Does the Federal Reserve Deserve Deference as a Bank Regulator? Kevin Warsh Says "No"
I find this very puzzling. I really must say that I did not expect to see anyone trying to play the “Federal Reserve should defer to the Treasury on bank regulation” card that Kevin Warsh is...
I find this very puzzling. I really must say that I did not expect to see anyone trying to play the “Federal Reserve should defer to the Treasury on bank regulation” card that Kevin Warsh is playing here. I confess I do not understand it—either as a matter of intellectual logic, policy design, or political gamesmanship. What is going on here?
I must say that I was somewhat surprised when Kristalina Georgieva introduced Kevin Warsh for his G-30 2025 Spring Lecture “Central Banking at a Crossroads” <https://www.youtube.com/watch?v=kXuXhIBP3cw> by saying that he had served on the Federal Reserve Board “with distinction”:
As I recall, back in 2007 and 2008 Kevin had conspicuously failed to see through the veil of time and ignorance. Thus he had been blindsided by the actual risks and shocks. (As was I.)
But that is not my problem with the characterization. My problem is that he has not (at least not to my knowledge) done any kind of Bayesian updating of his own models and beliefs as a result. What he thought back in 2007 as he was facing in the wrong direction, he thinks now.
Refusing to face up and learn from one’s past mistakes, and to revise your Visualization of the Cosmic All in response, can be seen as a kind of distinction—but not the kind you want. Enabling that kind of see-no-error reaction is truly one of the many, many choices we make that makes us, considered as an anthology intelligence, much stupider than we should and could be. We should be polite. But we should also be more straightforward and honest in our intellectual critiques of one another.
Be all that as it may.
Take a look at the end of Warsh’s speech. It’s an attempt to make a weird distinction: that the Federal Reserve ought rightfully to be an independent agency when it comes to monetary policy and thus macroeconomic stabilization, but not when it comes to bank regulation and thus financial-crisis prevention:
[Central bank] independence is not a policy goal unto itself. It's a means a means of achieving certain important and particular policy outcomes. Independence is reflexively declared a bit too often for my taste when the Fed is criticized. But Congress has granted important functions to the Federal Reserve far removed from monetary policy. I'm thinking for example of banking and supervision. I do not believe the Fed is owed any particular deference in bank regulatory or supervisory policy. Fed claims of independence in bank matters undermine the case for independence in the conduct of monetary policy. And when the Fed turns away from its creed and traditions, exercising powers that were once in the province of our Treasury Department, or take positions on societal issues, whether popular or not, it further jeopardizes the operational independence in what matters most.
I studied economics more than I studied law, but my parents wanted me to go to law school. So in their spirit as they're looking down I'll make a single reference to the courts. Since Marbury versus Madison, a famous case in 1803, Article 3 courts have been in the business of policing Article 1 and Article 2 powers—that is powers of the congress and the president. And since McCulloch v Maryland in 1819, the courts have wrestled time after time about the role and authority of a central bank in our republic.
Others are far better situated than I to sort out the constitutional imperatives and legislative authorities of the current conjuncture. But what I believe is this: I strongly believe operational independence in the conduct of monetary policy is a wise political economy decision, and I believe Fed independence is chiefly up to the Fed. That doesn't mean central bankers should be treated as pampered princes. When monetary policy outcomes are poor, the Fed should be subjected to serious questioning, strong oversight, and even opprobrium. But a narrow central bank, we have to recognize, has more going for it than mere tradition.
Our constitutional republic is accepting of an independent central bank only if it sticks to its congressionally-directed duty and successfully performs its task.
Ours is, after all, our third experiment in the US with a central bank not because of the success of its predecessors but their failure. We don't become the third central bank the way you win a third Super Bowl—like keep at it and we keep giving you more. It's the third because we've struggled with the questions that are in the current policy conjuncture since the founding of the republic. My historical lesson from those old fights about the Bank of the United States, we should remember, the revealed preference of the body politic is a deep distaste for inflation, also for bailouts and power grabs. The governance objective, it strikes me as clear, is to make the central bank safe for democracy, not to make democracy safe for the central bank.
So, in conclusion, before Ragu comes up here and asks me a series of tough questions, I should say: The Fed's current wounds are largely self-inflicted, and its plot armor isn't what it once was. A strategic reset is necessary now more than ever to mitigate losses of credibility, changes in standing, and—most important—worse economic outcomes for our fellow citizens.
