Deep Dive Episode 170 – Engine of Inequality: The Fed and the Future of Wealth in America

In her landmark book, financial services doyenne Karen Petrou explains how, despite better intentions, Federal Reserve policies have been major drivers of economic inequality in America. Beginning with 2010 policies that widened the wealth gap, the Fed more than doubled down on its errors in 2020. Petrou, however, proposes a program of politically plausible changes in Fed policies to promote greater financial equality, economic growth, and financial stability, without requiring changes in legislation. In this live podcast, former Treasury Assistant Secretary Wayne Abernathy engages in a frank discussion with Petrou about her new book, the problems she identifies in Fed policies, and how she sees her proposals rising above partisanship to achieve the goals she sets out.


Although this transcript is largely accurate, in some cases it could be incomplete or inaccurate due to inaudible passages or transcription errors.


Evelyn Hildebrand:  Welcome to The Federalist Society’s Teleforum conference call. This afternoon, March 25th, we discuss Engine of Inequality: The Fed and the Future of Wealth in America. My name is Evelyn Hildebrand, and I’m an Associate Director of Practice Groups at The Federalist Society.


As always, please note that all expressions of opinion are those of the experts on today’s call.


Today we are fortunate to have with us Wayne Abernathy, former U.S. Treasury Assistant Secretary for Financial Institutions and one time staff director of the Senate Banking Committee, and Karen Petrou, Managing Partner of Federal Financial Analytics, Inc., and author of today’s book, Engine of Inequality: The Fed and the Future of Wealth in America.

After our speakers give their opening remarks, we will turn to you, the audience for questions, so be thinking of those as we go a long and have them in mind for when we get to that portion of the call. With that, thank you for being with us today. Wayne, the floor is yours.

Hon. Wayne Abernathy:  All right. Thank you very much, Evelyn, and thank you everybody who’s listening in to our Teleforum discussion today. I think you’ll find it very interesting, very stimulating. And it’s the kind of discussion that I believe is powerful because it rises above the discord that there is in a lot of these issues and searches for what I think are some really meaningful answers. That’s what we’ll dive into.


The way we’re going to work this today is we’re going to give time to Karen Petrou, the author of this book, to take a period of time to lay out for us all some of the key points and recommendations that are in her book. Then she and I will engage for a few minutes in a little bit of dialogue and back and forth. I’ll put a few questions to her, maybe draw a few of her points out. And then, we will turn the time to the listeners for questions that come from you, and that’s the way we’ll proceed. And with that introduction, let me know turn the time to Karen Petrou.


Karen Petrou:  Thank you so much, Wayne. It is really a great pleasure to be on this program with you after knowing you so long and respecting your work from Senate Banking Committee through Treasury and on to the American Bankers Association. I think you’ve been a terrific thought leader for the industry across your career, and I’m looking forward to your questioning and those of the rest of the audience.


As Evelyn said, the title of my book is Engine of Inequality: The Fed and the Future of Wealth in America. It’s about a cause of economic inequality that isn’t, I don’t think, well enough understood. The fact that it’s often overlooked means that we are also missing one avenue for near-term solutions to income and wealth inequality that do not even require an act of Congress and I don’t think are going to be anywhere near as controversial as some other proposals like wealth taxes or universal basic income or certain other proposals.


So what I’m trying, as Wayne said, is first to build the case for a significant cause, unrecognized cause, of economic inequality which is financial, monetary, and regulatory policy led by the Federal Reserve and where some other regulators, particularly over the banking sector play a role, and then bring out some solutions to how best to resolve them.


I’d written the book without the solutions and, unfortunately, the publisher said nope. The editor said, “We’ve got to add some solutions here.” So that was the hardest part of the book, but I hope it’s part of the most constructive part because, obviously, income inequality and wealth inequality are a huge form of personal, national, and political discord, disagreement, and even suffering.


Why the engine of inequality in the title? That’s because as Thomas Piketty’s book Capital in the Twenty-First Century demonstrates so well, economic inequality is like an engine. It has cumulative force. The richer you are, the richer you get, you and your heirs, and the poorer you are, the poorer you get, unless something slows and then reverses that engine. Sometimes the things that change the engine are wars. Sometimes they’re revolutions. Sometimes they’re more modest changes, but significant typically in the tax code, inheritance taxes, things like the wealth tax Elizabeth Warren is talking about. Many times those changes are relatively ineffective because the engine is so powerful.


Financial policy isn’t the only reason that engine of inequality is so powerful. The United States has become increasingly unequal, judged by income and wealth since the 1980s, and that is due to the combination of tax policy, education policy, trade policy, and demographics, among others.


But when I started working on this book, the reason I started working on this book, in fact, was when I looked and I saw something happened in 2010. The United States, as I said, was economically unequal and becoming more so starting in about 1980.  But in 2010, income and wealth inequality took off.  In chapter two of my book there are some charts, and you’ll see there’s just a sharp jackknife up in the inequality rate. We didn’t all get older. Tax policy didn’t become suddenly more regressive. In fact, in 2010, 2011, it was quite progressive due to the Obama tax cuts. Trade policy didn’t change. Education policy didn’t change.


What really changed was the post-2008 crisis, monetary policy set by the Fed, and rules that govern the financial services sector. And that might seem pretty arcane until you think about, well, what is economic inequality? It’s about income and wealth, and what are they but money? What federal agency has more power over money than the Federal Reserve?


