Summer Rerun: “Toothless Fed”

This post first appeared on March 26, 2007

The post below is from a reader, DS. He focuses on the fact that the Fed has basically admitted that its powers are limited due to the extent of financial activity that takes place outside its purview (the Fed supervises federally-chartered banks; securities firms, which are regulated by the SEC and hedge funds, which are not regulated as far as their investments or solvency is concerned, are increasingly the key players in the credit markets).

Yet the Fed is treated by pretty much everyone, including sophisticated investors who ought to know better, as having the ability to stem a crisis. In reality, its main power these days is moral suasion and its PERCEIVED clout, which is has used to great effect, but once that fails, it will not have much real firepower.

He goes further to tell us, quite persuasively, that financial innovations that may initially have been beneficial to many have moved into innovations that serve only the few, and can be argued to have corrosive effects (undue concentration of wealth, exploitation of the middle/lower class, weakening of values of prudence and deferred gratification) yet the powers that be keep defending them.

I have some related posts (here and here and here, time stamped earlier so that e-mail subscribers will get them in the right order).

To DS:

As often happens, I find reading across multiple posts — connecting dots — quite fascinating. Today, you observe that New York Fed president Geithner’s speech pointedly admits the Fed is toothless as a proactive guide in our contemporary financial markets. He declares the only thing — only, only, only thing — the Fed can do now that it has lost its capability and knowledge to guide in advance is to provide possible ‘shock absorbers’. The core admission of the Fed’s toothlessness with regard to proactivity comes here:

We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

Re-read that. “We do not have the capacity to monitor or control….” “We cannot identify….”

The Fed is now on the sidelines and utterly, completely lacks the capability or knowledge to understand what is going on…..

So, Geithner says, we can try our best to respond and provide shock absorbers. In other words, the Fed is now FEMA. And we’ve seen how well FEMA has fared under the Bush Administration and our new Culture of Greed and Incompetence. (Yes, there is some hope of the Fed’s supposed independence — but, then, one reads your post about the Fed’s manipulation of elections….)

Anyway, onto the Chemotherapy post. I’m guessing Barry Ritholtz is a really smart and savvy guy (and I mean that). So, I find it fascinating that his comments at the bottom of the quoted portion are written with the classic assumption that the Fed’s actions are to be read as proactive efforts to reign in pending problems etc (i.e. not just ‘shock absorber’ efforts from an institution that is incapable to provide any effective guidance because it is an institution that is flying blind — just like everyone else). Put differently, his language continues the deep seated assumption that the Fed is — well The Fed — not just FEMA.

And, in light of my concern that defining inflation so that it doesn’t include asset inflation like housing is missing something crucial, it’s also interesting to note that his cautions on that score remain the classic goods and services type — not the cancerous asset bubble type. He talks of oil and copper. He doesn’t speak to Geithner’s focus on how unregulated, unmonitorable financial innovation have created a world of finance that is beyond anyone’s understanding.

Last: both Geithner and Ritholtz blithely state things that strike me as yet more examples of a failure of imagination and nerve. Geithner speaks of “the substantial benefits of credit market innovation”. I’m struck that he would do well to spell out those benefits: what benefits and for whom? And how have both the nature of the benefits and those who benefited changed over time?

Go back to the 1980s and the innovation of mortgage backed securities. I believe history would say: major positive benefits and spread of benefits to people broadly.

But, look at cancerous Ponzi schemes of the past several years and ask same question. Has there been broad benefit spread across the economy? No. We see dramatic growth in income inequality. We see an economy where the top 1% have 40% of the assets. We see usurious, predatory abuse of folks in what used to pass as the middle and lower-middle class. And, by the way, we see corporate profits going to shareholders as opposed to either labor OR investment in the future.

We see profit grabs and Ponzi schemes. We do not see substantial benefits.

What may have begun as innovation in service of the economy has, by ‘natural forces’, become a cancer that, among other things, has converted the Fed into FEMA, eviscerated the middle class, turned the financial system into a casino, and seriously weakened the values (both in terms of real economic value as well as shared beliefs and behaviors such as ‘hard work’, ‘invest in future’, ‘be prudent’) on which the nation depends.

Geithner seems like a reasonable guy. And that is what ought to trouble us. He seems to have drunk the Kook Aid by which reasonable people believe it is important to continue to demonstrate reasonableness by assuming that others with great power are also reasonable. Yet, as we’ve seen in the political sphere, that is a fatal assumption. And, I believe we’ll see the same thing in the financial sphere. The folks in charge are not reasonable. They are after profits and wealth for themselves. And, while self-interest has a long storied past as a powerful motive force for the good when it is kept in check by reason, even Adam Smith noted that the assumption that reason would keep it in check was foolish.