The Fed Gets a New Job Description - A Commentary By Professor Robert J. Shiller
"The Fed Gets a New Job Description"
By Robert J. Shiller
Published in the New York Times on April 6, 2008
Read the article in its original context on the New York Times website.
The plan of Treasury Secretary Henry M. Paulson Jr. to overhaul the financial system includes a crucial proposal: it would officially transform the Federal Reserve into a “market stability regulator” rather than merely a banker’s bank.
This aspect of the Treasury plan is a natural step in a historical trend. The Fed is no longer just a regulatory agency presiding over a narrow group of businesses called banks. Rather, its mission increasingly is to maintain macro confidence — confidence that the entire financial system is functioning well as part of the whole economy.
In contrast, traditional securities regulators like the Securities and Exchange Commission have as their primary mission the maintenance of micro confidence — confidence that individual firms are disclosing the truth about their own internal operations and are not manipulating information.
But as the current financial crisis attests, it is macro confidence that requires the most subtle attention. The instability in even the most modern economies accounts for the growing respect for the financial stabilization offered by central banks.
Moreover, the nature of financial institutions is changing, and as finance becomes more sophisticated, the traditional boundaries of banking have blurred. In the current crisis, for example, there have been significant liquidity problems associated with “special-purpose vehicles” or “conduits,” which issue asset-backed commercial paper. These entities resemble banks but are not technically banks. In the new financial order, in fact, we do not clearly know what is or is not a bank, so a narrow definition of the mission of the central bank is no longer appropriate.
In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.
The trend toward greater powers for the Fed isn’t new. In 1932, Congress extended the Fed’s power by giving it the authority “in unusual and exigent circumstances” to make discount-window loans to any organization or individual, not just to member banks. In 1980, Congress gave the Fed the authority to use its discount window in the normal course of business for all depository institutions, including savings associations and credit unions, and to set reserve requirements for them as well.
The Fed has been taking an expansive view of its own powers recently, for the most part with considerable public approval. Witness its decision to give a $29 billion line of credit to JPMorgan Chase to encourage the purchase and rescue of Bear Stearns. There was very little criticism of this move because so many people rightly feared the systemic effects on financial institutions if the Fed did not act. Bear might have had to dump its troubled assets on the market, and the whole financial house of cards could have collapsed. Because we sense that maintaining confidence in our financial system is so important, we are permitting the Fed to expand its role.
The trend toward greater reliance on central banks has been global. These institutions have been given more independence, as with the Bank of Mexico in 1994, both the Bank of England and the Bank of Japan in 1997, and the creation of the European Central Bank in 1998. Independence, of course, means more power.
Two of the Fed’s most important innovations were internationally coordinated measures. These were the establishment of the Term Auction Facility in December, for the auctioning of 28-day advances to depository institutions, and the creation last month of the Term Securities Lending Facility, which lends Treasury securities to so-called primary dealers — banks and securities firms like Goldman Sachs, Morgan Stanley and Lehman Brothers. The rising prestige of the world’s central bankers is apparent, as these have been perhaps the most significant international steps to deal with the financial crisis.
It has been said that Ben S. Bernanke chose an awful time to become chairman of the Federal Reserve — in February 2006, just as the economy was about to enter its worst financial crisis since the 1930s. But it was also the perfect time, because it presented him with challenges for which he had a lifetime of preparation. His most famous academic work concerned the crisis of the Great Depression, and he has thought deeply about systemic economic problems.
Mr. Bernanke’s own analysis of history, as well as that of other economists, emphasizes the essential importance of confidence in financial institutions and the subtlety of the issues involved in promoting such confidence.
For example, Mr. Bernanke has said that a significant motivation for starting the Term Auction Facility was to make it possible for troubled banks to borrow from the Fed discount window without encountering “the so-called stigma problem.” What is stigma? We are not talking about emotions here, but about banks’ efforts to act in such a way as to maintain the confidence of people who deal with them. We are talking about discovering subtle instabilities in the house of cards, and fixing them.
Confidence is too complex for the consumer confidence indexes — which are based on surveys of ordinary people — to measure adequately. It has to do with confidence in specific institutions — confidence that they will behave properly and that the leaders who are trying to promote others’ confidence will act in a constructive way.
Formalizing the Fed’s transformation into a market stability regulator makes sense. The Fed has already begun to play this role. And by doing so, it is taking a significant step toward reducing the fundamental instability of our economy.
Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.