The Real LIBOR Scandal

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Whatever can be said for and against Barclays and Bob Diamond, the story is in danger of exhausting itself at the wrong link in the chain. It has sidelined BubbleTV’s around-the-clock coverage of Facebook. Mark Zuckerberg’s dog walker has been waiting in a studio sound booth for a week now.

The populace has been so successfully coached and beaten to a pulp that the source of interest-rate price fixing is not mentioned. That source is the Federal Reserve.

Upon its invention, the Fed had no such authority. In 1923, New York Federal Reserve President Benjamin Strong wrote a letter to friend, which says about all that needs to be said about the Federal Reserve’s open market operations: "What I can’t understand is the willingness of thoughtful, studious men who presumably have been brought up in the spirit of American institutions and should be imbued with their principles, proposing a scheme to Congress which in effect delegates avowedly and consciously this vast power for price fixing to a small group of men who, in an economic sense, might come to be regarded as nothing short of a super-government. It is undemocratic, absolutely contrary to the spirit of America institutions, and so dangerous in its possible ultimate developments that I cannot see the slightest merits for its proposal." [My underlining – FJS]

It should be noted that Strong was a Morgan man (Bankers Trust). He headed the New York Fed upon its birth in 1914. It is also of note that "Fed policy" was run by Strong, not by the Chairman of the Federal Reserve System in Washington. Power moved to Washington in the 1930s.

(Today, this appearance of power in the capital may be more form than substance. The current chairman of the board of the New York Fed is a Morgan man, in fact, he is the Morgan man: J.P. Morgan Chairman and CEO Jamie Dimon. The board of directors of the Federal Reserve Bank of New York chooses its own president: currently William C. Dudley, formerly, chief economist of Goldman Sachs. Dudley was hired by then-New York Fed president Timothy Geithner in 2007 to run the Federal Reserve’s open market operations (buying and selling Treasury securities through his primary dealer network), which still operate from 33 Liberty Street in Lower Manhattan. The neo-Florentine palazzo has been home to the New York Fed since its construction was completed in 1924. As president of the New York Fed, Dudley’s top responsibility is to find buyers of Treasury securities to plug Treasury Secretary Timothy Geithner’s $1-trillion-plus annual gap between revenues and spending.) 

Despite his Morgan interests, and his power, Benjamin Strong saw no good in the Federal Reserve setting market interest rates. This was soon to change. The New York Fed contorted interest rates in 1922, 1924, and in 1927. (The 1922 operation was benign. In the words of Lester Chandler, author of Benjamin Strong: Central Banker: The "prime motivation was to assure themselves [the Federal Reserve district banks] of enough earnings to cover expenses and dividend requirements.")

Strong’s change of heart might be chalked up to "absolute power corrupts absolutely." Strong was human. Senator Elihu Root of New York attempted to kill the 1913 Federal Reserve Act. He understood its inevitable folly: "[W]ith the exhaustless reservoir of the government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community. Bankers are not free of it. They are human…when credit exceeds the legitimate demands of the currency and the currency becomes suspected and gold leaves the country…it is the United States that is discredited by the inflation of its demand obligations which it cannot pay."

The Morgan man at Banker’s Trust helped Senator Root prepare that speech.

Strong’s decision to drive down interest rates in 1927 had the greatest consequence. Adolph Miller, a member of the Federal Reserve Board at the time, testified before the Senate in 1931. He described the explosive nature of the Fed’s open market operations: "In the year 1927, you will note the pronounced increases in these [Federal Reserve holdings of Government securities] in the second half of the year. Coupled with the purchases of acceptances, it was the greatest and boldest operation ever undertaken by the Federal Reserve System, and, in my judgment, resulted in one of the most costly errors committed by it or any other banking system in the last 75 years…. [T]he Federal Reserve [put] money into the markets, not because member banks asked for it by offering paper for rediscount, but in pursuance of a policy of our own which in effect said, ‘We shall not wait to be asked to provide increased money through rediscounts; we will operate upon our own responsibility….’"

Miller, unlike the fashionable economists of the 1920s, including Irving Fisher and John Maynard Keynes, did not fall for the New Era: "That was a time of business recession. Business could not use and was not asking for increased money at that time. But the banks do not want to and in fact do not carry uninvited moneys or idle reserves. Here then, in 1927, came an accession to their reserves for which they had to find a use."

Barclays and Bob Diamond, not free of the spirit of optimism, acted as described in the speech written by Senator Elihu Root and soon-to-be head of the New York Fed, Benjamin Strong.

"One of the most costly errors committed by it or any other banking system in the last 75 years" led to the Great Depression, during which, even third-rate pupils of the period learned that over production of money through open market operations can in fact lead banks to "carry uninvited moneys or idle reserves."

It would be better if Mark Zuckerberg’s dog walker were Federal Reserve chairman today.

Since Libor is the purported subject here, the nagging question shall be raised: Why is an interest rate set in London fundamental to the structure of mortgage rates on the North American continent? Recidivist homage to the United States’ former sovereign? This seems to be one more practice that has gone on for so long that its dissonance is forgotten.

Having raised one, another nagging question: Should it be LIBOR or Libor?