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Feature
The Fed Fails Upward
Thanks to Washington’s growing regulatory mood, the Federal Reserve is about to be handed unprecedented controls over the market functions of the American economy.
Let’s understand something. Increasing regulation, and spreading it over the rest of the financial economy, only solves Congress’s problem; it makes everything else worse. We’ve seen this before. The Sarbanes-Oxley Act in 2002 imposed immense costs on U.S. companies and drove foreign companies out of our markets. Now we are seeing members of Congress prepare to adopt legislation that will impair innovation, raise costs, and destroy competition because—once again—they have to be seen doing “something, anything,” to address the financial crisis. That urge, combined with pressure from the Democratic left to gain greater control over the financial system, could produce an outcome second only to the Card Check legislation in its adverse effect on the U.S. economy.
Although there is no draft legislation yet available, the broad outlines of what congressional leaders are likely to propose in the wake of the financial crisis are becoming clear. Statements by Barney Frank, the influential chairman of the House Financial Services Committee, indicate that he would like to regulate all “systemically significant” financial institutions in addition to banks, and thus would extend safety and soundness regulation to the largest hedge funds, securities firms, insurance companies, finance companies, private equity firms, and possibly other financial intermediaries. There is also seemingly widespread agreement in Washington that the agency to perform this role is the Federal Reserve. Both proposals are deeply troubling and reflect little serious thought to their unintended consequences.
Defining Systemically Significant Institutions
One of the most difficult problems confronting a Congress determined to allay systemic risk is to decide what it is. The traditional conception of systemic risk is that it arises from contagion—a cascade of losses coming from the failure of one large institution; as it goes down, its failure damages many others and eventually the economy as a whole. But if we look at the current financial crisis, that didn’t happen. Instead, its origin can be found in the combination of a deflating housing bubble, an unprecedented number of sub-prime and other non-prime mortgages, and a mark-to-market accounting system that caused asset values (and hence bank capital) to spiral down as distress sales drove down market prices. The failure of Lehman Brothers and the rescue of Bear Stearns, AIG, and many of the largest banks came many months after the market for asset-backed securities had completely dried up, forcing banks to write down their assets to values far below what those assets were actually worth based on their cash flows. In other words, there was no single institutional failure that caused the current crisis, simply the fact that large numbers of the world’s major financial institutions purchased and held low- quality U.S. mortgages that are now failing in unprecedented numbers.
So why, if the current financial crisis was not started by the failure of any systemically significant company, are Barney Frank, others in Congress, and—if one believes the media—the Obama administration looking to regulate systemically significant companies in the future? Good question. The best answer comes from Obama chief of staff Rahm Emanuel: “Never waste a good crisis.” The left has always wanted to get the government’s fingers more deeply into the private economy, and this financial crisis may provide the momentum for more—and more intrusive—regulation. Even though the current crisis was not started by a systemically significant firm’s failure, perhaps no one will notice as the administration and a compliant Congress seek greater regulatory authority over systemically significant companies.
The Effect of Designating Systemically Significant Firms
The plan to regulate systemically significant firms is by far the most dangerous of the regulatory ideas currently circulating on Capitol Hill and within the administration. In terms of its potential impact on competition in the financial services industry, it may be the most dangerous regulatory idea ever to have been advanced in Congress. Yet it has been endorsed by top international financial specialists led by Obama adviser Paul Volcker, and by such unlikely private sector (and supposedly free market) groups as the U.S. Chamber of Commerce and the Securities Indus try and Financial Markets Association (known as SIFMA). The reason is simple: firms that are designated as systemically significant will be seen by the market as too big to fail—that’s why they’re considered systemically significant. Once it becomes clear that they will not be allowed to fail, these firms will in effect have the implicit backing of the government. As we have seen with Fannie Mae and Freddie Mac, when a private firm has the implicit backing of the government—especially if the backing comes from an agency like the Fed, with the power to extend financing—it has easier and less costly access to credit and capital, and can usually grow faster and become more profitable than its competitors. Eventually, every financial sector will come to look like the housing market, with giant government-backed companies that drive out or gobble up smaller competitors. It is astonishing, after our experience with Fannie Mae and Freddie Mac, that so many Washington groups can be backing this idea, and equally astonishing that smaller companies around the country have not been protesting an idea that has gained so much momentum in the capital.
