By Simon Johnson
The Federal Reserve has a legitimacy problem. Fortunately, a potential policy shift is available that offers both the right thing for the Fed to do and a way to please sensible people on both sides of the political spectrum: raise capital requirements for megabanks.
As the election season progresses, Republican politicians are increasingly criticizing the monetary policy of Ben Bernanke and his colleagues on the grounds that they are exceeding their authority, particularly by buying assets and trying to lower interest rates in what is known as “quantitative easing.”
There is growing concern in Republican circles that the Fed is tipping the election toward President Obama, and Mitt Romney repeated unambiguously in August that he would not reappoint Mr. Bernanke (a Republican originally appointed by President George W. Bush).
At the same time, a significant number of people on the left of American politics are concerned about how the Fed acted in the period leading up to the crisis of 2008 – blaming it for a significant failure of regulation and supervision – and about how much support it currently provides to big banks.
If the right and the left were ever to come together on this issue, they might enact legal changes that would reduce the independence of the Federal Reserve, making it more subject to Congressional pressures. At the very least, the implicit buffers that protect the Fed from political interference could easily weaken, depending on the outcome of the November election. The Fed has no special constitutional protection, from either the original Constitution or any subsequent amendment. The Federal Reserve System was created in 1913 by an act of Congress and its mandate, functions and authority have been amended by Congress over the years. Most recently, some small but potentially significant changes were enacted as part of the Dodd-Frank financial legislation in 2010.
The Fed has been unpopular before, most notably when under Paul A. Volcker, its chairman, it tightened monetary policy to bring down inflation in the early 1980s. And some tension is built into the very objectives of the organization. Section 2A of the Federal Reserve Act, as amended, now reads:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
(This so-called dual mandate came from the Full Employment and Balanced Growth Act of 1978, sometimes known as the Humphrey-Hawkins legislation. This language was not in the Federal Reserve Act of 1913 or the 1946 Employment Act).
Most of the previous political concerns were from the left of the political spectrum and concerned with whether the Fed placed too much weight on low inflation and not enough weight on achieving a high level of employment. Strong voices from the left currently assert that Mr. Bernanke’s team should have done more, earlier and faster, to speed the economic recovery.
But now the brunt of the attack comes from the right, where trouble for the Fed has been brewing for some time.
Open season on the Fed was declared last year by Rick Perry, governor of Texas and then a Republican presidential candidate. On the campaign trail in summer 2011, he remarked memorably:
“If this guy prints more money between now and the election, I don’t know what you all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous – treasonous, in my opinion.”
Mr. Perry was picking up on longstanding themes from that part of the Republican right that feels the very existence of the Federal Reserve undermines the Republic. Ron Paul’s book on the subject is titled “End the Fed.” Mr. Paul is sometimes regarded as a fringe figure, but anti-Fed sentiment is no longer a marginal view within the Republican Party – see, for example, the range of voices quoted by Politico this week.
(Mr. Paul’s and, to some extent, Governor Perry’s intellectual predecessor was Wright Patman, a populist Democrat from Texan who served in the House for almost 50 years and was a regular bête noire of Fed chairmen from William Martin to Arthur Burns. In one hearing on the Fed’s monetary policy, for example, Mr. Patman opened the session by caustically asking Mr. Burns, “Can you give me any reason why you should not be in the penitentiary?” Mr. Patman, it should be noted, was described by the historian Robert Caro as to the left of Lyndon B. Johnson.)
Fortunately there is a way for the Fed to reaffirm its legitimacy: the Board of Governors should strengthen capital requirements for the largest United States banks and other systemically important financial institutions. Ideally it should move policy in a direction that is responsible and that would be welcomed on both sides of the political spectrum.
The best way to do this would be to increase capital requirements for very large banks and other financial institutions that the Fed deems to be systemically important. Both sides of the aisle increasingly show some understanding that higher capital requirements for megabanks would make them generally safer and more resilient in the face of really big unusual shocks – and therefore reduce the degree of public subsidy they receive, implicitly, because they are too big to fail (and therefore able to get support, when needed, from the Fed).
(The Dodd-Frank Act constrained the ability of the Fed to help individual financial institutions. but in my assessment left the door open to various kinds of broader assistance to classes of assets or groups of companies – either through the Fed discount window for lending to banks or through some mechanism to be specified later.)
The recent letter to Mr. Bernanke by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana – which I wrote about recently – is a perfect example of the emerging cross-partisan consensus. In private, I hear strong voices from right and left echoing the sentiments of this letter.
The megabanks, naturally, are opposed. They contend that higher capital requirements would be bad for the economy. That is a myth, fully exploded by the Stanford professor Anat Admati and her colleagues (if you have not already seen their Web site, you should look at it now.)
The Fed has the ability and the opportunity to make a move on capital requirements for systemically important financial institutions – we are currently in a comment period that runs until Oct. 22 on exactly this issue. Higher requirements would make the financial system safer. They would also represent an important step toward rebuilding the political legitimacy of the Federal Reserve System.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.