Greenspan, Ms. Yellen sug- decreasing supply and demand.3 (To reduce gested: The Fed adopted a more predictable the funds rate the Fed must increase the sup- approach to policy making and placed a ply of reserves.) growing emphasis on open communication and transparency. The two traditional man- dates for the Fed—keeping inflation low Addressing uncertainty in the financial and stable and promoting maximum sus- system tainable employment—were consistently The FOMC attempts to remove uncertainty followed, at times with aggressive inter- (and to provide certainty) in the capital vention to address any increase (real markets for the vital banking industry as or perceived) in inflation. Core price well as for "non-bank" participants. Chair- inflation mostly trended down in the man Alan Greenspan noted in 2003 that Greenspan era, often approaching one "[uncertainty is not just an important fea- percent (in effect, for government ture of the monetary policy landscape; it and business, a "zero" inflation rate). is the defining characteristic of that land- In 1994, just before scape."4 His position has been that central equity prices took off like a rocket banks such as the Fed are driven to a risk- (the Dow Jones Index rose 6,000 points in management approach to policymaking. six years), Chairman Greenspan's Fed raised Similar to corporate finance executives' funds rates in response to early indicators attempts at divining the immediate future suggesting that labor and product mar- and adopting strategies and tactics to deal kers) demand exceeded capacity. Just with uncertain outcomes, in Chairman months earlier, when the unemployment Greenspan's view it is the mission of Fed rate had been rising (after the late-1980s policymakers to "reach a judgment about real estate bust, thrift failures, the tightening the probabilities, costs, and benefits of the of bank credit standards, and the start of various possible outcomes under alterna- recession in many regions), the Fed inter- tive choices for policy."5 While numerous vened and eased credit policy to stimulate economic models are used by bank econ- growth. omists, there is still a significant level of These actions, suggested Ms. Yellen, "uncertainty" in the US and world enhanced the ability of financial markets economies. and corporations to anticipate the Federal Reserve's response to economic developments and to respond independently in advance 2006: year of transition at the Fed of the Fed's movements. Alan Greenspan ended eighteen years of And consumer confidence steadily service as chairman of the Board of Gov- strengthened as public confidence grew in ernors of the Federal Reserve System, and the Fed's ability to "control" and promote on February 1, veteran economist and economic stability—and the Fed stated its Princeton University academic Ben firm commitment to rein in inflation. It Bernanke succeeded him. According to helped that in 1994 the system began a Janet Yellen, president/CEO of the Fed- practice of issuing press releases after eral Reserve Bank of San Francisco, Chair- FOMC meetings to announce changes in man Greenspan had skillfully managed the federal funds target rate (something monetary policy during his tenure. The we now take for granted). Before, it could US economy has been extraordinarily sta- take days, weeks, and at times months to ble— and frequently it has been the sta- ascertain correctly the Fed's policy on rates. bilizing force for other nations. The nation So the key to understanding the power experienced just two mild (and short) of the Greenspan legacy, suggests Ms. Yellen, is to link the system's disciplined approach equities, debt securities, and bank to policy combined with more communi- claims. cation on the approach and policies • There is a substantial gap in returns adopted—this has strengthened the pub- on foreign direct investments (FDI): lic's confidence in the Fed and anchored US companies operating abroad are inflation expectations to price stability. far more profitable than foreign firms operating in the US. The good news must be tempered with two The New York Fed—watching canaries realities, however: in financial coal mines • Net investment income will not The Federal Reserve Bank of New York is a remain positive for much longer, given key monitor and watchdog of the capital mar- the continuing buildup in net foreign kets, which are generally considered to be liabilities (all those billions we borrow located in or around the city of New York. from China and other countries). (The New York Fed occupies a literal fortress • Any rise in US and/or global interest with several-feet-thick stone walls located rates will bring forward that time just a few steps from Wall and Broad streets, when the US will have to begin making home of the New York Stock Exchange trad- net income payments. ing floors.) The following are two important results Recovery after September 11, 2001 was with serious implications for your busi- relatively rapid for most of New York's cap- ness: ital market players, and the New York • A shift to growing net income pay- bank and Fed system was credited ments means the US trade deficit with quick response and stabiliza- would have to narrow in order to sta- tion of the capital markets. bilize the current account deficit (the But some concerns remained monthly headline-making statistic). and New York bank researchers at • The shrinking of the trade deficit the end of 2005 were addressing the would mean that the US economy issue of rising US international couldn't continue to consume more liabilities and the effects on cap- ital markets. Years of maintaining than it produces. large current account deficits have The New York research team noted that