A quarterly magazine of the IMF

December 2001, Volume 38, Number 4

The Fed
The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets

Free Press, New York, xiii + 350 pp., $27.50/Can$41.95 (cloth).

In Martin Mayer's view, the U.S. Federal Reserve is not unlike the Wizard of Oz: behind the imposing facade and stunning special effects lurks an institution that is very puny indeed. The transformation of the financial landscape in recent decades has reduced the central bank's power, and so the Fed's ability to shape what goes on in financial markets now largely comes down to psychology. It is the markets' anticipation of, and response to, actions by the Fed that constitute the real basis of its influence. Although by no means an uncritical admirer of Alan Greenspan, Mayer recognizes that one of the Fed Chairman's strengths is to have grasped this fundamental insight into the nature of the Fed's power on the contemporary scene.

Mayer's book is essentially two separate stories rolled into one. The first, and strongest part of the book, is an account of the Fed's history over the past fifty years, told from the perspectives of its successive chairmen. Mayer, a veteran financial journalist with nearly thirty books to his credit, has excellent sources and is personally acquainted with many of the key players. Although his tone is at times irascible, Mayer tells his tale well. Two episodes deserve to be singled out: the first is the 1951 "accord" between the U.S. Treasury and the Fed concerning their respective roles in debt management and monetary policy. As Mayer remarks, this little-noticed agreement laid the foundation for the Fed's operational autonomy in monetary policy and, hence, is the starting point for much of the recent debate about central bank independence.

The second episode was the Fed's being given overarching responsibility for regulating financial conglomerates under the 1999 Gramm-Leach-Bliley legislation. This development bucks an international trend toward diminishing, rather than increasing, the regulatory role of central banks and thus requires explanation. In Mayer's view, it owed much to Chairman Greenspan's personal prestige and was powered by the Fed's need to carve out a new role for itself.

The second strand of Mayer's story, which provides the background to the first, is an account of the evolution of modern finance and of the policy response to the growth of derivatives markets, financial conglomerates, disintermediation, and internationalization. These developments have fundamentally altered—and diminished—the functions and powers of a central bank, Mayer believes, although he acknowledges that they have not yet had much impact outside the industrial countries. In this part of the story, Mayer's grasp seems to slip. His account is reminiscent of the famous cartoon of the world as seen from the New Yorker's offices: events in New York and Washington loom large, while those in Europe, Japan, and the emerging markets are seen as vague dots on the horizon. Mayer's access and sources outside the United States are clearly not as good as those nearer to home, and he appears to have leaned heavily on a library of press cuttings. This often leads him into error. For example, his account of the collapse of Barings is factually incorrect. The Bank of England did, at first, attempt to prevent the collapse but could not organize a consortium of banks to take over Barings's derivatives liabilities. In the end, it made a virtue of necessity.

There is undoubtedly some truth to Mayer's thesis that the role of central banks has been transformed. But the question is whether the transformation is fundamental or only a matter of degree. As Walter Bagehot (1826-77) well understood, a large element of psychology underpins the central banker's power. In Lombard Street, a compilation of Bagehot's articles that appeared in The Economist, he remarked on the smallness of the Bank of England's reserves compared with the enormous credit structure constructed on it and emphasized that the very word "credit" has its root in the Latin word for "belief." As long as the market believes all is well, credit will not be disrupted; the central banker's key task is to maintain that belief and to restore it once things go wrong. Despite the growth of derivatives markets and sophisticated mathematical modeling, this principle of central banking stands unaltered, although its application may need to change to reflect the new financial landscape. This subject cries out for a latter-day Bagehot. But for that we will need to wait a while longer.

Michael Taylor

The Rules of the Global Game
A New Look at U.S. International Economic Policymaking

University of Chicago Press, Chicago, Illinois, 2001, xvi + 329 pp., $32.50 (cloth).

