Book Review: The Road Ahead for the Fed

by: John M. Mason

The Road Ahead For The Fed, edited by John D. Ciorciari and John B. Taylor (Hoover Institute Press, July 2009) is an important book, not only for the history and analysis of recent events contained in it, but because of the “provocative proposals” that are presented. Three of the articles in the book are each, in themselves, worth the price of the book: the articles by Allan Meltzer, a historian of the Fed; Myron Scholes of Black/Scholes fame; and Nobel prize winner, and co-editor John Taylor, of the Taylor Rule. This review cannot even come close to revealing the richness of all the papers that are included in the volume.

The book is the result of a workshop on “The Future of Central Banking” hosted by the Global Markets Working Group at the Hoover Institute on March 30, 2009 so it is quite timely. Although there are participants at the workshop that represent different points of view, the balance of thought tends to be toward the side of the spectrum occupied by the Hoover Institute. No surprise here.

I will concentrate on two of the big themes that run throughout this book rather than on specific articles. The first has to do with the role of the Federal Reserve in the economy in good times and bad. The second relates to the role and impact of regulation on the financial sector. In terms of the present crisis, the general view of most of the authors is that the performance of the Federal Reserve and the government has fallen far short of adequate.

With respect to the role of the Federal Reserve, Allan Meltzer argues that the Fed had, and has, no strategy for the conduct of monetary policy and had, and has, no strategy for carrying out its role as the Lender of Last Resort. As a consequence, no one — bankers, market participants, or even policymakers themselves — has any idea of how they should react in any given situation. In essence, policymaking is arbitrary, or, in other words, is solely at the discretion of the policymakers.

Two instances of this arbitrariness are given by Meltzer. In terms of discretionary monetary policy, the example given is the period of the excessively loose monetary policy followed by the Fed in the 2002-2005 period. The reason given for this action was a fear, on the part of Chairman Greenspan, and supported by Ben Bernanke, that the country faced risk of deflation. Meltzer argues that “Deflation is very unlikely to occur in a country with a relatively large budget deficit, a long-term depreciating currency, and positive money growth.” (Are you listening, Mr. Bernanke?) There was no rule or other guidance to provide direction for monetary policy other than the belief of Mr. Greenspan. Discretion ruled the day!

The second instance has to do with the Fed’s role as the Lender of Last Resort. Meltzer argues that the Federal Reserve currently has no strategy for how this role should be executed. As a consequence, when faced with the very real threat of a liquidity crisis in December 2007 the Federal Reserve abandoned “classical” central bank procedures and innovated. Instead, the Federal Reserve created something called the Term Auction Facility (TAF) to supply the market with the liquidity it needed. John Taylor, in his article, cites his research that shows that “the Term Auction Facility had no noticeable impact on interest rate spreads.” And, consequently, TAF did little or nothing extra to help resolve the liquidity crisis. All that is left is ambiguity with respect to the Fed’s actions.

These two examples deal with getting into the crisis. Taylor’s article, “The Need for a Clear and Credible Exit Strategy”, deals with getting out of the crisis. This subject is very timely, especially given the testimony presented to Congress by Mr. Bernanke last week. What Mr. Bernanke did was confirm the criticism raised by Taylor, that there are no guidelines, no rules, no exit strategy for reversing recent Federal Reserve policy. The Fed really can’t articulate how it will respond in the recovery.

Mr. Bernanke was an exceptional academic. He served in several different roles in the government including a previous term at the Fed in 2002-2005. He held such positions as Chair of the Economics Department at Princeton and Chairman of the President’s Council of Economic Advisors before he took on the second most important position in the United States government. His research specialty was the history of the Great Depression. The lesson he learned from his research on the Great Depression was that in a period of financial and economic crisis, the government needed to act in a big way and not err on the side of doing too little. It is obvious from most of the papers in this collection that Mr. Bernanke had no other policy guidelines going into the financial crisis (see my post relating to Bernanke and the bailout plan) and he has no policy guidelines about how to get the country out of what the Federal Reserve and the government has done. ‘Nuff said!

The second big theme in the workshop papers has to do with regulation. No author claims that there should not be regulation and oversight of the financial system. However, they give several examples of how regulation can exacerbate a crisis. For one, to quote Meltzer, “experience shows that lawyers and bureaucrats choose regulations, but markets circumvent costly regulations.” Regulations should align incentives bringing the interests of the regulated together with the outcomes that are socially desirable.

Several authors deal with this issue; especially see the articles by Myron Scholes and Darrell Duffie. Scholes gives examples of how regulation has proved to be counterproductive and argues, for one, that more risks need to be moved to (regulated) markets rather than being dealt with by trying to regulate market makers in the over-the-counter market. Duffie proposes regulations that deal with processes rather than outcomes because the latter kind of regulation creates costs that result in attempts by market participants to get around those regulations.

The excellent article by Dick Herring provides some figures that say a whole lot about the state of regulation in the United States. First, “many of the systemically important institutions have taken great pains to avoid being classified and regulated as banks.” Second, “many of the largest banks that have experienced solvency problems have booked 20% to 40% of their assets in their Bank Holding Companies, which are not subject to the FDIC’s authority and must be taken through bankruptcy court.” Third, “many of these institutions have acquired hundreds of foreign subsidiaries that would necessarily be dealt with under local resolution procedures which are often very different than those employed in the United States.” And, finally,

On average…16 Large Complex Financial Institutions (LCFI) have nearly 2.5 times as many majority-owned subsidiaries as the 16 largest non-financial firms. Much of the difference is surely a result of attempts to avoid costly taxes and regulations.

These are major points that Congress, in their rush to create a new regulatory environment, need to consider. It also raises the issue that the financial crisis may not have reached the proportions it did because of a lack of regulations but because some of the regulations that existed contained the wrong incentives, incentives that ended up hurting the system rather than helping it.

In short, I think you will be well rewarded if you acquire this book and dig deeply into it. There is much food for thought in this volume, whether or not you agree with some of what is contained within it.