That, of course, has power over lots of other things, and I actually got started thinking about these issues because in 2016, I was asked by a client, one of the banking industry associations, about what—not Wayne, another one—to look at the unintended consequences of the intersection of post-crisis rules up to the point in  2016, particularly the capital and liquidity rules from a financial stability perspective. And I could see some significant warning signs of what actually happened in 2020.


But I think because I happened to be reading Piketty’s book at the time, income inequality was on my mind, and I started to look and see just what happens when markets go up due to the Fed’s enormous footprint in the markets. And what happens when bank regulations — certainly, it made banks a great deal safer than they were before 2008, but it also changed the financial crisis.


I was invited to give a dinner speech right before the election in 2016 by a group of global central bankers. And I ran these ideas by them, and they were actually, “Huh, maybe we are having an inequality impact, and maybe we should start thinking about it.” Then I decided that, given how much drinking was going on at the dinner, they might not think about it hard enough, and I decided to write this book.


What are the things the Fed does, along with the other banking agencies, to make inequality, economic inequality, worse than it otherwise might be? I think there are four aspects of the Fed’s monetary policy and that overlap with post-crisis regulatory policy. Now, let me run through those pretty quickly.


First, inequality worths in the engine that the Fed drives are interest rates. Interest rates, since 2008 and especially after 2010 when the economy began to recover, had been very, very, very low. Most of the time from 2010 to 2020, negative when judged against inflation, i.e. negative, real in negative, in nominal — sorry, negative in real inflation adjusted terms, as opposed to the slightly nominal positive rates you see when you walk by a bank.


Rates that low distort the financial markets because they change critical practice such as the net interest margin which determines what kind of assets banks hold. If banks can’t make a profit making a loan because their cost of capital is too high and the interest rate they can get on it too low, they will not make the loan. The Fed thought that banks would just lower the rates that they charged on loans, and that would increase equality. But in fact, it didn’t work.


Part of that is because the United States, as a country without a strong middle class, did not have enough people in the economy with strong capacity to consume, just go out, rates drop, they go out. The old theory of monetary policy is the Feds, the central banks drop rates, people say, “Huh, gee. Now I can get a car loan for a lot cheaper. You know, honey, let’s go out and buy that car.” They go out and buy the car. That boosts output. That puts employment and the economy’s recovery.


But when you have a middle class — and the United States has people from the 25th to the 75th spec part of the income as a wealth spectrum with more debt than assets, living essentially hand to mouth. In 2019, 25 percent of the middle class skipped medical treatments they couldn’t afford for themselves or their kids. They aren’t going to buy a new car unless their old one breaks down. They aren’t going to buy a new house, partly because the banking rules made it much harder for people to get homes without large down payments, but often because they don’t have the capacity to support buying a home, and therefore the lawn mower and everything else that was supposed to spark output. So ultra-low rates drove market speculation, not growth, especially not equitable growth.


They also has a very profound and adverse impact on the ability of American households to save for the future. This is through their own direct savings because if you put your money in the bank now, you lose money in real inflation adjusted terms. But it’s also true in pension plans.


In insurance companies, we have significant gaps across the spectrum of financial institutions that are critical to long-term family financial security who are chasing yield, taking risks, speculating in ways — I was on a phone call earlier today with life insurance companies who were talking about buying bitcoin. This is not the old kind of investment that insurance companies, knowing that they need to honor life insurance claims 30, 40 years out, were once even allowed to take, let alone wanted to take. And they’re doing it now. They’re speculating.


The Fed’s huge portfolio increases this speculative frenzy because the Fed, after 2008, took safe assets out of the financial markets by buying trillions of Treasury obligations and agency securities. That was designed to give banks cash to lend, but it didn’t. Banks, again, because of new rules combined with the fact that the economic recovery was very weak, and banks weren’t going to take any more risks than they had to nor should they, banks didn’t just say, “Okay, thanks, Fed, for the trillions. We’ll just — now we’re going to go out and lend to a lot of people who don’t actually seem to want to borrow.”


Demand for new loans was very low. We’re going to put that right back — it’s a round trip back into the Fed deposits and what are called excess reserves at the central bank, where banks actually made a pretty good interest rate compared to what they could by taking risks out there in the market, again, taking their cost of capital into account. That’s the second thing. First thing that the Fed did to rev up the engine of inequality was ultra-low rates. Second thing was its huge portfolio.


The third thing was the fact that as the Fed was driving financial markets, particularly the stock market, higher and higher, it basically said, “You know what? You can’t lose.” This was called the Greenspan put because it said always step in when the market started to look a little rocky. It dropped rates to ensure that investors looking at their options said, “You know, I can make — on a risk adjusted return, I can’t make enough by putting my money in a savings account or other investments. I’d better dive even more deeply in the equity market.” That’s the Greenspan put. It protects investors from losing too much.


That was the Bernanke Put, the Yellen put, and now it’s the Powell put. Every time markets shake even a little, the taper tantrum that everybody cites as the reason why the Fed chickened out of reducing its portfolio in 2013 was a very modest three percent drop, but it spooked the Fed, and they said, “Oops, sorry.”


Markets will never normalize when the Fed controls the market. The word of traders is never bet against the Fed. And it’s a no risk bet. And again, average Americans, they take big risks, especially if they try to be prudent and put their money in the savings account. Investors, not so much, and that creates what is known as moral hazard, essentially markets that never go down as much because no matter how much speculation there is, until they blow up like they did in 2008, they did in 2020, and then the Fed steps in and essentially doubles down on its ultra-low interest rates, its gigantic portfolio, and its iron clad safety net between the financial markets.