This is three books in one: one on political economy, one on the fundamentals of international economics, and one on the nature of international economic agreements. The three books are linked, of course, but each makes for rewarding reading on its own. As an eminent scholar and a distinguished policymaker, Kenneth Dam is uniquely placed to comment on how domestic politics causes international economic policy to diverge from what it should be. He points the finger at lobbyists who steer the policy agenda in favor of special interests. U.S. living standards, Dam argues, would benefit from a more open system of international trade and finance. To that end, he proposes that policymakers develop the tools of "statecraft"—legislative and executive procedures that would counteract and deflect pressures from interest groups.

For each of the 535 members of the U.S. Congress, there are 38 registered lobbyists and $2.7 million in annual lobbying expenditures. The sustained growth of the lobbying industry is rooted in the system of decision making, characterized by checks and balances. This system, Dam argues, encourages some interest groups to seek profits from the congressional appropriation process. A symbiotic relationship thus exists between the "regulators" (the Congress and executive agencies) and the "regulated" (the various interest groups).

A bewildering array of interest groups have emerged over the years and, Dam claims, have more influence on economic policymaking than the electoral process itself. As evidence, he points to the strong support offered by these groups to all incumbent lawmakers without distinction along party lines. Dam notes, in particular, the growth of nongovernmental organizations (NGOs). These citizens groups emerged in the 1970s and, by 1980, made up more than one-fifth of all interest groups active in influencing congressional lawmaking. Though representing social, environmental, and consumer interests, as distinct from private business interests, they are no different from traditional business lobbyists in their methods and funding operations.

The net outcome is that forces promoting profits for a few prevail over those seeking a more efficient international flow of goods, people, and financial capital. For example, trade barriers favoring particular constituencies imply forgoing the benefits of international competition. One example of the statecraft Dam proposes is fast-track authority in international trade negotiations, which limited the U.S. Congress to approving or rejecting entire packages proposed by the U.S. president rather than voting on its various components. U.S. presidents had such authority from 1974 to 1994. However, the very success of fast-track authorization led to opposition: after it expired, the authority was not renewed, setting back further trade reform. Dam cautions that statecraft can also be used to negative ends: antidumping procedures have evolved into an "increasingly protectionist device."

From trade, Dam moves to international finance, which, he observes, is ever more on the minds of policymakers. He discusses the rules that govern international monetary policies, foreign direct investment (FDI), and bank lending and portfolio flows, reaching a pessimistic conclusion: "The problem is that, imperfect and porous as statecraft solutions are in trade, they are necessarily more primitive in the present exploding world of international investment and finance."

Written presumably before his own recent appointment as a senior official at the U.S. Treasury, Dam is critical of his predecessors' conduct of international monetary policy. He argues that the Treasury, working for its principal constituency, the U.S. financial community, has encouraged premature liberalization of capital flows into countries that were not ready to receive them and then orchestrated bailouts of private creditors unable to collect on their debts. In this context, he says, statecraft requires rules and institutions that foster financial transparency and prudence, which may raise the costs of financial transactions but would ultimately be the most efficient course of action.

Continued restrictions on FDI into the United States reflect interests within regulated sectors that fear competition. Dam points the finger at the lobbying efforts of multinational firms, which are often reluctant to face additional competition in their host countries, and also at NGOs, whose "head- on attack," he concludes, was largely responsible for the failure of the Multilateral Agreement on Investment proposed by the Organization for Economic Cooperation and Development. That attack, in turn, was based on a view that international investment can have harmful social consequences through alleged exploitation of the environment and low-wage labor—a claim for which there is little empirical support. Dam also criticizes the U.S. government for its failure to counteract NGO pressures.

In conclusion, the book could well have been titled, "A primer for international policymakers." It lays out an astonishing range of economic reasoning to guide decision making. With his heavy focus on U.S. politics and policymaking, the one challenge that Dam does not take on is how to move toward an internationally cooperative policymaking process. He does refer approvingly to the system of reciprocal obligations that was the cornerstone of international trade libera- lization. But perhaps the events of September 11 will prompt him to consider a new book, one that recognizes that the need for more active coalition building is as urgent in the economic as in the political sphere.

Ashoka Mody