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Reshaping the Fed

(Epicharmus)

Regardless of one’s opinion on Ben Bernanke, there is no denying the extraordinary impact he has had on the Federal Reserve since taking over as Chairman in 2006. A case can be made that the very nature and scope of the Fed has changed under Bernanke’s stewardship. Originally envisioned as a politically neutral institution meant to contain systemic risks and head off banking panics, the Federal Reserve has taken a considerably more “hands-on” role in the economy of late. It began in March 2008 with the fire sale of Bear Stearns to J.P. Morgan Chase – a maneuver largely engineered by Bernanke in conjunction with then-Treasury Secretary Hank Paulson. The Fed’s response to the recession continued with a $182 billion rescue of troubled financial services firm AIG, characterized by the Huffington Post as a, “…backdoor bailout” due to a lack of transparency about its execution. Wikipedia also reveals troubling testimony from Kentucky Senator Jim Bunning, who, “…said on CNBC that he had seen documents which show Bernanke overruled recommendations from his staff in bailing out AIG.” Even more significant than how AIG’s bailout was executed, however, is the pretext it created for future bailouts and government takeovers – including the TAARP program. Furthermore, the Fed’s initial responses to the recession were hardly the last of its politically consequential changes. By August, Bloomberg observed that Chairman Bernanke had, “…led the biggest expansion of the central bank’s power in its 95-year history.”

In a relatively short period of time, the Federal Reserve has morphed from a supposedly independent entity to one which actively takes sides in shaping economic outcomes of particular firms and industries. It has become, more than ever before, a political institution. Below, we’ll examine how the 2,100 employee Federal Reserve has changed since Bernanke took office, what’s ahead, and what it means for the American people.

More Political Power

(cliff1066™)

As alluded earlier, the political power of the Federal Reserve has increased substantially during Bernanke’s tenure at the helm. It began in earnest at the outset of the fall 2008 financial meltdown, when Bernanke took a lead role in the government’s bailouts of Bear Stearns and AIG. As a longtime scholar of the Great Depression, Bernanke was well aware of the systemic risks posed by the failure of such integral financial institutions. However, much suspicion has arisen regarding the clandestine exercise of its power. Bloomberg News reporters had to file a Freedom of Information Act request in summer 2009 after the Fed, “…refused to name the financial firms it lent to or disclose the amounts or the assets put up as collateral under 11 programs” instituted to ameliorate the financial crisis. While the Federal Reserve argued that revealing the recipients would harm their competitive positions, Manhattan Chief U.S. District Judge Loretta Preska ruled instead that the Fed had, “…improperly withheld agency records” and ordered it to overturn hundreds of pages of reports requested by Bloomberg. Among the facts that came to light around the time of this ruling were how “…The Fed’s balance sheet about doubled after lending standards were relaxed” following the collapse of Lehman Brothers. This marked a quiet but foundational change in the scope of the Fed’s activities. Prior to 2009, the Federal Reserve was not permitted to purchase non-government securities or to hold them as assets. However, during Bernanke’s aggressive new campaign to relieve banks of toxic assets, “…Fed assets rose 2.3 percent to $2.06 trillion” by the week ending August 19, 2009 – an increase up made almost entirely of private, mortgage-backed securities. Regardless of the merits or demerits of the Fed owning these particular securities, what matters from an institutional standpoint is that the Fed can now own private securities – a major departure from long-standing precedent.

Nor was purchasing non-government securities the only power Bernanke sought to bestow upon the Federal Reserve. In March 2009, Brady Dennis of the Washington Post reported that Bernanke had ,”…pressured Congress to give the federal government unprecedented new power” to take over distressed financial firms deemed to be essential to the overall financial system. Citing the, “…1930s-style global financial and economic meltdown, with catastrophic implications for production, income and jobs” that could have followed a failed AIG, Bernanke argued passionately for permitting the federal government to seize insurers and financial services firms, “…the way that the Federal Deposit Insurance Corp. can take over banks.” The Los Angeles Times likewise spoke of, “…the increased power of the complex and mysterious Fed” in October 2009. Despite, “…more than two-thirds of the House of Representatives” lending their legislative support to, “…a bill that would subject the central bank to increased congressional oversight through expanded audits”, Bernanke was intransigent in defending the, “…major new role” he and the Obama Administration had in mind for the Fed – specifically, “…supervising large financial institutions that pose a risk to the entire economy.” Such a role means the Fed would cease being merely an entity concerned with setting interest rates and become, essentially, an all-purpose financial regulatory agency.