Those are, I think, the most important monetary policy drivers of economic inequality. Each of them can be addressed through normalized, rapidly introduced, if careful, adjustments to Fed policies so that the Fed stops running the U.S. financial system, and private investors and financial markets again take their prime role as the arbiters of who wins and who loses, not the Fed.


The regulatory side of the inequality engine, those turbines in the engine, were designed by the Fed to make any other banking agencies — to make the banking system safer. And as I said, that was important. Banks were taking far too much risk, in part because they also enjoyed moral hazard, that so-called Greenspan put. Everybody thought all of the big banks were too big to fail. When they started to take undue risks in 2008, or late 2007, early 2008, the markets went up. Let’s get a few extra points here. We’ve been betting on the banks. It was again iron clad safety net beneath them, no risk for us. That works until it doesn’t. So new rules came in.


However, it wasn’t just the banks that went awry in 2008. It was Fannie Freddie. It was big insurance companies. It was money market funds. It was both banks and non-banks. The rules after 2010, the Dodd-Frank Act and through the Fed, were bank only. We can argue about the rules, whether they were warranted or not and too intrusive and too costly. I don’t think we can argue about the fact that they were asymmetric. Only banks were regulated for the most part.


What the Fed thought banks would do was say, “Okay, we have these high cost capital rules or these new liquidity requirements.” The Fed said banks can afford them. It’s only going to cost them a little bit of this, a little bit of that, in terms of reduced profitability. So the banks can certainly handle these rules and keep their business as it was, taking deposits and making loans.


The banks looked at them and said, “We can’t, on a risk adjusted return on capital, make the kinds of profits our investors require. The Fed is right. Maybe the profit isn’t harmed that much, but investors don’t like profits that are lower even by a little, so we are going to change our business model.” And every bank in the United States changed its business model as the post-crisis rules came into effect in the midst of a very weak recovery.


And the basic business of banking disappeared, went to the government, through Fannie and Freddie, for example, for mortgage finance, or to non-banks. Many of them, in the absence of rules, took a lot of risks. We saw this in the mortgage sector where the non-bank mortgage lenders and servicers took a lot of risks banks were barred from doing, and in 2020 almost blew up. They were saved by a variety of actions from the government, but the banks did not deed.


Many of the new entrants, some of them were more innovative, and many of them claim that they’re working on financial inclusion, but in fact, a lot of the products are dangerous for vulnerable households. There aren’t service centers. There aren’t call centers. People are used to having that protection of more than $50 at risk if a check or credit card payment is fraud. That doesn’t exist with a lot of non-banks, and we’ve seen some of those risks materialize. When you get the financial system out from under the rules — many of the rules may well seem unnecessary, but you get a really distorted result when they only apply to some providers in the same service not to all.


I would finally point out that these rules and the asymmetry in them created another really significant new development, which is money, new forms of money, money outside the regulated banking system, and outside even the Fed: cryptocurrencies, virtual currencies, or what’s now being discussed, central bank digital currencies. These have significant equality implications because, again, innovative as they are, it’s fairly unclear that bitcoin and these new currencies that are very interesting forms of speculative investment have the characteristics of what we need for money, which is that it be a reliable medium of exchange and storehouse of value.


Interesting, lower income households rely, to a far greater degree than most Americans, on cash and the importance of preserving a central bank that has a reliable payment system with sufficient private sector participation to ensure speed, efficiency, and finality. It’s important, and I would emphasize finality because we’re all really used to just writing a check or a sending funds to somebody and knowing that it’s going to get there. Getting paid, you know your money is direct deposited into your banking account as it gets into your banking account.


For all the fact we take that for granted, that’s a relatively new development, and a raft of rules that Wayne at the treasury and in the banking roles he’s played is very familiar with, and many of them put in place to solve problems that occurred, things like Expedited Funds Availability and Electronic Funds Transfer Act. All those standards were put into place by Congress in the wake of problems created in the banking system. I think, in the absence of like kind-rules, we’re going see that outside the banking system.


Wayne, let me stop there because I think what I’ve talked about are the engines of inequality in financial policy and how powerful they are. Maybe we should top here and talk about them and then move on to some of the solutions.


Hon. Wayne Abernathy:  Very good. There’s certainly never enough time to get into everything we want. That’s why you write it as a book, and it’s not a monograph. But I appreciate what you’ve put on the table, plenty to discuss there.


If I may, I want to put one question to you that it comes from one of the things I really appreciate greatly from you book, and that is that you carefully endeavor to stay above partisanship while yet at the same time offering very real, significant, but doable reforms. I’ll give you one example of that, and this one is obviously every doable because it just goes to what the Fed leaders say.


You recommend that they ought to say publicly something, for example, along the following, and this I’m quoting from your book. You say they should put out a statement that says something to the following, “Equitable financial policy starts with an understanding of who has and owes how much and proceeds to public statements from the Fed that, while it seeks market stability, it cannot and indeed will not guarantee it.” That is a statement that the Fed chairman could make today. Who could argue with such a statement?


Tell us, in your view, why is it important and what kind of a change would a statement like that mean?