The Federal Reserve as Systemic Risk Regulator
It is not surprising, however, that when new regulation is in the offing all eyes on Capitol Hill turn to the Fed. For reasons that are far from clear, the Fed’s monumental errors in monetary policy and regulation of banks and bank holding companies (BHCs) never seem to tarnish its support in Congress. An example is right in front of our eyes.
Somehow, the Fed survives its failures
Since 1970, the Fed has had authority under the Bank Holding Company Act to supervise and regulate companies that control banks. It has sweeping powers under the act—in every way the equal of the powers that might be given to a systemic regulator. The act allows the Fed to regulate BHCs in the same way that a bank supervisor can regulate a bank—by regulating their capital and their non-banking activities and influencing the lending policies of the underlying bank. If the Fed had wanted to control the risk-taking of the largest banks—the institutions most likely to be declared systemically significant— it could have done so through its control over their holding companies.
However, the Fed has not exercised this authority, as we can tell from the fact that the government has had to rescue Citibank, the principal subsidiary of BHC Citigroup and an institution that everyone would define as systemically significant. Nor did it prevent the failure of Wachovia and many other smaller institutions that were controlled by BHCs operating under the Fed’s supervision. Despite these failures, Chairman Frank and many others see the Fed as the right agency to take on the role of systemic regulator. Strange, but as I say, not surprising.
Threats to the independence of monetary policy
The Federal Reserve System was designed to be independent of both Congress and the executive branch. Its members are appointed for 14-year terms, and its chair cannot be changed by a newly elected president for two years after his inauguration. This extraordinary insulation gives the Fed credibility with the financial markets, which are justifiably concerned that policies on price stability will eventually start to follow election returns, allowing the dollar to devalue for political rather than economic reasons. Long-term interest rates, which are essential for investment planning by business, remain stable only as long as the credit markets believe that the Fed will continue to follow a stable price policy in the future. The credit markets understand that the political pressures in a democracy favor inflation—there are simply many more borrowers than lenders—and so they watch carefully to determine if the Fed is buckling under pressure from Congress and the president. Thus, while the Fed’s independence is inconsistent with democracy, it reflects a practical judgment that the nation’s economy will be better off if its monetary policy is determined by economic rather than political considerations.
It is through this lens that the Fed’s power over systemically significant companies should be viewed. Giving the Fed the power to regulate all the key financial firms in the U.S. economy would involve the agency in major decisions about how business is carried out by whole industries. Unlike monetary policy—which depends for its success on the financial markets’ belief that the Fed is making its decisions on the basis of economic rather than political factors—in a democracy the president and Congress should be able to influence how regulatory authority is pursued. There is a serious danger that the Fed’s involvement in these political and policy issues will compromise its monetary role and cast doubt on the objectivity of its decisions. The result could be a loss of faith in the dollar itself as a store of value.
Letter to the Editor View all comments (42) | Leave a comment
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Ken| 5.1.09 @ 8:53AM
According to the S&P 500 index, the stock market just had its best month in 9 years.
I sure hope the Fed keeps 'failing upward' for as long as it can.
duh Ken| 5.1.09 @ 12:35PM
Ken, hate to boggle your tiny brain, but the markets move in trends, not month. A countertrend rally (aka bear market rally) is the expected norm and will serve as a GIFT to anyone smart enough to pull what remains of their retirement funds out of the banks.
Simply look at a trending chart of ANYTHING, and you'll see the countertrend rallies on ANY bear market in history.
jack| 5.4.09 @ 6:24AM
Buy gold. Great idea, let barney frank and the guys whose looting of fannie and freddie caused our financial crisis continue the insanity and corruption. buy more gold. Obama appears to be a Chavez or Castro clone. he is on tv 24/7. He is taking over as much of private markets as he can.
You need a complete liberal lunatic every 30 years so people realize the fantasy does not work and these people not only are incompetent but stone cold moron who will steal anything they can.
