The Public Policy

Depressed About Paulson

The Treasury secretary doesn't understand why it could be a perfectly dreadful idea to give the Fed more power.

By 4.1.08

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He had me worried at "Market Stability Regulator."

U.S. Treasury Secretary Henry Paulson on Monday proposed a sweeping overhaul of nation's financial regulations intended to update an outmoded patchwork of competing government agencies that currently oversee the banking sector and capital markets.

In a speech unveiling the "Blueprint for a Modernized Financial Regulatory Structure," Paulson insisted that the proposal had been in the works for a year and was not intended as a response to the current turmoil in the markets. He cautioned against making snap judgments.

"This is a complex subject deserving serious attention," Paulson said. "Those who want to quickly label the Blueprint as advocating 'more' or 'less' regulation are over-simplifying this critical and inevitable debate."

To be sure, it will take some time to fully assess the potential ramifications of the 212-page proposal, which is unlikely to be adopted in its entirety, if even in parts. There is no doubt room for changes that streamline government regulation and improve transparency for investors, but one aspect of the proposal -- which sees a new role for the Federal Reserve Board as the "Market Stability Regulator" -- is a cause for alarm.

Paulson said the new role would "replace the Fed's more limited role of bank holding company supervision" and give it "enhanced regulatory authority" to deal with systemic risk.

"The Fed would have the authority to go wherever in the system it thinks it needs to go for a deeper look to preserve stability," he declared.

He went on to say that the Fed would have the ability to "collect information" from "commercial banks, investment banks, insurance companies, hedge funds, commodity pool operators" and it would possess "broad powers and the necessary corrective authorities to deal with deficiencies that pose threats to our financial stability."

THE IDEA OF creating a new Federal Reserve Board on steroids, with broad but ill-defined powers to jump in an out of the financial system like a character from The Matrix, is troubling.

Historically, government regulatory agencies are not known for showing restraint, and giving such discretionary power to a body that already operates independently and clandestinely is an added cause for concern.

Even if one assumes the best intentions from members of the Fed, we cannot forget that they are only human. As intelligent and well educated as they may be, they are just as capable of making mistakes as the clever bankers who bet billions on mortgage investments that turned sour.

Milton Friedman famously compared government intervening in the economy to "a fool in the shower" who turns the temperature from one extreme to another because of the lag time it takes for the water to respond to his previous adjustment. Friedman helped build his reputation by demonstrating that the Fed turned a recession into the Great Depression, by contracting the money supply by a third between 1930 and 1933.

When the economic history of this decade is written, Alan Greenspan and Ben Bernanke may each come to resemble the fool in Friedman's analogy.

Under Greenspan's leadership, the Fed slashed interest rates 13 times from January 2001 to June 2003, bringing the federal funds rate from 6.5 percent to 1 percent, where it stayed until mid-2004. By keeping rates so low for so long, the Fed helped push mortgage rates to their lowest levels since the Eisenhower era. That spurred stratospheric growth in housing prices and created the easy money environment that allowed banks to issue increasingly risky loans.

BY JUNE 2004, the Fed became concerned about inflation, and so it embarked on a rate hiking campaign that brought the federal funds rate up to 5.25 percent two years later. Yet last September, in response to concerns that there was a liquidity crisis, the Fed under Bernanke began to cut rates again.

After six aggressive moves including one last month, the federal funds rate now stands at 2.25 percent. Given the weakness of the dollar, we can only guess how long it will be before the Fed will have to bring rates up again.

Paulson sees the Fed's potential as a stabilizing force, but Fed members are not prophets who can predict precisely when markets are in the midst of an asset bubble.

In 2004, Greenspan wasn't oblivious to the potential dangers posed by a housing bubble. He gave this issue great consideration, but ultimately concluded that it wasn't a major concern because, "while local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity."

Greenspan and Bernanke, to their credit, understand the limitations of the Fed. As the Washington Post noted in 2005, they "have both said it is unrealistic to expect the Fed to identify a bubble in stock or real estate prices as it is inflating, or to be able to pop it without hurting the economy. Instead, the Fed should stand ready to mop up the economic aftermath of a bubble."

Even in his speech announcing Treasury's proposal to make the Fed into a market stabilizer, Paulson acknowledged that "No regulator can prevent all instability and market turmoil, and this one won't either" and said he expected that "we will continue to go through periods of market stress every five to ten years."

BUT PAULSON ONLY considers whether the super-regulator will fail to "prevent" a crisis, rather than whether it will make a crisis far more severe, as the Fed did in the 1930s, and as it arguably did in this decade.

Even though the Fed helped bring about the Great Depression, the economic catastrophe resulted in the body being given yet more power by politicians who concluded that the under-regulated free market had failed. We cannot afford to make the same mistake again.

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About the Author

Philip Klein is The American Spectator's Washington correspondent. You can follow him on Twitter at: http://twitter.com/Philipaklein