Now this all might strike you as quite a surprise to hear, because we central bankers are trained to be careful with our critiques lest the daylight reveal the magic. A bigger risk, it strikes me, is that of the sorcerer's apprentice—the misuse of magical powers producing trouble. Assembled in this room are dear friends who served with me in the financial crisis, colleagues who served with me on the G30, who are doing their best in our country and around the world to strengthen the economy, to ensure duty to its remits in various places. We're stewards of good and important purposes. We can ill afford the closing of the monetary mind. And, if anything, today what I hope for is a richer discourse and a richer inquiry.
We should be a bit less worried about violating pieties, prepared to endure periodic frowns of disapproval, because the benefits are huge. We can reclaim our intellectual freedom. We can get policy back on track. We can get stable prices and strong economic outcomes. Central bank legitimacy demands nothing less.
I appreciate your time. Thank you for listening. Ragu, please come on up and rough me up a bit.
Let me pick up with Warsh’s:
implicit claim that and that the congressionally-directed duty of the Federal Reserve is monetary policy and not bank regulation,
and his:
explicit claim that our constitutional republic is accepting of an independent central bank only if it sticks to its congressionally-directed duty and successfully performs its task.
With respect to the implicit claim that the independent Fed is for monetary policy only, not bank supervision:
There is a strange darkness in American economic history in the half-century after the Civil War in the institutional arrangements for managing the economy, The United States, then-emerging as the richest and most productive economy in the world, found itself repeatedly brought low by banking panics—most notably in 1873, 1893, and 1907. These crises were not just financial hiccups. They were existential threats to the national economy, bringing down major institutions, throwing millions out of work, and draining the moral authority of capitalism itself.
By the end of the first decade of the 20th century, it was clear to most serious observers that the American financial system lacked something fundamental: a central bank. Or rather, it lacked an institution that could do what a central bank must do when the storm comes—lend freely, on good collateral (or rather collateral good in normal times), at a penalty rate, to institutions that were illiquid but not insolvent (or rather would not be insolvent if times were normal—because, after all, if you are known to be solvent you are not illiquid), and do so without hesitation or partisan restraint.
Yet such an institution was lacking. The U.S. was left with a patchwork of state and national banks, bound together by a system of correspondent accounts, and overseen by little more than the blandly named Office of the Comptroller of the Currency.
Which brings us to October 1907, and to John Pierpont Morgan—railroad-reorganizer, industrial-promoter, financial-titan, and, for a brief and terrifying moment, the unelected and unappointed central banker of the United States.
The Panic of 1907 was, in some sense, the inevitable result of a fragile system working precisely as designed—designed, that is, by those who preferred a decentralized, lightly regulated, and politically neutered financial architecture. It began with a failed cornering attempt on United Copper Company by a group of speculators connected to the Knickerbocker Trust, one of New York’s largest and most visible financial institutions. When the corner collapsed, rumors of insolvency spread quickly. Withdrawals surged. The Knickerbocker Trust suspended operations. Contagion set in.
As depositors fled not only trusts but also banks, and call money rates spiked, it became clear that there was no institutional backstop. The U.S. Treasury under Secretary George Cortelyou injected some liquidity, but it was neither large enough nor fast enough to restore confidence. There was no discount window. No lender of last resort. No Bagehotian doctrine animating state response.
There was only J.P. Morgan.
It is one of the great ironies of American financial history that, when the federal government refused to organize a central bank, the market gave it one anyway—in the person of Morgan. At age 70, in declining health, Morgan took it upon himself to organize the rescue. He summoned the leaders of New York’s financial elite—bank presidents, trust executives, and industrial magnates—to his library at 23 Wall Street.
What followed was a remarkable week of candlelit triage and forced coordination. Morgan and his associates poured over balance sheets, dispatched auditors, and demanded full access to the books of institutions seeking assistance. Those judged solvent received emergency liquidity; those found wanting were allowed—or forced—to fail.
In a particularly dramatic moment, Morgan locked a group of trust company presidents in his library and refused to let them leave until they agreed to contribute $25 million in collective support for the Trust Company of America. When one wavered, he blocked the door and told him to sit down.
Morgan's methods were neither democratic nor especially transparent. But they worked. His ability to command capital, to assess creditworthiness, and to act swiftly and unilaterally was exactly what the moment required. By early November, the worst of the panic had passed.
Morgan’s role in resolving the 1907 panic was both heroic and terrifying.
It was heroic because it stemmed the collapse of the financial system.
