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Geithner is wrong -- Expanding Fed's regulatory role would compromise core monetary function

The business media is abuzz about a speech and Financial Times op-ed today by Federal Reserve Bank of New York President Tim Geithner calling for more power for the Fed to regulate to prevent financial crises. What a news flash! A bureaucrat calls for more power for his own agency. The real man-bites-dog story would be a regulator calling for limiting his agency's power (which has, believe it or not, occasionaly happened. Civil Aerounatics Board head Alfred Kahn ushering airline deregulation under the Carter presidency is one excellent, but all-too-rare, example.)

Some background. Geithner was the Fed official most responsible for putting together the deal to sell Bear Stearns to JP Morgan Chase and bail out Bear Stearns' creditors. Syndicated columnist Robert Novak called Geithner the "initiator" of the bailout, and wrote wrote a very disturbing account of how Geithner -- a former Clinton administration Treasury appointee who is not an economist -- crafted the plan that the Bush administration basically just rubber-stamped. As Novak described it, "The Federal Reserve's unprecedented bailout of Bear Stearns was crafted not at the White House or Treasury, but in secret by a New York central banker."

Now Geithner uses the bailout he rammed through to argue that the Fed's role has changed, and now that it has assumed the responsibility for bailing out investment banks, it needs to add regulations as well. Geithner says: "We have to increase the shock absorbers held in normal times against bad macroeconomic and financial outcomes. This will require more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning."

Among other things, Geithner calls for "higher levels of margin and collateral in normal times against derivatives and secured borrowing to cover better the risk of market illiquidity." And he concludes that "the Federal Reserve should play a central role in such a framework."

Geithner's statements parallel the regulatory "Blueprint" released by the Treasury Department two months ago. The report and Treasury Secretary Hank Paulson call for the Fed to broaden its role and become the nation's "market stability regulator."

Geithner echoes this when he says, "At present the Fed has broad responsibility for financial stability not matched by direct authority and the consequences of the actions we have taken in this crisis make it more important that we close that gap." Never mind that the Fed, through Geithner, thrust this "responsibility" upon itself.

The problem with this expansion of power is several-fold. First, what exactly Fed supervision of investment houses would add it unclear. Contrary to assertions that Wall Street operated completely free of regulation, the Securities and Exchange Commission and Commodity Futures Trading Commission have long imposed margin and capital requirements on broker-dealers and other non-bank financial institutions. These agencies would be the logical ones to put through any changes that were needed.

Second, as Eli Lehrer and I argued in the CEI paper critiquing the Treasury "Blueprint," the Fed assuming authority for "market stability" would likely compromise its core function of monetary stability. Almost by necessity, the Fed's more direct role in supervising the economy would force it to become less independent and more subject to political demand. This could increase pressure to make less prudent decisions on its basic priorities such as dollar policy and interest rates.

Indeed, it is striking that when Geithner discusses the factors that led to the subprime mess, he leaves out any discussion of the Fed's own role in the crisis through its monetary policy. At the beginning of the op-ed, he declares: "The world experienced a financial boom. The boom fed demand for risk." But the Fed's policy of pushing low interest rates had more than a little to do with this "boom" and "demand for risk." See Gerald O'Driscoll's excellent Cato Institute paper on the Fed's role in creating the real estate bubble.