What to do with the Fed

The Fed is in trouble.  Obama administration proposals for enhancing the Fed’s supervisory and regulatory role and for  assigning it new macro-prudential responsibilities and powers – effectively turning it into the nation’s systemic risk regulator - are meeting with strong and vocal opposition.  The criticism is not just coming from the other agencies in the US financial sector regulatory and supervisory spaghetti bowl – agencies that would stand to lose power and influence or could be put out of business completely. The desire for stronger Congressional oversight of the Fed is no longer confined to a few libertarian fruitcakes, conspiracy theorists and old lefties.  It is a mainstream view that the Fed has failed to foresee and prevent the crisis, that it has managed it ineffectively since it started, and that it has allowed itself to be used as a quasi-fiscal instrument of the US Treasury, by-passing Congressional control. Are any or all of these criticisms justified? Let’s ponder a few of them.

The Fed did not see the crisis coming

This criticism is clearly correct.  The Fed’s failure to foresee the storm, even when it was imminent, represents an indictment of its competence at one of its key tasks: discerning developments likely to lead to systemic financial instability before the instability manifests itself, and taking preventive measures.

The Fed failed utterly in this task, but so did every other regulator, supervisor and government agency or official with even an indirect responsibility for financial stability.  Alan Greenspan did not see it coming during the almost 20 years (1987 till 2006) he spent at the Fed; neither did Ben Bernanke, a member of the Board of Governors of the Federal Reserve Systemfrom 2002 to 2005, Chairman of the President’s Council of Economic Advisers from June 2005 to January 2006 and Chairman of the Fed since February 1, 2006. Hank Paulson did not discern any financial crisis clouds on the horizon, either during his many years with Goldman Sachs (1974-2006), or during the first year of his tenure as Treasury Secretary (July 2006 – January 2009).  Likewise, Tim Geithner failed to foresee the crisis when he was Under Secretary of the Treasury for International Affairs(1998–2001) under Treasury Secretaries Bob Rubin and Larry Summers or as President of the New York Fed (2003 – 2009). Larry Summers was similarly blinded by the light during his years at the US Treasury (1993 -2001), including his years as Deputy Secretary under Bob Rubin (1995-1999) and his tenure as Treasury Secretary (1999-2001). There was not a Dicky Bird either from  Don Kohn or Bill Dudley.  So the list of dogs that did not bark is a long and distinguished one.

In fairness I should add that no academic scribbler, least of all I, foresaw the full force of what was about to descend upon us.  Academics are joined in the ranks of these who failed to foresee the financial cataclysm by gurus, pundits, economic and financial journalists, futurologists, urologists and other practitioners of cleromancy.

The Fed has actively contributed to the crisis, both through sins of omission and sins of commission

It is hard to disagree with this.  The Greenspan Fed kept the Federal Funds target rate too low for too long after June 2003.  This contributed to the oversupply of domestic and global liquidity that permitted the credit and asset market boom and bubble that ultimately brought us the crisis.  Ben Bernanke was a member of the Board of Governors through most of this period.  Tim Geithner was President of the New York Fed and Vice Chairman of the FOMC for virtually all of this period. Don Kohn was a member of the Board of Governors since August 2002.

Interest rate policy by the Fed since the crisis started has been competent, if we ignore the rather panicky out-of-phase and announced-out-of-normal-working-hours, 75 basis points cut in the Federal Funds target rate on January 21/22, 2008, following the Kerviel/Société Générale stock market blowout in Europe.  This instance of the ‘Fed put’ – aka excessive sensitivity of monetary policy to sharp declines in stock prices – mars an interest rate response to the crisis that was otherwise superior to what was produced in the Euro Area and the UK.

One aspect of interest rate policy where the Fed, along with the Bank of England and the ECB, has dropped the ball is the spread between the official policy rate and the rate banks earn on reserves held with the central bank.  The Fed, which started paying interest on reserves (both required reserves and excess reserves) only on October 9, 2008, initially set the rate on reserves as as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.  As the Federal Funds target rate has moved down to zero (it currently hovers between 0 and 0.25%), the spread was reduced from 75 basis points to something between zero and 25 basis points, with the interest rate on reserves at zero.

