Belmont Club

Central blanking

An 89-page document entitled Financial Regulatory Reform, authored by the Department of the Treasury, outlines the steps the administration plans to take in order to close “gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government’s ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole”. According to the document, government authority will be expanded in five areas.

The supervision and regulation of financial firms;
The comprehensive supervision of financial markets;
The protection of consumers and investors from financial abuse;
The provision to the government of additional tools “it needs to manage financial crises”; and
Raising international regulatory standards and to improve international cooperation.

By any definition this represents a large increase in the role of government over the financial markets. That is an avowed intent which its supporters believe is necessary to safeguard future growth and to prevent another recession. However, one reader of the Belmont Club thinks the proposal contains hidden dangers. The reader believes that unless we are careful, “financial regulatory reform” may lead to a loss of independence of the Federal Reserve.

From what I can see, this is a two-step gambit for a Executive and Legislative branch takeover of the Fed. The first step was taken this week: announce sweeping new reforms that significantly concentrate regulatory oversight in the Federal Reserve. Here are some of the bullet points from the Introduction section of the white paper:

• New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks.

• Elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.

• New authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

At first blush, this looks like a major coup for the Fed, as it gives them broad influence over financial markets, including hedge funds and non-financial firms that have significant financial operations (e.g. GE). But the white paper also contains the following statements:

• A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation. To help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities, this Council would include the heads of the principal federal financial regulators and would maintain a permanent staff at Treasury. [Note that this oversight extends to the Fed.]

• Revisions to the Federal Reserve’s emergency lending authority to improve accountability. In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its “unusual and exigent circumstances” authority.

These put the Fed more under the control of the President, as he appoints most members of the FSOC (actually all of them, except for the Fed Chairman), and the Secretary of the Treasury. But the big one is this:

The Federal Reserve, in consultation with Treasury and external experts, should propose recommendations by October 1, 2009 to better align its structure and governance with its authorities and responsibilities.

[The report goes on to say]

This report proposes a number of major changes to the formal powers and duties of the Federal Reserve System, including the addition of several new financial stability responsibilities and a reduction in its consumer protection role. These proposals would put into effect the biggest changes to the Federal Reserve’s authority in decades. For that reason, we propose a comprehensive review of the ways in which the structure and governance of the Federal Reserve System affect its ability to accomplish its existing and proposed functions. This review should include, among other things, the governance of the Federal Reserve Banks and the role of Reserve Bank boards in supervision and regulation. This review should be led by the Federal Reserve Board, but to promote a diversity of views within and without government, Treasury and a wide range of external experts should have substantial input into the review and resulting report. Once the report is issued, Treasury will consider the recommendations in the report and will propose any changes to the governance and structure of the Federal Reserve that are appropriate to improve its accountability and its capacity to achieve its statutory responsibilities.

Translation: the Treasury Department will propose changes to the governance structure of the Fed toward the end of 2009. This means that at a time when unemployment is likely in double-digits and the financial markets have stabilized, the Obama Administration will propose a change to the governance of the Fed. This is the second step of the gambit.

At this point, there will be strong pressure inflationary pressure, as the economy has found a bottom and demand for capital starts to rise. So the Fed, if it is to maintain its commitment to a stable money supply, will need to increase interest rates. The President and Congress will not want this to happen, as rising interest rates will mean a slower recovery and therefore slower job growth. This will be the perfect opportunity for the Administration to force a change in the way that regional Federal Reserve Bank Presidents (the core of the Fed’s governance) are chosen. My guess at the change: the President nominates Fed Bank Presidents, and Congress must approve. This will give the Executive and Legislative branches effective control over monetary policy.

So the gambit can be summarized thusly: I’m going to give you a lot more authority, but because you have all this authority I must control you.

If this were to occur, the dollar would collapse as foreign lenders (primarily other countries) sell dollars and buy other stuff (probably IMF SDRs [Special Drawing Rights]). You see, right now the Fed is the most trusted monetary entity in the world because its policy is basically set by professionals who are not controlled by politicians. This means that the FOMC can make decisions without requiring Congressional hearings or Presidential consent. The OODA loop is therefore tight, and the folks responsible are dedicated to maintaining monetary stability.

But if the dollar collapses, there would be a rapid rise in inflation, as commodity prices increase, and we’d enter a new period of stagflation. This would increase calls for fiscal stimulus to “put people back to work,” and it would make repayment of our massive deficits easier to pull off. Washington’s power over the economy would dramatically increase, and a lot of damage would be done.

The showdown is coming. I pray that our nation has the foresight to resist this power grab.

This is one interpretation of the possible outcomes inherent in “financial regulatory reform”. The reader’s main fear, as I see it, is the possibility that ‘financial regulatory reform’ will lock the Fed into the political goals of the administration. Thenceforth, the two will then be joined at the hip and the Fed will become a creature of the politicians. There has been a disturbing trend of late, highlighted by the firing of Inspectors General, to simultaneously concentrate power and reduce independent oversight. That is a dangerous combination of developments. And while not everyone may agree that an emasculation of the Fed is in the works, it is an issue that is important enough to merit a wide public policy debate. I hope the reader’s article can in some way, start the ball rolling.

Open thread.


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