Karen Petrou:  I think it’s extraordinarily important because we — I just do not think the American economy and markets will live up to their full potential if only one entity, an all-powerful, well-meaning, all-powerful, bureaucratic, risk averse Fed is in charge. The Fed should be risk averse in charge of things like the payment system, so it doesn’t say, “Hey, let’s see if this works,” and then the whole payment system blows up. It should be risk averse when it comes to rules. Let’s see if banks can get away with X, Y, Z. And that’s not — but markets are for loss, not gain. That’s that essential market discipline, and if you don’t have that, you get asset bubbles, and they almost never end well.


Hon. Wayne Abernathy:  That’s great. In essence, I think what you’re saying is they ought to be saying, “We’re taking away the put.”


Karen Petrou:  That’s right. Yep, we will step in. The statute, the law actually says that—and this is Section 13(3) of the Federal Reserve Act—that the Fed is to provide only emergency liquidity—I think that’s an important word—liquidity support, and then only in exigent and unusual circumstances at penalty rates. And instead, what the Fed did in 2008 and did again just last March is it provided tremendous amounts of liquidity for entities whose solvency was far from assured, say junk bonds.


Think about the Fed creating an enormous facility for the corporate bond market, one in which you had highly leveraged, high risk taking instruments, tremendous numbers of debt instruments doing nothing but paying for greater dividend than corporate shared by backs from speculative or certain types of bought due IPO or bought out firms. Those are markets in which people should lose money.


We have had a series of amazing IPOs for all sorts of companies that have never made a nickel because nobody thinks anything can go wrong. I really lay that at the Fed’s feet. It is so afraid of volatility—it’s rightly desirous of financial stability—that it has washed risk discipline and, I think frankly, the freedom of the free market out of the financial system.


Hon. Wayne Abernathy:  I’ll mention again — I’m talking a little bit more about Section 13(3) because that’s very important. One of the original purposes for which the Fed was created was to have this liquidity role. You wrote, and I’m again quoting from your book, that The Fed “actually took over the market instead of only supporting it in extremis, as the law’s intent clearly requires.” Can the Fed, now that they’ve established this precedent, can they back out of its control of the financial market?


Karen Petrou:  I say this in the book. Every one of us that — we’ve all been driving our kids around in kids’ safety seats in the back seat, and they as they get older, you let them out of the safety seat, but you still strap them in really tightly. And then one of these days, the kid wants to drive the car.


And this is where the Fed has had the market in a safety seat, facing backwards, double strapped in, and it’s driving a car far better than the kid could as it grows up. But first of all, the kid’s a lot bigger than that kid in the safety seat. And secondly, eventually, they have to learn to drive. Otherwise, a parent, i.e. the Fed, is going to be driving them around to their retirement home. It certainly satisfies the worried central bank that somehow there will be financial stability because it has promised it, and, lo, it is so. But it is not a recipe for freedom, experimentation, and again, the risk that uncovers new opportunity.


Hon. Wayne Abernathy:  Even though they say, or they would say, as you recommend, that they’re taking away the guarantee, that they’re not going to guarantee that the markets are going to go along smoothly, they need to take specific action to demonstrate they’re not just saying it. They actually have to demonstrate they mean it.


Karen Petrou:  I think they do. There are technical details here that they said in the Dodd-Frank Act, Title 11, tried because there was so much, I think, correct congressional opposition to what was viewed as the bailout of the big banks, the bailout of AIG, the bailout of Fannie Freddie. These are all different, and there are discussions about them, but the fact remains that the money market funds — there was a whole lot of tax payer money being flung around in 2008, often for companies that no one would have ever thought had the safety net strung beneath them, and most of whom never should have had the safety net strung beneath them.


So Congress, in 2010, on a bipartisan basis — I think, Wayne, you would agree that this was Democrats, Republicans, really Progressives, and Populists. The middle was a little uncomfortable with this, but both sides of the farther ends of the political spectrum really agreed that they did not want the Fed bailing out giant financial institutions. It’s just really seen as not the way the American financial system is supposed to work.


So Title 11 days to the Fed, again, you can only provide the kind of support you did in 2008 in limited circumstances, unusual exigent ones, and then not to bail out companies only for what is a traditional central bank purpose, discount window liquidity support more broadly. Okay. Fine. The financial system is now a non-bank one more than a bank one. You can do it for non-banks, but you still have to do it at penalty rates again and only in exceptional circumstances. Then Congress directed the Fed to write rules saying exactly what I now wanted to say, which is, “You know what, we won’t do this unless we really, really have to. And then we’re going to do it in the smallest possible amounts and liquidity only support, and it’s going to cost you.”


What’s really fascinating — the Fed refused to do that every time. The only reason the Fed finally issued the rule implementing that Title 11 requirement of Dodd-Frank was when Janet Yellen was being confirmed for chairwoman of the Fed. Senator’s Elizabeth Warren and I think Senator Shelby—I’m not sure—basically said, “We will not approve you until the Fed issues that the rule saying how it’s going to implement these 13(3) powers.”


So what the Fed did in its wisdom was issue a rule that basically reiterates the statute and then leaves it all profitable options to do exactly what it did in 2020, which was bail out junk bonds and exchange traded funds. It really is very afraid to let the kid drive.


Hon. Wayne Abernathy:  Well, one of your recommendations, and one with which I strongly agree, is that the Fed needs to shrink its portfolio, which is approaching a size equal to about half the national GDP. You write that the Fed used its portfolio, again quoting from your book, “not for full employment or price stability or moderate rates.” I’ll point out those are the three. It’s not a dual mandate, the Fed, it has three mandates.  And back to your quote, “but instead for the Fed’s preferred definition of financial stability,” which you then give as their preferred definition, “financial markets that never go down more than wealthy investors would like or high risk companies can endure.” Now that’s your statement about shrinking the portfolio.


