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Financial Reform: Fixing the Fed

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Ben Bernanke, Chairman of the Federal Reserve, staked out a clear position for the upcoming debate over financial regulation at the American Economic Association on January 3. Bernanke had to make his case because the role of the Federal Reserve Bank is central to financial reform, and that debate starts in earnest now that the Congress and the President are returning from Christmas vacations. Not surprisingly, Bernanke argued that the Fed ought to have a broad mandate, and that it would be a mistake to take away its role in the supervision of financial institutions as some legislative proposals would. I agree with him but understanding the reasoning is very important.

Bernanke's argument on January 3 was two-fold. He said that supervision of financial institutions had to be strengthened and he took great pains to show with data and slides that those who believe that is monetary policy --- low interest rates --- caused the 2008 financial debacle are mistaken.

Bernanke said unambiguously that the Fed had almost failed to avoid a catastrophe but he did not fully explain how that was connected to the monetary argument he was at such pains to address. To understand why the Federal Reserve allowed the dot com and sub-prime crises to build and explode, we have understand why the Fed did not better supervise the banks and financial system in the years prior to 2008 and why the monetary argument Bernanke spoke about at length is so important.

The short answer to these questions is that monitoring private sector excesses and supervising banks had become a secondary task for the Fed because for the last 30 years it has been preoccupied with inflation and monetary issues even when inflation was not a problem. The Fed's leaders, Wall Street, and the media for over three decades had repeated a catechism that described the Fed's role as inflation fighting, and which rarely if ever mentioned supervision of private sector players. Facing catastrophe in 2008, Bernanke put aside that pernicious preoccupation and did what the Fed was created to do: As the designated agent of the Federal government, he threw roughly two trillion Fed dollars into saving the financial system, which had to be done. He stopped thinking of the Fed as the Federal Anti-inflation Bank and used it as the Federal Reserve Bank as it was intended.

Bernanke made clear on January 3 that he now understands that reform must center on better supervision and regulation because hands-off faith in the wisdom of financiers bolstered by shamanistic statements about inflation and interest rates did not work. Bernanke knows that inflation was not the reason for the Fed's creation, which followed a financial panic and deep recession. Nor did inflation cause the Great Depression or any of the milder job-killing recessions of the post-World War II era. Collapsing speculations like the one we are still working through have caused far more damage. Bernanke and the Fed came to the support of the financial system in 2008 and 2009 because the Bernanke is a student of the Great Depression. In the 1930s, when the Fed failed to supply reserves, economic collapse followed and the Fed was consigned to irrelevance for the following 20 years. Bernanke does not want that to happen again and perhaps he fears that some legislative proposals now being considered could do just that.

Republican electoral calculations, more specifically Richard Nixon's electoral strategy in 1968, were what transformed the Federal Reserve Bank into the Federal Anti-Inflation Bank. The 1968 election marked the triumph of monetarists and inflation hawks who had been hanging around on the outskirts of academic economics for decades. Why did Nixon decide to support this particular group of academics in 1968? That is an interesting question that I wrote a few pages about in my book, The Competition Solution: The Bipartisan Secret behind American Prosperity (AEI Press 2005).

In a nutshell, Nixon was facing Lyndon Johnson's vice president, Hubert Humphrey in the 1968 election and wanted to undermine Humphrey's support among union workers. Unemployment was less than four percent and inflation was low but rising. Low unemployment did not make the unions happy, however, because they were not getting wage settlements as big as they wanted. Johnson had kept inflation down by twisting the arms of powerful business and labor interests that had more power to raise prices and wages at that time than they do today. Not surprisingly, the unions did not like this because they saw it as keeping wages down.

The annual reports of Johnson's Council of Economic Advisors show that Johnson had many fights with unions from 1966 through 1968. He, like every president since World War II, had locked horns with Big Steel and the steel workers union. The newspapers also covered his battle with the International Association of Machinists, representing workers at the established airlines. The IAM's president, Roy Siemiller, contemptuously defied Johnson's 3 percent wage increase guidelines and got more than 5 percent. The powerful head of the AFL-CIO, George Meany, deplored Johnson's efforts to keep wages in check. Other union leaders shared his views. Nixon, an astute politician, wanted to play on this discontent.

University of Chicago economists led by Milton Friedman offered Nixon a monetary theory of inflation that ignored the issue of union and business power, just what Nixon wanted. Republican business allies had long preferred this approach because it absolved them of responsibility for the "price push" aspect of inflation. The Chicagoans said that inflation was caused by errors in setting money supply not by greedy companies and unions. This was a huge difference in political terms because it shifted the primary blame for inflation from bad actors in the private sector to the government's money supply policy directed by the Federal Reserve.

Leaning on monetarist theory, Nixon promised Meany and the other labor leaders that he would not twist their arms to keep wages down. Instead he would use the Fed to control inflation. He repeated this promise all through the 1968 campaign and made it again explicitly at his first press conference in January 1969 after taking office. As a result, after 1968 the Federal Reserve might more rightfully have been called the Federal Anti-inflation Bank.

Of course, monetary policy aimed at controlling inflation by raising interest rates failed in the early 1970s. Prices continued to rise despite higher interest rates and slower economic growth. Nixon recognized that the new policy was not helping him so he junked it before the 1972 election. He broke his promise and began pressuring powerful industries and unions to hold prices and wages down just as Johnson had. When this did not work either, he instituted wage and price controls which were popular for long enough to secure his reelection. Both steps recognized that market power in the hands of companies and unions was a root cause of rising prices, and that Fed-engineered monetary policy could not do the job if companies and unions continued to have the power to set prices and wages.

Unfortunately, the idea that the Fed's role was almost exclusively to fight inflation long outlived Nixon. It did so because it absolves the private sector --- financial institutions in the most recent debacle --- of responsibility for the country's economic ills, and blames government, the favorite whipping boy of many Americans. Bernanke acknowledged this at the AEA, clearly blaming the economic crisis on abuses by the private sector and arguing that monetary policy had little or nothing to do with the housing catastrophe. He is right, but the day after the speech, the Wall Street Journal was already emphasizing in its headlines a few words in the speech about monetary policy, in effect discounting Bernanke's much lengthier endorsement of stronger supervision and regulation of private sector abusers.

To reform financial regulation in 2010, policy makers need to abandon the discredited monetarist accretions of recent decades. A more realistic approach would recognize that in most cases inflation as well as speculations are the result of abuses in private markets that must be exposed. Take healthcare as an example. Inflation in healthcare is not the result of Fed monetary policy anymore than the housing fiasco was, as Bernanke showed during his speech. Cozy, non-transparent, and non-competitive arrangements throughout the U.S. healthcare system are what keep driving costs up and government must use regulation and competition policy to dismantle them.

Financial reform means recasting the role of the Federal Reserve Bank in keeping with its title. Its job is to provide reserves to financial institutions when bad investments threaten to cripple their ability to lend to healthy borrowers, and supervising the various financial players so that they do not get in such trouble that they have to turn to the government to bail them out. Coordinating policy with other central banks is an important Fed role and fighting inflation sometimes is too, but better supervision, as Bernanke emphasized, is crucial.