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 Date:2/3/2010

 

It's Your Call
Wall Street is to Blame
Attempts to derail Bernanke’s reappointment do little to shift blame for the Great Recession from where it belongs, says William R. Hawkins.

Americans on Main Street can breathe a sigh of relief that the political attacks on Federal Reserve Bank Chairman Ben S. Bernanke failed to derail his reappointment. Criticism of Bernanke in particular, and of the Fed in general, were motivated by a desire to shift the focus of the inquiry into what caused the Great Recession from Congress and Wall Street to an institution which was purposely created to be outside the debilitating tumult of partisan politics. The Fed is an organization of experts whose principle duties are to manage the monetary and credit conditions in the economy so as to maximize employment while avoiding inflation, and to provide stability to the private banking and financial system upon which modern capitalism depends.

It has always been easy for critics to portray the Fed as “elitist” and “undemocratic” even though its chairman, vice chairman and the seven members of its board of directors are appointed by the president and confirmed by the Senate. The Fed operates with a great deal of independence and autonomy, as it was designed to do. It supports itself from the interest collected on U.S. government securities acquired through open market operations and loans to depository institutions; and from fees received for services provided such as check clearing, funds transfers, and automated clearinghouse operations. It is thus free of Congressional purse strings. Indeed, after paying its expenses, it gives 95 percent of its revenue to the Treasury. The principle is that monetary policy is too important to be left in the hands of politicians who are subject to mood swings, partisan ideologies, and special interest lobbying.

The brief campaign against Bernanke, which was launched from both the far right and far left, proved the wisdom of keeping a firewall between the Fed and politics. On the surface, the criticism seemed the same from both extremes. Sen. Russell Feingold (D-WI) claimed, “Under the watch of Ben Bernanke, the Federal Reserve permitted grossly irresponsible financial activities that led to the worst financial crisis since the Great Depression.” Sen. John Cornyn (R-TX) joined in, "I'm not saying that Mr. Bernanke hadn't done a good job….I think he's probably mitigated a lot of the harm that could have happened. But I think he should have seen it coming….The bubble in housing and easy money which led to a huge increase in housing prices over a short period of time and then collapsed I think has contributed a lot to the problems that he then was required to help try to clean up.”

Some Democrats opposed Bernanke because he was originally appointed by Republican President George W. Bush and was a follower of Nobel Laureate economist Milton Friedman. Indeed, it was from Bernanke’s study of Friedman’s classic critique of the “confused and misguided” policies of the Fed during the onset of the Great Depression (set out in Friedman’s Monetary History of the United States) that led him to react so quickly and massively to pump money back into the hemorrhaging banking system. According to Friedman, it was the collapse of the banks and the decline in the supply of money that pushed a normal business cycle into unprecedented economic disaster in the 1930s.

Opposition from the right had a different motive. Many Republicans and putative conservatives have from the start tried to shift blame for the recent meltdown away from Wall Street (which they try to equate improperly with the private sector as a whole) towards government. In this libertarian view, capitalists cannot make mistakes unless pushed into them by “statists.” Therefore, the way forward is to keep Wall Street free of any new (or reinstated) regulations. Bernanke has drawn fire from this crowd because he heads a government institution whose research has placed the blame for the crash squarely on Wall Street.

At the annual meeting of the American Economic Association on Jan. 3, Bernanke gave a major speech on the crisis, looking in particular at the “bubble” in the housing market whose bursting triggered the financial meltdown. Fed analysis and modeling found that the market had been running on its own internal dynamic and behaving outside the bounds of historical experience during the decade prior to the crash.

As for monetary policy, the Federal Funds rate was raised steadily during the 2004-2006 period, after having been cut to combat the 2001 recession. The Fed was not driving decisions on Wall Street with a loose monetary policy, nor making the decisions for the banks on how to allocate their resources. And while oversight should have been tighter in many government agencies, including the Fed, the banks designed their new instruments to fall outside the normal regulatory process to avoid constraints.

