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In last week’s Money and Markets column, I gave you a broad outline of the Obama administration’s regulatory reform scheme. This week, I want to zero in on one of its weakest links. I’m talking about the idea of making the Federal Reserve an “uber-regulator,” responsible for managing system-wide risk.
First, what in the world is system-wide risk?
Well, that’s the risk that interconnected-institutions will drag down the whole financial system when they gamble with other people’s money and then blow up! Think AIG, Citigroup and other disgraceful members of the notorious “Too Big to Fail” club. Obama’s plan calls for giving the Fed more power to oversee these guys and to proactively head off any future systemic risks.
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| Obama now wants to make the Fed an “uber-regulator” in order to head off any future systemic risks. |
There’s just one humongous problem: The Fed has proven time and time again that it isn’t up to the challenge!
It has been too timid to use the regulatory authority it already has. It has repeatedly proven to be behind the curve when it comes to both cutting and raising rates. And lately, it has sacrificed all semblance of being an independent body. The Fed is now clearly a politicized institution, working hand-in-glove with the Treasury and the rest of the administration.
In short, the Fed is NOT an independent body willing and able to see around the economic corner and take decisive, proactive steps to head off disaster. Instead, it’s an institution that has failed repeatedly to uphold its responsibilities in the regulatory and monetary policy arenas. And thankfully, policymakers are coming around to that view, which I’ve expressed time and again over the past couple of years.
A Sorry Track Record on Bubbles, Inflation,
Regulation — You Name It
You probably don’t need me to tell you the whole long, sorry history of the Fed’s easy money policies — and their repercussions. Suffice it to say that under former Chairman Alan Greenspan, and later Ben Bernanke, the Fed’s policy has been to ignore asset bubbles as they inflate … then come in with monetary guns blazing when they burst, thereby laying the foundation for the next bubble.
In 1998, the Fed went totally overboard after the collapse of Long-Term Capital Management, slashing rates to soothe the capital markets even as the economy was heating up. Then it pumped huge amounts of money into the economy out of fear of the Y2K bug. These two events pumped even more helium into the Nasdaq bubble, which then popped in 2000.
The Fed’s response to that bust was to drive the cost of money into the gutter. Thanks to that policy, and the reckless disregard for prudence throughout the lending industry, we experienced the biggest housing and mortgage bubble in the history of the U.S. We also saw too much dumb lending and asset inflation in the leveraged buyout business, in the commercial real estate arena, in commodities, and in the emerging markets.
Rather than combat those bubbles head on, though, the Fed deferred. And now we’re living with the painful fallout.
Yet remarkably, after two huge bubbles and busts fueled in part by misguided policy actions, the Fed is going back to its old playbook. It’s flooding the economy with the biggest tsunami of easy money the world has ever seen. And predictably, it’s having a whole host of unintended consequences, as I spelled out on in my June 12 Money and Markets column.
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| Greenspan pooh-poohed the housing bubble while everyone else saw it coming like a runaway freight train. |
Look, how many speeches did Greenspan give pooh-poohing the housing bubble, even as anyone with half a brain could see disaster coming?
How many Fed governors essentially washed their hands of any concern for asset bubbles?
How many said that these bubbles were too tough to identify in advance, and that the only rational policy was to let them inflate, then burst, and then try to clean up the mess — rather than proactively attack them?
And what about Bernanke? The Wall Street Journal noted this week that it had sounded a huge warning about the falling dollar, surging commodities prices, and the inflation threat they posed way back in late 2003. In an editorial called “Speed Demons at the Fed,” the Journal urged policymakers to start reversing course and lay off the monetary gas pedal.
Bernanke’s response?
According to minutes of a Fed meeting at the time, he reverted to Ivory Tower theory to play down the inflation threat. He cited studies that essentially said the declining dollar doesn’t matter, commodities prices don’t matter, and weak labor markets would keep inflation tame. He added that anyone who disagreed with him was “not particularly well informed.”
Oops!
Within a few quarters, home prices were soaring at their fastest rate since the late 1980s. Oil prices surged 782 percent from their low. Gold more than quadrupled. The Consumer Price Index eventually notched a 5.6 percent year-over-year gain — the biggest in 17 years. Import prices soared by a whopping 21 percent in 2008, the biggest increase in recorded U.S. history.
Is there any doubt that Bernanke was dead wrong … and the Journal dead right? I don’t think so.
Then there’s the Fed’s regulatory track record. As I discussed in my landmark 2007 white paper, “How Federal Regulators, Lenders, and Wall Street Created America’s Housing Crisis — Nine Proposals for a Long-Term Recovery”:
“By 2004, it was nearly impossible to ignore that the housing market was overheating …
“Yet the Federal Reserve did not believe it should play a forceful role in stemming this mania via monetary policy, focusing instead on traditional measures of inflation, and deciding not to begin raising short-term rates until June 2004. Furthermore, the rate adjustments were slower and more hesitant than those of the preceding down phase of the interest rate cycle.
“Adding fuel to the speculative fires, monetary policymakers used their public pulpits to send mixed signals to the marketplace, often encouraging continued risk-taking that has proven harmful to borrowers, lenders and the industry as a whole.”
In the paper, I added that …
“Federal regulators, for their part, warned about high-risk mortgage lending. But they failed to back up those warnings with rules or regulations designed to contain or reduce lending abuses. So lenders routinely ignored the warnings.
“We believe these constitute a series of fatal policy errors. And we believe they virtually ensured the outcome: A climactic period of unrestrained risk-taking in the residential real estate market, followed by the painful bust we are now witnessing.”
Fed-Worship Finally Ending …
Good Riddance!
Throughout the 1990s and early 2000s, Fed worship was widespread in Washington. We had to endure endless claptrap about how great Alan Greenspan was (remember his nickname, “The Maestro”?).
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| Several Republicans AND Democrats gave Geithner a tongue-lashing when he submitted Obama’s newest regulatory plan. |
That’s ancient history. A new skepticism is apparent in Congress and elsewhere in D.C., and I couldn’t be happier. Heck, when Treasury Secretary Geithner went before the Senate Banking Committee to champion the Obama regulatory plan, he got an earful from legislators:
- Sen. Chris Dodd of Connecticut said giving the Fed uber-regulator status was “like a parent giving his son a bigger, faster car right after he crashed the family station wagon.”
- Sen. Jim Bunning of Kentucky said “Your plan puts a lot of faith in the Federal Reserve’s ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators had been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess … What makes you think that the Fed will do better this time around?”
- In an interview given to The American Banker, Senator Richard Shelby of Alabama went even further. He said: “The idea of putting more and more power in the Federal Reserve is, in my judgment, a huge mistake … They have utterly failed the American people as the regulator of the bank holding companies, most of which have gotten into bad, bad trouble financially. They are doing so many things outside the norm that nobody knows — no accountability for — and to run to the Federal Reserve and to say ‘Gosh, they are going to be the winner of everything out of all this,’ that is just nonsense.”
My bottom line verdict: Entrusting the Fed with more power makes no sense. Policymakers there have gotten so many things so wrong over the past several years, that you could easily make a case that the whole lot of ’em should get the hook … not the keys to the financial kingdom.
Until next time,
Mike
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