Sure glad we have a Republican party to stand up to these facists. Is there a more worthless party than the Rep party?
Melvin| 5.4.09 @ 8:02AM
Come on gang. We are allowing a government to run private industry and they cannot even operate their own dining facilities at a profit.
The Congress and the Senate turned over their dining facilities to private contractors because after years and years of running in the red with no improvement in food quality Congress and the Senate let their stomachs do the thinking and decided if they wanted better chow they better turn it over to private food service.
The US Treasury is nothing more than a personal piggy bank to those politicians that discovered that they can vote, skim, steal, borrow (another PC term for stealing) all forms of funding into obscure political and or community organizations.
Son Of Sam | 5.4.09 @ 10:37AM
Ken,I also hope that markets keep rising, for the sake of all the people about to retire or who are retired already, and depend on those markets to do well. However, I think you're being incredibly shortsighted, and I'd like to give you an analogy:
let's just say for example that my wife is a doctor. Let's also assume that she's working with a patient who's oh,I don't know,22 years old. He wasn't wearing a seat belt when the car rolled over five times on its way down the embankment and into a tree. He was rushed into emergency surgery, and a miracle took place: HE ISN'T DEAD! But, his back is broken in three places,he has shattered ribs, a punctured lung and it's looking like he may never regain the use of his left hand -- and he's a left handed carpenter. Yeah, he's alive; but just barely, and he was in A DAMNED CAR WRECK.
Yes Ken, the market isn't dead yet. But it has been in a car wreck, and economic illiterates like Barney Frank and Chris Dodd were at the wheel. Now they've hired themselves a tow truck driver from Illinois who is equally clueless.
And that sounds like a positive development to you? Hoo, boy!
stay strong until freedom dawns
Son Of Sam
http://www.geocities.com/samadamssos
JP| 5.4.09 @ 12:32PM
Ken,
This is a suckers market. Institutional investors are keeping prices artificially high in order to lure people like you back in. Once the price creeps high enough (where they can recoup some of thier 2008 losses), there will be a giant sell-off, and people like you will get hammered.
And since when did the 1 month S&P trend become a bellwether?
Jerome Brick| 5.4.09 @ 1:10PM
I would like to make two points relevant to this article: (1) The universe of systemic risk grew exponentially with the repeal of Glass-Steagall in 1999. This ill-advised legislation paved the way for the mass marketing of asset-backed securities and the development of various complex derivative instruments that were sold as a means to diffuse risk in said securities.
I was always confounded by the fact that "Tiny" Tim Geithner sailed through his confirmation hearings as Treasury Secretary (notwithstanding his personal tax problem) with nary a word about his digusting performance as President of the New York Fed. In this capacity he was responsible for the supervision of BHC Citigroup which had been engaging in egregious risk-taking activities. Geithner was never called to account for is regulatory failure in this regard.
Bob| 5.4.09 @ 5:11PM
This article fails because one of its underlying assumptions is just plain false.
"Instead, its origin can be found in the combination of a deflating housing bubble, an unprecedented number of sub-prime and other non-prime mortgages, and a mark-to-market accounting system that caused asset values (and hence bank capital) to spiral down as distress sales drove down market prices."
The real cause for this downturn was the fact that securitization and resultant derivatives were allowed to be leveraged at 40-1 ratios without capital reserves backed up by default swaps with virtually no reserves. Without this leverage and lack of capital requirements, this would never have happened. When you have unregulated entities that have unlimited leverage, it doesn't take much to bring down a house of cards.
The author conveniently leaves this out. Without this consideration, the article is moot. Yes, there is a danger of over regulation, but I don't consider capital requirements for securities to be over the top. Furthermore, securitization separated origination from loan risk which is extremely dangerous as the originator is the best judge of loan risk.
DaveS| 5.4.09 @ 7:21PM
Please, government, drop the shovels.
aware| 5.4.09 @ 8:01PM
Bob, I still maintain that the cheap credit had to be available first to fund everything else at 40 to 1. Since this was not backed up by real savings it had to be created and it was by the Fed and pumped into the system by its fractional reserve banking system, which acts as a magnifier (one dollar in becomes 10 dollars out). How else can you "create" 40 dollars to loan out for only 1 on deposit?