It was terrifying because it underscored how utterly dependent the U.S. economy was on the benevolence and balance-sheet strength of a single private citizen.
That dependence became intolerable. Critics from across the ideological spectrum—from Progressives to Populists to plutocrats themselves—recognized that such concentrated power, resting outside the formal political system, was both undemocratic and unsustainable. If the United States was to continue growing as an industrial and financial power, it could not afford to rely on the ad hoc mobilization of private fortunes whenever the gears of commerce seized up.
The Panic of 1907 therefore marked an inflection point. It generated a consensus that financial modernization was not just desirable but necessary. And it planted the seeds for institutional reform. In 1908, the Aldrich-Vreeland Act was passed, establishing the National Monetary Commission to study alternatives.
Senator Nelson Aldrich, the Republican senator from Rhode Island and longtime ally of industrial finance, led a two-year inquiry into the monetary systems of Europe. His preferred model resembled something like the Bank of England—a strong, centralized institution closely tied to private banking interests.
In 1910, in what has become the stuff of conspiracy theory and gilded-age myth, Aldrich met secretly with Paul Warburg and other financiers at the Jekyll Island Club off the coast of Georgia to draft a plan for a U.S. central bank. The result was the Aldrich Plan—technocratic, privately governed, and business-aligned. But it was politically dead on arrival. The 1912 election swept the Democrats, led by Woodrow Wilson, into power. Wilson was willing to pursue a central bank, but not one that would be seen as a creature of Wall Street.
Thus emerged the Federal Reserve Act of 1913, a political compromise if ever there was one. The Act established a system of 12 regional Federal Reserve Banks, coordinated by a Board in Washington, and designed to balance the interests of East Coast finance, agrarian populism, and progressive oversight. It was not Hamilton’s Bank. Nor was it Aldrich’s. It was something sui generis: part public, part private; part centralized, part regionalized; part executive, part technocratic. It was American.
The Panic of 1907 and the improvised heroics of J.P. Morgan compelled the creation of a central bank not out of ideological conversion but of practical necessity. It was a classic case of institutional lag catching up to economic reality.
By 1907, the U.S. economy was too big, too integrated, and too dependent on financial intermediation to survive without a systemic backstop. The pretense that the market could self-regulate through dispersed private action had collapsed. Morgan’s candlelit crisis management was the final, undeniable proof.
The Federal Reserve System that emerged in 1913 was, like so many American institutions, a compromise forged in crisis. It was designed not just to prevent panics, but to do so without concentrating too much power in any one set of hands—whether in Washington, New York, or a robber baron’s library.
We forget sometimes that central banking is not just about interest rates or inflation targets. It is about authority: who gets to act in the name of economic stability when time is short and confidence is crumbling. In 1907, that authority belonged to J.P. Morgan. After 1913, it belonged—however awkwardly—to the Federal Reserve. And that, in the end, is the story: how the modern American state acquired its lender of last resort. Not because it wanted one. But because it could no longer afford not to have one.
Bu there is a crux—a point that then-Fed Chair Alan Greenspan made to my boss then-Deputy Treasury Secretary Frank Newman when Frank wanted to reorganize bank regulation, not (as Warsh appears to do) to subordinate the Fed’s regulatory powers to the Treasury Department’s, but rather to create a single bank regulatory agency separate from both. The crux is this: you cannot be an effective lender of last resort unless you have been regulating banks and the financial system and understand the risks and the leverage points before the bailouts begin. Alan was right. And so it has been since the founding of the Fed: setting and requiring compliance by Federal Reserve system member banks with capital adequacy and reserve requirements has been a core power of the Fed since 1913.
Warsh’s idea that the congressional direction is that the independent Fed—the Governors’ fourteen-year terms, dismissal for cause, and so forth—is for monetary policy and not for bank regulation thus seems to me to be absurd. UPDATE: As Jerry Caprio points out in email, the title of the 1913 Federal Reserve Act is:
An Act to Provide for the Establishment of Federal Reserve Banks, to Furnish an Elastic Currency, to Afford Means of Rediscounting Commercial Paper, to Establish a More Effective Supervision of Banking in the United States, and for Other Purposes…
If anything, I think that social learning and the evolution of our economy has led to more (very desirable) mission creep in the monetary-policy mission than in the bank-supervision mission.
