If not the Fed, then what?

The New York Times’ David Leonhart has an excellent article on today’s front page exploring one of the central dilemmas concerning current efforts to reform financial regulations. On the one hand, as I alluded to on Monday, the central bank is the only authority currently existing that has the power and independence to referee economic disputes, such as what constitutes an “asset bubble,” but the trouble is that, in the past, the Fed has displayed a woeful level of competence at seeing the bubbles as they occur. Mr. Leonhart’s article is a rather more skillful exposition of what I was getting at earlier this week, namely, bubble-spotting is something the Fed should do, but I’m not at all sure it is up to the job.

One thing Mr. Leonhart neglects to consider is to what extent ideology and turf conditioned the responses of the Fed during the Noughties, whether under Alan Greenspan or Ben Bernanke. He quotes liberally from each to demonstrate how they basically missed seeing the housing bubble, and definitely, the choicest quotations are very damaging in terms of personal credibility; however, all quotations have a context. A sure way in Washington of getting whacked is in trying to expand your domain (ask Sheila Bair). Doing so brings unwanted attention, especially from legislators. So, with that in mind, it makes perfect sense for central bankers to keep their heads down…doubly so if the job description is merely to be an inflation watchdog. Why offer opinions on other bits of the economy when it strays from your regulatory domain and into someone else’s?

My point here is that you might have gotten different responses from the Fed if it was clear that (a) the central bank’s prerogative extended to things other than monetary policy, strictly defined, and (b) there was no regulatory ambiguity in terms of what each agency is in charge of. Lacking these things, there was a strong disincentive to central bankers becoming the kind of systemic-risk watchdogs that we needed.

A second point regarding the this morning’s article…Mr. Leonhart alludes to congressman Ron Paul (R-TX) as the sponsor of legislation that would reduce the Fed’s independence, or as Mr. Leonhart has it, “that would give Congress the power to review interest rates.” Mr. Paul is a unique figure in Washington, an outspoken hard-money enthusiast who has made no secret of his enmity towards the central bank. He has consistently called for more accountability from the Fed, which, by itself, is not a bad thing. Too often, the Fed’s definition of independence is tantamount to a lack of institutional accountability. The Fed should be politically independent, but it still must be held accountable for its actions. It is not – and has never been – an ivory tower of finance.

But we should be careful from whom we take counsel regarding the Fed. Mr. Paul’s intention is not to reform the Fed, but to abolish it, which is lunacy. Unfortunately, some folks find it impossible to separate the two issues at play concerning Mr. Paul. His calls for greater accountability are laudable – his ultimate policy goals are not. To the extent that his calls for reform are motivated by this deeper desire to do away with the Fed, he has the unfortunate potential to discredit the reform process. People will begin associating all calls for greater Fed accountability with the fringe who seek to abolish the bank, an outcome that would be bad for everyone. It is not inconsistent or mutually exclusive to want a stronger Federal Reserve, but one that is also more transparent in its decision-making. In fact, that’s precisely what is needed, if for no other reason, a lack of viable options.