The Federal Reserve Under Attack

J.W. Verret —  30 November 2009

The WSJ describes how Chairman Bernanke is going on the offensive in advance of his confirmation hearings, using them as an opportunity to oppose those elements of the Dodd Bill that would strip the Fed of some of its powers.  However you feel about the policy debate, you’ve got to give him some credit for using his confirmation hearings to defend his agency, the safer course would be to secure his helmet, dive into a foxhole, and wait until post-confirmation to enter the fray.

One of Bernanke’s concerns is that Ron Paul’s new bill to audit the Fed might compromise its ability to manage monetary policy.  I am one of those people conditioned to worry about the Federal Reserve’s independence, but Ron Paul’s Bill to require the Comptroller to audit the Fed’s books doesn’t seem to me to be all that big a deal.  The GAO is one of the most non-partisan, capable organizations in the beltway, and the Fed’s deliberations would stay confidential despite Ron Paul’s Bill.  The GAO would, however, get a chance to examine transactions taking place at the discount window that have nothing to do with monetary policy.

The Fed is in part to blame for this controversy, during the crisis it used the discount window to lend to non-bank companies in an unprecedented manner that has since put its balance sheet under severe stress.  The discount window is supposed to be a vehicle for monetary policy, but the Fed was the one who chose to confuse that distinction by using the discount window as a vehicle for bailouts.  Bernanke is concerned in part that if institutions thought their loans from the Fed became public knowledge, the institutions would think twice about taking them.  That doesn’t sound like a problem to me, I want firms to think long and hard before they seek handouts from the discount window when they are in trouble.

Some also want to give the Fed resolution authority over systematically risky institutions, an equally bad idea.  As long as the Fed maintains supervisory authority over banks or other institutions, and the power to lend to them, it should not have the power to decide when to liquidate them.  Otherwise, the decision facing the Fed will be to admit it failed as a regulator, and place the institution into receivership, or lend more to the institution and hope to vindicate its record.  Call it a regulatory reverse-moral hazard.

The Dodd Bill also seeks to strip the Fed of its supervisory powers over banks.  I am predisposed to favor regulatory competition, both horizontally among federal agencies and vertically between states and the feds.  But it is not clear to me why the Fed has a competitive advantage as supervisory regulator.  Activities not related to monetary policy, like banking supervision or-even worse- consumer protection regulation, threaten to distract the Fed from its primary mission.  Managing interest rates to tame inflation by buying and selling Treasury bonds is a herculean task, and giving the Fed too many extracirricular activities threatens the very things we like about the Fed.

When I was growing up my father told me that a man only needs three things in life: a good bartender, a good priest, and a good tailor.  I think Dad intended that different people wear those three hats, otherwise it just doesn’t work.  But wearing conflicting hats is the unfortunate mission we have given to the Fed at this point.  Some regulatory re-gearing, and an enhanced audit capability for non-monetary policy activities at the discount window, could be what we need to get the Fed on the right track.

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