saddled the United States with the the large, ongoing current account deficits world's largest stock of international of the United States were leading to a steady liabilities, approaching $2.5 trillion buildup of US net liabilities to the rest of (or 22% of the US GDP) at the start of the world, and the consequences have been 2005. That's the bad news. The good masked to date by the superior rate of return news, New York bank research shows, is that the US earns on FDI assets. (We've that the nation earned $36 billion more been helped by the recent drop in global inter- on its own collective foreign assets than est rates as well.) it paid out to service its foreign lia- But this situation is not sustainable, and bilities. Here are some important data for a country that imports far more than it that have been of value to policymak- exports, there is a day of reckoning—and ers (and should be of interest to cor- if the balance tips against the US in the porate finance managers with global near future, the "adjustments" necessary operations). will be very challenging for business, gov- The US has been earning a higher rate ernment, and consumers. of return on its large stock of interna- This is the kind of research available tional assets. Some surprising findings free to corporate managers seeking data or by the New York Fed may be excellent trend lines or windows into the Fed's think- points to make around the water cooler ing. (Consider the twelve banks your own in your office as the negative media head- "think tanks" on various aspects of finance, lines trumpet our "deficit" economy: monetary policy, key financial trends, pro- • There is barely any gap at all in rates- ductivity, and dozens of other key issues that of-return on assets and liabilities for affect your business.) The Fed is not omnipotent, however tive political and economic systems. (No won- Given the collective brainpower and expe- der many citizens of those countries are in rience of the Fed staff, impressive results the dark about what their central bankers are becoming "the expected." But as Pro- are up to!) fessor Geoffrey Miller — law professor Four months before the September and director of the Center for the Study 11, 2001 terrorist attacks in the United of Central Banks at New York Univer- States, Professor Miller observed that sity— commented in May 2001, as central one of the most important functions of banks emerged from their relative obscu- the central bank is to help a nation rity, they began to be perceived as one of address a crisis such as a threat to the most powerful institutions in the national security. In these times, the world — politically, socially, economi- bankers may decide to fund the response cally— and as forces for cultural and his- through inflation rather than the slower, torical change. Not so fast, counsels the more desirable means of raising taxes. professor. Central banks are not omnipo- That is what the Federal Reserve did tent; they do not control the business just weeks after 9/11: pump money into cycle nor ensure an endless cycle of pros- the banking and capital markets sys- perity. tems. Professor Miller's extensive research showed that central bank tools of mon- etary policy can sometimes be too broad For the future: a warning to deal effectively with sector phenom- The various Fed banks regularly conduct ena, and that bank intervention (such as seminars, workshops, and symposia that the Bank of Japan's actions in recent attract stellar talent in economics years) may be limited in such areas of and other fields. In February 2005, concern as the stock market and real the San Francisco Federal Reserve estate market. A second "myth" that has Bank's Center for Pacific Basin Stud- grown up around central banks is that ies and the University of Califor- their only monetary function has to do nia at Berkeley's Clausen Center for with price stabilization. Stability is not International Economics conducted the only goal of the Fed or other central a seminar on Asian development. Con- banks. ference participants discussed the cur- The "power" given to the indepen- rent international exchange rate system, dent central bank would appear to be the sustainability of global trade imbal- counterintuitive to what most govern- ances— especially that of the United ment officials — especially politicians — States — and what imbalances mean for would want to do. But doing so works emerging markets. to their interest: "Politicians recognize Professor Maurice Obstfeld of the Uni- the value of offering a credible com- versity of California discussed the like- mitment to not give in to the tempta- lihood that the US might soon face an tion to undo political deals by creating emerging markets style of "sudden stop" inflation," Professor Miller explained, crisis. He questioned the sustainability of and they can merrily maximize short- US current account imbalances, which term campaign contributions by giv- reached a record monthly high of $68.5 ing up power to the central bank. billion in January 2006 and suggested Long-term "deals" are more credible that a large depreciation of the US dol- because they will not be threatened by lar was very likely. inflation and do not have to resort to A number of scholars debated the impor- highly unpopular gimmicks such as tance of China's maintaining its peg to the price indexing or public sector price dollar for the renminbi and the "free-float" control schemes. of China's currency and revaluing to the The effect is to have a central bank like dollar or other currencies. (Five months the Federal Reserve, or the Bundesbank of later, in July 2005, the Chinese government Germany or Bank of Japan, operate both announced it was revaluing