Inflation is a general increase in price levels usually due to an excessive increase in the money supply. But inflation, as measured by the consumer price index, was low and fairly constant during the 2004-2008 period except for the impact of exogenous swings in the price of imported oil. Growth in the M1 money supply and the adjusted monetary base slowed after 2003 and flat-lined 2005-2008. M2 growth also slowed coming out of the recession, stabilizing at a rate lower than during the late 1990s. The run up in housing prices was not part of a larger inflationary push, but was driven by actions unique to that sector and the credit innovations contrived by the financiers.

As Bernanke told the AEA, “the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards…. Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”

A prime reason there was not stronger regulation and supervision is that Congress had given in to Wall Street lobbyists who had argued that the financiers were the “smartest guys in the room” who should be allowed to integrate and innovate in a “free market” to supposedly make capitalism more dynamic and efficient. Years of deregulation culminated in the Financial Services Modernization Act of 1999 (S. 900), whose name evokes the philosophy behind the legislation. The bill eliminated provisions of the Glass-Steagall Banking Act of 1933 which prohibited commercial banks from engaging in certain risky investment activity or owning other kinds of financial companies. Glass-Steagall had been enacted to protect the commercial banking sector, upon which the real economy depends for the financing of productive activity, from the temptations of speculation.

The bankers thought they had improved their ability to manage high risks, while still earning high profits. In the short-term, being let “free” did generate lavish returns and extravagant bonuses, but in the long run the wild ride ended in disaster on a global scale. The losses inflicted across national economies and which penetrated deep into society far exceeded the private gains to financiers. Institutions that had proudly boasted of their independence from government had to turn to government for their survival. Laissez-faire failed (again) in spectacular fashion.

Sen. Cornyn holds the Texas seat previously held by fellow Republican Sen. Phil Gramm, the lead sponsor of the Financial Services Modernization Act. Though the bill was passed in the Senate along party lines, when it moved to the House of Representatives, it was passed by unanimous consent! And the conference reports in both houses were adopted by large, bipartisan majorities, so there is plenty of blame to pass around among the politicians. Thus, the demand from some quarters for Congress to take control of monetary policy from the Fed does not pass the smell test.

The unacceptable risks posed to the real economy from excesses in the financial sector are nothing new. In his 1959 book Bankers and Pashas: International Finance and Economic Imperialism in Egypt, the eminent historian David S. Landes presented an objective look at the problem over centuries divorced from current debates. “The compleat and orthodox banker was guided by one fundamental principle: commercial credit must be based on commercial transactions.” he wrote. In other words, finance has to be tied to the real economy. When it became detached, the results are always disastrous. Landes argues, “When pillars of commercial integrity lent themselves to such machinations, they could do so on a scale that lesser houses could hardly hope to match: false credits piled on false credits, accommodation paper covered by accommodation paper, forgeries, straw men, all the apparatus that ingenuity could devise to present to the world a legitimate front to obtain money on transactions that never were.” A fair description of the behavior of the most prestigious banks at the dawn of the 21st century: institutions that were “too big to fail” but nevertheless did.

Economic recovery is a two step process. First, the financial system had to be saved, even if it meant “bailing out” those whose blunders had created the mess. Now it must be reformed to prevent the crisis from recurring, which means reining in the speculators. Industry, at the core of the real economy, has a vital interest in seeing that the commercial banking sector stays focused on productive activity and not speculation. It is business firms and workers who suffer when the financiers go rogue.

President Obama hopes, “Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers.” It will, however, take legislation to restore the protections once provided by Glass-Steagall. Lessons were learned in the 1930s which served to guide legislation and policy so that recessions were shorter and the financial system was stronger during the rest of the 20th century. Partisanship and special interest lobbying should not prevent the restoration of sound banking principles enforced by public oversight agencies dedicated to the advancement of the national economy. The Federal Reserve should be seen as a model, not a scapegoat.

William R. Hawkins is a consultant specializing in international economic and national security issues. He is a former economics professor, Congressional staff member and think tank scholar who has authored three books and hundreds of academic and editorial articles.