Questions for Bernanke

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable (bio here). He may be reached at Bob.Eisenbeis -at-

November 30, 2009

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at He may be reached at

In an unusual communication on Sunday in the Washington Post, Fed Chairman Bernanke drove a stake in the ground to his inquisitors in advance of his confirmation hearing latter this week. He wrote about the Fed’s role in stemming the financial crisis and the importance of not tampering with the structure of the Federal Reserve. He makes a number of points.

First, he argues that despite the public outcry at the costs, the bailout of financial institutions saved the country from financial and economic collapse. Second, he admits to regulatory failures on the part of the Fed and its foreign counterparts, but argues that these have now been fixed. Third, he argues that because of the Fed’s unique role in monetary policy it is also qualified to continue its role in supervising large, complex institutions. Fourth, he states that it is important to maintain the independence of the central bank, especially since not to do so would run counter to trends in other countries.

Critical assessment of these arguments will obviously take place during Confirmation and Congressional hearings, but there is a risk that the key issues will soon be forgotten as the regulatory reform process unfolds.

Let us consider the points raised above. First, his assertion that Fed actions saved the US economy is not verifiable. Such assertions aren’t evidence, nor are the claims for Bernanke’s special expertise. What we do know is that the rescue efforts cost taxpayers more – several multiples more – than the thrift crisis of the 1980s. In fact, the final taxpayer cost of saving AIG may probably exceed the entire cost of the thrift crisis. No analysis has as yet been done of the true exposure to counterparties of AIG, Bear Stearns, or Lehman Brothers. What we do know is that the unwinding of Lehman Brothers under current bankruptcy statues has proceeded in a more orderly way than most might have guessed.

Second, he states that past regulatory defects have been remedied; but again, no evidence is provided as to what changes have been made or how those changes may have addressed the failure of regulators to enforce the early-intervention and prompt corrective-action requirements of the FDICIA Act of 1991. In fact, he makes no reference to that law or what it requires of regulators in dealing with troubled institutions.

Perhaps one of the most strained arguments Chairman Bernanke makes is that the Fed’s role in monetary policy qualifies it to supervise large institutions. Historically, the Fed has argued just the opposite: that its role in supervising large institutions has helped it to be better informed in the making of monetary policy. The obvious question this time around is what knowledge did the Fed glean from its supervisory role that was critical to its policy decisions? It is a fact that Fed supervisory staff don’t participate in the FOMC meetings or briefings, nor do they provide official written input to the deliberations. So it is fair to ask what critical information the Fed learned that made a difference in its policy discussions.

Putting aside what are essentially political and regulatory turf issues, another key issue raised concerns the Fed’s independence. There has been an historical bias in the US against the concentration of financial power and undue influence by New York money-center banks, and this is why compromises led to the creation of a decentralized central bank. Over time, power has become more and more concentrated at the Board of Governors in Washington and through the NY Federal Reserve Bank and its connections to Wall Street.

We need to put aside the personal issues and first address the policy question of whether the US truly desires to have an independent central bank. The legislative proposals coming out of both the House and Senate Banking Committees seemed to reflect the desire to have more Congressional influence over the Fed, through changes in its structure.

We are now faced with the classic problem of unscrambling the egg. The perception is that government-supported institutions are now too big to fail and will be so in the future. The claim is that revising the financial institution failure-resolution procedures will solve that problem, but no one has suggested how additional policies will change market perceptions. Simply putting in place a resolution process in no way guarantees that it will be used or that it in any way deals with the too-big-to-fail problem.

Chairman Bernanke also needs to address several dimensions of the policy-unwinding process. For example, exactly how will he shrink the Fed’s balance sheet, and how likely will capital losses on asset sales be handled? We need details on how the Fed plans to wean Freddie and Fannie from reliance upon Fed purchases of their mortgage-backed securities and who will step in as willing investors. Simply slowing purchases doesn’t replace the needed supply of funds to the GSEs.

Along with claiming that the supervisory process has been fixed, it would be important to explain what procedures have been put in place to ensure that Fed examiners carry out their responsibilities the next time. In the recent crisis, the key supervisory problem proved to be an unwillingness to enforce existing standards, more than a failure to understand the risks that were being taken. Adding economists and other experts to supervisory staffs in Washington won’t necessarily improve the quality of field examinations unless that expertise is widely disbursed, which it isn’t at present.

Similarly, it isn’t clear how the Fed’s belated promulgation of tougher ethics standards would have prevented some of the problems that were experienced at the Federal Reserve Bank of NY. The answers to these questions will go a long way to clarifying what kinds of financial and regulatory reforms are or are not needed.

But the important questions remain unanswered. Do we want, as a matter of public policy, an independent central bank? Or do we want to further the accelerating evolution of increased political influence in the setting of monetary policy? We have argued, in another commentaries, that the failure to fill vacancies on the Board of Governors – due to political interference and delay on the part of Senator Dodd – coupled with failures on the part of both the previous and current administrations to press to fill those vacancies, contributed to the politicization of policy. The dominance of the Fed by the Treasury during the previous administration only added to perception that the Fed and its balance sheet were at the beck and call of the Treasury.

Do we want, as a matter of public policy, an independent central bank? If so, then what is the best way to ensure that outcome?

There are several rather easy steps that could be taken to ensure Fed independence. Perhaps the most important are steps that would strengthen rather than weaken the role of the twelve reserve banks and their presidents in the policy-setting process. First, all twelve bank presidents should be permitted to vote on policy, rather than just five. Second, the position of vice-chairman of the FOMC could be rotated among the reserve banks rather than being the permanent responsibility of the president of the Federal Reserve Bank of NY. Third, opening the bidding process of the daily System Open Market Account auctions to all member banks would reduce the FOMC’s dependence upon the primary dealers and powerful institutions in New York. Finally, it would be a mistake to change the selection process for reserve bank presidents, to parallel the centralized political process for selecting members of the Federal Reserve Board by the president.

One hopes, as Chairman Bernanke appears in his confirmation hearings that these bigger issues will be at the center of discussion. Hard questions need to be asked and answered, and the fate of the Federal Reserve System as we have known it, and the health of the country, rest on the outcome of those discussions. One wonders whether a Senator will ask Chairman Bernanke some of the following structural and operational questions: Why should not all of the Federal Reserve Bank presidents have a vote at each FOMC meeting? Why is it important that the NY Fed president have a permanent vote at the FOMC but also always be the vice-chairman of the Committee? Why shouldn’t that position rotate or be elected by FOMC members? Exactly what information did the FOMC glean from the Fed’s involvement in banking supervision that affected a specific decision on monetary policy during the crisis? Should the Fed broaden the access of member banks to the SOMA desk daily auction process? Why can’t the Fed transact with 500 banks like the ECB instead of using 17 primary dealers who are especially privileged? Why was it necessary to change the code of ethics for the boards of directors of Federal Reserve Banks? At what point and by how much will the Fed reduce its balance sheet? Will it return to the pre-crisis level? How much inflation is tolerable for the U.S. economy and how much will inflation have to accelerate before the Fed acts? If the Fed is truly committed to transparency, accountability and openness, then these are among the questions that should be answered.

Bob Eisenbeis, Chief Monetary Economist, email:


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