Alford: Time to Stop Giving the Fed a Free Pass

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Wide swaths of families, businesses, investors, taxpayers, and others have had not just their net worth but their lives damaged by the recent financial crisis and its aftermath. Many are looking for an explanation. Many are content to attribute blame and much anger has been directed at Wall Street firms, the credit rating agencies and increasingly the Fed. However, I find ironic that the Fed is escaping criticism for egregious policy errors, while being blamed for decisions and actions that were precipitated by the failure of other agencies to shoulder their responsibilities.
Errors for which the Fed should be held accountable, but for which it has largely escaped criticism, include the following:

• The Fed managed to completely miss the housing bubble. It continues to argue that it should not be held accountable for missing the housing bubble because no one saw the housing bubble, when in fact many knowledgeable and well-respected analysts and policy makers, inside as well as outside the Fed, called attention to the bubble.

• The Fed adopted a macro-economic framework for policy analysis that systematically underestimated (i.e., ignored) the importance of financial markets and institutions to policy and economic performance. Not surprisingly, it ignored its supervisory regulatory responsibilities.

• The Fed allowed increased concentration in the financial services sector, which implied the growth of TBTF institutions, concentrations of market power, and informational asymmetries that are inconsistent with fair and well-functioning markets.

• The Fed publicly and repeatedly claimed credit for the great moderation. The view that it could produce trend growth in low inflation and interest rate environments, coupled with the low-and-slow-to-tighten interest rate policy contributed to an atmosphere in which financial institutions and households believed that there was no risk in highly leveraged positions.

• The Fed temporarily masked the costs of the decline of the tradable goods sector (in part a reflection of a dysfunctional exchange system) while at the same time ignoring its responsibility as the bank of issue of the world’s reserve currency.

• The Fed failed to learn from the LTCM crisis. In fact, the current crises can be accurately viewed as the LTCM crisis repeated on a nationwide scale.

• The Fed dismissed critics who charged that excess liquidity was fueling asset price bubbles, arguing that the liquidity was 1) a vague concept, 2) impossible to define, and 3) impossible to measure. In short, the Fed argued that liquidity could not be used as a policy tool. However, once the crisis broke, the Fed immediately made what had previously been indefinable the focus of policy. Furthermore, it knew how to allocate the liquidity by type of counterparty and collateral. Unfortunately, the problem of excess liquidity had already morphed in to a solvency crisis.

• Most importantly, the Fed failed to achieve the target it set for monetary. Starting in the mid-1990s, the Fed assured the public that it would use monetary policy to prevent the US from experiencing the problems that had beset Japan. Unfortunately, the US is repeating the Japanese experience: a stock market bubble, a real estate bubble, the collapse of the financial system, a recession (by many measures the worst since the Great Depression), unemployment, a ballooning of the fiscal deficit, and inflation low enough that the Fed was forced to adopt unconventional policies that resulted in its balance sheet doubling. (Short version: the Fed learned nothing from the Japanese experience.)

• The Fed has also exhibited a profound political naiveté. It allowed itself to become a political punching bag. This will compromise its ability to set policy with an eye to longer-run developments just when the political demands on the Fed will rise as the scale of the debt and deficits crimp fiscal policy.

The Fed role in the AIG fiasco straddles the fence. The Fed made a one decision that was a major blunder, but many of the criticisms directed at the Fed also reflect the errors and failures of others.

Post-Bear and the GSES, the Treasury should have prepared contingency plans to be used in the event of crises at systemically important firms, e.g. AIG and Lehman. Instead it simply waited until there was “blood in the street”. The Treasury abdicated its responsibilities.

The Fed had absolutely no business substituting itself for the executive and legislative branches of government by “bailing out” AIG. Making a loan based on acquiring a 79.9% ownership interest in the borrower is not a loan—I don’t care what the Fed lawyers opined at the time any more than I care about what E&Y opines about Lehman’s 105 repos. The Fed assuming indirect operational control of any company, especially an insolvent one, was a bridge too far. Assuming a bailout was necessary, the de facto nationalization or resolution of AIG should have been accomplished de jure under terms and conditions approved by Congress and the President, as was the case with the GSEs and the auto makers.

