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Thursday, April 24, 2008

Re Examining the Role of the Fed

Steve Forbes recently wrote a fascinating piece about the role of the Fed in the recent housing crisis and what lessons we should take from it. Many of the things that Forbes said I have been echoing prior to the article. He agrees with me that the Fed lowered rates far too low at the beginning of the decade and this was a precursor to problems ahead. Forbes sees the action differently than I do though...

Since World War II most countries have regarded monetary policy as a critical instrument (the other biggies being government spending and taxation) in regulating the economy. If economic activity is slowing, so the thinking has gone, the central bank should rev up the printing presses: The extra money will stimulate growth. Conversely, if the economy is growing too quickly, the central bank should tighten up on money creation, slowing things down to avoid the economy's careening off the road in the equivalent of a car wreck. The longest-serving Federal Reserve Chairman, William McChesney Martin Jr., liked to say that it was the Fed's job to take away the punch bowl just when the party really gets going.

This is a misbegotten view of what central banking's main mission should be. The Federal Reserve should have two key tasks--and only two: preserving the integrity of the dollar and dealing vigorously with financial panics to limit unnecessary damage.

While I saw Greenspan's action as an overreaction to a problem he should have been trying to solve, Forbes saw Greenspan as trying to solve something even the Fed has no control over. In Forbes' estimation trying to manage the direction of the economy is something even the "all powerful" Fed cannot do. Instead, Forbes sees the role of the Fed as much more narrow...

Greenspan's woes came about precisely because he lost sight of the Fed's prime job: ensuring a stable dollar. In the late 1990s Greenspan inadvertently tightened up. The most sensitive barometer of market mistakes is gold. During that time the yellow metal plunged to a low of $250 an ounce. Other commodities crashed, with oil dropping to nearly $10 a barrel. For a time the dollar became too dear, which contributed to the 2000--01 recession. When it became clear--just before George W. Bush was sworn in as President on Jan. 20, 2001--that the economy was skidding, Greenspan realized his mistake and started to reverse gears. But he stayed too easy, even when the economy was back on track. In 2004 gold began to surge well above its 12-year average, and oil began its long, rapid ascent, as did all other commodities. The dollar weakened not only against gold but also against other currencies, such as the yen, the Swiss franc and the pound. With money easy, the already buoyant U.S. housing market began to go berserk as lending standards started to decline precipitously.

Now, here is an idea that I must admit had never crossed my mind. In my estensive study of the Fed, I was always under the impression that monetary policy should be used to smooth out the natural movements of the economy. Forbes sees the role of the Fed as stabiliizing our currency. (clearly he sees the current chair as failing in this endeavor)

This is a concept that has some validity in my mind however I have a very grave concern. In managing the economy, the Fed's action is fairly simple. If you want to slow the economy down raise rates and vice versa. The relation between monetary policy and the currency, on the other hand, appears, to me at least, to be a lot more nebulous. Most people agree that the aggressive rate decreases have lead to contributing to a weak dollar, however I am not so sure that the relationship is quite that simple.

Still, one thing I know is that the Fed's power is understood by far too few people considering the enormous power it has. Forbes is on the right track if not exactly there is specificying a myopic view of the role of the Fed. One of the biggest fears of everyone should be the enormous new power that everyone wants to grant to an organization with far too much power already.


Chris said...

The Fed has another primary responsibility, and that is to keep inflation under control. They are currently failing in that regard. A steadily declining dollar almost guarantees inflation.

Steve Forbes would probably make a good Fed Chairman. Greenspan politicized his role beyond any comprehension and it's no surprise that we're still paying the price today. The idea that we're not supposed to have slowdowns/recessions is stupid and everytime the Fed intervenes to prevent one, the bill only gets larger. Eventually, you get to where we are now, the FR pushing on a string.

I don't blame them for intervening in the Bear Stearns meltdown. That was one move where I think Bernanke will get some credit in the future. His mimickry of Greenspan on rates is not going to earn any accoleades, however.

mike volpe said...

That is essentially the view I have. I believe that the Fed should manage the economy. That includes slowing down inflation when that is appropriate.

Clearly, Forbes disagrees with that view. All three of us agree though that the role of the Fed has been greatly expanded.

My biggest problem with the move by the Fed regarding Bear is that it was a great power grab. It has set a very dangerous precedent.

Chris said...

BSC was a one-off, I think. Yes, they bailed out the financial system but in the process, Bear paid the ultimate price so to speak. This should hopefully signal to others not to get into the precarious position of melting down and expecting a government bailout in the future.

It was a power grab to some extent. But it was probably the best of several bad choices. The alternative would have been a run on the bank(s), I think.

Should everyone have suffered? In a perfect world, yes. The problem is that main street would have done most of the bleeding had the Fed let BSC collapse, IMO.

mike volpe said...

Let's hope it was a one time thing, however this will not be the last financial crisis the U.S. will have and now the Fed has basically said that in such a case it can do pretty much whatever it wants or thinks is necessary to stop the next crisis.

I know that it is much harder to take away power than it is to give it.