The Public Policy

The Greenspan Gamble

It almost worked. Now we may see a "Super Fed."

By 4.10.08

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The most notable thing about Treasury Secretary Hank Paulson's proposed plan for restructuring financial regulation is the expansion of the Federal Reserve into a sort of "Super Fed." This new Fed would have oversight of all financial markets and firms, including investment banks. It would be responsible for financial market stability and would be expected to spot and control "systemic risks."

The Treasury has proposed a number of changes that will likely go nowhere. However, it appears to me that the "Super Fed" could actually happen. Many of the other changes require consolidation of regulatory agencies, and bureaucracies seldom go gently into that good night. They and their constituents will fight for survival and probably win. But the Fed expansion is likely to be seen as the solution the problem of risk that the housing bust has made apparent.

But wait. Isn't this the same Fed whose 1 percent fed funds rate helped inflate the great Housing and Mortgage Bubble that is now popping? Didn't this lead to massive losses, illiquidity, and panic? Wasn't the bubble exactly the sort of systemic risk that the new, more powerful Fed is expected to effectively manage?

Full points for irony, but this "Super Fed" idea is actually consistent with what the Fed founders had in mind in 1913, when Congress passed the Federal Reserve Act. The great idea was to mitigate market panics.

Much has been made lately of the Fed's extending discount window lending to Wall Street investment banks, rather than only to commercial, deposit-taking banks. But this is nothing new. In fact, the separation of banking into these two parts had not occurred in 1913. It came 20 years later with the passage of the Glass-Steagall Act.

In 1913, J.P. Morgan and Co. was still both an investment bank and a commercial bank. It did not split into Morgan the commercial bank and Morgan Stanley the investment bank until forced to in 1935.

Of course, today it is again both an investment bank and a commercial bank, after the repeal of the Glass-Steagall prohibition in 1999, and will be even more so with its pending acquisition of Bear Stearns, as arranged by the Fed. The Treasury proposal could simply produce a Fed that deals with the banking structures of the future.

AS THE FED GOT organized in 1914, hopes were high for what it would accomplish. The Comptroller of the Currency expressed the view that with the new Federal Reserve, "financial and commercial crises or panics seem to be mathematically impossible." A bold call!

As we know, it didn't quite turn out that way -- financial crises and panics have continued right up to the housing bubble and bust of our new 21st century. But hope for what the Fed might do springs eternal. The prestige and authority of the Fed has been on a long term ascent, in spite of the problems it could not prevent, or has aggravated, or even caused.

The history of the Fed has been marked by periods of severe economic and financial problems, after which its policies have come in for sharp attack as deflationary or inflationary blunders.

Bernard Shull, in his insightful history of the Fed's evolution, discusses three of these instances: the "roller coaster" of inflation and deflation in 1919-21; the Great Depression with the collapse of the financial system, including the Fed's 1937 "tragic mistake" of pushing the economy back into contraction; and the Great Inflation, then stagflation, of the 1970s.

Now with the current bubble become bust we have a fourth instance and resulting criticism, such as a recent statement by Columbia Professor Jeffrey Sachs: "The U.S. crisis was actually made by the Fed...one main culprit was none other than Alan Greenspan."

A typical phase in the reaction to a bust is the search for the guilty, so we should not be surprised at the rhetoric of a "culprit."

SHULL OBSERVES THAT the Fed "has been winning battles since its establishment in 1914, regardless of the merits of its policies."

Its position and power "ratcheted upward...in several distinct periods during which its policies were so profoundly disappointing." It managed somehow to "[transcend] its failures." Shull quotes an economist colleague who "disconsolately asked, 'How is it that the Federal Reserve always wins?'" And perhaps it will once again.

A reason frequently given for financial market behavior in recent years is said to be the "Greenspan Put" -- the belief that the Fed will bail out the market's mistakes. I believe instead we should call it the "Greenspan Gamble."

Here's how that went: In the wake of the burst tech stock bubble, an impending recession from industrial overinvestment, and also the shock of the terrorist attacks, the Greenspan Gamble was purposefully to ignite a housing boom to offset industrial weakness and bridge the economy until, with the help of a falling dollar, industrial growth resumed.

It was a reasonable gamble and it almost worked -- but the intended housing boom turned into a bubble, nourished by a great credit overextension. We now focus on the unintended costs: falling prices for houses, most people's principal asset, the severe credit contraction, and illiquidity. But remember a year ago we were being treated to pontifications about the "global liquidity glut" which would insure robust markets for financial assets.

The ultimate failure of the Greenspan Gamble notwithstanding, the Fed will continue to be extremely useful in helping ameliorate busts and financial panics, just as it was intended to do in 1913. Its usefulness to the government insures its continued influence and authority, which may very possibly include acquiring wider jurisdiction as the "Super Fed."

But it is foolish to think that the Fed (or "Super Fed") can foresee all future problems or prevent future bubbles and busts. It is even foolish to think that the Fed will consistently make correct forecasts of the results of its own actions.

After all, everybody, no matter how clever and diligent, no matter how many economists and computers one employs, makes mistakes when it comes to predicting the future.

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About the Author

Alex J. Pollock is a resident fellow at the American Enterprise Institute.