Given the speed of developments, it may have been incumbent on the Fed:

1. to have temporarily financed Treasury’s acquisition of AIG while Treasury sought the enabling legislation; or

2. to have lent Treasury the funds to meet AIG liquidity needs contingent on Congressional approval and funding of a resolution vehicle; or

3. to have taken steps to relieve the pressure on AIG while Congress and the President established the legal framework to nationalize and or unwind AIG.

However, the Fed should never have agreed to take an ownership interest in (even if placed in a Trust) and exercised any degree of management control over AIG.

If the Fed had limited its role to the temporary financing of the AIG bailout (much as it provided financing until Congress created the GSEs conservatorships), then decisions made about AIG, including treatment of its various creditors and the payment of bonuses would have been in the hands of the Executive and Legislative branches of government where they belonged.

The Fed was and is not a bankruptcy court. Congress or an entity explicitly authorized and appropriately empowered by the Congress should have been designated to deal with AIG and the issues such as the payment of bonuses and payouts by the clearly insolvent AIGFP. The Fed had no business adjudicating claims or arbitrarily imposing haircuts on AIGFP’s creditors, counterparties, or other claimants. If senior status was to be granted to investors in AIGFP’s GIAs relative to CDS counterparties or other claimants, it is up to Congress to decide and the courts to enforce. Note that AIG is the only company that the Fed is “resolving”. The Fed wasn’t chosen as the conservator of the GSEs. The Fed wasn’t chosen as the vehicle to revive GM and Chrysler. The Fed doesn’t even unwind failed banks.

The Fed should never have put itself in a position where it could be called upon to use public money to make any of a bankrupt firm’s creditors whole without authorization and appropriation from the Congress.

The Fed made a series of errors, but they were precipitated by the failure the Treasury to act and presumably the inability of Congress to make a decision in a timely fashion. The Fed should have had the backbone to just say NO to the then-Secretary of the Treasury Paulson when it was asked to bail out and assume control of AIG. Treasury had stepped up and bailed out the GSEs (with temporary Fed-supplied financing). The Treasury also arranged guarantees for money market funds. Why was it the job of the Fed to bail out and unwind an insolvent insurance holding company and assorted subsidiaries?

If the Treasury and the Congress had been up to their responsibilities, the Fed would not have had to abandon its lending function whereby it makes overly collateralized recourse loans to solvent firms.

In short, the Fed should be criticized and admonished for foolishly exceeding its legal authority. The Fed made decisions and some of them have proved to be unpopular. However, two-plus years after Bear we still do not have a law providing a framework for resolving financially impaired systemically important firms. What kinds of decisions, if any, would the Congress have made in the middle of the AIG crisis? We know that Treasury was incapable of planning a response to a crisis and ducked responsibility for difficult and potentially politically costly decisions. The Fed should have stepped aside, but instead it stepped up and made some decisions which have proven to be unpopular. Would Paulson have made better decisions? Could Congress have made a decision?

The failure of Lehman is in the headlines once again. Not surprisingly, the Fed is in the cross hairs of numerous commentators. I am not surprised. The free ride given to the SEC does surprise me. The SEC failed in regard to Bear. It failed in regard to Merrill. It failed in regard to Madoff. It failed in regard to Lehman. The SEC was Lehman’s regulator. While on the SEC’s watch, Lehman became a large, complex, grossly overleveraged securities firm with a concentration of illiquid under-performing assets and dodgy bookkeeping.

Where is the outrage at the SEC? The only mention of the SEC in the summaries of the Dodd financial reform bill that I read was funding for the SEC independent of Congressional appropriation. It seems the only thing that the SEC succeeded at was lowering its performance bar to the point that a snake would trip over it. On the other hand, the Fed is portrayed by many critics as an omniscient, omnipotent, Machiavellian operative responsible for all that is less than optimal. (This is in stark contrast to some at the Fed who believe the Fed to financial market version of a comic book super hero: incapable of doing evil, i.e. Fed policy cannot possibly have unwanted unintended negative side effects and undesirable outcomes must be somebody else’s fault.)

