The Audit of Federal Reserve Governance: Wiggle Room for the GAO? 

We’ve recently endured the worst financial and economic crisis since the Great Depression, and for many people, it isn’t over yet.  We’ve had 11 recessions since World War II, and our latest included the largest decline in employment of all of them.  It has also been by far the worst jobs ‘recovery’ despite that fact that it was also the worst recession.  Hard recessions are typically followed by relatively rapid recoveries, but that hasn’t been the case this time.  Total nonfarm payroll employment in the U.S. remains 7 million jobs below where it was at the time the recession started – over 40 months ago. 

During the latest downturn, the national unemployment rate went from about 4.5% to 10%, and remains above 9% at the latest reading.  A recovery has been underway over the last year and a half, led, until recently anyway, by the manufacturing sector.  But the jobs picture has remained very bleak.  Since 1960, we never had a three-year interval where U.S. private sector employment fell at an average annual rate over 1%.  In 2009, that happened for the first time since the Great Depression, and again in 2010.

As the financial crisis was gathering steam in 2008, and as millions of people were losing their jobs, the Federal Reserve lent extraordinarily large amounts of money to large financial institutions.  The assistance was provided to banks as well as other parties not normally able to access central bank credit directly, including American International Group (AIG), one of the largest insurance enterprises in the world.  Loans to nonbanks arose under provisions in Section 13(3) of the Federal Reserve Act that allow the Fed to lend to ‘individuals, partnerships, and corporations,’ e.g., not just banks, in ‘unusual and exigent circumstances.’  The Fed’s emergency lending also included huge loans for foreign financial institutions.  The Fed extended over $1 trillion in emergency credit, at peak levels.  And the Fed’s balance sheet also mushroomed as it embarked on a buying spree of ‘mortgage-backed’ and other securities.

The Fed has asserted that the extraordinary recent expansion of its lending activity generally, and its emergency lending specifically, had been necessary to avoid an even wider calamity.  Putting aside the Fed’s (shared) responsibility for getting us into calamity in the first place, critics have also been angered how many ‘private’ parties that were responsible not only for their own near-demise, but the widespread economic crisis as well, were able to receive so much cheap survival money from our public central bank – particularly in light of the close relationships these larger private organizations have had with leadership in the Fed.  Were they effectively backed by cheap public capital, reaping the fruits on the upside and sticking us with the downside?   And critics have also been suspicious whether the Fed was receiving fair prices for the securities purchases it has undertaken in its ‘quantitative easing’ and other monetary policy transactions.  So, in fits and starts, financial reform legislation passed by the Congress in 2010 finally included a directive that the General Accountability Office (GAO) audit the Fed’s emergency lending during the crisis, and to also undertake a second audit examining Federal Reserve bank governance practices.

On July 21, the GAO issued its first of two reports on its auditing of the Fed’s emergency lending in the crisis.  A bruising 266-page read, it provides a lengthy factual overview of the complex set of circumstances underlying these programs, documents the timing and extent of the lending, and provides some occasionally mild criticism and recommendations for shoring up procedures under which conflict of interest and other management challenge are managed in the future. 

I’ve read the report through once, and am still reflecting on it.  I’ll be reviewing several elements of that report soon, including a few things that aren’t in there that don’t appear to have drawn attention elsewhere, either.  But I’d also like to start setting the stage for Boiling Frogs readers for Part II of the GAO audit(s) mandated by Dodd-Frank – the audit of Federal Reserve governance.  That report is due in October.

Specifically, what will that second audit cover? 

There are four main elements identified for the second GAO audit under Dodd-Frank.  They include:

• an examination of the extent to which the selection of Reserve Bank directors results in boards that effectively represent ‘the public’ as required under the Federal Reserve Act,

 

• an examination whether there are actual or potential conflicts of interest arising in executing supervisory responsibilities when Reserve Bank directors are elected by member banks,

 

• an examination of the lending programs covered in the first audit with specific reference to Reserve Bank governance, and

 

• a requirement that the GAO ‘identify changes to selection procedures’ for Federal Reserve Bank directors, and other Fed governance procedures, that would ‘improve public representation, eliminate conflicts of interest in bank supervision, increase the availability of information useful for monetary policy, or … increase the effectiveness or efficiency of reserve banks.’ 

 

It is possible the final ‘or’ leaves some wiggle room for the GAO to abstain from making explicit findings or recommendations if it so chooses, but we shall see.

Just stepping back for a moment, however, it is worth noting that the topic of Federal Reserve bank governance and accusations of favoritism and conflicts of interest during the bailouts provided some of the more spectacular grist for the mill during the meltdown.  The GAO’s second audit report may yet provide newsworthy support for anyone looking for greater accountability, and reform, of the fundamentals underlying our banking system.

In my next article, I’ll take a closer look at the whos, whys and hows of Federal Reserve bank governance now under scrutiny by the GAO, and also look for some perspective for the upcoming GAO report from a 1976 study by the House Banking Committee titled “Reserve Bank Directors:  A Study of Corporate and Banking Influence.”

Broader Audit Authority — Still In the Works?

Significant resistance to the current GAO audit(s) arose within the Fed and among its friends in high places.  Those parties have been asserting a need to preserve the Fed’s independence within government.  In the face of this opposition, the House still passed an early version of what became enacted as ‘Dodd-Frank’ that contained surprisingly vigorous audit provisions, only to see them shriveled by later compromise.  Some of those championing broader general audits of the Fed’s actions remain disappointed, and concerned, about the scope of GAO authority.

In early 2011, Rep. Ron Paul introduced H.R. 459, the “The Federal Reserve Transparency Act of 2011.”  This is a new version of the broader audit bill he and others were looking for back in 2010.  Rep. Paul’s remarks while introducing the measure in early 2011 can be read here.  This legislation would direct the GAO to conduct a more general audit of Fed operations, including transactions with foreign central banks and monetary policy operations such as the large-scale purchases of suspect mortgage-backed securities where GAO scrutiny had been constricted. This new bill has attracted over 160 co-sponsors, but still faces meaningful opposition from the Fed and its defenders in Congress. A website focused on H.R. 459 (and the Senate version, S. 202) can be viewed here.

The actual text of Rep. Paul’s bill accomplishes the goal of extending GAO audit authority by eliminating previous statutory restrictions in 31 U.S.C. 714(b) that foreclosed GAO audits of Fed transactions with foreign governments, central banks, or ‘nonprivate international financial organizations.’  The bill would also eliminate constraints on GAO audits for monetary policy matters including open market operations and traditional discount window lending, and transactions under the direction of the FOMC more generally. 

The Fed and its defenders have fended off efforts like these thus far, citing among other things academic studies suggesting that countries with central banks with greater independence also enjoy better economic performance.  But the Fed had greater political independence in the 1920s than it has today, and the Fed still helped contribute to the worst financial and economic disaster in our nation’s history in the Great Depression.  In turn, it seems hard for the Fed to point to our conditions in recent years as providing any ringing endorsement for defending or cementing Fed independence, at least as it has evolved to date. 

The latest GAO audit report may put too much stock for its own conclusions in the validity of the Fed’s existing reporting and auditing controls.  We need closer scrutiny for its actions in recent years, particularly any choices designed or with the effect of benefitting the few at the expense of the many.

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