The Bush Administration’s proposals for reforming the nation’s financial sector inspire creativity. In decades of teaching, I have used all sorts of metaphors to explain the Federal Reserve system. But until this week, I never compared the Fed to Billy Graham.
The proposals include a much broader role for the Federal Reserve in regulating the entire U.S. financial sector. Historically, this is not a core function for central banks. Is the administration trying to improve its own increasingly tarnished image by glomming onto the Federal Reserve, an institution with a better reputation?
That was how various presidents from Lyndon Johnson and Richard Nixon to Bill Clinton used evangelist Billy Graham. Whenever a president’s reputation for honesty was in the pits, it was time to have Graham, an icon of rectitude, visit the White House. The public would see that the president was serious about cleaning up his act.
That analogy may be unfair. If we are going to ask the Fed to serve as the bailer-outer of last resort for financial institutions as a whole, and not just for commercial banks, then the Fed needs to know what is going on across a wide range of financial institutions. Broadening its regulatory scope is one way to do that.
On the other hand, a wider regulatory role may cause problems. You don’t need a central bank to regulate financial institutions, but you do need one to manage a nation’s money supply. No other institution can do that in a modern economy.
Because it manages the U.S. money supply, the Fed was created with considerable autonomy. Yes, the president appoints Fed governors with Senate approval. Yes, Congress requires the Fed’s chair to testify on economic matters. But the sort of direct political control that exists for other federal agencies is lacking for the Fed. Is that a healthy situation if the Fed is going to gain increased regulatory powers?
Besides expanding the Fed’s responsibilities, the package contains a mix of useful proposals. Reducing the number of agencies that regulate banks has been suggested for decades. Yes, credit unions and state-chartered banks have legitimate concerns about being swept into the same bag with large Wall Street companies. But the existing structure is needlessly complex, with overlapping and unclear responsibilities.
Bringing commodity exchange regulation into the same agency that regulates securities also has been discussed for years. A separate Commodity Futures Trading Commission made sense when these exchanges dealt only with physical commodities like pork bellies and wheat. In recent decades, however, the commodities exchanges have eagerly expanded into a whole panoply of increasingly complex financial instruments including exchange-rate and interest-rate futures, stock options and more. Letting these exchanges pile further and further into financial instruments while maintaining a separate regulatory agency does not make sense.
The exchanges have political power, however, and this proposal is going to cause a fierce congressional battle.
The proposal to establish the federal government as an insurance-industry regulator also will be controversial. The idea has a certain logic. The boundaries between traditional insurance products and innovative financial instruments for investors are breaking down. Companies that once specialized in stocks, bonds or mutual funds now offer consumers a broad range of products, including insurance.
Moreover, insurance companies are major players in capital markets. If we are trying to rationalize a jerry-built regulatory system that arose over time, it makes sense to include insurance regulation in the new structure.
In practical terms, however, this is a major change. Regulating insurers long has been the near-exclusive purview of state governments. State insurance commissioners, together with the legislatures and governors that supervise them, will see this as a major federal usurpation of state powers.
Overall, the package includes good items. But it would constitute the most sweeping revision of federal financial regulation since 1935. This is not something we should do in haste, nor under the illusion that swift action is needed to fend off a looming financial crisis.
That is a key consideration. This administration, and those of Bill Clinton and other presidents before it, long saw no pressing need for comprehensive regulatory reform. Now, in the light of the last nine months, everyone is scrambling to fix things.
Regulatory changes may help us avoid recreating our current mess again in the future. Closing a carelessly unlatched stable door is not a bad idea. But recognize that the big problems right now are horses that are galloping out of site over the horizon. Getting the door hooked just right does nothing to round them up.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.