The Economist magazine in conjunction with the Marjorie Deane foundation offers an annual internship to aspiring journalists interested in writing on topics of finance and economics. I figured I took a shot despite my paucity of journalistic experience. The blog and an unremarkable stint on my high school newspaper are the extent of my experience. So, this is what I managed to cobble together. The specific news item is old, but the broader subject of an interventionist Federal Reserve is still quite topical. Though it is likely that someone sprightlier, with better style, sources and credentials to boot, will wind up spending summer in London, I am proud of what I wrote. Hence, I am taking another chance and submit for the approval of my very narrow and sporadic readership. Enjoy.
Feed your Fed
Washington D.C.
On March 31, citing needs to revitalize competitiveness and to fix the ills of the American economy, Treasury Secretary Henry Paulson unveiled “The Optimal Financial Regulatory Model.” In a speech, he outlined plans to provide the Fed, “…with a different, yet critically important regulatory role with broad powers focusing on the overall financial system.”
The administration is keen on granting the Fed more authority to examine the practices and the accounts of hedge funds and investment banks. Mr. Paulson said, “The Fed would have the authority to go wherever in the system it thinks it needs to go for a deeper look to preserve stability.” Strangely, he has chosen an inauspicious time in the history of the institution to raise its profile, for the Fed did much to precipitate instability.
Loose monetary policy made credit too available, and that is to blame for much of what is wrong. Cheap money has been causing inflation, simultaneously depressing the value of the dollar. The resulting rolling asset bubbles have caused unnecessary employment displacement.
At issue is whether the Fed as super-regulator is indeed the “optimal” choice. By pumping up the value of the Fed, this proposal comes off as a no-confidence vote in existing regulatory bodies. Critics of the administration claim adequately funding agencies such as the Justice Department Antitrust division, Securities and Exchange Commission, and Federal Trade Commission makes more pragmatic sense, but the language in Mr. Paulson’s speech points to a clear favorite.
“The premise of our optimal structure is that clarity of mission and objective will lead to strengthened regulation and improved capital markets efficiency,” added Mr. Paulson. Yet, closer scrutiny reveals the more likely chance that “clarity” will result in muddle and inefficiency for three reasons.
First, bigger does not preclude better, especially if the objective is to streamline. Increased influence over financial market activity conflicts with the first order statutory missions of the Fed to maintain price stability, full employment, and an elastic currency. These areas command priority; adding to the load will only make the Fed unwieldy.
Secondly, ‘Fed policing’ is useless without enforcement. Instead of agents, it would have the authority to go where it deems necessary. However, the blanket warrant will have to pass legal muster, and this is unlikely. In practice, even with greater supervisory powers but without an enforcement mechanism, the Fed would still have to coordinate efforts with other agencies. This means fundamental changes to the intellectual and professional cultures of the Fed where economists will start behaving as bureaucrats. Consequently, the Fed stands to jeopardize its status as a credible, politically independent institution.
Lastly, new powers for the Fed do not deter moral hazard on the part of investors, borrowers and creditors. Supervising hedge funds and investment banks may even exacerbate risky behavior if the Fed extends to them some of the privileges and rights as retail banks. Such new powers in no way provide a deterrent to the behavior of aggressive firms. Moreover, that sort of behavior was a response to the loose credit conditions the Fed created in the first place. Nothing in the new model addresses the root cause of the systemic fracture.
Though Mr. Paulson concluded his speech by saying, “As a nation we have placed great faith in the powers of market discipline,” there were no allusions to a potential, painful, endogenous market correction. Further deferring the consequences of a fifteen year borrowing binge will cause deeper damage that even a beefed-up Fed could not forestall. Little wonder that the most attractive models are the thinnest.
