Monday, April 26, 2010

Lit in review: The US Central Bank's Future

Blinder and Feldstein in the latest Journal of Economic Literature hold surprisingly similar opinions about how the Federal Reserve's powers should be amended in light of the recent financial crisis. There are important differences in how they approach the problem, but at heart their solutions seem to have a similar focus: the Fed should be granted more explicit supervisory authority over systemic risks and the largest financial institutions while smaller institutions should be regulated elsewhere. They are also unanimous in their concerns over section 13.3 - which gives the Fed power to loan to anyone with only itself for oversight and is the primary emergency powers clause used in the financial crisis - and want there to be some Treasury and Congressional oversight in how it is used. They differ on what to do about the Fed's authority for consumer protection: Blinder favors moving it to another, less-burdened institution, Feldstein favors keeping it with the experienced Fed. Their different ways of getting there are interesting and instructive.

Blinder (ungated) argues that, in order to perform the central bank's primary monetary policy functions, some parts of the bank's authority should be expanded while others could be folded into other institutions. Running monetary policy requires some regulation of systemic financial risk, and this largely involves regulation of large financial institutions whose "messy" failure could cause system financial problems (he thumbnails about 15-25 of them). Central banks have been doing this, and did it in the last/current recession, but without express permission, guidelines, or structure. Central banks are the right place for the job, he contends, because large financial institutions are well-connected politically and so their regulators should be as politically independent as possible.

This would be a large increase in Fed power. What does he want to remove? 1 - Change section 13.3 to require Treasury secretary sign-off and prompt reporting to Congress. 2 - "lose its current supervisory authority over the 800-900 small state member banks" and 3 - "its responsibilities for enforcing the many consumer protection laws" which have less to do directly with macro policy and stability.

In response to the concern that his plan would create a conflict of interest - the organization responsible for chastening imprudent banks is the one responsible for rescuing them during bad times they may have caused - he says it would be better than leaving both actions in different hands, one hand smiting them and reducing lending just as the other hand is trying to get them to increase lending. The conflict of interest would enable a single organization to internalize both demands and balance them more appropriately than two "competing" institutions.

Feldstein expresses more disapproval of section 13.3 than Blinder and appears more concerned about the $2 trillion of additional assets the Fed purchased and the $1 trillion in excess reserves it handed out only to have them "lie dormant" at the Fed, which is paying interest on them, which could cost the Fed significant sums and lead to future inflation expectations. (Sumner would probably point out that this would mean we expect to expect inflation in the future, but are not currently expecting inflation. "Hunh?" he says.) Limiting the time of section 13.3 actions would reduce some of these risks.

Feldstein faults the Fed for poor supervision of the large financial institutions. In fact, one of his opening statements avers that "the financial crisis was not due to a lack of regulation but to a failure of supervision and of policy actions more generally." While he does not advocate moving supervisory actions to a new institution - the current solution may not have worked well, but a new institutions would have difficulty doing better with a whole new staff - he would like to see the Fed reorganized to emphasize supervision of the large banks and given complete authority over them. For the smaller banks, he advocates giving authority either to the FDIC or to state authorities, but to avoid letting them be governed by both. Feldstein also states that, while coordination between different public financial institutions would be useful in identifying systemic risks, the ultimate responsibility for dealing with them should either be with the Fed or the Treasury.

Feldstein also gets into some more of the nitty gritty of how the Fed works. He wants to amend how the Fed determines if a bank has sufficient capital: give mortgages different weights depending on their quality and pay attention to off-balance-sheet assets. The Fed has the authority and power to set some credit terms, but has not used them. Primary terms could include requiring minimum, sizable down payments and limit use of "teaser" interest rates. He would like to remove from all government the ability to set compensation regulations, which banks should be able to set themselves.

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