The Right Reform for the Fed

Ben Bernanke has an editorial in the Washington Post that attempts to defend the Fed.  Here is my discussion of his editorial:

These matters are complex, and Congress is still in the midst of considering how best to reform financial regulation. I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation.

1) A fiat money system cannot control inflation without controlling credit.  Bank regulatory powers natively belong to the Fed as a result.  Rather than remove the regulation powers, give them to the Fed exclusively, so that we can watch them fail at the task without any charges of banks choosing their regulators.  There should only be one regulator of banks.  Let it be the Fed.

This is not to say the Fed has done a good job in the past.  Far from it.  But other regulators have failed as well.  Let’s have one regulator, so that we can assign blame when there is failure, and eliminate the errors in the long run.

2) Away from that, since Volcker and Martin, when has the Fed truly been independent?  When has it done something politically unpopular?  When has it done something that angered politicians?  Mr. Bernanke, your Fed has gone with the flow, and prostituted the credit of our nation to satisfy political ends, not protect the value of the currency.

The proposed measures are at least in part the product of public anger over the financial crisis and the government’s response, particularly the rescues of some individual financial firms. The government’s actions to avoid financial collapse last fall — as distasteful and unfair as some undoubtedly were — were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Moreover, looking to the future, we strongly support measures — including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system — to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is “too big to fail” — while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

3) What the Fed did not do in the past it recommends now, that bankrupt institutions be taken through bankruptcy.  Duh, I recommended that many times in 2008.  There was no reason that any of the bailouts should have happened.  All we needed to do was follow existing law, and if no DIP lender showed up, the US Government could have played DIP lender, in order to liquidate the portions of complex institutions that were systematically important.

The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems.

4) There were regulators that did better, including Australia and Canada.

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

5) Why should we believe that the Fed that did not use its powers to the full in the past, will do so in the future?  The Fed has had these experts available in the past, and did not use them.  What should make us think that they will be more successful in the future?  The failure to regulate properly is systematic.  There needs to be a change at the top of the Fed if it is to have a chance of regulating properly.

There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks, as demonstrated by the success of the stress tests.

This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed’s unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.

6) 1987 and 2001 were failures, not successes.  No policy accommodation should have been given.  Would Martin or Volcker have done it?  Financial firms need to learn to run with more slack capital for disasters.  As for the present crisis, please take credit for the glut of liquidity provided 2001-2004.  The Fed is to blame for that.  The kid gets no credit for saying, “Ma, I broke the window,” when she saw him do it.

7) The Fed should regulate systemic risk, because it creates the systemic risk.  No other reason.  Make the Fed tighten policy when Debt/GDP goes above 200%.  We’re over 350% on that ratio now.  We need to save to bring down debt.

Of course, the ultimate goal of all our efforts is to restore and sustain economic prosperity. To support economic growth, the Fed has cut interest rates aggressively and provided further stimulus through lending and asset-purchase programs. Our ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance, including lower inflation and interest rates.

Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities developed during the crisis. Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation.

We have come a long way in our battle against the financial and economic crisis, but there is a long way to go. Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

8) The Fed has been anything but independent.  An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.  A transparent Fed would have full transcripts published within a year, not five years.  Testimony before Congress is a joke, because Congressmen use it to play for their own advantage, rather than overseeing the Fed.

I repeat what I have said before — If we had truly independent central bank governors like Volcker, Martin and Eccles, the Fed could work.  The Fed needs to work, or we may as well go back to a gold standard.

Given the  lack of independence of the Fed over the past 23 years, additional Congressional oversight could not hurt much.  Better that the Fed should have tough men as leaders, willing to stand up to the politicians and say no, we won’t inflate.  If we can’t have that, bring back the gold standard.  Gold is impersonal, and bends to the whims of no one.  It is a friend to those that want something fixed to rely on.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

5 Comments

  • matt wilbert says:

    “The Fed has been anything but independent. An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

    This seems completely wrong to me. First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power. Perhaps they will in the future, but it is a bit early to assert that, I think.

  • andrew says:

    Dave, please tell me you are forwarding thios to the members of the Banking Committee to help them prepare for Ben’s upcomming hearing.

  • Doug says:

    “Away from that, since Volcker and Martin, when has the Fed truly been independent? When has it done something politically unpopular? When has it done something that angered politicians?”

    I think that this is generally correct, but would add that Alan Greenspan, of all people, incurred the wrath of George H. W. Bush by tightening into an election. That was probably his last “independent” act.

  • carol says:

    ¨Make the Fed tighten policy when Debt/GDP goes above 200%. We’re over 350% on that ratio now. We need to save to bring down debt.¨

    David, I fully agree (as with your other points).
    However, I do not see it happening.

    Why would we save when others electronically ´print´ money to buy our debt?

    See todays Bloomberg News:
    ¨Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.¨

    Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

    Please also note that all of a sudden, earlier this year, the definition of ´indirect bidders´ was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ´purchased´ by the printing presses of foreign central banks.

    This could explain both the record amount of debt issued and the record low yields.

    As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ´printing´ by foreign central banks — CB´s ´buying´ each others debt — for at least 10 more years?
    That would free us from saving, enabling us to ´consume´ our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

    I´d appreciate your, and other readers´, take on this.

  • But What do I Know? says:

    Good stuff, David.

    @andrew: It’s a great idea, this and Yves Smith’s comments might do a world of good. . . Now, if someone would just invite them to sit down with some Treasury officials. . . :>)