The question I have is how, in practice, do they do it?


Karen Petrou:  They do it first by saying it. The Fed’s a huge fan of forward guidance. Some of the second of my Fed solutions is forward guidance. I do not think the Fed should lob bombs into the marketplace. It needs to warn them and be gradual because, by now, the system is so dependent on the Fed in every aspect of stock market prices, bond market functioning, and so much else. The Fed has to move with caution or bad things will happen. A spooked market is not a good market.


It should start by saying, as it tried to do in 2013, Bernanke hinted—he didn’t even say—he hinted that the Fed would reduce the portfolio, the bond market threw the now infamous taper tantrum, and the Fed chickened out. I think the Fed needs to say, “This time, we are serious. When we believe the economy is recovering, we will reduce our portfolio to the greatest extent possible as quickly as possible.” I think that’s all it has to say, and then not chicken out when the market gyrates some, because it will.


Note that the taper tantrum, that spooked the market. The Fed said it was just barely a three percent not even a correction. They went, “Ah, never mind.” This time it has to hold its course. It can, for example — I’m sorry. Go ahead, Wayne, please.


Hon. Wayne Abernathy:  No, you. Please go ahead.


Karen Petrou:  I was going to say — and there are ways the Fed can start doing that. For example, on the now seven and a half trillion, soon to be far larger trillions, on the Fed’s balance sheet, both of those are treasury obligations. Why does the Fed keep holding on to these treasury obligations, dramatically affecting and increasing that by a changing the way the bond market works, because everybody knows that how much of the Fed’s going to — the Fed is going to buy close to $120 billion of treasury obligations each month. The market counts on that and sets prices accordingly.


First of all, slow down the purchases. And secondly, the Fed is part of the federal government, just basically forgive the Treasury debt, as opposed to this roundtrip cycle in which the Fed holds all these Treasurys and then pays interest back to Treasury. It’s just kind of — it’s insane. You could shrink the portfolio by — basically make it disappear.


Hon. Wayne Abernathy: Well, I think as somebody pointed out to me, which folks don’t fully understand, the Treasury and the Fed are all part of the same organization, the federal government. Besides just borrowing treasury securities, it’s the government buying its own product.


Karen Petrou:  [Laughter] That’s right. Absolutely.


Hon. Wayne Abernathy:  I want to ask one more question if I may, and then let’s open the floor to questions from our listeners if I may. And the question really is to ask you to expound a little bit more upon one of the points you make about ultra-low interest rates. In your book, you say the following. “Ultra-low interest rates fundamentally eviscerate the ability of all but the wealthy to gain an economic toehold.” Tell us a little bit more about how these ultra-low interest rates are so harmful.


Karen Petrou:  The reason is that ultra-low rates create the strong incentives we’ve discussed, combined especially with the Fed’s big portfolio, and the iron clad safety net. All three together create strong incentives to invest in financial markets because that’s where we’ve seen — since 2007 the return on the S&P is up 162 percent. That’s a lot.


And you would say well, look, lots of Americans own stock. Well, many in the middle class own some stock through 401(k)s. But the top 1 percent of the United States owns 53 percent of American equities, and the top 10 percent owns 88 percent. So the benefit of rising financial markets are hugely and disproportionately enjoyed by the very few and the very wealthy. The top 0.1 percent of wealthy, last year alone, increased their wealth $4 trillion through equity blanket pricing.


Lower income people, unless they have 401(k) plans, don’t have access, whether it’s through mutual funds, through other investment vehicles, through brokerage accounts, into the market because it takes education, even with — we’ve seen a significant change with zero commissions and fractional shares, the kind of Robin Hood GameStop events which are worth a whole discussion in their own right.


But why does that happen? It’s because those investors also know they put their money in the bank, they lose. The same person who couldn’t put their money in the equity market lost a quarter, and actually closer to 30 percent, of their money by putting it in the bank over that same period of time. Pension funds and insurance companies, I said, acting on their behalf face the same problem with many of them going broke. It is impossible to secure a home down payment, save for a child’s education, or a retirement the traditional way of putting money aside because you lose money, given what the interest rates are after taking inflation into account.


Hon. Wayne Abernathy:  And this is not a change, as you point out, that would require a change in the law. It’s a change in a policy that the Federal Reserve has complete control over, or at least significant control of it. They don’t completely control those markets, but they significantly influence them.


Karen Petrou:  I would be a lot more convinced that ultra-low interest rates stoke the kind of economic growth the Fed keeps touting for them if it had worked. From 2010 to 2020, we had the weakest economic recovery in U.S. history, the greatest increase in income and especially wealth inequality, and yet another financial crash in 2020. That is not a good record for ultra-low interest rates.


Hon. Wayne Abernathy:  Yeah. You make a very good point in your book that ultra-low interest rates don’t stimulate the broad membership of the economy. It stimulates only part of it that’s been a part of it that, frankly, was well situated.


Karen Petrou:  Yep. That’s right.


Hon. Wayne Abernathy:  Well, let’s open the floor to questions from some of our callers. Evelyn, if you would give people the information they need to know to offer a question.


Evelyn Hildebrand:  Absolutely. Thank you. I’ll now turn the floor over to our first caller.


Hon. Wayne Abernathy:  Caller, please go ahead.