You and Peter are actually pointing out different results of this monetary expansion. And as far as the leverage and lending policies go, no one should be in any doubt that the lenders were doing exactly as the government wanted them to do. There was no outlawry here, it's just that because of adherence to an obviously derelict economic philosophy their "models" didn't warn them of the likely results. But those results are predictable.
Funding for bubbles of this magnitude have to come from the State and that sets the train in motion. Everything descends from that. What other entity has control over so many of the disparate elements?
The Fed lights the fuse then stands back like an innocent bystander while it goes off and then proclaims it a failure of the free market. Is this an example of social behavior or anti-social? There are bombs and then there are bombs, there are terrorists and then....
Robert Rosencrans| 5.4.09 @ 8:12PM
Here is a good article which defines the impending disaster which will be caused by the FED becoming an appendage of the Obama White House.
http://www.americanthinker.com/2009/05/the_top_ten_reasons_obamanomic.html
A brute inflationary monetary policy of the kind we are experiencing today can hardly avoid leading to a growth in GDP that, after all, is largely a record of consumer spending. But we cannot judge an economic policy to be "working" simply by detecting such an increase in GDP. Nor may we say policy has "succeeded" just from increases in government jobs or government-subsidized jobs. An economy's success, properly speaking, is one that increases long-term levels of production with robust private sector employment. In short, inflation and public sector growth do not mean a policy has "worked." As the essence of Obamanomics is easy money and government aggrandizement, there are lots of reasons for pessimism. Here are ten of them
10. The Obama economic team really does not know how we got into this mess. For example, Christina Romer, chair of the Council of Economic Advisors, claims that the "fundamental cause" of the current economic downturn is the decline in asset prices from the levels reached in 2006 and 2007, i.e., from the peak of arguably the biggest and broadest asset bubble in history. In other words, she believes that the retreat from absurd valuations is giving us problems.
9. Obama himself follows the scapegoating line initiated by Bush. He blames both the general asset bubble and its collapse on insufficiently regulated companies, rather than on fiat money and central banking -- the sacred institutions of the failed macroeconomic establishment -- which financed every aspect of the Great Bubble.
8. Larry Summers and Ben Bernanke consider credit and liquidity to be the "lifeblood" of the economy. So they will supply untold quantities of it to somehow "restart" financial markets. They are unaware that economic freedom -- let's call it the "oxygen" of the economy -- makes possible credit, liquidity, and financial markets.
7. The Administration tries to meddle with private contracts -- see its attempts to pre-empt the bankruptcy courts and undercut the functions of mortgage foreclosure clauses. For a few cosmetic results, it chills confidence in all future investments.
6. The federal government burdens what is now left of free markets by raising its own spending and borrowing and, of course, by planning to increase taxes and regulation.
5. Government creates a new welfare system for union members when it preserves zombie auto companies in order to save "jobs." It creates a sham "financial system" when it bails out "systemically important" banks and insurance companies -- those that are too embarrassing to fail.
4. The Administration's efforts to manipulate prices upward (as in the markets for residences and "toxic" securities) are irrelevant, at best, and are more likely to delay a return to normal functioning in those markets.
3. President Obama apparently believes that increasing taxes on some of us and then redistributing the money to favored groups and promoters somehow "stimulates" the economy. Who besides macroeconomists (and their former students) believes this?
2. The Federal Reserve Board has transformed itself into an obedient appendage of the Executive Branch of government. Few seem aware that it is managing our monetary system more recklessly than ever in its history. The historic quattuordecupling of bank reserves in the last six months (that's a multiplication by 14) sets the stage for a doubling or more of the money supply. (The Fed has never before dared to promote annual money supply increases of more than around 10 percent.) When and if a bogus "recovery" does actually begin under these conditions, remnants of sanity will force the Administration to reverse its easy money policy. (Reluctantly, to be sure. Romer recently warned of the dangers of reversing too soon.) That reversal, of course, will bring on still another economic relapse. So, American entrepreneurs, are you feeling brave?
