The Fed's Moral Hazard
The Washington Post reports Thursday morning ("Paulson to Urge New Fed Powers," p. D01) on Treasury Secretary Paulson's call for expanded regulatory role for the Fed of the financial industry. Some excerpts:
"We should quickly consider how to appropriately give the Fed the authority to access necessary information from highly complex financial institutions and the responsibility to intervene in order to protect the system," Paulson plans to say, "so they can carry out the role our nation has come to expect." [...]
Paulson's argument, which is shared by leaders of the Fed, is that even when the emergency Fed lending program for investment banks goes away -- it is scheduled to expire in September, though the central bank could choose to extend it -- financial players will assume they would be bailed out again in a crisis. That means they may be more willing to take risks that could threaten the financial system and thus require greater policing.
"We must limit the perception that some institutions are either too big to fail or too interconnected to fail," Paulson is to say. "If we are to do that credibly, we must address the reality that some are."
In truth, Paulson is recommending the Fed be allowed to intervene to minimize the effects of bad congressional regulation, as well as its own, of the financial sector. To buy such an argument, one must assume that market failure, and not doubling the MZM money supply in relatively short time periods, is the true cause of systemic risk in the economy.
Comments (12)
Chris, thanks for reporting this.
Paulson's logic is truly perverse: because he fears that the Fed's initial intervention will increase systemic risks by encouraging moral hazard among investment banks, the best way to remove the moral hazard is to give the Fed authority to monitor investment banks and to intervene again?
Surely he can see that the guaranteed effect is just the opposite - to increase the moral hazard problem, and to shift risk from private actors to taxpayers, while increasing the power of the Fed and Treasury.
Published: June 19, 2008 6:14 AM
Excellent article. This is just further evidence of our slow slide into fascism. Each new regulatory scheme require another to fix the problems created by the first until the state micromanages every aspect of the economy. Even though people hold a piece of paper that gives them the rights to property, the state controls every aspect of it. Mises called this German socialism as opposed to Soviet socialism. So who thinks the US is stil a capitalist nation?
Published: June 19, 2008 7:00 AM
Westly writes: To buy such an argument, one must assume that market failure...is the true cause of systemic risk in the economy.
No, to buy such an argument one must suspend belief in the truth.
Published: June 19, 2008 12:15 PM
In addition to the Fed's loose monetary policy, Paulsen should look at Fannie May's contribution to the mess. FM is a state agency. It creates a secondary market for mortgages with state money. The secondary market in mortgages paid banks well for generating mortgages and took the risk of poor credit away from banks, so banks could make huge fees without taking any of the risk. Then people like Paulsen wonder why banks and mortgage companies didn't care about the credit risks of borrowers.
Published: June 19, 2008 12:40 PM
The Secretary speaks as if this is risky for the regulators? The Federal Reserve loves this stupid idea. Then they get complete control of the entire financial system.
What is amazing is that so called "Economists" believe that the current regulations are not complicated enough and that greed requires that they enact even more complicated ones to dull the unintended consequences of the previous ones.
Published: June 19, 2008 2:12 PM
Chris wrote
In truth, Paulson is recommending the Fed be allowed to intervene to minimize the effects of bad congressional regulation, as well as its own, of the financial sector. To buy such an argument, one must assume that market failure, and not doubling the MZM money supply in relatively short time periods, is the true cause of systemic risk in the economy.
It seems we have an even stronger argument
Either:
a) The Fed is incompetent and that the financial crisis caused by its policies, from the Fed's point of view,was unforseable or attributable to other agents.
or
b)The Fed knew exactly what it was doing and deliberately, or indifferently, implemented policies that caused the crisis.
In either case, why would we want to give the Fed increased powers?
Published: June 19, 2008 3:09 PM
i'm still confused about what happens when the loans that the fed has made, using compromised paper, have to be repaid. the banks have dodged a bullet for the time being, but unless the loans are rolled over forever, surely the the crap paper will eventually return to the banks, devastating their balance sheets. or am i missing something?
Published: June 19, 2008 10:03 PM
should read "...using compromised paper as collateral...
Published: June 19, 2008 10:09 PM
This is so wrong that I wrote an entire blog piece titled "KEEP THE FED AWAY FROM BROKERAGES: IS PAULSON'S PROPOSAL IS BAD FOR AMERICA?" which is posted at http://www.onecitizenspeaking.com/2008/06/keep-the-fed-aw.html. I was wondering if anyone else shared my apprehension of this Administration end-run around Congress to insure that the TSLF funds keep flowing to the large brokerages past the Fed's announced September cut-off date and regardless of who wins the White House. I think this is another gambit in the bailout of the large institutional brokers who have tons of residual toxic paper on their books.
Published: June 20, 2008 3:18 AM
Newson: "...what happens when the loans that the fed has made, using compromised paper, have to be repaid"
I think you understand it correctly. It seem to be a short term cosmetic fix. I think Bernanke is hoping no one else notices and the problem fixes itself, then he can quit rolling over the debt. Otherwise he has accomplished nothing.
Published: June 20, 2008 6:40 AM
I don't think Paulson is being unreasonable.
We have a system in which the banks can create as much money as they can loan out, with few restrictions. They learnt how to evade the reserve limit years ago. Only the Basel requirements constrain them now.
The relationship between the Fed and the banks has moved strongly in the banks' favor. If the Fed fails to do what the banks expect, then it risks monetary collapse under our unstable monetary system.
The banks control MZM, not the Fed. The Fed answers to M0, the monetary base, and that has increased by only 5% (total) since early 2006. Over the same period, MZM has increased by over 25%.
fundamentalist is right. Once you start rewarding recklessness, you have to impose tighter and tighter regulations to micro-manage people's behaviour. It's just so typical of modern society.
Of course the best fix is to smash the banking cartel by subjecting banks to the same liquidity laws as all other companies. But, failing that, the cartel should at least be made less dysfunctional.
Newson asks:
what happens when the loans that the fed has made, using compromised paper, have to be repaid
First, the paper would not have been accepted without a haircut - though how severe a haircut has not been disclosed. Second, Bernanke believes that the problem is not solvency but a temporary lack of liquidity. Once the liquidity crisis is over, the theory goes, the paper will again be tradeable at something close to its book value, and the balance sheet of the bank will be unaffected.
Whether Bernanke can ultimately restore liquidity while throttling M0 remains to be seen.
Published: June 20, 2008 8:13 AM
Walt D. wrote:
"b)The Fed knew exactly what it was doing and deliberately, or indifferently, implemented policies that caused the crisis."
Correcto-mundo. This is the modus operandi of the Fed (which is controlled by the banking cartel):
1) Encourage cheap,cheap credit by lowering the discount rate to 1% for 2 years (Greenspan).
2) Wait until the high-risk paper begins to go bad (Wall Streets' CDO's and SIV's).
3) Rush in to bail out the holders of the bad paper.
4) Then claim it must have more power to "prevent" this from happening again.
5) Instruct the syncophant Paulson to parrot the "solution".
fusgerm wrote:
"Of course the best fix is to smash the banking cartel by subjecting banks to the same liquidity laws as all other companies. But, failing that, the cartel should at least be made less dysfunctional."
Congress could pass the necessary liquidity laws, but they haven't shown the slightest interest in reigning in the Fed and Big Banks in the last 95 years. Furthermore, how do you make the cartel "less dysfunctional"? Same problem as trying to make a mother-to-be "less pregnant".
The only real solution is to get rid of the Fed, and return control of issuing currency (other than coins, which the Treasury now controls) to the government.
Published: June 21, 2008 1:57 AM