against the US within and without the nation's respec- dollar and would be "flexible" in the future. China, as of March 2006, has almost $850 Depression, and its lessons, are still billion in reserves.) relevant today."7 An important consensus was Chairman Bernanke's original research reached concerning whether the cur- published in 1983 explored the macroeco- rent system was sustainable as the US nomic implications of financial crises, current account deficit continued to which then received broader attention as grow. Near-term, the answer seems the East Asian financial crises occurred a to be yes, but three to ten years hence, few years later. He has served in various several scholars argue, the system Federal Reserve System capacities since will be unsustainable and Asian coun- the late 1980s and was a member of the tries may decide not to finance the Board of Governors from 2002 to 2005. deficit by purchasing more US secu- It is too soon to define "the Bernanke rities. Fed," but it may be comforting to finance But, we have the Federal Reserve System executives to know that the new helmsman to address extreme volatility in currency and is a leader who will not ignore the lessons bank reserves and to meet the "shocks" of of the past; indeed, the lessons of history key capital markets systems. appear to continue to be important guide- posts for current Federal Reserve System decision making. • Chairman Ben S. Bernanke—looking to the future... and lessons of the past NOTES On February 1, 2006, Princeton economist 1 The regional Federal Reserve Banks are located in Ben Bernanke became the Chair of the Fed- the following cities: Boston, New York, Philadelphia, Richmond, Atlanta, Dallas, Kansas City, St. Louis, eral Reserve System. He has served as a Chicago, Cleveland, Minneapolis, and San Fran- member of the Board of Governors of the cisco. 2 W. Gavin, "FOMC Forecasts: Is All the Information US Federal Reserve System and is a widely in the Central Tendency?" (May/June 2003), avail- published author. (He was appointed to the able online at http://research.stlouisfed.org/publi- Board for a fourteen-year term ending Jan- cations/review/03/05/Gavin.pdf. The homepage of the Federal Reserve Bank of St. Louis is www.stlou- uary 31,2020, and a four-year term as Chair- isfed.org. man, expiring January 31, 2010.) 3 D.L. Thornton, "Alternative Policy Weapons?" (August 2003), published by the Federal Reserve Chairman Bernanke has long studied the Bank of St. Louis. Available online at effects of the of the 1930s http://research.stlouisfed.org/publications/mt/20030801 on the US and global economies, a time in /cover.pdf. 4 Alan Greenspan's remarks on the importance of which there was unemployment for one in monetary policymaking are quoted from a speech four heads of household, large numbers of delivered at a symposium sponsored by the Kansas City Federal Reserve Bank at Jackson Hole, Wyoming, bank failures, currency speculation, price 2003. The speech is available online at depression, and other catastrophic events. http://www.federalreserve.gov/boarddocs/Speeches/20 03/20030829/default.htm. In his book entitled Essays on the 5 Ibid. Great Depression, published in 2000, B.S. Bernanke, Essays on the Great Depression (Princeton University Press, 2000): preface. Mr. Bernanke noted, "[T]hroughout my 7 academic career, I have returned many Ibid. times to the study of the vertiginous eco- nomic decline of the 1930s .... there is REFERENCES . . . much to learn from the Depression Federal Reserve Bank of San Francisco, "The Bret- 6 ton Woods Systems: Are We Experiencing a Revival?" about the workings of the economy." FHBSF Economic Letter (November 25, 2005), avail- able online at http://www.frbsf.org/publications/eco- Further, he wrote, "Those who doubt nomics/letter/2005/el2005-32.pdf. This is a summary that there is much connection between of the papers presented at the symposium held at the Federal Reserve Bank of San Francisco on Feb- the economy of the 1930s and the super- ruary 4, 2005, under the joint sponsorship of the charged, information-age economy of the Bank's Center for Pacific Basin Studies and the Uni- versity of California at Berkeley's Clausen Center twenty-first century are invited to look for International Economics. Included as part of the at the current [year 2000] economic symposium was a paper by M. Obstfeld and K. Rogoff entitled "The Unsustainable U.S. Current headlines — about high unemployment, Account Position Revisited." The papers from the failing banks, volatile financial mar- symposium are available at http://www.frbsf.org/eco- kets, currency crises, and even defla- nomics/conferences/0502/. Higgins M., T. Klitgaard, and C. Tille, "Current Issues tion. The issues raised by the in Economics and Finance," issued by the Federal Reserve Bank of New York (December 2005). The Conference on the Origins and Evolution of Central authors are employed in the bank's International Banking, sponsored by the Central Bank Institute of Research Function. The article is available online the Federal Reserve Bank of Cleveland in May 2001. at www.newyorkfed.org/research/currentjssues, The article is available online at http://www.deve- under December 2005. Subscriptions are free. landfed.Org/Research/com2002/1101.pdf. Yellen, J.L., "2006: A Year of Transition at the Fed- Miller G.P., "Three Myths About Central Banks," eral Reserve," a speech delivered to the Los Ange- Economic Commentary of the Federal Reserve Bank les Chapter, National Association of Business of Cleveland (November 2002). The article is based Economists, January 19, 2006, available online at on a speech delivered by Professor Miller to the http://www.frbsf.org/news/speeches/2006/0118.html.