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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.
(Page 2 of 2)
The Fed’s expertise
The Fed is a bank regulator; it has no expertise in regulating or understanding the details of businesses like hedge funds, securities firms, or insurance companies. Yet, as the regulator of systemically significant companies, the Fed would be required to make important decisions about such things as appropriate capital levels, leverage, products, and risk management that require deep understanding of any industry in which a systemically significant firm is located. In order to decide these issues the Fed would have to have a detailed knowledge of the business practices, accounting standards, and taxation of each business model.
Accordingly, as the systemic risk regulator for the varied financial industries and business sectors, the Fed would have to acquire a great deal of expertise in other fields of finance. In addition, because all these industries compete with one another, every regulatory change for one sector would have an effect not only on the competition within the industry in which the particular systemically significant firm is located, but also on that firm’s ability to compete with other members of the financial services sector.
Finally, the underlying theory of a systemic risk regulator is that the agency will not only be able to supervise the systemically significant members of the financial services industry—no matter what business form they take—but will also be able to recognize the development of systemic risks before they place the financial system in jeopardy. So the Fed would not only have to be able to forecast the effect of new products and business activities on the future financial health of the economy generally, but also to understand what particular activities or investments present excessive risks when undertaken by a particular business model. It is exceedingly doubtful that any single agency can make these varied judgments, and certainly not more effectively than the market itself.
Use of the discount window
The Fed has one authority that no other regulator possesses: the ability to create and lend money without an appropriation from Congress. The flexibility of the Fed’s authority as lender of last resort has been demonstrated in the current financial crisis by the agency’s willingness to lend on an emergency basis to companies and organizations that are not banks or BHCs. The continued availability of this authority raises troubling questions if the Fed is to become the regulator of all systemically significant financial institutions, because it will institutionalize a substantial broadening of the Fed’s lender-of-last-resort functions. Giving the Fed authority to regulate and supervise systemically significant firms is essentially the same thing as giving it authority to use its lender-of- last-resort facility to provide them with the liquidity necessary to prevent their failure, and will confirm for the market that these companies will be bailed out if they get into financial difficulty.
Conclusion
The case for creating a systemic risk regulator has not been made. There is no clear definition of systemic risk, and specially supervising companies arbitrarily designated as systemically significant would seriously impair competition in every field in which a systemically significant company operates.
In addition, even if it were possible to identify systemically significant companies and to overcome the competitive problems such a policy would entail, the Federal Reserve would be a very poor choice for the systemic supervisor. Such an assignment for the Fed would create significant conflicts with its monetary policy role and impair the independence that the agency needs to carry out that role effectively. As unintended consequences, impairing competition and endangering the dollar would be a good day’s work for a financial wrecking crew; we shouldn’t expect it of the administration and Congress.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. Karen Dubas assisted him in the preparation of this article.
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...
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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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