Critics charge that the Fed should have made public the fact that Lehman was insolvent. Given that the Treasury had decided not to develop or propose a means to deal with failures of systemically important non-banks until after a crisis had occurred, any such announcement would have precipitated the crisis we all rue. Historically, the bank regulators have acted to minimize both potential market disruptions and the cost to the insurance fund/taxpayers. This was the modus operandi behind the JPMorgan/Bear and BOA/Merrill mergers. The fact that the Fed and the SEC said nothing while Lehman continued to shop itself should not be newsworthy.

Many charge that the Fed should have also independently taken steps to avoid the disorderly unwind of Lehman, but many of the same critics take issue with decisions and choices made at AIG even though Lehman would have been AIGFP in spades.
A frequently cited reason for Fed involvement in AIG is that Congress could not have put together a rescue plan in a timely fashion as it did for the GSEs; however that is really an additional reason for the Fed to have refrained from getting involved in AIG. The Fed is not empowered to substitute its judgment for that of the President and the Congress.

It is inconsistent and hypocritical to charge the Fed with being undemocratic while requiring it or expecting to take actions outside its legal mandate. If the Fed is to be a democratic institution, it must constrained by its legal mandate at all times. It cannot violate its mandate simply because it deems it expeditious; it cannot assume the role of a bankruptcy judge; it cannot usurp the role of the Congress by distributing public monies. On the other hand, if you want or approve of the Fed exceeding its mandate and taking extra-legal actions by performing functions mandated to other agencies, or the courts, or the taking it upon itself action to fill loopholes in legislation on-the-fly, then you must cede that the Fed will be anti-democratic.

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it
Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms.
Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG.

Criticize the Fed, but keep in mind the relative costs of all the mistakes and failures to act by all the participants.

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  1. fresno dan

    “However, I find ironic that the Fed is escaping criticism for egregious policy errors, while being blamed for decisions and actions that were precipitated by the failure of other agencies to shoulder their responsibilities”
    You can go duck hunting with a rifle or a shotgun, but you’ll eat more duck with a shotgun. If some of those extraneous criticisms blow the Fed out of the sky, so be it.
    What is amazing is that many still say that the Fed saved the economy.

    1. call me ahab

      fresno dan says-

      “What is amazing is that many still say that the Fed saved the economy.”

      exactly- after these chumps send the economy over the cliff repeatedly due to policies that promote bubbles and busts- you would think that people would start to understand that they are not the cure- but the disease

  2. nowhereman

    “Criticize the Fed, but keep in mind the relative costs of all the mistakes and failures to act by all the participants.”

    While it is correct that regulatory capture is as responsible for this crisis as the FED’s policy, but …”Limit criticism of the Fed for not being what it was never designed to be”…
    Seems to me that this post isn’t what it appears to be, it’s an attempt to shape what criticism of the FED should look like when there is no viable option other than closing it down and putting control of the money supply where it belongs, with the Congress.

  3. Siggy

    Is this an apologia for the Fed? The Fed’s egregious errors are: Easy money when it was unnecessary, failure to enforce regulations, funding a bailout of AIG when the proper course would have been to force a bankruptcy.

    Do other parties share responsibility? Yes, but this mess begins with the money supply and the extension of the credit.

  4. Jim in SC

    What exactly is a ‘trading floor economist’? I thought traders were focused on the next two minutes.

  5. Expat

    I have no criticism for the Fed because the Fed acted precisely as the system designed it. The Fed is not a public institution; it is a for-profit private company run by and for the private banks (in the larger sense of the term meaning the FIRE industry). The FIRE industry has other seemingly public institutions which are in fact its “bitches”, such as Congress and the White House.

    It is endearing but naive to criticize the Fed or our government’s actions with regard to the financial industry. Heck, my son is nine and still believes in Father Christmas. La la la la la.

  6. AK

    Good article.

    >> The Fed was and is not a bankruptcy court.

    Completely agree.

    Bernanke and Geithner should resign, Paulson go to jail, and GS be dissolved.

