Is Financial Regulation Overhaul Stumbling? And Can the Fed Remain ‘the Fed’ After the Overhaul?

(Update: In other news out of Washington DC today, my sixteen year old daughter got her driver’s license this morning, in a road test that she herself described as “weirdly easy” and which Dad will rephrase as “alarmingly” so.)

“Overhaul Stumbles” is how the headline the Wall Street Journal put things this morning in its account of a high level meeting of Treasury Secretary with other top financial regulation officials, including Fed chief Bernanke, SEC Chairman Schapiro, and FDIC head Sheila Bair: “Geithner Vents as Overhaul Stumbles.” (WSJ, Tuesday, Aug. 4, 2009.) According to the article:

Treasury Secretary Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration’s faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting.

The proposed regulatory revamp is one of President Barack Obama’s top domestic priorities. But since it was unveiled in June, the plan has been criticized by the financial-services industry, as well as by financial regulators wary of encroachment on their turf.

Mr. Geithner told the regulators Friday that “enough is enough,” said one person familiar with the meeting. Mr. Geithner said regulators had been given a chance to air their concerns, but that it was time to stop, this person said.

What’s the pushback about? Turf battles among agencies, according to the article. Put substantively, Bair and Schapiro both object to the Administration’s plan to vest so much of the authority for dealing with financial crises, under the doctrine of safeguarding against systemic risk, in the Fed:

Ms. Schapiro and Ms. Bair, among others, have argued that more authority should be shared among a council of regulators.

“You are talking about tremendous regulatory power being invested in whatever this entity is going to be,” Ms. Bair told the Senate Banking Committee last month. “And I think, in terms of checks and balances, it’s also helpful to have multiple views being expressed and coming to a consensus.”

Officials from the Federal Reserve and the Office of the Comptroller of the Currency, meanwhile, have questioned the creation of a new federal agency to oversee consumer regulations, a move that would take away powers from both institutions.

But the article makes reasonably clear that, despite the agency battles over who gets or does what, the legislative actions on the various piece of the reform plan will mostly – not completely by any means, but mostly – take place. As has been noted, industry groups have gotten active in lobbying on this or that, threatening to kill the Administration’s overall proposal by a thousand small cuts, but my impression is that at least at this stage, the Administration’s basic plan is on-track legislatively. (I put up an earlier post about the Treasury plan and its views on global financial regulation reform; I will try to put up some other posts going to particular parts of the Treasury proposal – and if I’m lucky, get them up before anything happens legislatively (!))

An important question is raised by the Administration’s plan to place so much of the power for addressing systemic risk in the Fed, and it does not appear to me to have been extensively discussed, at least not in the terms I suggest here. The question is whether the Fed, so empowered with all these new functions and duties and powers and authority, can remain the Fed. Will the Fed remain the Fed?

(This is leaving aside the other huge policy presumptions of the Administration’s proposals, starting with acceptance of certain institutions as too big to fail and attendant moral hazard.)

A principal reason why the Administration’s plan proposes to use the Fed is that it has enormous latent powers to act and legitimacy to do so. But its ability so to act depends upon a peculiar expression of legitimacy in a democratic system – its reputation for being above day-to-day politics while still taking the most profoundly political actions conceivable (the issuance of fiat money). Its relationship to Congress is one of reporting and expressing all the properly democratic sentiments of obeisance to the crowd of nitwits, blowhards, and self-dealers who have managed to entrench themselves as rent-extractors on the dividing line of public and private; but who, for all that, are the People’s Representatives (God save us all) in our extended exercise in democratic self-government.

The system for its legitimacy depends upon exquisite attention to the forms of democratic obeisance while taking actions that will almost certainly cause pain to many of those democrats’ cherished constituents, in the larger cause of managing the currency and the banking system. Our democracy depends in many respects upon establishing institutions that we empower to inflict short term pain in pursuit of our collective long term interests. Institutions that sit uneasily in a fully democratic system because they are, in one sense, a complement to it, but in another sense something close to a rebuke. Above all it is a question of legitimacy. The Fed cannot ground its legitimacy solely in its technocratic expertise, because that is finally incompatible with democracy; it cannot ground its legitimacy in purely democratic exercises, because its exercises of power are constructed by a democratic system to be, in its most profound actions, taken on the basis of expertise, not popular democratic will in the ordinary sense.

The peculiar mixture of legitimacy is a little like bait and switch, but deliberately designed to be that way. uggest that the Fed should do ‘x’ because it is the will of the Congress, and it will do whatever it does asserting that it acts from its expertise. Suggest that the Fed should do ‘y’ because that is the expert thing to do, and it will do whatever it does asserting that, after all, it is a democratically accountable institution with a governing statute and specific limited power, despite their discretionary nature. That’s what gives it the ability to act with legitimacy. But it is a delicately balanced form of legitimacy that sits far more uneasily as a matter of both politics and democratic political theory than it might appear. It is a source of legitimacy that is far more easily upset and destabilized than we think; we take the Fed’s vaunted ‘independence’ – even understanding that as a highly nuanced, complicated, ad hoc, shifting balance of power than it first appears – quite possibly far too much for granted.

Arguably the Treasury plan takes the permanency of the Fed’s legitimacy far more for granted than it should. Very little in the new grant of power or authority to the Fed takes account of the idea that, for example, a Fed that is supposed to supervise, scrutinize, divinize, and so on, in all these new ways will not the same Fed, the stable ideal of which we relied upon in giving it all these new functions. To the contrary, giving it these new functions shifts the balance of legitimacy – surely in the minds of Congress, to start with – toward the idea that the institution is and ought to be far more politically accountable in the day to day to Congress than it is now. Even a shift in the expectation has an important possibility in shifting, and undermining, the Fed’s legitimacy – and yet it was precisely that legitimacy which was the attraction of putting all these functions onto the Fed in the first place. Time will tell how new functions will alter the political nature of the Fed, and its balance of power with Congress. And most of all its legitimacy to be able to inflict short term, severe pain (think Volker in the early 1980s) in the interests of the long term good.

This is not necessarily a reason not to go down this path. No doubt this very question – it is not un-obvious, after all – has been extensively discussed in formulating the Treasury plan, and the failure to raise it a deliberate one (if a mistake, in my view). But there is good reason to wonder whether the ideal of the Fed on which we place so many new duties can be, in virtue of those new duties, the old Fed. Are we asking to have our cake and eat it too?

(Note: Several years ago, Yale constitutional law scholar Jed Rubenfeld published a short book on time horizons in a democracy, on Jefferson’s views on whether the dead hand of the past should be able to bind the future, Freedom and Time (2001). When I read it, I thought it an extraordinarily smart and profound take on a topic that, however, seemed to me then an almost wholly abstract jurisprudential proposition. I’ve since changed my mind completely, and re-read the book; it’s a book whose argument deserves a close re-consideration in our present circumstances. There’s a very important connection to be made between the arguments in that book, and consideration of the relationship of a democracy to … long term credit markets and ethical and legal considerations in making decisions what burdens to impose or not impose upon future generations. I would be curious whether Jed has had any thoughts on the application of those arguments from almost a decade ago to today’s circumstances.)

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