Wednesday, December 2, 2009

In Praise of the Bernanke Fed

(Fair warning: This is a long article. It requires more than 20 seconds to read it!)

It certainly feels as if the favorite game among members of Congress these days is to outbid each other in trying to limit the various aspects of the Fed's powers and independence. The underlying reason is both transparent and cynical, all blended with a strong hint of ignorance.

Playing the populist card in attempting to show how outraged they are too by Wall Street's bailout in the midst of the financial crisis, while Main Street was left holding the bag (also known, as the bailout cost), people in Congress are focusing their criticism on the Fed. Such criticism has flared up in recent days, with Bernanke's own confirmation hearings underway and various bills designed to overhaul the bank regulatory framework making their way through Congressional committees.

That rising level of attacks on the Fed, and the implied threat to its regulatory and monetary policymaking authority, prompted the Fed Chairman to write an article in The Washington Post this past weekend, offering a spirited defense of the Fed's independence and crucial leadership role that it should continue to play in the context of any regulatory overhaul.

The main arguments of those who cannot criticize the Fed quickly enough are three:

a) The Fed, as a bank regulator and supervisor, did a very poor job at recognizing the steadily growing risks to the financial system that led up to its near-meltdown following Lehman's demise.

b) The Fed was at the forefront of the drive to bailout the major financial institutions once the crisis erupted, although it was precisely those same institutions that, by way of their reckless and dubious behavior, were responsible for the financial crisis itself.

c) It is unacceptable in a "democratic society" for the Fed to have so much power and independence from both the executive and legislative branches of the government; therefore, it needs to be brought under more supervision and some of its powers to be taken away.

The first of the above points can be disposed of fairly easily, by admitting that indeed the Fed did a miserable job at identifying the build-up to the financial crisis and had shown little interest in trying to rein in the tremendous proliferation of exotic derivative instruments for the most part of the decade. Although the bulk of of this failure should -out of fairness- be assigned to Greenspan's irrepressibly free-market, hands-off, philosophy, there is no dispute over the Fed's, as an institution, embarrassing failure here. Bernanke plainly acknowledges this in his article and highlights a number of concrete measures the Fed has taken recently to prevent such an enormous lapse again in the future, like beefing up bank examiners' teams, tightening the supervision practices etc. One can raise questions as to how effective these measures will be in correcting the problem but there is little reason to believe that another regulator would, for some unexplained reason, be more nimble and effective in dealing with such problems.

The second of the above points is where a giant misconception and a good dose of hypocrisy by the Fed's Congressional critics merge. The bailout of "Wall Street" was not an elective action but borne out of necessity to prevent the collapse of the entire financial system, which would have had unspeakable consequences for Congress's favorite constituency- the "Main Street". As Bernanke had pointed out at one point during the heady days of the crisis, you don't let a whole neighborhood burn down to punish the arsonist who may live in that neighborhood himself; you first put out the fire any way you can and then try to deal with the arsonist.

The whole idea that, somehow, the major financial institutions should have been allowed to collapse because we didn't want to burden the Main Street with the cost of keeping them alive enters squarely into the sphere of absurd. Someone in Congress should perhaps find the time, and courage, to explain to that famous "average American on the street" that this is the way the capitalist system that they all learn to worship from kindergarten on really works. It is based on the unspoken pact that when the financial industry does well, those that are part of it get obscenely compensated for their spirit of "entrepreneurship" and "willingness to take risk". Rewarding success is the ultimate value in the society and no one is complaining.

But, when the industry suffers a life-threatening heart attack (irrespective of whether it is due to its own fault or that of others), and threatens to plunge the economy and global financial system into an abyss, the only available course of action is to frantically try to resuscitate it at all costs. And, given the close symbiotic relationship that Congress, the Executive branch, and corporations enjoy in the brand of unfettered capitalism in this country, the cost of salvaging the financial system will naturally need to be borne by those who can be forced to do so- that is the Main Street. It is a pity, and arguably a high point of hypocrisy, that no one has explained to the "average person on the street" how the true free-market system is really meant to work- not on paper, but in reality. Otherwise, extensive government intervention to meaningfully rein in the systemically dangerous greed of the system is quickly labeled as "socialism" which, again, in the eyes of the Main Street is probably far more abhorrent than Wall Street.

On that last seemingly unfair issue, the Bernanke Fed has actually been at the forefront of supporting a provision in the proposed overhaul of the regulatory system, according to which all major financial institutions will be required to pay a premium to a special fund to cover the cosy of any such bailouts in the future. An innovative and sensible idea, although its final version, if enacted at all, will probably be watered down appreciably. But, at least, the Fed is showing tangible signs that they are drawing some sensible conclusions from the crisis.

And, then, there is the paramount issue that those who savage the Fed's role in the recent banking crisis either ignore or are simply unable to appreciate.

The Fed's response to the crisis was phenomenally aggressive, imaginative, and, ultimately, effective in preserving the financial system's integrity. They invented an array of new tools on the fly to combat the crisis, they turned traditional monetary policymaking at times on its head, they assumed some major risks. The Bernanke Fed's response to the events of the post-Lehman period will probably be studied at all major Business Schools around the country (and beyond) 30, 40 years, or more, from now. The determination and swiftness that the Fed showed during that period have already become part of the global finance's history books. It is ironic that against that backdrop some of the nation's elected representatives now profess outrage by the Fed's role in the financial crisis. Ignorance can be their best excuse, but still...

As for the third argument used by Bernanke's critics, that the Fed is too unaccountable for the amount of power that it wields within the entire financial system, that "power" needs to be broken down into its two key components:

On the count of conducting monetary policy independently, it would require an enormous amount of bad faith to argue that it is best to subject such decisions to direct influence by either the executive or the legislative branches of the government and bring them under the control of people that would give priority to short-term political expediency objectives rather than the Fed's long-term goals of sustainable economic growth and price stability. On the count of the Fed's becoming more transparent in the way it operates, this is probably one of the major prevailing misconceptions about the Fed. As Bernanke's article points out, he personally delivers several lengthy Congressional testimonies each year answering questions at great length, the Fed's balance sheet is regularly audited, the Fed provides monthly detailed reports about its various special facilities, and the FOMC always announces in detail its decisions regarding monetary policy. A transparency problem?

Perhaps, it's time for those who do actually have a better understanding than some in Congress of how the Fed operates and what its role exactly was in the recent financial crisis, to stand up and defend the Fed and its independence.

The financial system is still standing today, and Ben Bernanke may be the single most important reason for that.

Anthony Karydakis

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