That said, politicians from both ends of the political spectrum have begun mobilizing against the greater concentration of power in Federal Reserve hands. In addition to the aforementioned House bill, the LA Times notes that, “…a key senator” was pushing to …”strip the Fed of its authority to regulate banks” due to its lax oversight in the years and months leading up to the meltdown. Jaret Seiberg, a financial policy analyst with Concept Capital’s Washington Research Group, also opined that the Fed was encountering “…unprecedented opposition on Capitol Hill” in its quest for greater regulatory powers. What the Fed does have is the unwavering support of President Obama, who recently granted Bernanke a second term as Chairman.

Enhancing Moral Hazard

(danperry.com)

One of the foundational purposes of the Federal Reserve was promoting overall financial stability. However, a growing strain of opinion holds that the Fed (under Bernanke’s leadership) has actually increased the likelihood of moral hazard and financial irresponsibility. As far back as October 2008, SeekingAlpha.com published a reader e-mail about the lack of a bailout for Lehman Brothers – a decision Bernanke was instrumental in making. The e-mail pointed out that, “…a lack of a Lehman bailout only reduces moral hazard if investors think it is a preview of future actions.” But because the non-bailout was roundly questioned and considered a mistake, it actually, “…makes a bailout for the next major financial institution more likely.” In other words, because most analysts and experts outside of the Federal Reserve and Treasury Department believed bailing out Lehman was necessary to avert systemic failure, the decision not to do so actually made moral hazard more likely. Sure enough, SeekingAlpha notes, “…no further failures could be allowed” after Lehman went under, and, “…indeed, one of the main functions of the TARP bill was to make government bailouts much easier.”

The non-bailout of Lehman Brothers was not the only way in which the Federal Reserve enhanced the risks of moral hazard. In January 2010, ZeroHedge.com revealed that Goldman Sachs was actually willing to, “…tear up AIG’s derivative contracts”, and essentially, “…take a haircut” on the losses incurred by doing so. Had this been done, the need for a federal bailout of AIG would have been greatly diminished, if not completely eliminated. As ZeroHedge astutely observes, the Federal Reserve Bank of New York ,”…not only did not save US taxpayers’ money, but in fact ended up costing money” because they, “…funded the marginal difference between par and whatever discount would have been applicable to the contract tear down” that Goldman Sachs proposed a month prior. Admittedly, the full details of this story have yet to emerge, as have the long-term consequences of the various bailouts and non-bailouts. What is known currently is that Ben Bernanke, in his role as Fed Chairman, put the central bank in a position to actually enhance the very risks of moral hazard that it is institutionally mandated to discourage.

The Future

It remains to be seen whether the Federal Reserve will actually get all of the new regulatory power that Chairman Bernanke and President Obama are seeking. Even more uncertain is whether an avowedly independent entity can carry out its duties while also meting out regulatory discipline. Project Syndicate opines that, “…only with great difficulty” is it possible to, “…maintain a rigorously independent chairman when it comes to interest rates” (the historical role of the Fed), “…and a tightly accountable chairman when he is making regulatory decisions” (the new role desired by Bernanke and Obama.) Ironically, it is feasible that the continued expansion of Federal Reserve power could actually create new risks, aside from the risks that prompted the expansion in the first place. This being the case, Project Syndicate continues, President Obama, “…should not draw the conclusion that arguments about the Fed’s accountability have gone away with Bernanke’s confirmation.” Congressman Ron Paul, for instance, has repeatedly agitated for a full audit of the Fed’s activities – opposed by Bernanke on the grounds that it would be, “…highly destructive to the stability of the financial system, the dollar and our national economic situation.” Regardless, as the Federal Reserve grows in size and scope, the eyes of citizens and lawmakers will remain increasingly fixed on its activities.