Beedy-eyed critics

The Real Time Economics blog in the WSJ has pointed to the legal basis for the eye-bursting $85 billion loan from the Fed to AIG to bail it, and the rest of civilization as we know it, out of its mess.

Although a good broker friend of Guambat advises that Paulson et al. got a very sweet rate on the loan and will likely return a tidy profit to the Fed treasury when the dust settles, the shrill from the comments section to that post was ear and eye-popping, but not as painful as their analysis, both economic and political, e.g., "This bailout was done to save McCain", and from another "Shame on Bush, Shame on McCain, Shame on Obama, Shame on Pelosi, Shame on Shumer and Shame on Dodd", which are all comments beside the point. The point being that shining spot you can see as you look cross-eyed down the bridge or your nose to the tip just before you cut it off to spite yourself.

But getting back to the legal nitty-gritty, it seems there is a fairly unrestricted authority for the Fed to do exactly what it did, whatever anyone, Congressional or otherwise, may think.

As explained by the Minneapolis Fed,

On June 19, 1934, President Franklin Roosevelt signed a bill into law that added Section 13(b) to the Federal Reserve Act, which authorized the Federal Reserve to "make credit available for the purpose of supplying working capital to established industrial and commercial businesses," according to the Federal Reserve Board's 1934 annual report.

he Federal Reserve System was established, in part, "to afford means of rediscounting commercial paper," according to the 1913 Act. Essentially, this means that member banks of the Federal Reserve System would borrow money from their district Reserve bank based on loans made at the member bank, and it worked like this:

* A bank makes loans to business customers.
* This bank eventually comes under high demand for loans and finds that its reserves are running low.
* The bank then takes some of its business loans, or paper, and borrows from its Federal Reserve bank, using the paper as security; this was known as rediscounting.
* Reserves at the bank would thus increase and, likewise, so would the reserves of the entire banking system in accordance with the economy's needs at the time.
* When the loans at the bank reached maturity, or were paid off, the bank would then be flush with reserves and would likewise pay off the Federal Reserve bank; this resulting decrease in bank reserves would keep reserves in line with the needs of the economy.

This was how the Fed was intended to provide an elastic currency for the economy, that is, a currency that could respond to the ups and downs of an economic cycle. An important point for our discussion is that this discount policy, which was based on high-quality bank loans backed by good collateral, was administered by the individual Reserve banks.

The 1934 bill that would open the Fed to industrial lending had its genesis under the Hoover administration two years earlier. Tucked inside a highway construction bill in 1932 was an amendment to the Federal Reserve Act allowing the Fed to allocate credit to individuals, partnerships and corporations in emergency situations. This language, amended again in 1991, as we shall see later, is still with us today. The major difference between this enduring legislation and Section 13(b) passed two years later is that the 1932 amendment is only meant to address crisis situations.

The 1932 bill became law on July 21, 10 days after President Hoover had vetoed similar legislation, arguing that such a plan would "violate the very principle of public relations upon which we have builded [sic] our Nation, and render insecure its very foundations."

The article chronicles the history of the rare usages of the loan facility, up to the market crash after 9/11, when the article was written. It particularly notes the many detractors who criticized the power, starting right off the bat when the law was first passed with

the chagrin of one Rep. C.L. Beedy:

"The Federal Reserve banks, 12 in number, which were never designed to do business with any individual or any person, but were banks of issue or rediscount to deal with other banks, ought never, in my opinion, to be put into the lending business. It is a perversion of the original purpose for which those banks were established."

It concludes,

To some this lending legacy is likely a harmless anachronism, to others it's still a useful insurance policy, and to others it's a ticking time bomb of political chicanery. Doubtless, the discount window will continue to evolve.

And so, here we have the Bush Administration boldly going forth under that banner of evolution.

Darwinian economics?