Tuesday, July 14, 2009

Financial Regulatory Reform: We Should Taketh From, As Well As Giveth To, the Fed?

The wide scope of the Obama administration's regulatory reform proposals has triggered an economic recovery for lobbyists, and their frenzied paid, professional bewailing and whining has obscured some basic issues. We already knew, without being told, that banks wouldn't like the idea of a financial consumer protection agency. It also comes as no surprise that Wall Street would like to limit as much as possible the intrusion of regulators into their high margin derivatives business, even though that business brought the economy down last year with its reckless pursuit of profits without regard to risk.

But one issue that deserves more attention is whether the Federal Reserve should have responsibility for safeguarding the economy against systemic risk. This is the biggest regulatory reform issue. The reason why the current economic downturn has proven so intractable is the failure of a major part of the banking system due to uncontrolled systemic risk. We're talking about the unregulated multi-trillion dollar asset securitization market underlying the real estate and credit bubbles that popped so painfully. Banking collapses presage painful economic contractions (see, e.g., the history of the Great Depression and the Panic of 1907 for further details). The securitization market operated with virtually no meaningful risk management, either from Wall Street or the government. That's why things spun out of control and its risks became hideously large.

The Fed seems to be the principal nominee to serve as the systemic risk czar. It, after all, has played the biggest role in combating the current downturn and has regulatory authority over all the major Wall Street banks anyway. But is the Fed the best choice?

The Fed's current regulatory responsibilities already fill its plate. It is required to serve as the central bank--the lender of last resort to the banking system. It also is supposed to manage the economy. Section 225a of Title 12 of the United States Code provides that "[t]he Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, the Fed is supposed aim for "maximum employment, stable prices, and moderate long term-interest rates."

This is mandate makes the Fed a regulatory pushmi-pullyu. When the Fed is confronted by a slowing economy, it is supposed to lower interest rates to promote growth and employment. But doing so can run the risk of price inflation and asset bubbles. In the 1970s, the Fed chose to favor growth and employment, instead of raising interest rates to control inflation. The result was price inflation and little growth (the now infamous stagflation). In the late 1990s, the Fed lowered interest rates to promote growth, facilitating the expansion of the money supply that fueled the tech stock bubble. Then, in the aftermath of that bubble bursting, and the threat of recession from the 9-11-2001 terrorist bombings in New York and Washington, the Fed again lowered interest rates. This time, it fueled the real estate and credit bubbles that produced the train wreck we're now on. In other words, the Fed's legal mandate, as it has been interpreted for much of the past 40 years, appears to be inherently destabilizing.

If the Fed became the czar of systemic risk, things would only get murkier. In the world of commerce and economic enterprise, risk is a predicate to growth. Systemic risk is a predicate to systemic growth. Given its competing legal responsibilities, would the Fed be tempted to favor growth while allowing "some" systemic risk? Could the Fed, given its seemingly unlimited ability to print money, subsidize (at taxpayer risk and expense) Wall Street firms and others taking systemic risk in the hope of fostering more growth? The Fed's performance in the last 15 years reveals a tendency to underestimate systemic risk. People with a history of driving too fast usually have their licenses suspended or revoked. Why should we give a regulator that has a history of incautiousness the job of safeguarding the economy against systemic incautiousness?

The literary pushmi-pullyu exists only in fiction, and perhaps the regulatory pushmi-pullyu should no longer be a reality. Wouldn't it be better to relieve the Fed of the responsibility for promoting growth and employment? Shouldn't that responsibility rest in the hands of the elected government--the President and Congress? After all, fiscal policy, not monetary policy, fostered America's recovery from the Great Depression. The massive wartime spending that was required to fight World War II made America prosperous again. The federal government financed the war by sharply raising income taxes and borrowing record amounts of money. There were no Hail Mary pass-type policy measures by the Fed to print money in new and ever more creative ways.

The Fed's primary monetary policy tool--the level of interest rates--operates as a government price control. The government sets the price of short term credit. Doesn't the evidence now allow us to stipulate that such price controls have had the perverse impact that government price controls usually have? The government's underpricing of credit has produced repeated booms and busts in the asset markets during the last 15 years. We're now slogging through the worst recession since the 1930s as a consequence. Isn't it clear that government pricing of credit has produced distorted allocations of capital that may hamper long term economic growth? Cheap money goes into investments that produce the greatest short term returns. Higher interest rates induce more disciplined and thoughtful investing aimed at longer term gains. Don't we want more capital invested in ways that would produce the greatest long term returns--which tend to benefit workers and communities, as well as investors, instead of the privileged few that have profited from the short-mindedness of recent years? Have we just seen the latest manifestation of this perversity with the 60% jump in oil prices this year, in the face of a terrible recession? One wonders who, besides oil producers and perhaps Goldman Sachs, a noted commodities trader that just reported exceptional earnings, would have benefited from this latest asset bubble? Wouldn't systemic risk be fueled by lower interest rates? From a borrower's standpoint, as money becomes cheaper, higher risks become logical. If the Fed lowers short term interest rates marketwide, it may be increasing the levels of systemic risk. This, indeed, is likely an important reason for the astronomical size of the recent credit bubble.

Relieving the Fed of the responsibility to manage the economy would allow it to serve as the czar of systemic risk in a way consistent with its other legal responsibilities. After all, a central bank primarily focused on maintaining the health of the banking system would want to prevent high levels of systemic risk. It would no longer be tempted to compromise the safety and soundness of banks, and the moderation of systemic risk, in order to maximize employment and economic growth.

In Washington, it is axiomatic that government agencies do not readily give up power. After all, the more powerful you are, the more important you become. Minor bureaucrats are not invited to soirees in Georgetown. It would be unlikely that the Fed would give up its responsibility for the management of the economy without the mother of all bureaucratic battles. And Congress and the White House might not want to take it away because then they'd have the hot tamale in their laps.

So how do we avoid making the regulatory pushmi-pullyu even larger? Give the systemic risk job to the FDIC. Such a responsibility would be consistent with the FDIC's mandate to safeguard the banking system--no pushmi-pullyu problem there. And the FDIC is perhaps the only federal agency that has distinguished itself in the recent financial markets debacle, spotting problems earlier and proposing better solutions than more powerful players. Good performance and sensible ideas are rarely rewarded in Washington, a city where the well-connected and undeserving manipulate power to triumph over the meritorious. But perhaps once, just this once, we could make an exception.

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