Wednesday, November 11, 2009

The FED's independence at risk

The past two years the global economy has been rocked by violent turbulence with its root causes in the uncontrolled sub-prime mortgage fall out. With the concept of spreading risk via new financial instruments such as CDO (Collateralized Debt Obligations) and CDS (Credit Default swaps), many financial institutions literally created a fiscal time bomb that could not be defused. As the mortgage crisis began to unfold, the global economy was literally on the brink of collapse. With massive bailouts and heavy tax-payer funded government intervention a second great depression has been avoided or at least delayed.

Some economists partly blame Alan Greenspan and his policies as head of the Federal Reserve (FED). In fact Greenspan himself publicly admitted that the US free-market ideology that he and others have championed for decades may be flawed. Greenspan, in his testimony before the US House Committee on Oversight and Government, said he was shocked at the banks' inability to self-regulate and blamed over-eager investors for the sub-prime housing meltdown that led to the financial crisis. Obviously the low interest rates that the FED pushed during his time as the head of the institution was partly to blame for the crisis. But the FED alone is not the sole perpetrator of the near fiscal collapse. There were a number of other parties who bet their banks on financial instruments that they had no idea about.

In response to all this, Senator Christopher Dodd plans to push for a new Financial Institutions Regulatory Administration (FIRA) that in effect would strip the current FED of its role as a bank supervisor. While this proposal seems like a good move at first, what is alarming is that it gives Congress a greater voice in naming the officials who set interest rates. This is the one last place where we need political interference. This newly proposed FIRA clearly opens the door to political interference with respect to interest rates. Imagine the political uproar every time the FIRA acts on the rates and a member of the Congress does not agree with it, especially if his/her constituents would be directly affected by such a decision. The FED's ability to act independently would be at risk as they would have to pander to political pressures.

As the nation's central bank, the FED has had the unique power in the U.S. financial system to create money, giving it the ability to conduct monetary policy for the U.S. economy. That same power also enables the FED to provide liquidity to the financial system when under stress. The FED has done so and the current FED chairman Ben Bernanke has done quite well given the circumstances. However, it seems that this crisis is pushing Sen. Dodd to do the unthinkable. That is, push politicians to have the ability to influence monetary policy for the country. This should be done so only indirectly and not with such direct powers as Sen. Dodd is suggesting. That would be akin to letting loose a bunch of monkeys in a china shop.

In his comments while announcing the new FIRA proposal, Sen. Dodd said that, "The FED’s regulation of banks has been an abysmal failure,”. He blamed the FED for not preventing the practices that contributed to the financial crisis and led to taxpayer bailouts of major banks. The key question is whether the FED ever had oversight responsibility. I believe it never did. Sen. Dodd's new proposal at most is a knee jerk reaction to the crisis and must be fully evaluated before it is passed. Global investor's perception that this could be the start of political interference in policy setting could harm the already fragile dollar and the US economy. Bank oversight is a must, but not at the risk of harming the FED's independence.