The Federal Reserve and the Rule of Law

Testimony Before the House Committee on Financial Services

Lawrence H. White's testimony to the Subcommittee on Monetary Policy and Trade House Committee on Financial Services.

Chairman Campbell, Ranking Member Clay, and members of the Subcommittee, thank you for inviting me to testify. Much of what I am going to say today draws on my previous research, which is cited below.1

The principle of the rule of law—as opposed to the arbitrary rule of those in authority—would have helped us to properly resolve the financial crisis of 2007–10, and can help us to avoid future financial crises. As David Hume said more than two hundred years ago, the benefits of consistently adhering to rule of law greatly outweigh any short-term convenience from ad hoc measures.

The approach of Federal Reserve and Treasury officials during the crisis, unfortunately, was to consider every possible remedy but following the rule of law. Fed chairman Ben Bernanke was quoted by the New York Times as declaring in 2008, at a strategy meeting with other Fed and Treasury officials, “There are no atheists in foxholes and no ideologues in financial crises.” 2 The implication was that anything goes in a crisis: the Fed can ignore durable principles and its own statutory limits.

Most notoriously, the Fed at its own initiative

  1. Created an unprecedented special-purpose vehicle (called “Maiden Lane LLC”) to protect the bondholders of the failed investment house Bear Stearns by taking $30 billion of the firm’s most doubtful assets off of its books, thereby sweetening an acquisition deal for JP Morgan Chase to take over the remainder of the firm’s assets and liabilities; 
  2. Declined to do the same for the investment house Lehman Brothers; and 
  3. Created two other vehicles—Maiden Lane II and Maiden Lane III—to buy and hold bad assets from the failed insurance company AIG. 

There was no precedent, and no apparent legal authority in the Federal Reserve Act, for such special-purpose funding operations. The Fed abandoned the rule of law, which requires those in authority to execute the law as written, predictably, and in accordance with established precedent. 

The Fed’s established monetary policy role as “lender of last resort” directs it to inject cash into the system to keep the broader money stock from shrinking, not to inject capital into failing firms by overpaying for assets or lending at subsidized rates, actions that put taxpayers at risk. The Fed’s statutory authority to lend is limited and was never meant to encompass the sort of capital injections that the Fed undertook in 2008 through the special purpose vehicles. While the Dodd-Frank Act of 2010 properly places new limits on the Fed’s discretion to conduct such bailout operations, it unfortunately ratifies the Fed’s discretion in other respects. Dodd-Frank also enshrines the “too big to fail” doctrine, the application of which inherently requires arbitrary judgments. It thereby erodes the rule of law, increases the probability of future taxpayer-funded bailouts, and weakens market discipline between risk and reward. 

The Rule of Law

At the core of the rule of law concept is the constitutional principle of nondiscretionary governance, in contrast to arbitrary or discretionary governance by those currently in executive positions. In common parlance, either we have the rule of law or we have the rule of authorities. Under the rule of law, government agencies faithfully enforce statutes already on the books, and only such statutes.3 Under the rule of authorities, those in positions of executive authority can make up substantive new decrees as they go along and forgo enforcing statutes on the books. 

It is of course true that laws must be executed by people in authority. We also know that the referees in a football match will be people. But they can either be referees who impartially enforce the rules of the sport as they were known at the outset of the match—that is, referees who follow the rule of law—or they can be pseudo-referees who arbitrarily enforce rules against one team but not the other, or (even worse) who penalize or favor one team with novel interventions that they have improvised mid-contest.

The rule of law concept has deep historical roots. David Hume’s classic History of England, written more than two centuries ago, famously emphasizes the value of establishing the rule of law in place of the unconstrained discretion of government officials. Hume acknowledges that it is not always convenient in the short run to forgo ad hoc measures. He writes that “some inconveniences arise from the maxim of adhering strictly to law,” but Hume affirms the lesson of history that in the long run we are better off from adhering to the rule of law. According to Hume, “It has been found that . . . the advantages so much overbalance” the inconveniences that we should salute our ancestors who established the principle. 

Consistent adherence to the rule of law has the great advantage, as the economics Nobel laureate F. A. Hayek has noted, that “government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.” 

In this way, the rule of law allows a society to combine freedom, justice, and a thriving economic order.5 To the extent that they can predict the actions of their government’s executive branch, Americans can confidently plan their lives and businesses, and they can coordinate their plans with one another through the market economy. Taxpayers need not fear being burdened (by being arbitrarily placed on the hook for bailing out failed businesses, for example) by executive branch agencies acting without authorization by their representatives in Congress.

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