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- Economist.com | WASHINGTON
- Monetary policy
When deregulation began nearly thirty years ago, some leading Fed governors, including [Paul] Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer."
....The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets....In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.
The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly.
Not long ago, in the pages of the Wall Street Journal, Alan Greenspan wrote along similar lines. After suggesting that it was the global savings glut which depressed long-term mortgage rates that caused the housing bubble (and not the Fed) he said:
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
The solution is improvements in regulatory practice, according to Mr Greenspan. But both Mr Greenspan and Mr Greider seem to be of the opinion that the Fed was powerless in this respect. Earlier this week, my colleague disagreed with this assessment:
There was, of course, an alternative between letting the bubble inflate and inviting recession. Had Mr Greenspan and his colleagues concluded housing prices were too high and there was value in taming them, they could have used regulatory tools instead of monetary policy. They could have insisted on a margin requirement for home purchases—no one could put down less than 20% unless they obtained mortgage insurance. (At the peak of the bubble, the widespread use of second liens made 100% loan-to-value mortgages without insurance commonplace.) This would have been politically difficult since it would have deprived lots of people the opportunity to own a home, in violation of America’s credo. It would have also contradicted Mr Greenspan’s own deregulatory impulses. He resisted raising margin requirements on stocks in the 1990s in part out of a conviction that only small investors would be affected; big sophisticated players would find a way around them.
Mr Greider recommends that the regulatory system be widened to include the shadow banking system, but the shadow banking system arose in order to skirt regulatory limits—to lever up more effectively. Mr Greenspan also wants us to put in place a regulatory system which, "will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy", but it's difficult to imagine what such a perfect system might look like. Financial players live to get around the rules and increase leverage. Given enough time, financial tools will develop to accomplish this goal.
Assuming we're comfortable with an independent and powerful Fed, I think the necessary changes are much more modest. The Federal Reserve has explicit policy goals—price stability, low unemployment. It's a safe bet that a president wouldn't nominate someone for the position of Fed chairman who believed the Fed shouldn't interfere in the economy to achieve those goals. And yet, multiple presidents had no problem nominating an Ayn Rand acolyte with a visceral distaste for regulatory interference to the chairmanship.
Regulations ought to be flexible; as Mr Greider rightly notes, the capital requirements necessary amid a boom are quite different from those necessary during a crisis. The Fed should be charged with limiting financial leverage and systemic risk, and should have some flexibility in achieving these goals (as it has flexibility in tweaking the economy's money supply). Then we won't have non-interventionists in an explicitly interventionist position, and Fed chairmen won't have the luxury of shrugging off dangerous imbalances as someone else's problem."Me: