Politicizing the Fed?

Wednesday, November 11, 2009

SENATE BANKING Committee Chairman Christopher J. Dodd (D-Conn.) insists the ambitious draft financial regulation bill that he unveiled Tuesday is not about Fed-bashing. Yes, it would transfer the Fed's consumer protection functions to a new agency. And true, whereas House Financial Services Committee Chairman Barney Frank (D-Mass.) would put the Fed in charge of "systemically important" financial firms, Mr. Dodd would create a board on which the Fed is merely represented. But the goal, Mr. Dodd says, is to enhance Fed independence by allowing it "to get back to its core enterprise."

He has a point. The key to a central bank's power is credibility, which in turn hinges on the perception and reality that it is focused on setting interest rates and not doing the short-term bidding of politicians. Under Paul A. Volcker, the Fed broke the back of inflation in the 1980s through sustained high interest rates. This put the country in recession and made the Fed unpopular. It could withstand the pressure because it was so clearly acting within its core technical and legal competencies. A lesson of the current crisis, by contrast, is that mission creep is not good for political independence. The more the Fed becomes enmeshed in lending to particular companies or regulating particular industries, the more it opens itself up to criticism and lobbying. This is true regardless of whether the Fed's decisions are necessary and proper, as they have been in this emergency.

In that sense, it might be a good idea to assign the Fed's regulatory responsibilities elsewhere as Mr. Dodd proposes. In other respects, however, Mr. Dodd's bill seems to increase the Fed's politicization. For example, he would subject to Senate confirmation the presidents of the regional Federal Reserve Banks, who have rotating seats on the committee that sets monetary policy. (Currently, the board of each regional bank chooses its president.) He would require the Fed to set up a public comment process on potential regional bank directors, so as "to ensure the interests of agriculture, commerce, industry, services, labor and consumers are adequately represented."

The draft bill would also narrow the Fed's powers to make loans in a crisis and subject any loans it did make to detailed oversight by Congress. This is intended, apparently, to address situations such as the Fed's bailout of AIG. The action was deeply unpopular, because AIG had so irresponsibly built itself into an institution whose collapse the world economy might not withstand. On the other hand, for that very reason the bailout was probably necessary -- and only the Fed, with its broad authorities and capacity for fast action, was in a position to do the deed. The wisdom of limiting the Fed's "lender of last resort" powers depends largely on the efficacy of the alternative resolution authority that Congress and the administration are developing to deal with "too big to fail" institutions. If it is capable of acting as swiftly and comprehensively as the Fed did in the past year, with full accountability to the political branches, well and good. If not, then this cure could prove worse than the disease.


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