Whither the Fed?

There has been quite a bit of discussion recently about the future both of the Federal Reserve Board with respect o its role as a regulator, and the future of Ben Bernanke its current chairman who term comes up for renewal in the not too distant future.

Let me wade into the discussion.

“It is possibly allowable to fail to see the tsunami building, but it is inexcusable to have allowed the risk prevention systems at the banks it regulated to atrophy to the degree they did. That’s akin to not checking whether the fire hoses work or whether the lifeboats float.”

First: Bernanke.

I must admit to a certain ambivalence here. Bernanke is a highly respected economist. He is an expert on the problems of the Depression, and the author of a well known text book. So his credentials are both good and mainstream. His actions to stave off economic disaster have been imaginative and forceful: the Fed has taken some extremely unconventional steps to flood the economy with liquidity even to the level that some are now worried about the inflationary consequences of that activity. As you know I think inflationary fears are way overblown presently – that’s something we can worry about in a couple of years – and, in any case, Bernanke’s recent testimony before Congress was full of all the right plans to suck that liquidity out before it does any long term damage.

It is the timing of the counter measures to the monetary expansion that we should be concerned about, and that’s where my ambivalence creeps in. That timing will require judgement – does Bernanke have it?

The problem I have with Bernanke is this: if he’s an expert, as he is, on matters such as the Depression, why did he not have a better handle on the crisis we are going through as it grew? Some of his statements and speeches from a few years back are too full of fawning praise for the likes of Milton Friedman and Robert Lucas whose monetary and general economic theories contributed so much to the disaster. I realize that due to the hegemony of neo-classical and monetarist thinking about macro economics that very few major economists saw what was coming – for which we should never forgive them – but he is the one who we rely on, the rest are merely commentators.

His handling of AIG and Merrill Lynch were heavy handed, but in the absence of solid background information I have no reason to fault him for being drastic on either. He was caught squarely in the ‘too-big-to-fail’ conundrum that none of us has yet to find a good solution to. Then again isn’t he supposed to be leading the search for such a solution?

My problem with replacing Bernanke ultimately boils down to two issues:

• Who would replace him? There are very few names being floated that don’t suffer from the same issues that Bernanke has: notably their attachment to outmoded economics.
• Independence. One of the Fed’s assets is its independence from politics. In its role as monetary policy arbiter the Fed needs to be seen as separate from political influence so that it can periodically pursue politically unpalatable policies. A major difficulty of the Fed during the Greenspan era was his very open advocacy of right of center politics. Ultimately this blinded him to the errors within neo-classical economics and especially its failure with respect to asset price bubbles. So: for Obama to change Bernanke right in the middle of the current crisis may be seen as a little too much politicking and a loss of independence.

For these two reasons Bernanke should stay … just.

That brings us to the second issue: that of the Fed itself, because errors made by Bernanke where supported by the work done elsewhere within the Fed. And there seem to have been plenty of errors.

Let’s look at some of the details:

When the crisis was building the Fed ignored the depth and breadth of the collapse in real estate. Bernanke kept telling us that the end was in sight, yet here we are three years into the down cycle and the bottom is only now tentatively on the horizon. Obviously there were major analytical problems in the Fed’s understanding of the real estate market. Which is odd since the Fed is a major regulator of the mortgage market. They of all folks should have a handle on real estate.

Next: the Fed and Bernanke seemed to have a very limited notion of the extent of the potential damage the implosion of real estate would or could do. In particular they had no notion, it now appears, of the volume of derivative type products dependent upon real estate that littered bank balance sheets. Not only this they had no idea of the tsunami like impact that the inter-connected nature of the derivative market would unleash: apparently they couldn’t, or didn’t, model the systemic nature of the derivative overlay on the banking system. And it isn’t as if derivatives are totally new. Nor has their growth been unobtrusive. That the Fed analytically overlooked the possible systemic risk being built up within one of the banking system’s fastest growing profit sources must be viewed as a major oversight and contributory factor to the crisis.

And this is a criticism of both the Fed and Bernanke: they were complacent within their economic theoretical constructs. So much so that they were blinded to more prosaic methods of control: any major systemic accumulation within a market such as derivatives should have drawn the attention of an auditor. So the Fed as controller/auditor failed because it was too invested in it economic role as central banker. I simply don’t care what all the experts – they call them ‘quants’ on Wall Street – were saying about the risk mitigation of derivatives, someone [at the Fed] with an old fashioned, and very dull auditing mentality, should have cast a skeptical eye over the market. Especially given its explosive growth and apparent profitability.

When a regulator uses precisely the same techniques as the regulated; when they both appear at the same conferences; when they both recruit from the same schools; and when they cross fertilize by exchanging personnel, the regulator becomes indistinguishable from the regulated. Group think and complacency build. Independence is lost. And no one is left taking a jaundiced view of likely outcomes.

This, I fear, is where the Fed has arrived: bereft of independent thought. Or at least bereft enough for it to fail just when it should have been raising the alarm.

Is this Bernanke’s fault?

Not especially.

The same argument can be made across the entire financial system. There is little diversity of theory and method in the places that matter: in the centers of risk management.

Further: those places where the alarm was raised were swamped by the rush for short term profit.

This raises another criticism of the Fed. The conflict between the incentive presented by short term profit, and its reinforcement by the aggressive bonus structures common on Wall Street, contradicted and disabled the proper functioning of the risk management processes of all our biggest banks. It destroyed a few, and ended up costing the taxpayers a fortune. Any competent auditor should have sensed this conflict and tested the controls in place to allow the voice of the risk managers to prevail if needed. The Fed fell flat on this issue too.

It is possibly allowable to fail to see the tsunami building, but it is inexcusable to have allowed the risk prevention systems at the banks it regulated to atrophy to the degree they did. That’s akin to not checking whether the fire hoses work or whether the lifeboats float.

I understand that checking control systems is boring work – heck I walked away from a career in auditing very quickly for that reason – but if it’s your job, you should do it well. Especially if the safety and soundness of the nation’s banking system relies upon your work.

All of this leads me to conclude that the Fed as an regulatory institution failed miserably. It gets a good grade for monetary policy and a failing grade for regulation.

This implies that the Fed is unfit to play a major role in the rejigged regulatory structure now being debated. Unfortunately the outcome looks to be very different: the Fed is making a strong play to remain the systemic risk overseer. This was exactly where it fell down. Frankly without radical changes in its staff and procedures I cannot see the Fed being credible in this role. Already it is failing to rein in the return of the conflict between bonus structures and risk management at places within its ambit of control – Goldman Sachs is the obvious name. That does not inspire a great deal of confidence.

So that’s it:

Bernanke can stay; but the Fed should be exclusively a central bank – as a regulator it failed and so it should exit gracefully from that line of work.

Personally I would advocate a single regulator overseeing the entire financial system and replacing the current fragmented approach we have now. Will that happen? I doubt it. Radical just doesn’t seem to be popular these days.

Addendum:

I just came across [via The Big Picture] a CBS story reporting that the Fed gets a low rating amongst all government agencies. maybe i wasn’t hard enough on them!