Often when we talk about the Fed, we talk about a dual mandate — low inflation, and low labor unemployment.  But as I suggested at RealMoney many times, there is a hidden third mandate: protect the integrity of the banking system.

Often,  a tightening cycle would end with a bang, with some credit starved entity (Residential Housing, Nasdaq, LTCM, Lesser-developed Asia, Mexico, etc.) dying.  The Federal Reserve would then spring into action and say, “We must fight the threat of unemployment.”  Would they?  No, they would invoke protecting the financial system, which protects the banks.  After all, monetary policy does not work when banks are compromised, as they are today.  No wonder there is Credit Easing.

So when I hear the Fed proposed to be the systemic risk regulator, I have two thoughts:

1) You did a bad job with monetary policy and bank supervision, but you are nice guys, because you do for the US Government all of the things the Treasury Department can’t Constitutionally do.  Now let’s see if you can do better with controlling systemic risk, even though we haven’t granted you control over all the levers necessary to do so.

2)  Maybe this will make them better with monetary policy; it makes the triple mandate explicit.

My view is that the Fed is one of the major creators of systemic risk in our economy through the use of monetary policy to stimulate our way out of bad times.  The temptation that Greenspan succumbed to was to throw liquidity at problems too early, which avoided liquidation of marginal debts, and the debt levels built up.

If the  Fed has to minimize systemic risk in the economy, maybe it becomes less willing to loosen policy profligately.  I would hope it would work that way.

That said, given the lack of success for the Fed on its goals, I suspect that if it were given the task of reining in systemic risk, it would fall prey to political pressure, and fail at that as well.

I go back to my earlier proposal — the Fed would have to keep the US economy under a limit of private debts being less than 2x GDP.  But can you imagine the Fed tightening during a boom to avoid systemic risk, or raising margin requirements?  I can’t, so even though ideally the Fed would be the right player to manage systemic risk, in practice, systemic risk is unmanageable, because there are too many interests that benefit from boom times.  That’s why I don’t expect much from the proposals to manage systemic risk, regardless of who gets the power to do so.

This entry was posted on Friday, June 19th, 2009 at 11:58 pm and is filed under Fed Policy, Macroeconomics, public policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.