Who captured the Fed?

In a must read NY Times' Economix column, economists Daron Acemoglu and Simon Johnson look at the myth of central bank independence and the implications for monetary and regulatory policy.

A hundred years ago, monetary policy – control over interest rates and the availability of credit – was viewed as a highly contentious political issue. 

People on the left of the political spectrum feared the central bank would be used to prop up Wall Street banks; those on the right thought it would unduly expand the role of government, giving too much power to politicians....

Incredibly, the fears of both the left and the right have been realized with the Fed.

There is no doubt that Fed policies are propping up Wall Street banks.  These policies range from regulatory forbearance on troubled assets to suspension of mark-to-market accounting to stress tests proclaiming all is well.

There is also no doubt that Fed policies have given too much power to politicians.  The Greenspan Put reflects this as the Fed was an equal opportunist across Republican and Democratic administrations when it came to lowering rates whenever the stock market declined.

The origins of the Federal Reserve System lie in an emotional debate, conducted more than 100 years ago, about whether the government should seek to affect interest rates – and support the credit of Wall Street firms during times of crisis – and, if so, how.... 

The Federal Reserve System, created in 1913, was a uniquely American compromise, trying to balance public and private interests. Banks controlled the boards of the 12 regional Feds – with big Wall Street firms holding great sway over the New York Fed, which had a disproportionate influence within the system as a whole — and still does. 

This version of the system presided over a crazed and highly leveraged stock market boom in the 1920s and the catastrophic collapse of credit in the early 1930s, while protecting the big Wall Street firms. 

So clearly there was a lesson for the Fed to learn here about the need for regulating Wall Street firms.

Under Franklin Delano Roosevelt, the role of the Federal Reserve Board of Governors, based in Washington, was strengthened, and Wall Street was more generally constrained by effective changes to a wide range of banking and securities laws. 

Banking and securities laws that have been repealed over the last 30+ years.

However, these banking and securities laws did give the Fed a significant responsibility in bank supervision and regulation.

A responsibility that the Fed abandoned under Chairman Greenspan in the run up to the financial crisis as part of his personal adherence to the ideas of enlightened self-interest and market discipline.

These reforms and the effects of World War II pulled the central bank away from powerful bankers and further into the orbit of elected officials. 

Unfortunately, as the United States and other countries learned after 1945, clever politicians can use central banks to manipulate the business cycle, boosting output growth and cutting unemployment ahead of elections.... 

The chairman of the Federal Reserve is nominated by the president to a four-year term (subject to confirmation by the Senate); anyone who would like be reappointed needs to please the White House.... 

One way of pleasing the White House is to please Wall Street.  Hence the accolades for Greenspan and Bernanke for their policies of stepping in and lowering interest rates whenever the stock market declines (originally known as the Greenspan Put).

In 1979 Paul A. Volcker became chairman of the Fed and tamed inflation by raising interest rates and inducing a sharp recession. The more general lesson was simple: Move monetary policy further from the hands of politicians by delegating it to credible technocrats. 

Thus was born the idea of independent central bankers, steering the monetary ship purely on the basis of disinterested, objective and scientific analysis. When inflation is too high, they are supposed to raise interest rates. When unemployment is too high, they should make it cheaper and easier to borrow, all the while working to make sure that inflation expectations remain under control. 

Increasingly, however, it seems that technocratic policy-making is just a myth. We have come full circle, and the Wall Street banks are calling the shots again.

A myth created by economists.

I worked at the Fed during this time in the area that was directly responsible for producing the monetary aggregates and the research to show the influence of the Fed's policy on inflation.

It was common knowledge that the White House wanted inflation to be defeated.

Crucially, the idea that politics is just about electioneering misses the point. 

Politics is about getting what you want, not just through the ballot box but by persuading people in public office to take actions that help you.... 

Monetary policy has an impact on inflation, output and employment. But it also has a major impact on stock market prices. Any central banker raising interest rates is reducing stock market values and thus eroding the bonuses of top bankers and other chief executives. 

Those people will lobby, asserting that higher interest rates will undermine the economy and cause us to plummet into recession, or worse. 

In principle, the Fed could stand up to the bankers, pushing back against all specious arguments. In practice, unfortunately, the New York Fed and the Board of Governors are quite deferential to financial-sector “experts.” Bankers are persuasive; many are smart people, armed with fancy models, and they offer very nice income-earning opportunities to former central bankers. 

Regulatory capture at its finest.

We have lost track of the number of research notes from major banks pleading for easier credit, lower capital requirements, delay in implementing financial reforms or all of the above. 

In recent decades the Fed has given way completely, at the highest level and with disastrous consequences, when the bankers bring their influence to bear – for example, over deregulating finance, keeping interest rates low in the middle of a boom after 2003, providing unconditional bailouts in 2007-8 and subsequently resisting attempts to raise capital requirements by enough to make a difference. 

It is not surprising that being led by economists, the Fed gave way.

Supervision and regulation is all about detail and the economists at the top of the Fed are big picture monetary policy oriented individuals.  A focus on the type of detail necessary for successful supervision and regulation is hard for these individuals as they have been trained to make assumptions rather than examine all the small details.

A classic example of how the economists do not understand the small details is the ongoing discussion of raising capital requirements.  What part of the OECD's observation that bank book capital is meaningless do economists and finance professors not understand?

When the Fed practices regulatory forbearance and encouraged an end to mark-to-market accounting, the Fed undermined the relationship between bank book equity and the true financial condition of the bank.  Bankers seem to get this point as the interbank lending market periodically freezes as every bank knows that it is hiding losses on and off its balance sheet and assumes that the other banks are too!

The reason your humble blogger has advocated for requiring banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details is that it frees market participants from dependence on a Fed that is subject to both regulatory and political capture.

With this data, market participants can determine the riskiness of each bank.  Base on this assessment, market participants can adjust their exposure to each bank to what they are willing to lose.  Unlike the regulators, this market discipline is not subject to being captured by the bankers.