And the number one reason Obamanomics won't work:
1. You can't push off the costs to our descendants. Many Americans worry that their "children and grandchildren" will suffer the economic hardship of repaying the Bush-bama trillion dollar deficits. But they won't. (The little darlings will repudiate the debt one way -- monetary depreciation -- or the other. Explicit repudiation. They will, that is, if the present generation doesn't do it first.) The current follies of economic policy are not an extravagance for which we can charge someone else in the remote future. We are the ones who, passively allowing this conversion to a command economy, will experience the deprivations it supplies to all but the politically connected. The transition starts now, with the private sector mired in paralysis and Washington, D.C., beginning to flex its muscle in earnest.
Roy| 5.4.09 @ 10:32PM
This article touches an extremely sore point for me.
The forcible taking of people's money in order to hand it to huge, politically favored corporations, for no reason other than to insulate them from the costs of the rists they took, is an absolutely disgusting, tyrannical act. So what I think policy should be concerned to prevent is not economic downturns, which cannot be prevented, but future bailouts. Bailouts happened because of the perception of companies as "too big to fail"(well, that's the most charitable reason; in the case of Chrysler for instance, after the taxpayers had been cowed into submission, it was raw exercise of political power by special interests, ie, the UAW.)
Granted that politicians were right that we were DOOMED, DOOMED I tell you, if Citibank were to reap the just rewards for their policies, future policy should be aimed at preventing that situation. My recommended regulation would be that if you get that big, you have to regularly be certified as ready for bankruptcy. You have to constantly keep a bankruptcy plan on file and have people who every day ask the question "what if we went bankrupt tomorrow?" I realize this would increase the regulatory burden on the largest companies, but now that I see how easily the American people roll over when told they are DOOMED, DOOMED if some company goes bankrupt - I see it as a very small price to pay. If that prevented some of the biggest mergers - well, that would be too bad, but not a patch on what billions upon bajillions upon supercalafragillions in bailouts have cost the economy.
Bob| 5.5.09 @ 8:27AM
Aware -- it wasn't government funds that funded the bubble. The money came from companies and sovereign funds around the world that wanted to achieve a higher rate of return on their investments. Some of the more exotic derivatives had a return rate of 30% or so and were rated high by the ratings agencies.
The Fed contributed by lowering the funds rate making the spread between the borrowing of Fed money by the banks and the return of these derivatives very large. So investment banks were using the Fed money to gamble on these derivatives instead of their own capital. This is exactly the definition of leverage. If leverage were limited by capital requirements, this Fed money would never have been borrowed. This cause and effect is important in understanding the bubble.
Ken| 5.5.09 @ 9:20AM
Now that the overall stock market is up 12.7% since President Obama took office, and the tech-heavy NASDAQ is up 22.4%, here's more news to upset the likes of 'duh', 'jack', 'Sam', and 'JP':
The Recession Is Over
Brian S. Wesbury and Robert Stein, Forbes.Com:
Indicators point to a fast-approaching end date: May 2009.
Once the "real" recession started--the one that began in September--we consistently forecast it would be over by mid-2009, earlier than many (including the Federal Reserve) predicted. Now it looks like our V-shaped recovery is underway. When the NBER eventually gets around to declaring the recession end date, we think it will be May 2009.
New claims for unemployment insurance are probably the very best single indicator of the end of a recession. The monthly average for claims normally peaks one or two months before the economy bottoms--and it appears to have peaked in March, at 658,000, versus April's 635,000.
Robert Rosencrans| 5.5.09 @ 9:32AM
The stock market is not up 12.7% as Ken states since Obama took over. The DOW was at 7949 when Obama was inaugurated. If you take 12.7% of that figure it would have to be at 8958 or so. It closed at 8424 meaning it's up about 5% or so.
Bob| 5.5.09 @ 10:14AM
Rosencrans -- again you show your lack of economic logic. When Obama took office the S&P 500 -- a broader index of market value -- was 840. Today it is 905 at this moment, an increase of 7.7%. The fact that Ken didn't get the number precisely right doesn't change the conclusion that most economists, including Republican ones like Wesbury, believe that the recession is coming to an end. So why are you trying to discredit someone whose point and conclusions are generally correct? This is, again, something you should discuss with your shrink...