It would obviously have been far superior to set the Federal Funds Target rate at zero and the interest rate on reserves at negative 75 basis points.  That way banks would be discouraged from taking advantage of the Fed’s wide range of liquidity-enhancing facilities only to redeposit the money with the Fed as excess reserves.  In mitigation it must be said that the Bank of England and the ECB are doing even worse as regards the levels of their official policy rates and the spreads over the interest rates on reserves (or deposit rate).  Bank rate in the UK still stands at 0.50 percent with the deposit rate 25 basis points lower. Again, a zero Bank rate and a deposit rate of -0.75 percent or lower would make a lot more sense.  The ECB does have a 75 basis point spread of its official policy rate over the deposit rate, but its official policy rate still stands at 1.00 percent, defying both logic and gravity.  With the recession in the Euro Area as deep as or deeper than in the US and the UK and with price inflation already in negative territory, a zero official policy rate and a deposit rate no higher than -0.75 percent is the only rate configuration that makes sense.

Of course the Fed hardly has the monopoly of actions that contributed to the crisis.  As Treasury Secretary, Larry Summers promoted and celebrated  the Gramm-Leach-Bliley Act of 1999, which repealed key provisions in the 1933 Glass-Steagall Act.  Some of his statements at the time must make uncomfortable reading for the NEC Director: “Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,” ….. “This historic legislation will better enable American companies to compete in the new economy.”[

After the departure of Arthur Levitt Jr. as Chairman of the SEC in 2001, that organisation played a central role in the mindless de-regulation and loss of oversight that characterised the subsequent years – the culmination of a process begun under the Clinton administration.  The nadir of this process was probably the repeal in 2004 of the net capital rule – the requirement that investment bank brokerages hold reserve capital that limited their leverage and risk exposure – after fierce lobbying by the large Wall Street investment banks.  Ironically, Hank Paulson, the future Treasury Secretary, played a leading role in this lobbying effort to repeal the net capital rule as Chairman and CEO of Goldman Sachs.  A few years later, as Treasury Secretary, he had to try to clean up the mess created in part by the abolition of that net capital rule.

Indeed, the whole mishmash of US financial regulation and supervision has long been viewed as a school book example of how not to structure such activities.  Fragmentation, balkanisation, overlap, turf battles and unproductive inter-agency rivalry and jealousy are the name of the game.  With federal commercial banking supervision split between the Fed, the FDIC and the Controller of the Currency (not counting the Office of Thrift Supervision for federal savings banks) and investment banks (not) supervised and regulated by the SEC, the US regulatory framework was an accident waiting to happen. Federal securities markets regulation and supervision is, for no good reason, split between the SEC and the Commodity Futures Trading Commission.  The SEC – discredited and without its investment bank constituency – is an organisation begging to be put out of its misery.

The reforms proposed by the Obama administration would merge the Office of Thrift Supervison into the Office of the Controller of the Currency.  It still leaves federal commercial banks with three regulators.

It is inconceivable but true that insurance continues to be regulated at the state level in the US.  Perhaps this should not be surprising, as the US legal profession too is balkanised at state level with only limited mutual recognition of bar membership among the states.

The Fed has expanded the size of its balance sheet quite massively since the crisis started in August 2007.  As of July 8, 2009, the size of the Fed’s balance sheet was just under 2 trillion US dollars, just over twice the size of a year earlier.  The monetary base increased over that same year from US$ 907bn to US$ 1722bn, almost all of it accounted for by a US$738bn increase in commercial bank deposits with the Fed.  Currency in circulation increased by only $77bn.

So as regards quantitative easing (expanding the size of the central bank balance sheet by purchasing government securities) and especially as regards qualitative easing or credit easing (expanding the amount of private sector securities or loans held on the central bank’s balance sheet, through outright purchases of private securities, by accepting private securities as collateral in repos (what the ECB calls enhanced credit support) or by lending unsecured to the private sector (something no central bank has done yet)) the Fed has held its own in the unconventional monetary policy stakes.  It cannot be faulted on the size of its operations.  It can be faulted on the terms of some of its operations and on its lack of openness about them.

