Why Sen. Dodd's Opposition to the Federal Reserve is Ill-Conceived

The Senate Banking Committee unveiled its proposal for financial reform. It differs from the Administration's proposal on one major point. It deprives the Federal Reserve of its regulatory responsibilities rather than entrusting it to oversee the "too big to fail" financial institutions. The explanation is that many Democrats resent the way the Federal Reserve has not anticipated the systemic risks contained in the financial bubbles that exploded.

Had Senate Banking Committee's Chairman, Chris Dodd's proposal been effective before the crisis, where would we be today? The Federal Reserve would be completely restricted to monetary policy and dissociated from any responsibility for the financial institutions. It might never have lowered interest rates as low as it did. It would therefore not have done what all Central Banks around the world have done: provide the liquidity at a time when banks were no longer prepared to trust each other. By the way, the first massive injection of cash did not come from Washington but from Frankfurt where the European Central Bank injected close to $ 150 billion into the system in one day.

The responsibility to act decisively and efficiently would have been devolved to Government Agencies, and the Administration would have had to go to Congress to obtain the amounts necessary to avoid the dislocation of the world financial markets. By the time Congress would have acted, based on the glorious records of Hank Paulson, John Mc Cain and the Republicans who only approved the TARP after being bribed, most US banking institutions would have been forced to file for bankruptcy and the system would have collapsed, making 1929 look like a kindergarten experience.

The FDIC Chairman, Sheila Bair, who was the first to draw the Administration's attention on the gravity of the situation and remarkably handled an impossible situation, would not have been able to fund the kind of interventions without massive injections of the Treasury, who would need Congress approval.

It is perfectly true that the Federal Reserve's performance was less than stellar before the crisis. Fed Chairman Greenspan did not see it coming, and his successor Bernanke often gave the impression that he was a great economist rather than a market leader. In order to avoid such a bloodbath during the crisis, it tripled its balance sheet, extended the access of its liquidity window to more institutions and more classes of assets. It required courage, determination and competence.

The Senate's anger at those who are responsible for this crisis is perfectly justified, and it can be directed as well at the bankers, their Boards, the Comptroller of the Currency, the SEC, the International Monetary Fund, the Forum for Financial Stability and the Bank for International Settlements.

The Federal Reserve, like every central bank in the world, has always combined monetary policy and regulatory oversight. This role is played by most of its counterparts around the world, although it is mostly confined to bank oversight. There is a rationale for it: accountability. It is important that the institution that will be asked to intervene at times of crisis and has the financial means to do so be held accountable for the oversight of those institutions who present a systemic risk for the US and the global financial markets.

Does that mean that the Fed is the ideal solution? There is no perfect solution to the problem of financial oversight. One thing is clear, however: there is a need for a single institution to act as a catalyst and a coordinator of all regulators and which will dispose of the global information needed to preempt systemic crises. The importance of the SEC as a market regulator and of the FDIC as the guarantor of deposits cannot be underestimated. The FDIC needs increased financial means to continue its current role of "distressed assets manager". But they are Government agencies, and as such report to Congress.

What is also very clear is that if the Federal Reserve System has to be trusted for this oversight, it needs to change its methods and its structure. There is indeed an imbedded conflict between monetary policy and financial oversight. But it is a structural one: the level of interest rates and the open market policy are inevitably intertwined with financial health. Those rates affect the general economy and the fight against inflation needs to recognize its effects on the financial system.

It is not because the Senate might not happy with the management of certain institutions, that the institution is disqualified to fulfill its duties. Again, the Senate is very justified to be angry at this situation but the Dodd bill's exclusion of the Federal Reserve's regulatory oversight is no way forward.

 

Comments

[Georges Ugeux - Huffpost Blogger]

It is exact that the Fed had to intervene in areas that were not part of their traditional open market poilicy. Most Central Banks around the world were effectively forced to improvise ad hoc solutions and it is that innovation that allowed our exonomies not to collapse.

What seems essential now is to structure the roles and the duties of each of the regulatory institutions. I see the role of the Fed as a federator of those agencies as well as a central point for the massive amount of data needed to create the right market surveillance.

The difficulty for Congress is to admit that they are not in control of the Federa Reserve System. It was structured precisely so that its interventions be made in the interest of the economy and the Nation. The other players in the regulatory arena are Government agencies: they are politically accountable. Isn't Congress indirectly trying to establish a poilitical control over the Fed

[unitron]

Are you sure it isn't the Fed itself which was "ill-conceived"?

[mbaty]

The Fed wasn't going to let the economy collapse because that would have meant the end of their power over the government. It's fine if the government wants to let someone else handle the minting of the money, but that doesn't mean we should then owe interest on the money created. It is indeed structural, and it needs to change. The U.S. will never be solvent unless this aspect of the Fed is changed.

[BassMonk]

Everything you've described here is the responsibility of Congress, according to the Constitution. What we need is a Congress that takes its responsibilities seriously.

[wldnswmmr]

I wonder if you've actually read the Federal Reserve Act. A great deal of what the Fed is doing is not statutorily authorized. It is buying assets it has no authority to buy, intervening in the markets without oversight, and taken many other actions under powers it has simply arrogated unto itself as the result of a leadership vacuum (i.e., a Congress which has no idea how to handle complicated financial matters, and a somnambulant SEC which could not catch Madoff even when given a road map). As for your comment that the Fed's performance was "less than stellar" before the crisis - you certainly have a gift for understatement.