Bert Ely:  This Bert Ely. Karen, I fully agree with you about the enormous negative impact on most people in America about low interest rates. I wish more people would, particularly inside the Beltway, would come to appreciate what that negative impact is.


I have a somewhat related question. Just before this teleforum started, I listened to an on-the-record Women in Housing Finance program with Charles Evans, the president of the Chicago Fed. And I emphasize it was on the record, so I’m not speaking out of turn here. But he talked about inflation which of course is a related factor here, and he said it was a problem for the economy if inflation was too low. And then he started talking about the Fed’s target of a two percent inflation rate.


My question for you is this. In the context of what your thinking is about where nominal interest rates are, does the, shall we say, the average middle class person, working class person really benefit from the Fed having the level of tolerance that it has today for inflation? Or is inflation over time going to be really harmful to middle class, working class folks?


Karen Petrou:  I think it’s a terrific question, Bert, because as Wayne pointed out, and my book lays out in considerable detail, the Fed’s mandate triple. If you read the law carefully, not just the 1913 Act, the 1946, the 1977, and the ’78 Acts, the Fed’s mandate is full employment, and not the way it’s measured employment just by one indicator of employment, even when one out of five Americans said at the time they wanted to work and couldn’t find work. That’s a 20 percent unemployment rate, not a record, quote, unquote, “three and a half.” That’s the first part, full employment. The second part is price stability which is why the Fed has long been focused on inflation and now has people worried because maybe it will tolerate a little bit more inflation.


But the way the Fed measures price stability, I think, is really distorted and misses a really critical point, which is what prices do to the middle class. If we see the cost of education has gone up 600 percent, most of that in recent years, the cost of housing affordability way up, the cost of — because the economy has been so weak, you can look and say, well, household income is up.


Well, the Fed prided itself on that through the 10 years up to 2020. But there reason household income was up wasn’t because real wages were up. It was because in most households more people were working more hours and more jobs, and that meant more childcare, so child care prices go up, medical care — in 2019, 25 percent of the middle class skipped medical treatments they couldn’t afford.


I would rather than focus on this mythical two percent inflation target that the Fed has and who wins or loses whether markets don’t like it or consumers, particularly low, moderate, and middle income houses, but what does it cost to be a low, moderate, and middle income consumer, and can you afford that? The price is critical to you, to your family’s security, safety, and long-term prosperity. Can you afford that, particularly if you’re in the middle class? And the answer to that is no. The price stability needs to be measured, in my opinion, with distribution of realities kept firmly in mind, not just the market, what bond investors think.


Bert Ely:  Thank you.


Hon. Wayne Abernathy:  Next question.


Evelyn Hildebrand:  Great. We’ll now move to our next caller.


Hon. Wayne Abernathy:  Go ahead.


Caller 2:  This is kind of a basic question, but you mentioned, you noted that the Fed has been buying all these bonds from the Treasury. And you say it’s just buying from ourselves, which I guess it is, and you suggest that the money all just be given back. I just don’t know what kind of an effect that would have. And if it would have no effect, then how did it have any effect to begin with when they purchased them?


Karen Petrou:  When the Fed purchased it, it bought them from private investors. It didn’t buy the bonds from — if the Fed had just bought the Treasury bills when the Treasury issued the bills, it would have had no effect because it would be like if you were standing in the shop and you walk across from behind the counter, you grab candy bar, and you eat it. It’s your candy bar. You eat it. So what. You don’t have to put money.


But the Fed put money in the cash register, and that money went to private investors. And the Fed’s goal was to stimulate economic growth by basically giving banks, and non-banks as well, all of this cash. So now it’s holding on to these Treasurys. Essentially, it forgives the Treasurys, and the cash stays out in the market. But the more — it’s not buying cash securities from the Treasury. It’s buying them from the market. And again, that distorts the market to a very considerable degree.


Caller 2:  But wouldn’t that be very inflationary if they just cancelled all those and gave them back?


Karen Petrou:  Well, they wouldn’t give them back. They would just disappear. If they gave them back, it could be. But they own — when the Fed owns Treasurys, it’s like you owning the candy bar. You eat it.


Hon. Wayne Abernathy:  And by the Fed holding those treasury securities now, again, because the Fed is part of the federal government, there really isn’t more than a paper difference between whether the Fed’s holding them or the Treasury’s holding their own securities again, if people recognize, again, that the Fed is already part of the federal government. Isn’t that the key point here?


Karen Petrou:  I think it is. Yeah. Some people say the Fed is monetizing U.S. debt. Essentially, it’s supporting the debt market and dramatically affecting the price of Treasurys, as opposed to letting the market do that. Now with our huge deficits, if the Fed weren’t buying, creating artificial demand for all these Treasurys, investors would demand a lot more to hold them. Now they know they can just recycle them back to the Treasury, get the cash, and get out of there. It’s a very different market. And that reduces the cost of government borrowing, but again, it’s artificial.


Caller 2:  Is that the same as being inflationary?


Karen Petrou:  It could be. Over time, it could be, but it’s a little bit — but there are a lot of other aspects to that. So the deficit itself is per se inflationary, potentially inflationary, as well.


Caller 2:  Isn’t the fact that we have — isn’t the fact is that we’ve had inflation that is just in equities and real estate and it isn’t in prices, everyday prices? Isn’t that where the bubble is?


Karen Petrou:  Well, I think those asset valuations are a little bit different than inflation. That’s markets driving up the prices, rather — in terms — you can call it inflation, but it’s typically thought of as asset valuation increases.