  7. Jackrabbit

    What a crock!
    Essentially, this long, long article boils down to this: The Fed got almost everything wrong, but we shouldn’t be concerned about actions taken to benefit a few banks/bankers via the AIG bailout because:
    1) the Fed was forced to act illegally because
    2) other agencies dropped the ball, and
    3) the bailout was “small change” compared to the enormity of the mess that other Fed failings created/enabled/assisted.

    It doesn’t matter if the wheel man (Geithner & Co.) doesn’t have a license to drive – he or she is just as guilty as the robbers.

    If anything, the author’s argument should be turned on its head: The Fed’s actions regarding AIG demonstrate a regulatory system that is MUCH too close to the industry and calls into question whether the numerous policy mistakes leading up to the crisis were made in good faith.

    1. Jackrabbit

      Can a former Fed economist who now works on Wall Street comment objectively on the subject of the Fed’s back door bailout?

      I appreciate the dissection of the Fed’s policy mistakes but it seems to me that Alford’s chief aim is to whitewash the backdoor bailout, and as a direct result, help Giethner and other participants in the backdoor bailout rehabilitate their reputations.

      Alford’s obfuscations (misdirection, diffusing responsibility, relativism) is not only transparent but useless (as can be seen from the comments).

      Yves: Why? Why put up such a post?

  8. Yearning to Learn

    Although I agree with the thrust of the article (that there are bigger fish to fry with the Fed than just AIG and Lehman), I’m still not sure that I agree with the assertion that I shouldn’t/can’t vilify the Fed for it’s actions with AIG and inactions with Lehman.

    I am angry because the Fed/Treasury/Administration were CLEARLY cherry picking which limitations were limitations, and which limitations were not limitations.

    They evidently in the end had no problem breaking tons of rules when it suited them (take over AIG, only invite GS to the table, pay AIGFPs counterparties at 100 cents on the dollar), but then at other times it would be “oops, sorry, these contracts are inviolable”. (yes, I know in the grand scheme of things that bonuses are a miniscule problem).

    So I feel that if you’re going to break laws to do something, then you take responsibility for the outcome.
    Sure, Congress/Administration/Treasury also have blame, but it doesn’t absolve you of the blame.

    to use a dumb example:
    let’s pretend that Treasury came to me that fitful AIG day, and said “we can’t get the deal done… we want you to figure out AIG”. Then let’s pretend I just went to AIG and blew it up, killing everybody inside. Then when its counterparties came to me, I’d kill them too. Eventually, all counterparties would be either dead or afraid to come for “resolution”.

    I’m guessing that would cause quite the cascade of events.

    Am I to be absolved for my sins of blowing up AIG and its counterparties?

    no. by accepting the illegal duty I accept culpability.

    1. Jerry Denim

      No! You were right the first time. The bonuses are a very big deal and they do matter. The compensation structure of the financial industry provided the motivation for individuals to make the very short-sighted very risky trades which imploded and pulled Wall Street down on top of the taxpayers. If the bonus structure was such that a trader never got paid while his/her trade was on the books and any of your trading losses came out of your next paycheck do you think someone might think twice before selling 500 million worth of naked CDS contracts on tranches of subprime garbage?

  9. Cujo359

    Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

    What individuals or institutions have actually done both? Different people have different views on this. Telling us that’s silly is in itself silly. It’s going to happen, particularly since this is a somewhat complicated question.

    Like some other commenters, I’m interested in Alford’s actual criticisms, but the sophistry is a bit hard to take.

