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How libertarian dogma led the Fed astray

By Henry Kaufman
Published: April 27 2009 19:16 | Last updated: April 27 2009 19:16

The Federal Reserve has been hobbled by at least two major shortcomings that were primarily responsible for the
current and several previous credit crises. Its failure to spot the importance of changing financial markets and its
commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed.

The first of these shortcomings was its failure to recognize the significance for monetary policy of structural
changes in the markets, changes that surfaced early in the postwar era. The Fed failed to grasp early on the
significance of financial innovations that eased the creation of new credit. Perhaps the most far-reaching of these
was the securitisation of hard-to-trade assets. This created the illusion that credit risk could be reduced if
instruments became marketable.

Moreover, elaborate new techniques employed in securitisation (such as credit guarantees and insurance) blurred
credit risks and raised – from my perspective, many years ago – the vexing question, “Who is the real guardian of
credit?” Instead of addressing these issues, the Fed was highly supportive of securitisation.

One of the Fed’s biggest blind spots has been its failure to recognise the problems that huge financial
conglomerates would pose for financial stability – including their key role in the current debt overload. The Fed
allowed the Glass-Steagall Act to succumb without appreciating the negative consequences of allowing
investment and commercial banks to be put together. Within two decades or so, financial conglomerates have
come to utterly dominate financial markets and financial behaviour. But monetary policymakers failed to recognise
that these behemoths were honeycombed with conflicts of interest that interfered with effective credit allocation.

Nor did the Fed recognise the crucial role that the large financial conglomerates have played in changing the
public’s perception of liquidity. Traditionally, liquidity was an asset-based concept. But this shifted to the liability
side, as liquidity came to be virtually synonymous with easy borrowing. That would not have happened without the
marketing efforts of large institutions.

My second major concern about the conduct of monetary policy is the Fed’s prevailing economic libertarianism. At
the heart of this economic dogma is the belief that markets know best and that those who compete well will
prosper, while those who do not will fail.

How did this affect the Fed’s actions and behaviour? First, it explains to a large extent why the Fed did not
strongly oppose the removal of Glass-Steagall restrictions.

Second, it also helps explain why the Fed failed to recognise that abandoning Glass-Steagall created more
institutions that were “too big to fail”.

Third, it diminished the supervisory role of the Fed, especially its direct responsibility to regulate bank holding
companies. To be sure, the Fed’s supervisory responsibilities have never been very visible in the monetary policy
decision-making process. But its tilt toward an economic libertarian approach pushed supervision a notch down
just at a time when financial market complexity was on the rise. Fourth, as hands-on supervision slackened,
quantitative risk modelling became increasingly acceptable. This approach, especially quantitative modelling to
assess the safety of a financial institution, was far from adequate. But it worked hand in glove with a philosophy
that markets knew best.

Fifth, adherence to economic libertarianism inhibited the Fed from using the bully pulpit or moral suasion to
constrain market excesses. It is difficult to believe that recourse to moral suasion by a Fed chairman would be
ineffective. Such public pronouncements about financial excesses are hard to ignore, reaching the broad public as
well as market participants.

Sixth, the Fed’s increasingly libertarian philosophy underpinned its view that it could not know how to recognise a
credit bubble but knew what to do once a bubble burst. This is a philosophy plagued with fallacies. Credit bubbles
can be detected in a number of ways, such as rapid growth of credit, very high price/earnings ratios and very
narrow yield spreads between high- and low-quality debt.

By guiding monetary policy in a libertarian direction, the Fed played a central role in creating a financial
environment defined by excessive credit growth and unrestrained profit seeking. Major participants came to fear
that if they failed to embrace the new world of securitised debt, proxy debt instruments, and quantitative risk
analysis, they stood a very good chance of seeing their market shares shrink, top staff defect, and profits dwindle.

Ironically, the problem was made worse by the fact that the Fed was inconsistently libertarian. The central bank

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stuck to its hands-off approach during monetary expansion but abandoned it when constraint was necessary. And
that, in turn, projected an unpredictable and inconsistent set of rules of the game.

We should, therefore, fundamentally re-examine the role of the Fed and the supervision of our financial
institutions. Are the current arrangements within the Fed structure adequate – from its regional representation to
its compensation for chairman and governors to its terms of office for governors? How can the Fed’s decision-
making process be improved? If we were to create a new central bank from the ground up, how would it differ? At
a minimum, the Fed’s sensitivity to financial excesses must be improved.

The writer is president, Henry Kaufman & Company

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