Caller 2:  Thank you.


Karen Petrou:  Thank you.


Hon. Wayne Abernathy:  Thank you. So, Karen, by holding the securities, they have to buy them by law. If I understand correctly, the Treasury, as you point out, cannot sell directly to the Fed. They have to sell to a bank or someone else, and the Fed buys from them. So if the Fed were to reduce its portfolio, there might be an inflationary impact of that. But afterwards, if they follow your advice of not allowing the portfolio to expand greatly like it did in the past, then you’re taking away the chance of that being a source of inflation in the future.


Karen Petrou:  I think that’s right because the government would have to recognize the cost of its debt, and that would begin to suspend the fiscal spending. We would start to have a more real economy. I’m not actually opposed to fiscal stimulus necessary for the COVID rescue. These are extraordinary times. I am opposed to the Fed trying to manage the market so none of this matters. This really does matter that we’re borrowing trillions of dollars. I think the Treasury, taxpayers, and Congress need to reckon with the reality, and they won’t until —


Hon. Wayne Abernathy:  — What the Fed said earlier is that they’re taking this discipline out of the market. And I think what your recommending is putting that discipline back into the market so that people recognize the risks that they have, they recognize what they’re doing, and then they would be able to see what impact that’s having all across the economy.


Karen Petrou:  And they’d manage it better. We don’t have to — look at what’s going on with the equity. No one has to manage risks because the Fed says there aren’t any.


Hon. Wayne Abernathy:  We’re ready for another question from the floor.


Evelyn Hildebrand:  Wonderful. We’ll move to our next caller.


Caller 3:  Hi. Really interesting points. It sounds like a great book, and that was my point as well because wouldn’t it be the case that if the Feds stopped buying Treasurys or stopped trying to increase demand for Treasurys to lower the interest rates of those bonds, that the interest rates would go up and a huge amount of federal debt exists that is in short term notes? As a result, you’d have all kinds of fiscal problems for the federal government. And wouldn’t it actually be better if the federal government ran a surplus as we did in the 1990s, in the later ’90s, when the economy was doing great? Thank you.


Karen Petrou:  It’s just going to be really — there’s not easy way out. Back to the caller who asked, from 617, who asked about inflation and your point about the government deficit, we just — this is a complicated problem compounded by 10 years of  engine of inequality, 10 years of unequal monetary and regulatory policy.


We have made it much easier, if not — look at the 2017 tax cuts. Whether you believe in them or not, they dramatically increased the federal deficit and that was “free.” Congress got away with it. We get away with a lot, like you get away with driving a hundred miles an hour because there is this deus ex machina that never lets you hit the guard rails. And sometimes people drive even faster than a secular authority can safeguard, and that, I think, is where we are.


Hon. Wayne Abernathy:  Great. Thank you for that question. I think we’re ready for the next question from the floor.


Evelyn Hildebrand:  Great. At the moment that was the last question in the queue. While we’re waiting for any other callers who would like to ask a question, I’ll hand the floor back over to you, Wayne, for additional questions.


Hon. Wayne Abernathy:  Yeah, thank you. There was one question I wanted to put to you, Karen, that time wasn’t allowing at the moment, but let me offer this now. You talked a little bit about the interaction between monetary policy and with regulatory policy. I have been concerned, as have others, that Federal Reserve Bank capital rules following the 2007-2009 recession were deflationary undermining the very stimulus policies.


Would you elaborate a bit about where you see and what you see in the interaction between monetary and regulatory policies, and how they together promote inequality, and how you believe that they should be coordinated instead to address those problems of inequality? I think you talked particularly about the impact on bank lending. I thought that was powerful in your book, if you could talk about that a little bit more.


Karen Petrou:  Oh, thank you very much, Wayne, because your expertise in this, I really, really appreciate that. Yeah, I think the Fed somehow expected that banks would keep on lending when interest rates dropped. As I said before, they — Wayne, you and I have read enough Federal Register notices to know that they always include these cost benefit analyses at the end in which the Fed says things like, “This rule will cost banks an additional $42.3 billion in capital, and that’s 5 percent of capital, so what the heck.”


The banks don’t think like that. They look at these ultra-low rates and then the higher cost of doing business. And as they think, they change their business model. That decreases output because the whole engine of output is — the whole point of ultra-low rates is that new money is put into the economy to generate plants and equipment. And instead, all it did was generate corporate buybacks and dividends because people couldn’t make the investment decision work.


I actually remember — in my day job, I run financial consulting company, and we spend a lot of time working with big financial companies and investors trying to help them figure out their strategies in 2010 through 2020. And we were working, for example, on a new bank charter. And there was just no way, with ultra-low interest rates and the cost of capital, we could make the 20 percent return on investments that the market demanded. So the new bank never opened and the loans and the financing it was going to offer never got made.


Hon. Wayne Abernathy:  Wow, that’s powerful, and I think that’s very important. And you see it now when you look at bank portfolios today. Do we have any other questions from the callers yet at this point?


Evelyn Hildebrand:  We do, yes. We do have two more questions.


Hon. Wayne Abernathy:  Go ahead.


Caller 4:  Hi. I certainly agree that this is unsustainable. I thought trillions in quantitative easing was going to come to a bad end, but it seems to go on and on. And what goes up does have to come down. But what is going to precipitate an understanding of that,  or what’s going to bring about the bad end of this if everybody sort of just holds hands and agrees that modern monetary theory works? And we keep doing this. I just don’t understand where it’s going to end. It seems to me, the longer we let it go on, the worse the reckoning is going to be. Sorry, long question.