With respect to the explicit claim: that our constitutional republic is accepting of an independent central bank only if it sticks to its congressionally-directed monetary policy duty, look again at the potted history Warsh presents to back this point up:
Ours is, after all, our third experiment in the US with a central bank, not because of the success of its predecessors but their failure. We don't become the third central bank the way you win a third Super Bowl—like keep at it and we keep giving you more. It's the third because we've struggled with the questions that are in the current policy conjuncture since the founding of the republic. My historical lesson from those old fights about the Bank of the United States, we should remember, the revealed preference of the body politic is a deep distaste for inflation, also for bailouts and power grabs…
Leave to one side the question of whether the First Bank of the United States (1791-1811) and the Second Bank of the United States (1816-1836) were in any sense monetary-policy conducting “central banks” as we understand the word. (I believe that they were not: I believe that monetary-policy conducting central banks have their origin in the Bank of England’s management of the Panic of 1825 and in the subsequent 1844 Peel recharter.)
Did either the First or the Second Bank of the United States produce any of “inflation, bailouts, and power grabs”?
With respect to the First (1791-1811) Bank of the United States, the answer is an unambiguous no for the first two:
The Bank was highly conservative in its lending and note issuance
It quickly established the practice of accepting only sound notes for deposit.
It quickly established the practice of redeeming state banknotes in specie (gold or silver), which discouraged reckless expansion by those banks
It acted as a hard-money anchor in a largely decentralized monetary landscape.
The Bank did occasionally act to provide short-term credit to prevent panic, but nothing resembling modern bailouts or systemic rescues.
In its role as the government's fiscal agent, it helped smooth Treasury operations: managing public debt, and accepting and transferring federal revenues.
But liquidity smoothing operations are not bailouts.
The third—power grabs—is more interesting. The Jeffersonian Republicans controlled all of the branches of the government from 1811 on, when Madison appointed Justices Story and Duvall to replace Paterson and Cushing, giving Republicans a 5-2 partisan majority. Madison was then President. The House was 106-36 Republican-Federalist. The Senate was 28-8. And when the First Bank came up for recharter in 1811, the Republican congressional majorities would not take the plunge. But it was a very close thing. Recharter passed the House. Recharter deadlocked in the Senate 17-17, and Vice President George Clinton then cast his decisive “nay”.
Enough Republicans back then thought that it was a power grab—an unconstitutional expansion of federal power beyond its proper limits via a misuse of the “necessary and proper” clause—to prevent recharter. But that was not because the First Bank of the United States had done anything to grab power. It was simply the fact of its being.
The orthodox Jeffersonian position was that the existence of a government-chartered bank had to be an illegitimate “power grab”. It had to be a source of financial corruption—or at least a vessel for the wrong kind of societal power. But it was not corruption in the legal or the Trumpian sense—fraud, embezzlement, or personal enrichment of insiders at public expense. Rather, it was that its very existence necessarily created concentrated financial power, elite entrenchment and patronage, the alignment of public institutions with private commercial interests, and the erosion of agrarian republican virtue by speculative finance.
The Bank’s shareholders were disproportionately wealthy Federalists from northern commercial centers. Hamilton and his allies had appointed competent people who were political friends with bank directorships and influence. To Jefferson, the Bank was the American analog of the British financial corruption complex: Crown-chartered companies, patronage networks, and elite insiders trading political loyalty for economic rent.
But no major scandals of embezzlement or misappropriation attached to its operations. However, Jefferson did not care. And the 1792 securities panic, in which financiers like William Duer and others speculated on government debt, lent fuel to Jeffersonian accusations.
For orthodox Jeffersonians, “corruption” did not require a bribe or a theft. It referred to the entanglement of state and finance, and the subordination of virtuous republican simplicity to complex, metropolitan, debt-fueled machinery. This view was ideological, but it was sincerely held, and informed by classical republican theory (Machiavelli, Cato’s Letters, British Country Party thought) in which corruption equals dependence, complexity, and self-dealing by rulers.
And the Republicans then quickly reversed their field. The War of 1812 began the year after recharter failed. The absence of a central fiscal agent created severe financial disarray. The U.S. Treasury struggled to finance the war. Many former opponents—including Madison—came to regret the Bank’s demise. And in 1816, Madison had signed the charter for the Second Bank of the United States, a reboot with similar structure and powers. And this reboot came with with the same time-limited 20-year charter as the First Bank. Came 1836, and it was time for the Second Bank of the United States’s recharter. And it ran smack into then-President Andrew Jackson. Bank recharter passed the Senate 28-20 and passed the House 107-85. Jackson vetoed. The veto override failed in the Senate 22-19.