The Fed has been actively contributing to the next crisis

Here indeed the Fed stands guilty as charged, although it is in good company.  The Fed, through its lender of last resort and market maker of last resort actions and through a wide range of quasi-fiscal support operations it has undertaken on behalf of  Wall Street and other segments of the US financial establishment (Fannie & Freddie, AIG), has made a major contribution to the creation of the biggest moral hazard machine ever seen in human history.

Probably the single most damaging  failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way).    An SRR is an ‘insolvency lite’ insolvency regime for banks and ohter systemically important financial institutions.  If early interventions fail, a bank that is judged (by a duly appointed administrator of the SRR, e.g. in  the FDIC in the case of insured deposit taking banks) to be at risk of becoming conventionally insolvent is instead rushed into a high-speed regulatory insolvency regime, the SRR.  There its balance sheet is restructured (typically existing equity is wiped out or diluted and unsecured creditors are turned into new equity holders).  The Administrator or Conservator has near-absolute powers to dispose of assets and to restructure liabilities.  Existing management, board and shareholders are disenfranchised for the duration of the institutions sojourn in the SRR.  The purpose of an SRR is that it wipes out a failing systemically important institution in a legal sense (by abrogating the property rights of shareholders, unsecured debt holders, mangement and board of directors) without wiping it out in the Army Corps of Engineers sense.  The bank (or insurance company) as a functioning organisation remains largely intact, and can continue to service existing contracts and commitments (at the discretion of the Adminstrator or Conservator of the SRR) and, most importantly, can engage in new lending, investment and funding activities, possibly with government support, including guarantees, for these new activity flows.

When the crisis started, an SRR existed for federally insured deposit-taking banks (administered by the FDIC), although the authorities did not have the nerve to put the largest insolvent institutions (such as Citi Group and Bank of America in it).  That SRR also did not apply to banking groups. There was an SRR for Fannie and Freddie, which was used effectively.  There was no SRR for investment banks.  There was no SRR for insurance companies like AIG.

The non-existence of an SRR for any systemically important institution amounts to a major policy failure of the executive and legistative branches of government.  The deafening silence of the Fed and the other regulators on the subject is a serious indictment of their competence.  After Bear Stearns went belly-up and was pushed into the terminal embrace of JP Morgan, it should have been clear even to the US authorities that either investment banks needed an SRR or that there ought to be no investment banks.  Yet we had to wait for the failure of Lehman and the forced acquisition of Merrill Lynch by Bank of America before the last two remaining large independent Wall Street investment banks, Goldman Sachs and Morgan Stanley, were ejected from the investment bank category and became bank holding companies.  This was not required  to give them access to the Fed’s discount window and other facilities.  If the Fed declares “unusual and exigent circumstances” to prevail, it can lend, against collateral of the Fed’s choosing, to individuals, partnerships and corporations (including non-financial corporations) , should it wish to.  It did, however, make it possible for these former investment banks to be put into an SRR.

If institutions are too systemically important to fail conventionally and if no SRR is available, they will have to bailed out at public expense should an emergency arise.  The regulators knew that.  The Treasury knew that.  The Congress knew that.  The banks knew that and their unsecured creditors knew that.   They permitted it to happen nevertheless.

The gradual creation and operation of this utterly disfunctional system of large, complex, interconnected and crossborder financial institutions and markets, which was both inefficient (real resource-wasting), distributionally unfair and regressive, and vulnerable to socially costly collapse unless bailed out by the tax payer, represents a form of crony capitalism without parallel in modern western economic history.  It is an interesting question, to which I don’t know the answer, whether those who presided over and contributed to the creation and operation were ignorant, cognitively captured or culturally by the financial interests for whom they created these fabulous opportunities for extracting rent, or captured in more direct and conventional ways.

