How the Fed Benefited from Its Own Failures

SMITH BRAIN TRUST — Markets will respond when President Trump nominates a new Federal Reserve chairperson in January 2018. But Wall Street legend and financial historian Henry Kaufman said the reason the decision matters so much has more to do with the Fed’s recent failures than its successes. “The Federal Reserve has vaulted itself into a position of high prominence not because of its achievements, but because of its shortcomings,” Kaufman writes in his latest book, which he discussed on Sept. 13, 2017, at the University of Maryland’s Robert H. Smith School of Business.

Exhibit A for Kaufman’s argument is the 1999 repeal of the Glass-Steagall Act, which separated commercial and investment banking and kept institutions at a manageable size. “The Federal Reserve did not warn Congress or the United States about the complications that the conglomeration of financial institutions would cause,” Kaufman told the audience of nearly 200 faculty, staff, students and others at the Smith School in College Park, Md.

Prior to the act’s repeal, the 10 largest financial institutions commanded about 10 percent of U.S. financial assets. “Today it’s over 80 percent,” said Kaufman, a former Salomon Brothers executive who founded his own economic and financial consulting firm in 1988. “It isn’t the smaller institutions that have caused problems. It is the bigger institutions that have caused the problems.”

He said that’s why Trump’s nomination will matter so much when Janet Yellen’s term expires on Feb. 3, 2018. Ending Glass-Steagall “was a tremendous shortcoming, but that shortcoming meant that the size of the financial institutions would get big, and the Federal Reserve would have to play a more important role in stabilizing the system,” Kaufman said. “So the power of the central bank increased because the power of the bigger institutions increased.”

Kaufman said the Fed chair worked mostly behind the scenes in past eras. “Back in the 1950s Bill Martin was known by financial institutions. But if he walked down Broadway in New York, very few people would recognize him,” Kaufman said. “Today the chairperson of the Fed is a highly visible individual, who seems to be more powerful than the secretary of the Treasury, often ranked next to the president of the United States in authority — an unthinkable thing when you look back in financial history.”

The Smith School event provided an opportunity for Kaufman to discuss his 2017 book, Tectonic Shifts in Financial Markets: People, Policies, and Institutions. It also marked the launch of the Henry Kaufman Chair in Financial History Endowment, established in fall 2017 to protect the status of history research and education at the Smith School for decades to come.

David B. Sicilia, the inaugural Henry Kaufman Associate Professor of Financial History, moderated the discussion. He also provided consulting services on Kaufman’s latest book and two previous books. “Over the years I feel like I’ve gotten more than the equivalent of another graduate degree in financial history by just talking with him and listening to his observations,” says Sicilia, an affiliate faculty member at the Smith School and an associate professor at the University of Maryland’s Department of History.

Smith School Dean Alexander Triantis, who introduced Kaufman, said it was a privilege to have a luminary such as Kaufman come to the Smith School to share his insights. “What he says moves markets.”

Kaufman shared insights on a range of other topics:

• Effective writing: When Kaufman was preparing the manuscript for his first book, a 1986 tome on the history of interest rates, a mentor encouraged him to read the entire thing aloud to his secretary. Kaufman said the activity allowed him to detect awkward phrasing and make refinements. “Read your papers aloud,” he encouraged students in the audience.
• National debt: U.S. debt passed the $20 trillion mark on Sept. 11, 2017, but Kaufman did not seem overly concerned. “If you want to have economic growth, you’ve got to have credit growth,” he said. Households and businesses can borrow, but Kaufman said the federal government has greater capacity to withstand the risk in the current economy. “If it goes too high, it is a problem,” he said. “But there is no economic law that says the government debt can’t be more than 100 percent of GDP.”
• Global markets: Kaufman said major central banks must cooperate in the global economy. But he also cautioned against having too much confidence in emerging market economies.