But was the Second Bank of the United States an agency of “inflation, bailouts, and power grabs”? Inflation? Under President William Jones (1817-19), it did expand credit aggressively—and the Panic of 1819 was the result. But thereafter, from 1819-36, it was as hard-money as anyone could wish and more hard-money than many wished. Bailouts? The complaints were always that it did not bailout enough distressed banks and their creditors.
Power grabs? The complaints before Jackson’s veto were all that the Second Bank would proactively find state banks that it thought had overissued bank notes and demand their immediate redemption in specie. But if this was a “power grab” rather than just doing their proper speculation-curbing business, it was a deflationary one.
But in the runup to and after Jackson’s Veto Message? Definitely. As I understand it, rather than working with Jackson, Bank President Nicholas Biddle signed on with Henry Clay for President in 1831 and pushed for early recharter, hoping for a recharter veto that then could become a mobilizing issue and carry Clay to the presidency in the 1832 election.
Thereafter it was total war:
“The Bank is trying to kill me, but I will kill it.”
“This worthy President thinks that because he has scalped Indians and imprisoned judges, he is to have his own way with the Bank. He is mistaken.”
But the Jackson-Biddle Bank War is too big a topic for here. I will have to come back to it another day, and Peter Temin’s refereeing of whether the economic distress of the 1830s was of Biddle’s or of Jackson’s and Taney’s creation.
References:
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Catterall, Ralph C.H. 1903. The Second Bank of the United States. Chicago: University of Chicago Press.
Chernow, Ron. 2004. Alexander Hamilton. New York: Penguin Press.
Clapham, J.H. 1944. The Bank of England: A History. 2 vols. Cambridge: Cambridge University Press.
Elkins, Stanley, and Eric McKitrick. 1993. The Age of Federalism. New York: Oxford University Press.
Govan, Thomas Payne. 1959. Nicholas Biddle: Nationalist and Public Banker, 1786–1844. Chicago: University of Chicago Press.
Hamilton, Alexander. 1790. “Report on a National Bank.” In The Papers of Alexander Hamilton, edited by Harold C. Syrett, vol. 7, 305–343. New York: Columbia University Press, 1963.
Hamilton, Alexander. 1791. “Final Report on the Bank.” In The Papers of Alexander Hamilton, edited by Harold C. Syrett, vol. 8, 91–134. New York: Columbia University Press, 1965.
Hammond, Bray. 1957. Banks and Politics in America: From the Revolution to the Civil War. Princeton, NJ: Princeton University Press.
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Brad's history is accurate. But I'm not sure that this is the place for a history lesson. The question posed by Warsh is whether, in the year 2025, the regulatory functions of the Fed should be dissociated from its monetary policy and crisis management functions.
I cannot see any direct synergy between regulation and monetary policy. (Neither can the many countries that have established currency boards.) The argument must be indirect: regulation interacts with crisis management interacts with monetary policy. I will concede that monetary policy and crisis management are difficult to separate--they both rely on the same tool: buying and selling stuff for vast quantities of money.
The question, then, is whether crisis management depends on regulation. Here, I think Our Host has half a point, but only half a point. I can't see any connection for small banks. Federal Home Loan Banks successfully manage small-bank crises all the time, with no regulatory powers. I think that Brad's half-point applies to big banks: the ones that the Fed traditionally cares about. This kind of lender-of-last resort function entails close and tacit knowledge of the industry, including personal relations with the big players.
But is regulation the best way to acquire this tacit knowledge? Regulation is a rule-of-law thing. Law--a verbal activity--ends before tacit knowledge begins. Supervision is a lot closer to the mark, but supervisory reports are only verbal activities, albeit verbal activities that draw on tacit knowledge. What you really need is something more intimate. Central banks get this, in part, by their payment system oversight role. Senior central bankers have close social relations with senior bankers and shadow bankers. (Everybody knew Dick Fuld's motivations in 2008.) These are the essential roles, and they are not regulatory in any conventional sense of the term.
At least before 1996, the Bank of Japan had an interesting solution to the problem. It had no regulatory powers and I believe no supervisory powers at law. But the big banks agreed to have the BoJ stay close to them, the better to help the BoJ understand the banks for its crisis management purposes.
Contortions for the banks to take more risk, reap more profit ... until something goes terribly wrong. Then it is either bailout or oblivion. We can see something similar with the proposal to privatize Fannie Mae's profits, but make their catastrophic credit losses public.