An article recently appeared in the Economist, titled the Collapse of Finance. Here, the Economist suggests that, at best, the current financial crisis represents a collapse of modern financial ideology, and in particular, a failure of Western Markets to manage the surge of sophisticated financial instruments and their access by less sophisticated nations (of course, coupled with differences in the management of capital flows).
“The suspicion is that American know-how and talent made the disaster worse… … Philip Lane, of Trinity College Dublin, thinks that sophisticated American financial services combined dangerously with relatively unsophisticated financial services elsewhere. “ To that end, it would, in turn make us wonder what role the Fed has played in all of this. As one of the leading regulatory authorities of “Western Capitalism”, we would expect that they would be equally leading the pack in the move to reform. Some would say that they are doing their best to respond to a bad situation. Others would suggest that the Fed has done more to fuel the financial crisis than to support stability.
Looking back over the past quarter, it isn’t difficult to wonder what precisely happened. Those of us close to the banking industry found many of even the most troubled institutions beginning to stabilize (towards September). Many banks were reporting growth in new originations in mortgage, capital constraints had begun to ease, and those that had managed deposits aggressively were even seeing some relative easing in their liquidity position. Even some of those considered most troubled were spending on growth strategies. Share prices began to improve. This doesn’t mean that everything was rosy, but it wasn’t plummeting – yet. The system was no doubt fragile, but it started to seem that we just may have it something close to the bottom and that, although bottom was where we might be for a while, there was hope that we could conceivably experience some market optimism in the spring.
Maybe it was for this reason that the Fed chose this moment to begin what some refer to as the “clean up”. Under the guise of saving the financial system, the Fed began a series of moves which some of us have known to be on the Fed docket for years. It became an opportunity to address a virtual wish list of systemic annoyances. These include the re-nationalization of Fannie Mae and Freddie Mac, the expansion of the bank holding company to draw in numerous investment banks. This was rapidly followed by the bail-out plan and what we now see as a series of aborted attempts to resuscitate the financial system.
In the end, each of these actions have resulted in a rocking of the financial system. The generation of this level of volatility has further eroded confidence and generated a steady decline beyond what had already gone on.
Choices the fed has made regarding use of bail out money are still obscure. It seems that many of those institutions that have needed it the most are the ones that were denied it. In essence, to date, we have seen the bail-out become a means for the fed to intimidate and threaten would-be recipients into towing the line. It’s not to say that there wasn’t some line-towing in order, but we have seen some outrageous moves where the Fed has been effectively architecting their own financial system – who stays, who goes, who wins and who loses, from the level of reconstruction of the industry structure itself to which individuals will remain as icons and leaders of whatever rebuilding will come. So, if we accept that this is the case, what do we think this system should look like? Which investment banks survive and which don’t, who merges with whom and which are fully dissolved. How many remaining players is optimum and does this fit into a scheme of supervision that is optimal for the Fed. Most importantly, when it is all done, how will it serve the consumer? Will there be sufficient competition remaining in the market to support efficient clearing prices, market disclosure, etc.?
All of these questions are still under debate, but coming back to the original question regarding reform and the role of the Fed in the world-wide economy, it is unclear if many or any of their moves have done much to address that. What role will the Fed ultimately take in the regulation and capital requirements for some of those sophisticated instruments that got us into trouble in the first place? It is clear that more needs to be said about the regulation and capital requirements for some of the sophisticated instruments that helped to put us in this situation to begin with. What will be done about the “shadow” banking system (unregulated entities) that also fueled the collapse is also in question. Dragging them all into bank holding company shells will work for some of the larger entities, but won’t work for all of them – and it is sure to fail when better times return. It is also clear that the markets are still nervous – and may be for some time. Perception continues to be a key problem and contributor to market stability.
The most important thing that the Fed can do right now is to instill confidence in the markets – not destabilization. Certainly, easier said than done, but surely some of their moves have added to the latter. In a separate article, the Economist accuses the Fed of “knew jerk reaction”. Oh so true.
The Economist finishes without suggesting any answer, other than that highly controlled economies have their fair share of issues and that that is probably not the answer either. The Fed has the means to set the way to a new economic governance regime, but is not showing that it is yet ready – or perhaps has the leadership at-hand to do so.