Should We Give the Fed More Power ... Or Less?

Congress is suggesting that the Fed be given more powers, making it the chief risk regulator of the entire banking system.

Specifically, as summarized by Huffington Post, a new bill introduced by Democrats in Congress "gives the Federal Reserve the power to determine which firms are actually 'too big to fail' and pose systemic risk to the financial system."

Given the Fed's history (as discussed below), that is like appointing the head of the Medellin drug cartel as drug tzar.

High-Level Fed Officials Speak Out

High-level officials of the Fed itself have criticized the Fed's actions. For example, the head of the Federal Reserve bank of San Francisco - during a talk on how runaway bubbles can lead to depressions - admitted:

Fed monetary policy may also have contributed to the U.S. credit boom and the associated house price bubble ...

Fed Vice Chairman Donald Kohn conceded that the government's actions "will reduce [companies'] incentive to be careful in the future." In other words, he's admitting that the government's actions will encourage financial companies to make even riskier gambles in the future.

Kansas City Fed President and veteran Fed official Thomas Hoenig said:

Too big has failed....

The sequence of [the government's] actions, unfortunately, has added to market uncertainty. Investors are understandably watching to see which institutions will receive public money and survive as wards of the state...

Any financial crisis leaves a stream of losses among the various participants, and these losses must ultimately be borne by someone. To start the resolution process, management responsible for the problems must be replaced and the losses identified and taken. Until these actions are taken, there is little chance to restore market confidence and get credit markets flowing. It is not a question of avoiding these losses, but one of how soon we will take them and get on to the process of recovery....

Many of the [government's current policy revolves around the idea of] "too big to fail" .... History, however, may show us a different experience. When examining previous financial crises, both in other countries as well as the United States, large institutions have been allowed to fail. Banking authorities have been successful in placing new and more responsible managers and directions in charge and then reprivatizing them. There is also evidence suggesting that countries that have tried to avoid taking such steps have been much slower to recover, and the ultimate cost to taxpayers has been larger...

Plosser urged the Fed to "proceed with caution" with the new policy. Others outside the Fed are much more strident and want plans in place immediately to reverse it. They believe an inflation storm is already in train.***

Bernanke argued that focusing on the size of the balance sheet misses the point, arguing the Fed's various asset purchase programs are not easily summarized in a single number.

But Plosser said that the growth of the Fed's balance sheet was a key metric.

"It is not appropriate to ignore quantitative metrics in this new policy environment," Plosser said.***

Plosser is bringing the spotlight right back to the Fed's balance sheet.

"The size of the balance sheet does offer a possible nominal anchor for monitoring the volume of our liquidity provisions," Plosser said.

"Every time you tinker with this delicate system even small changes can create big ripples,'' said Dino Kos, former head of the New York Fed's open-market operations . . . "This is the impossible situation they are in. The risks are that the government's $700 billion purchase of assets disturbs markets even more.''

Poole said he was very concerned that the Fed could simply lend money to anyone, without constraint.

In the Soviet Union and Eastern Europe during the Cold War era, economies were inefficient because they had a soft-budget constraint. If a firm got into trouble, the banking system would give them more money, Poole said.

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