  10. Paul Tioxon

    Well, much has been revealed here. Let’s aggregate much of what is posted here to see if can get a big picture, how do you business types put it, from 25,000 feet above. Anyhow, we have the primary institution for our economy, the central bank, which is packed with the best and the brightest economist from Ivy League schools completely fail in its primary roll to prevent financial collapse by allowing virtually every practice that has empirically been shown to be disastrous to any economy. Let’s couple this with the Pentagon and and National Intelligence apparatus which was reformulated in 1947, founding the CIA by the National Security Act, no, econ types, not those kind of securities, the other kind, specifically to prevent another Pearl Harbor, a sneak attack on American soil causing terrible military and human destruction. On Sept 11, 2001, another sneak attack got by the defenses of the last superpower, with more money spent for military defense than all other nations combined. The best and the brightest military minds trained in special military academies, the best civilian counter intelligence operatives recruited from the ranks of the best universities. The best technology available only to the US Govt Intelligence community. And what do we get people. The elites, who are in the position to make sure that our social order is preserved and advanced do not seem capable of executing that function. They certainly are paid enough, more than other people around the world. They do not have to worry about being taken out and getting shot ala Stalin or current day Iran. It would seem they are doing something but not what they are publicly advertised to be doing. Then, what are they doing and for whose benefit? Or are they really that incompetent? I find it hard to believe they are that incapable of handling the responsibilities. What prevents them? Individual corruption, a de facto predatory state in full kleptocratic bloom? If the Fed does not deserve a pass, and all of you reading here more or less agree, what is to be done? That would be, in the real world, where Obama baits and switches, and Ted Kennedy dies at just the worst time and the Mass electorate channels Shay’s rebellion, intractable, institutionalized resistance to change is rampant among reactionary politicians who still complain about the Yankee war of aggression. Just what to do? Your thoughts business men and women.

  11. Jackrabbit

    Much of what Alford writes has been described by others and/or widely acknowledged. And I don’t see that the Fed is getting a “free pass” Bernanke nearly lost the Fed chairmanship, and Greenspan has acknowledged that his view of the world was “seriously flawed” (Greenspan speak for “what the hell was I thinking?”). The Fed’s conceptual framework of good and noble free markets has been debunked.

    So what contribution does Alford have to offer? Answer: that we shouldn’t blame the Fed – and by extension Fed management and employees – for how AIG or Lehman was handled because these were special situations that were outside the boundary of the Fed’s mandate and competence.

    This message just seems disingenuous. The only ones that benefit from this point of view is the individuals that made the faulty decisions. And because we’ll probably never see prosecutions, the chief beneficiary is the reputation of Bernanke and Geithner and maybe a few top deputies.

    Yves has previously covered the Administrations attempt to rehabilitate Geithner’s reputation, so I am surprise that Yves posted Alford’s article since it seems to push the same agenda.

  12. Justicia

    News Flash (no surprise here):

    Financial Times

    Dimon attacks ‘demonisation’ of big banks
    By Francesco Guerrera in New York
    Published: April 1 2010 00:52 | Last updated: April 1 2010 00:52

    Jamie Dimon on Wednesday attacked the “demonisation” of large banks by politicians, arguing that multinational groups need large financial institutions to thrive in global markets.

  13. Evelyn Sinclair

    Foolish Fed???

    Here’s where the article fell apart, for me “…the Fed should be criticized and admonished for foolishly exceeding its legal authority.”


    How can you “foolishly” grab power and wield awesome authority you have no right to.

    I guess it’s once you foolishly get all the GOLDMAN people into position, capture the Fed and Treasury so they work in concert to subvert everything else, including Congress, which you buffalo and threaten.

    Then you foolishly transfer toxic sludge you and your kind have helped create from your private companies to the public.

    And you foolishly give AIG a HUGE pot of money with which to pay off the “insurance” that Goldman took out on it, so Goldman can have said huge pot of money.

  14. Evelyn Sinclair

    The FEd has been running up bubbles since the dotcom bubble and semi-bust. Greenspan never allowed the bubble to completely deflate; P/E ratios never went back to anything that looked sane from a pre-dotcom-bubble perspective.

    Greenspan was telling everyone to go get themselves a motgage, borrow mony at his great low rates and help buck up “the economy” of the USA, back around 2003. By 2004 I had pulled out of stocks in disgust, and it was dead obvious that housing was in a bubble.

    So now we hear the same “who coulda thunk it?” echos from when articles in the New York Times went on and on for weeks on end saying NOBODY saw the dotcom bubble as such or thought it could end. Disgusting hogwash. The same “no one” cheerleading the bubbles over the past decade is “shocked shocked…”

    The idea that this was foolishness or blindneess, as opposed to ‘lets keep this scam going in the “fun” bubble mode as long as possible, then flip over into “painful” harvest mode’ for the other side of the see-saw money ratchet.

    It works, both ways, to get the money flow in the same direction, into those Goldman Sachs.

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