What amounted to a statement of principles and a very few stakes in the ground from Timothy Geithner on financial reform got a largely hostile reaction from Congress (see Ed Harrison here and here for further detail).
The main criticism was that the notion of making the Fed the uber stability regulator/financial system overseer (officially, the systemic risk regulator, or SRR). was misguided. We agree with this concern, but even this criticism fails to engage the deeper issues, namely the lack of critical expertise anywhere in the regulatory apparatus, and the failure to do enough examination of the roots of the crisis to devise sound measures.
Those shortcomings are almost certainly features, not a bugs. As we have observed repeatedly, Obama is not inclined to spent his political capital engaging still-powerful financial lobby to push for root and branch reform. And picking Geithner and Summers, both badly captured by the industry, assures that outcome even if he were not predisposed to take at most modest steps here.
First to the role of Fed. Members on the Senate Banking Committee from both parties were unusually pointed in questioning whether the Fed as the right candidate for the job. For instance:
Mr. Dodd described himself as “open on the issue.” But, borrowing a quote from an economics professor, he went on to wonder aloud if giving the Federal Reserve more authority “is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.”
“The Federal Reserve system was not designed to carry out the systemic risk oversight mission the administration proposes to give it,” Senator Richard Shelby, the top Republican on the U.S. Senate Banking Committee, said at a hearing.
Concluding that the Fed is better qualified than any other government agency to handle such a job “represents a grossly inflated view of the Fed’s expertise.”
Shelby, unlike many other Republicans (at least until recently) has the sensibilities of an old-fashioned banker and believes in regulation to assure bank soundness. And his key point is well taken. The Fed is full of economists who worry about interest rate policy. What little enforcement and supervisory culture the Fed ever had was killed via neglect under Greenspan. Even the bank-friendly Office of the Comptroller of the Currency was far more serious about implementing the few and far between strictures imposed on banks pre-crisis, such as the Home Owners’ Equity Protection Act.
I am far less troubled by the skill gaps at the Fed (considerable) than its culture and priorities. It is, as Willem Buiter tartly observed, a victim of cognitive regulatory capture. Just as the Treasury-led stress tests were a charade, obviously too thinly staffed to make an independent assessment of what the banks served up, it’s almost a given that oversight by the Fed would be largely a matter of form. Supervisors at the Fed would continue to be second-class citizens, and too few in number to boot.
The second line of criticism of the idea of expanding the Fed’s powers is that it would compromise the Fed’s independence. This concern would be more accurately stated as “further compromise the Fed’s independence.” Greenspan traded on his Fed chairmanship; Bernanke constrained Fed autonomy further by allowing th Fed to be used by the Administration to circumvent budgetary limits and the need to seek Congressional approval for expenditures to rescue banks. Again, per Buiter, the Fed became a quasi-fiscal agent of the Treasury.
Former Fed economist Richard Alford wrote earlier about how much times had changed:
We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted. ….
Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.
Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.
Yves here. One must presume it was reappointment. Back to Alford:
Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.
While these are legitimate concerns, the contretemps about the Fed masks more serious issues. The first is, as mentioned above, the powers that be lack the competence to supervise the industry well. That is not insurmountable, particularly now that that Wall Street has shed jobs, particularly in the complex products that were the source of the trouble. But pretending the Fed as it is is competent will assure the needed skills are not developed. Note that regulators do not have to be state-of-the-art, but they do need to be sufficiently well versed to know where the dead bodies might lie, and confident enough not to be deterred by less than complete answers.
But the biggest gap is that the US is embarking on a program of reform without having done sufficient diagnosis of where the problems and vulnerabilities lie. By contrast, the securities laws passed in 1933 and 1934 were based on a detailed understanding of the chicanery and follies of the Roaring Twenties, and provided many specific mechanisms to prevent their recurrence. By the time the Bear Stearns crisis hit, it was clear that the financial system was not going to heal quickly, and that the eruptions were symptoms of far deeper problems. Yet every time, the authorities tried patching the patient up and hoping for the best in place of making a real diagnosis.
For instance, one of the assumptions of the current programs is that Something Must Be Done about too-big-to-fail institutions simply because we’ve just had to throw a lot of money at them. That may be a necessary part of any reform program, but is is complete? Doubtful. Bear Stearns would not have been on any list of systemically important institutions (it did not make the grade in the Bank of England’s April 2007 roster of “large complex financial institutions” deemed crucial for credit market intermediation). Yet the concern that it might be a big enough credit default swaps writer to take down a lot of the financial grid along with it led to Fed backstoping of its unwind. LTCM and AIG would not have been on a TBTF list prior to their implosions either.
That suggests that there needs to be not just an institution-based view of the financial markets, but probably also a product-based persepctive and increased attention to system dymanics. For instance, repos are very big source of non-bank funding for the investing community, and there is evidence that suggests that much higher haircuts on repo collateral played a significant role in the contraction of liquidity. Yet there are no official figures on the size of the repo market, and perilous little consideration of how it played into the crisis. As I read them, the proposals would not address this funding source, which some experts estimate at $10 trillion, comparable in size to the total assets of regulated banks (note there may be some double counting in the repo market size estimates, since it probably includes reverse repos).
Similarly, despite the rosy view we now have of exchanges being great ways to create separate centers of activity that can fail without taking down the financial system (yes, Virginia, exchanges do fail), that idea isn’t accurate. Fro instance, in the 1987 crash, the Chicago options exchange was within three minutes of failing, saved only by the personal intervention of Chase CEO Tom Theobald, who authorized a badly-needed overdraft. The equity exchanges, which were separate organizations, came to function as a single market in the crisis. If Chicago had failed, it is pretty certain the NYSE would not have opened. And many observers believed that if it did not open, enough specialists would fail, it might never open (this is a simplification of a discussion from Donald MacKenzie’s book An Engine, Not a Camera).
But economists don’t do systems dynamics. Nor do they have a theory of financial systems (they have theories that address particular elements, like financial economics, and some relevant constructs, like principal-agent and information asymmetry).
It’s bad enough that policy is typically made by looking at a rear-view mirror. But in this case, the authorities haven’t even bothered adjusting it to get a good look at the roadkill behind them.