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When the Fed Was Boring

Thursday, October 29, 2009

Sometimes people ask if I miss working for the Federal Reserve. Perhaps if it continues expanding its fiefdom.

“The Federal Reserve would police banks' pay policies to ensure they don't encourage employees to take reckless gambles like those that contributed to the financial crisis.”
The Associated Press, Oct. 23, 2009

The Federal Reserve announced that it will help resolve the thorny problems of compensation practices at the nation's financial institutions. The 28 largest institutions will have their pay policies and practices reviewed to determine their consistency with appropriate risk taking. Everyone else, whether large or small, national or local, will discuss compensation practices with their examiners to ensure they mesh with sound banking.

Some people might be alarmed at this apparent intrusion into private business decisions. They might also wonder why it is appropriate for the Federal Reserve to wade into an area where the administration and the Congress have failed to act. This, no doubt, reflects an ignorance of the Federal Reserve's special expertise in compensation schemes. Fed officials must have concluded that the market for financial executives works in a manner similar to that for federal funds. By next year, they presumably will promulgate price targets for both.

Skepticism of the Fed's increased entanglement in the private sector reflects a deeper ignorance of the purpose of the nation's central bank. After all, the preamble of the Federal Reserve Act explains that it was founded to provide "an elastic currency" and "for other purposes." Becoming the compensation cop clearly conforms with "other purposes" and is consistent with the instruction to be "elastic."

Some counseling on the virtues of yoga and a vegan diet could go a long way to prevent bad lending decisions and other threats to financial stability.

Fed officials, in fact, have been quite specific in justifying their preemptive strike against somebody, somewhere, potentially getting paid a lot. They read into the Federal Reserve Act a responsibility for preserving financial stability (the past few years notwithstanding). Compensation practices might induce excessive risk taking. Therefore, the Fed should sign off on compensation schemes.

Such logic scales up easily and may well usher in a new era of prosperity and stability. Indeed, we may be at the dawn of a Second Great Moderation (to update a term frequent in Federal Reserve Chairman Ben Bernanke's speeches, at least before this year). In future visits to local banks to review compensation, Fed examiners could invite both parties—management and workers—to the table. Self-esteem issues and a poor diet rich in animal flesh might be clouding bankers' judgment, thereby threatening financial stability. Some counseling on the virtues of yoga and a vegan diet could go a long way to prevent bad lending decisions and other threats to financial stability.

With such successes under their belt, Fed officials might understandably look for new areas to conquer. Worries about health insurance probably weigh on the decision making of bank employees. A Fed-sponsored public insurance option would let them focus their attention more fully on risk management and sound lending, to the benefit of the Fed's core mission of preserving financial stability.

There are other Fed responsibilities that could be accomplished more successfully with a wider perspective. For instance, the United States enjoys significant benefits from foreign ownership of our currency. According to Fed estimates, between one-half to two-thirds of our banknotes are held abroad. This provides an interest-free loan of around half a trillion dollars, sorely needed at a time of fiscal profligacy. Fed officials might be concerned that these benefits are at risk from global warming, either because some of the currency's customer base might go underwater, or printing all those green pieces of paper leaves too big a carbon footprint. Fed limitations on other carbon-spewing activities, such as driving cars or flying planes, could prolong our dominance as a currency issuer, central to satisfying the Fed's implied mission.

In many appearances before the Congress, Fed officials, defending their turf as tenaciously as a terrier, have argued that delving into areas other than monetary policy generate benefits for the conduct of that core function.

In many appearances before the Congress, Fed officials, defending their turf as tenaciously as a terrier, have argued that delving into areas other than monetary policy generate benefits for the conduct of that core function. No doubt they can explain even more forcefully that involving themselves in ever-more areas of what used to be the private economy will tighten any uncertainty surrounding their five-year plan for resource allocation.

I am sometimes asked if I miss working for the Fed. Up to now, I truthfully have answered that I have a great job and would not want to go back. But when I was at the Fed, we had mundane worries about the size of daily open-market operations, the level of the Fed funds target, and the wording of the Federal Open Market Committee's statement. I am not sure what my answer would be if I could be responsible for setting wages, option pay-outs, cafeteria menus, dress codes, and commuting routes for some set of financial institutions in the name of preserving financial stability.

The Fed fiefdom would not have to be big—say, the Midwest—to get me back into the game.

Vincent Reinhart is a resident scholar at the American Enterprise Institute and worked for almost 25 years at the Fed back when it was boring.

FURTHER READING: Reinhart wrote “The Peril of Anointing a Favored Financial Few,” on how the Obama administration’s financial reform package hits the trifecta of bad policy making, and “The High Cost of Getting the Story Wrong,” describing how the narrative first written about the Great Depression was mistaken in many important respects, as is the initial narrative on today’s crisis. His other pieces for The American include “Simple Rules for a Complex Financial World” and “When They Were Young,” a look back to the last time that Larry Summers, director of the National Economic Council, and Timothy Geithner, secretary of the Treasury, “saved the world.”

Image by Darren Wamboldt/Bergman Group.

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