The Libertarian Fed

FT.com print article

Page 1 of 2

COMMENT OPINION Close

How libertarian dogma led the Fed astray By Henry Kaufman Published: April 27 2009 19:16 | Last updated: April 27 2009 19:16

The Federal Reserve has been hobbled by at least two major shortcomings that were primarily responsible for the current and several previous credit crises. Its failure to spot the importance of changing financial markets and its commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed. The first of these shortcomings was its failure to recognize the significance for monetary policy of structural changes in the markets, changes that surfaced early in the postwar era. The Fed failed to grasp early on the significance of financial innovations that eased the creation of new credit. Perhaps the most far-reaching of these was the securitisation of hard-to-trade assets. This created the illusion that credit risk could be reduced if instruments became marketable. Moreover, elaborate new techniques employed in securitisation (such as credit guarantees and insurance) blurred credit risks and raised – from my perspective, many years ago – the vexing question, “Who is the real guardian of credit?” Instead of addressing these issues, the Fed was highly supportive of securitisation. One of the Fed’s biggest blind spots has been its failure to recognise the problems that huge financial conglomerates would pose for financial stability – including their key role in the current debt overload. The Fed allowed the Glass-Steagall Act to succumb without appreciating the negative consequences of allowing investment and commercial banks to be put together. Within two decades or so, financial conglomerates have come to utterly dominate financial markets and financial behaviour. But monetary policymakers failed to recognise that these behemoths were honeycombed with conflicts of interest that interfered with effective credit allocation. Nor did the Fed recognise the crucial role that the large financial conglomerates have played in changing the public’s perception of liquidity. Traditionally, liquidity was an asset-based concept. But this shifted to the liability side, as liquidity came to be virtually synonymous with easy borrowing. That would not have happened without the marketing efforts of large institutions. My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At the heart of this economic dogma is the belief that markets know best and that those who compete well will prosper, while those who do not will fail. How did this affect the Fed’s actions and behaviour? First, it explains to a large extent why the Fed did not strongly oppose the removal of Glass-Steagall restrictions. Second, it also helps explain why the Fed failed to recognise that abandoning Glass-Steagall created more institutions that were “too big to fail”. Third, it diminished the supervisory role of the Fed, especially its direct responsibility to regulate bank holding companies. To be sure, the Fed’s supervisory responsibilities have never been very visible in the monetary policy decision-making process. But its tilt toward an economic libertarian approach pushed supervision a notch down just at a time when financial market complexity was on the rise. Fourth, as hands-on supervision slackened, quantitative risk modelling became increasingly acceptable. This approach, especially quantitative modelling to assess the safety of a financial institution, was far from adequate. But it worked hand in glove with a philosophy that markets knew best. Fifth, adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to constrain market excesses. It is difficult to believe that recourse to moral suasion by a Fed chairman would be ineffective. Such public pronouncements about financial excesses are hard to ignore, reaching the broad public as well as market participants. Sixth, the Fed’s increasingly libertarian philosophy underpinned its view that it could not know how to recognise a credit bubble but knew what to do once a bubble burst. This is a philosophy plagued with fallacies. Credit bubbles can be detected in a number of ways, such as rapid growth of credit, very high price/earnings ratios and very narrow yield spreads between high- and low-quality debt. By guiding monetary policy in a libertarian direction, the Fed played a central role in creating a financial environment defined by excessive credit growth and unrestrained profit seeking. Major participants came to fear that if they failed to embrace the new world of securitised debt, proxy debt instruments, and quantitative risk analysis, they stood a very good chance of seeing their market shares shrink, top staff defect, and profits dwindle. Ironically, the problem was made worse by the fact that the Fed was inconsistently libertarian. The central bank

http://www.ft.com/cms/s/705574f2-3356-11de-8f1b-00144feabdc0,dwp_uuid=73adc504-2... 4/28/2009

FT.com print article

Page 2 of 2

stuck to its hands-off approach during monetary expansion but abandoned it when constraint was necessary. And that, in turn, projected an unpredictable and inconsistent set of rules of the game. We should, therefore, fundamentally re-examine the role of the Fed and the supervision of our financial institutions. Are the current arrangements within the Fed structure adequate – from its regional representation to its compensation for chairman and governors to its terms of office for governors? How can the Fed’s decisionmaking process be improved? If we were to create a new central bank from the ground up, how would it differ? At a minimum, the Fed’s sensitivity to financial excesses must be improved. The writer is president, Henry Kaufman & Company Copyright The Financial Times Limited 2009

"FT" and "Financial Times" are trademarks of the Financial Times. Privacy policy | Terms © Copyright The Financial Times Ltd 2009.

http://www.ft.com/cms/s/705574f2-3356-11de-8f1b-00144feabdc0,dwp_uuid=73adc504-2... 4/28/2009