Oooh, because I have to be on a plane at an ungodly early hour tomorrow, I do not have time to do Robert Shiller’s New York Times piece, “The Fed Gets a New Job Description.” justice.
In short, I don’t agree with this mission creep by the Fed becoming official. First, as Shiller implies, the Fed has been moving in that direction, thanks to Alan Greenspan. Greenspan also de-emphasized the Fed’s role as financial regulator, resorted to bubble inducing negative real interest rates to combat what would likely have been a garden variety recession, and though adjustable rate mortgages were entirely a good thing. Greenspan’s legacy, in the form of the worst financial crisis since the Depression, is enough to question the wisdom of any policies implemented on his watch.
Second, the Fed simply isn’t big enough either in terms of its financial resource or its purview to accomplish such a goal. What can the Fed do about our massive current account deficit? It clearly can’t continue at current levels, and its reversal is going to heighten our economic duress. The Fed can’t make Japan stop offering yen financing for the carry trade. It could raise interest rates, which would encourage more savings, but that would slow growth.
Which leads us to third, this new goal can conflict with the Fed’s other aims, of generating full employment and stable prices.
Fourth, the Fed lacks the understanding of and ability to gather information about numerous markets and products that affect “market stability.” The Fed could not obtain documentation for collateralized debt obligation agreements, for instance, unless an investor felt generous and slipped the Fed a copy. It has very little understanding of the credit default swaps market, beyond the fact that if it came apart, that would be a very bad thing indeed.
From the New York Times:
The plan of Treasury Secretary Henry M. Paulson Jr. to overhaul the financial system includes a crucial proposal: it would officially transform the Federal Reserve into a “market stability regulator” rather than merely a banker’s bank.
This aspect of the Treasury plan is a natural step in a historical trend. The Fed is no longer just a regulatory agency presiding over a narrow group of businesses called banks. Rather, its mission increasingly is to maintain macro confidence — confidence that the entire financial system is functioning well as part of the whole economy.
In contrast, traditional securities regulators like the Securities and Exchange Commission have as their primary mission the maintenance of micro confidence — confidence that individual firms are disclosing the truth about their own internal operations and are not manipulating information.
But as the current financial crisis attests, it is macro confidence that requires the most subtle attention. The instability in even in the most modern economies accounts for the growing respect for the financial stabilization offered by central banks.
Moreover, the nature of financial institutions is changing, and as finance becomes more sophisticated, the traditional boundaries of banking have blurred. In the current crisis, for example, there have been significant liquidity problems associated with “special-purpose vehicles” or “conduits,” which issue asset-backed commercial paper. These entities resemble banks but are not technically banks. In the new financial order, in fact, we do not clearly know what is or is not a bank, so a narrow definition of the mission of the central bank is no longer appropriate.
In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.
The trend toward greater powers for the Fed isn’t new. In 1932, Congress extended the Fed’s power by giving it the authority “in unusual and exigent circumstances” to make discount-window loans to any organization or individual, not just to member banks. In 1980, Congress gave the Fed the authority to use its discount window in the normal course of business for all depository institutions, including savings associations and credit unions, and to set reserve requirements for them as well.
The Fed has been taking an expansive view of its own powers recently, for the most part with considerable public approval. Witness its decision to give a $29 billion line of credit to JPMorgan Chase to encourage the purchase and rescue of Bear Stearns. There was very little criticism of this move because so many people rightly feared the systemic effects on financial institutions if the Fed did not act. Bear might have had to dump its troubled assets on the market, and the whole financial house of cards could have collapsed. Because we sense that maintaining confidence in our financial system is so important, we are permitting the Fed to expand its role.
The trend toward greater reliance on central banks has been global. These institutions have been given more independence, as with the Bank of Mexico in 1994, both the Bank of England and the Bank of Japan in 1997, and the creation of the European Central Bank in 1998. Independence, of course, means more power.
Two of the Fed’s most important innovations were internationally coordinated measures. These were the establishment of the Term Auction Facility in December, for the auctioning of 28-day advances to depository institutions, and the creation last month of the Term Securities Lending Facility, which lends Treasury securities to so-called primary dealers — banks and securities firms like Goldman Sachs, Morgan Stanley and Lehman Brothers. The rising prestige of the world’s central bankers is apparent, as these have been perhaps the most significant international steps to deal with the financial crisis…
Mr. Bernanke’s own analysis of history, as well as that of other economists, emphasizes the essential importance of confidence in financial institutions and the subtlety of the issues involved in promoting such confidence.
For example, Mr. Bernanke has said that a significant motivation for starting the Term Auction Facility was to make it possible for troubled banks to borrow from the Fed discount window without encountering “the so-called stigma problem.” What is stigma? We are not talking about emotions here, but about banks’ efforts to act in such a way as to maintain the confidence of people who deal with them. We are talking about discovering subtle instabilities in the house of cards, and fixing them.
Confidence is too complex for the consumer confidence indexes — which are based on surveys of ordinary people — to measure adequately. It has to do with confidence in specific institutions — confidence that they will behave properly and that the leaders who are trying to promote others’ confidence will act in a constructive way.
Formalizing the Fed’s transformation into a market stability regulator makes sense. The Fed has already begun to play this role. And by doing so, it is taking a significant step toward reducing the fundamental instability of our economy.