At one level the answer does not matter much.  The system that was created was a corruption of a true market economy, because it relied for its existence and survival on soft budget constraints for the main players.  At most, the shareholders (that is, the owners of the tangible common equity) of these institutions were somewhat at risk.  The unsecured creditors, even the owners of subordinated bank debt, were subsidised by the tax payers’ free guarantee.

In the short run, the directly tax-payer-financed rescue operations like the TARP, and the indirectly tax-payer-financed but directly Fed-financed or FDIC-financed rescue operations for the defunct US banking and financial behemoths have prevented a comprehensive collapse of the financial system.  With a proper SRR in place for all systemically important financial institutions (anything highly leveraged and characterised by asset-liability mismatch in maturity, liquidity or currency denomination) systemic stability could have preserved without presenting the bill to the tax payer.  It would instead have been presented where it belongs in a market economy: to the unsecured creditors of these institutions.

Not only do the rules of the market economy dictate that the shareholders and the unsecured creditors of insolvent institutions pay the bill, both fairness and efficiency call for that assignment of the burden of insolvency.  The US Treasury, the Congress, the Fed and the other financial regulators have, through their behaviour since August 2007, confirmed and re-inforced the incentives for excessive risk taking by crossborder banks and any other financial institution deemed too systemically important to fail.   The groundwork for the next financial boom and bust cycle, worse than what we are just emerging from, have been put in place.

From this perspective, the failure of Lehman Brothers, although an unnecessary, preventable and costly event in a rationally structured world, is likely to turn out to be a medium- to long-term blessing, even though it contributed to the temporary cardiac arrest that afflicted global financial markets for a few months after September 15, 2008.  Clearly, I wouldn’t have started from where we were with Lehman on September 14, 2008 but given the choice, at that juncture, of bailing out Lehman with tax payer money or letting it go under, letting it go under was the lesser evil.  If Lehman too had been bailed out, the next financial boom and bubble would already have started.

The Fed has acted as an off-budget, off-balance-sheet special purpose vehicle of the US Treasury

When you look at the balance sheet of the Federal Reserve System, you find such items as the Net portfolio holdings of Maiden Lane I (US$ 25,958 mn on July 8, 2009), Net portfolio holdings of Maiden Lane II (US$ 15,744 mn) and Net portfolio holdings of Maiden Lane III (US$ 18,784 mn).  These are the legacies of the Fed’sinterventions in Bear Stearns (Maiden Lane I) and AIG (Maiden Lane II and III).  The Bear Stearns-related assets are likely to be rubbish.  Maiden Lane II and III I know less about.  I believe the US Treasury has guaranteed these Fed assets.  That’s nice for the Fed, but does not address the problem that through guarantees or indeminities, the US Treasury has engaged in off-budget and off-balance sheet financial operations that involve contingent commitments that have not been the subject of proper Congressional vetting, voting and oversight.

And there is more where this came from.  There is the Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility, worth US$ 7,998 mn; the Credit extended to American International
Group, worth US$ 43,026 mn; the Term Asset-Backed Securities Loan Facility, worth US$ 26,338mn; net portfolio holdings of the Commercial Paper  Funding Facility, worth US$ 112,360 mn; net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility and net portfolio holdings of Maiden Lane.  There is also just udnder US$ 112 bn worth of swap facilities with other central banks.

This is serious money.  Much of it is credit extended by the Fed on non-transparent terms to private counterparties.  Quasi-fiscal subsidies of unknown magnitudes are involved, especially when the Fed purchases illiquid private securities or accepts them as collateral at valuations based on procedures that remain private to the Fed.

Under the US Constitution, the use of financial resources by the state is supposed to be approved by and voted by the US Congress.  That constitutional nuisance has irked governments since the creation of the Republic.  The executive branch of government has found a variety of ways to end-run the US Congress.  In this crisis, the Fed has been the principal institutional vehicle through which the executive (the US Treasury and the NEC) has run circles around the Constitutional requirement that Congress has to vote appropriations before the executive can spend the money.  They have done this by using the full array of modern off-budget and off-balance sheet financing tricks developed mainly by the private sector over the past few decades, and that culminated in the Enron debacle and the creation of the shadow banking sector with its SIVs and other special purpose vehicles.