Robert Rosencrans| 5.5.09 @ 1:54PM
Bob: The only thing shrinking around here is your intellect. There isn't any. On the trading day before Obama's inauguration the S&P 500 was at 850 not 840 as you state. On his inauguration day it closed at 805. Either way, you're wrong as usual.
Interestingly enough, your figures and percentages are closer to mine then Ken's, yet you imply that I'm wrong somehow. There's your logic. You're closer to agreeing with me but somehow someone else was more correct.
I've said it before and I'll say it again. You're really ignorant, but then again you know that don't you? That's why you try so hard.
Bob| 5.5.09 @ 2:30PM
Again, Rosencrans, you missed the entire point of the logic, that the market is up and the recession is probably ending. Actually, I chose the day after his inauguration on the theory that he was not President most of the day on the 20th. But again, you lack the intelligence and logic to think that through. You are not ignorant -- you just don't know how to think for yourself....
Again, please talk to that shrink of yours about your anger problem and blindness to using your brain....
Robert Rosencrans| 5.5.09 @ 2:42PM
Under Bob's logic, when the S&P 500 trends lower then 840 and it will, then Obama is a failure.
Bob| 5.5.09 @ 2:50PM
So, Rosencrans, under what economic indicators and market intelligence are you using to predict that the S&P 500 will drop below 840? Or is this another non-thinking, emotional, and angry comment? Do you believe we are just a bear market rally? What leads you to that conclusion? How do you explain the fact that production is now less than demand and inventories are at a low? Doesn't production have to increase to meet demand?
Please, Mighty Rosencrans, explain the economic logic backing up your market prognostication prowess...
Pingback| 5.5.09 @ 3:10PM
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Robert Rosencrans| 5.5.09 @ 4:02PM
Bob: You're boring me.
Bob| 5.5.09 @ 4:17PM
Yes, Rosencrans, since you can't support your contention that the S&P index will drop to 840, you just give up. I've asked you a bunch of questions about your prediction. Can't you answer any of them? Please show me that your capable of some sort of thought process...
aware| 5.5.09 @ 4:28PM
Bob(and Ken)... If you are so sure of your economic readings then put your money where your mouth is and jump in with both feet by all means. I said in Dec. there would be a "rally", that the Dow may even go to 10,000. If you play it right you may even make money. I hope you do. I don't underestimate the ability of the wizards of the State to blow another bubble that investors think is a ticket to paradise. This is exactly my point about them driving the boom/bust cycle.
But manufacturing is still dying, we still think we can build wealth with an economy of paper shufflers, and we still punish prudence and thrift, and we still think we can buy now and pay later. We still have 40 lawyers graduated yearly to 2 engineers. We still have an entitlement A bomb about to go off. All this is still deteriorating and shows no sign of turning around. Any "recovery" will just be another put off of the reckoning that is real close now.
The investor class is listening to talking heads that failed as late as spring of '08 to even see a problem. With nearly 10 trillion dollars pledged as of now to "fix" the economy, you are missing something if you think this money taken from the private sector will not have a detrimental impact for years to come. Put simply, this is money THEY spend now that YOU won't have to spend in the (near and far) future.
Even if I'm am wrong about how the Fed works and the (major, even starring)role they have in the boom/bust cycle, and I am wrong often, you still can see that the end result of all their world saving efforts in "our"(Hahaha) behalf is to reward bad business, bad behavior, and bad people. After all, only the ones that bit deep needed the remedy of taxpayer bailouts. And the only place to get the wealth to do it is from those who didn't bite deep. Good pays a fine for bad. Surely this alone is enough of an outrage to make you wonder about the wisdom of Fed control of any, let alone all, of our economy. I still say they are crooks executing the greatest transfer of wealth (and power) in the whole sorry history of mankind.
Penny | 5.9.09 @ 6:11PM
I just finished reading Gary D. Halbert's weekly e-letter and he figures we are going to be in a recession for the rest of the year. He said he hopes hes wrong but there is alot of bad stuff out there.
Aware, I agree with alot that you are saying.
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