Karen Petrou:  That’s not a question. It’s the reason why I wrote my book. [Laughter] I don’t need to sell books. I make a nice living, and I don’t need to things to do nights and weekends. I have a life.


I wrote it because I fear the worst. And it’s not just in the financial markets. I think we’ve seen — in the electorate, we have seen — look at what happened January — this is a very angry country. And a lot of people have reason to be. Look at — whether it’s the GameStop sagas, where people are doing all sorts of crazy things that they think the market is rigged, that they don’t have a fair chance. People feel that they’re working really hard and they’re not getting ahead, so it must be somebody else’s fault. People are just furious.


Racial equity issues, which I think point to the fact that — do you know that African Americans today are worse off than they were before the Civil Rights era began in terms of income and wealth equality? Their home ownership rates and the rest of the — the promises were never kept, and people are pretty annoyed about, angry about that. And that’s really destructive. It’s very dangerous, especially with fragile markets and a propped up government deficit based in part on the Fed’s willingness to support it.


There’s a lot of moving pieces here, and none of them in my opinion are well-greased other than to power this, the engine of inequality.


Hon. Wayne Abernathy:  What I’m very optimistic about thought — and I think that is a dark picture ahead, but your point is a lot of the reforms you’re recommending do not require legislation. These are things that the Fed and the other bank regulators have authority to do now.


Karen Petrou:  Yeah. I don’t think — financial policy isn’t the answer in entirety. There is no easy answer like that, but it’s part of the answer.  And as you say, Wayne, I think it’s the easiest part of the answer. And it’s very important to remember what I said at the start that inequality is an engine. It’s cumulative.


So let’s say, and I think we should, we make education better. And kids starting in — low income kids now have a far better shot starting in Pre-K, and K, and first, second grade, to get ahead, to get their reading scores, all that, up. That is going to take a full generation before those kids start to be part of the national economy, and by then it’s going to be even harder unless we act within the easier scope of solutions, like financial policy reform, to give them a better chance. We cannot wait another generation. As I said, the country’s too unequal and way too angry, I think, for us to assume we have time.


Hon. Wayne Abernathy:  I think we’ve got one further call that we can have time for, and I think there’s one more caller on the line. Is that right?


Evelyn Hildebrand:  There is one more final caller on the line, yes. So I will turn the floor over to our final caller.


Steve Dewey:  Yes. Hi, this is Steve Dewey calling. First of all, thanks very much to Wayne and Karen for this discussion. I found it very fascinating discussion. I would like to — I actually really liked the comment from the previous caller. I’m very concerned about the direction that our country’s heading and the direction the Fed has taken. The Fed just seems to be getting more and more involved in our economic activity.


So my question is, if it becomes so bad, is it feasible and would you agree that the Fed could be phased out? I know that sounds radical, and it’s probably very unrealistic. But if we got to a point where, say, inflation got really out of hand and the public sentiment really turned against the Fed, could the Fed be phased out? And if so, first of all, do you think that that would be desirable? And what would our world be without a Fed? How would that look if we did not have the Fed?


Karen Petrou:  My first goal would be to fix the Fed. I think as we said, that’s very feasible, and that would be preferable. When the United States did not have a central bank, we needed JP Morgan to save the financial system. There is a role for a stabilizing force in the economy, and I think a properly managed central bank is that force. It plays an important role, and it needs to be independent of political interference so that it can play that role without regard to election futures, as opposed to dropping rates to make the artificial sugar high, those kind of things, before elections.


But if we don’t fix the Fed, I think it certainly is contributing to the problem, to such a grave problem that the kind of solution you’re describing could well threaten central banking. I would hate to see that. I think I would like to reform it first.


Hon. Wayne Abernathy:  And Karen, we are just about out of time, but we have time for any final comment you’d like to make.


Karen Petrou:  I’d like to thank you, Wayne, the terrific questions, particularly from you. You know lots more than I do about the national debt after your stint at Treasury, and I really appreciate your perspective on it and the important points you’ve made to bring out the message of my book.


I really do hope that those of you on the line have learned a bit about both the engine of inequality and how the Fed’s role in it has significantly increased wealth inequality and therefore economic and market dysfunction and political anger. It is something we can all work together to fix, and I really look forward to trying to do that with all of you on this call.


Hon. Wayne Abernathy:  Great. Thank you very much, Karen. And thank you for giving us the time, especially the time to write the book and put some very important issues on the table. Evelyn, the time is back to you.


Evelyn Hildebrand:  Wonderful. Thank you. On behalf of The Federalist Society I want to thank our experts for the benefit of their valuable time and expertise today. And I want to thank our audience for calling in and participating. We welcome listener feedback by email at [email protected]. As always, keep an eye on our website and your emails for announcements about upcoming Teleforum calls and virtual events. Thank you all for joining us today. We are adjourned.



Wayne A. Abernathy

Former Assistant Secretary for Financial Institutions

U.S. Department of the Treasury

Karen Shaw Petrou

Managing Partner

Federal Financial Analytics, Inc.

Financial Services & Corporate Governance

Federalist Society’s Financial Services & E-Commerce Practice Group

The Federalist Society and Regulatory Transparency Project take no position on particular legal or public policy matters. All expressions of opinion are those of the speaker(s). To join the debate, please email us at [email protected].

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