It permits the commitment of massive resources by the executive, through such quasi-independent government agencies as the Fed and the FDIC, without accountability to the Congress, the tax payer and the citizen. It subverts the US Constitution.

Elsewhere, I have written a length about the quasi-fiscal actions of the Fed up to the middle of 2008, through the TAF (the temporary term auction facility), the TSLS (term securities lending facility), the PDCF (the primary dealer credit facility), the Fed’s Bear Stearns support operation and its support for the Fannie and Freddie rescue operations.  Since then, the Fed has been deeply involved (some would say implicated) in the AIG rescue, the TALF (thus far rather unsuccessful on its own terms) the other programs whose imprint on the Fed’s current balance sheet I have just referred to, and the Public-Private Investment Partnership, much of which has by now died a death.  All these programmes involve commitments, sometimes contingent, of public financial resources without Congressional approval or oversight, and most of the time without accountability of any kind for the use of these resources. It is not surprising that Congress is chomping at the bit to remedy this flagrant abrogation of its Constitutional prerogatives by demanding greater oversight and control over the Fed.  I expect Congress will succeed in this objective.  Of course the US Congress tends to be ill-informed, populist and mightily beholden to special interests, so its greater grip on the future Fed is by no means an unambiguous blessing.  But the US Treasury and the Fed have really been asking for a vigorous Congressional response through the casual manner in which they have thumbed their noses at the concept of Congressional control of the public purse strings.

Who but the Fed could be the systemic risk regulator?

The Fed has weak qualifications for presiding over macro-prudential regulation and supervision of the US financial system, its institutions, instruments and players.  But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions.

The FDIC has no raison d’être. Neither has the Office of Thrift Supervision.  Deposit runs on the banking sector as a whole cannot be insured by the banking sector.  Deposit insurance should therefore be run from the US Treasury, which should of course try to recover, in the medium to long term, the cost of the scheme from the banks involved. The Office of the Controller of the Currency has no economic rationale and should be abolished. The SEC and the CFTC should at the very least be merged.  It makes sense to abolish both of them and replace them with a single macro-prudential regulator/supervisor for systemically important institutions, clusters of institutions, markets and instruments, a micro-prudential regulator/supervisor for individual institutions and a consumer protection agency for financial products.

Only the Fed can fulfill the macro-prudential regulator-supervisor role.  That is because it has the short-term deep pockets.  It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money.  Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support.  It would be a toothless old hag.

The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts.  Lender of last resort operations to provide illiquid institutions with funding liquidity, market maker of last resort operations to support systemically important markets for financial instruments that have become illiquid, and credit-enhancing operations of the kind engaged in by the Fed, the ECB and the Bank of England, merge smoothly and without discontinuities into solvency support operations, recapitaliser of last resort operations and other quasi-fiscal support operations by the central bank.

When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential.  The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause.  Taxation without representation is incompatible with the American political tradition.

So the Fed as macro-prudential regulator will have to be subject to the close scrutiny of the GAO, and to much closer oversight by the Congress than it has been used to since the Treasury-Federal Reserve Accord of 1951.

Would changing the incumbents at the Fed help resolve the dilemma or would it amount to re-arranging the deckchairs on the Titanic (after it hit the iceberg)?  My view is that, despite everything I have just written, the current Federal Reserve Board is unlikely to be improved, as regard the quality of its pursuit of macroeconomic and financial stability, by any politically feasible change in the membership of the Board.  Only someone with macroeconomic stability and financial stability death wish would prefer a Federal Reserve Board with Larry Summers as Chairman instead of Ben Bernanke.

The kind of close Congressional and general political scrutiny and oversight that are absolutely essential in a healthy democracy when it comes to lender of last resort operations, market maker of last resort operations and other macro-prudential preventive and curative measures, are likely to lead to bad normal monetary policy (setting of the official policy rate) if past experience is anything to go by.  If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution.  Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.

You pick.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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