More Fed Power Won’t Save the Economy

After failing to catch the last bubble the Fed and Treasury have been selected to stop the next crisis... really?

Treasury Secretary Timothy Geithner is upbeat about the economy and sees a bright future ahead. “A review of recent data on the American economy shows that we are on a path back to growth,” he said in a The New York Times op-ed this week. Furthermore, according to Geithner, it has been by the power of government — from regulators to Congressional leadership — that the economy is recovering. “By taking aggressive action to fix the financial system, reduce growth in health-care costs, and improve education, we have put the American economy on a firmer foundation for future growth.” Picking up on that note of optimism about the economy was Federal Reserve Chairman Ben Bernanke, who recently said:

“We expect moderate growth going forward, we believe that if the housing sector begins to stabilize, and if some of the inventory corrections that are still going on in manufacturing begin to be completed that there is a reasonable possibility that we’ll see some strengthening in the economy some time in the middle of the year.”

Wait, I’m sorry. That was Bernanke talking about the economy back in February 2007, before the economic collapse. He went on to say that, in the Fed’s assessment, “there’s not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy. And the lending side of that still seems to be healthy.” Barely four months later, the Libor-OIS spread spiked through the roof and the credit crunch began, setting the stage for a wave of subprime losses, economic tightening, and the financial crisis.

Setting aside, for a moment, the debate about whether or not the economy is in recovery, consider this: Bernanke, Geithner, the Federal Reserve, the Treasury Department, and every other regulatory body missed the financial crisis buildup and explosion. And their response — misdiagnosing a confidence problem as a liquidity shortage — exacerbated much of the economic downturn.

In response, the Dodd-Frank Act aims to fix the problem of forecasting. Given the regulatory failure of the above-mentioned organizations, Congress has tasked — wait for it — the Federal Reserve and Treasury Department with watching over the economy.

Future financial crises, meet the Financial Stability Oversight Council, a body tasked with being the oracle of the American economy. The council will primarily be charged with identifying systemic risks to the economy that might result from the failure of a large, interconnected financial institution and then take steps to prevent them. The council is also paradoxically directed to find a way to convince the market that the government won’t bail out financial institutions, their creditors, or counterparties in the event of failure.

The council shouldn’t need to convince markets of the government’s firm intentions to ban bailouts if it successfully prevents economic downturns. But it appears as though Congress has correctly anticipated the biggest flaw with tasking a regulatory body with preventing a financial crisis: They can’t. At least, they can’t prevent every crisis.

Congress is hoping the council will watch the markets carefully and issue recommendations for financial regulators to increase prudential standards or increase safeguards when necessary. But regulators have tried that before. “I’m confident, in fact, that bank regulators will pay close attention to the kinds of loans that are being made and make sure that underwriting is done right,” said Bernanke in July. I mean, in July 2005. Are we to believe that this new council will magically be able to figure out more than the old regulators could?

The Treasury Secretary is set as the chair of the 10-member council, which includes the Federal Reserve, SEC, FDIC, CFTC, FHFA, National Credit Union Administration, US Comptroller, Bureau of Consumer Financial Protection, and a presidentially appointed independent member with insurance experience.

Independently, these organizations were caught completely off guard by the financial crisis. Congress hopes that by coordinating them — giving them authority to directly regulate large banks and even subject non-banks to Fed supervision — they will prevent another catastrophe. Even with the increased oversight, it’s hard to see how this council would have been able to prevent the last crisis by just combining their collectively mistaken perceptions of the economy.

Bernanke was fond of saying “our banking system remains healthy and well-regulated.” His predecessor confidently pronounced in 2005 — when the housing bubble was peaking — that while he saw “a lot of local bubbles” he was quite sure there was no “national bubble.”

The problem wasn’t completely a matter of data being unavailable; it was an issue of proper analysis. In the summer of 2008, before Fannie Mae (FNM) and Freddie Mac (FRE) were put in conservatorship, Treasury Secretary Henry Paulson asked Congress for authority to provide the government-sponsored enterprises (GSE) with a liquidity backstop if necessary. At the time he said he had no intention of using the authority and was only asking for it in order to give the markets confidence. In his memoir, Paulson said that, at the time, he had no idea how bad the problem with the GSEs was.

Neither was Congressional GSE overseer Rep. Barney Frank, a Democrat from Massachusetts, aware of the problems with Fannie Mae and Freddie Mac. Just weeks before the GSEs were taken into conservatorship, Frank confidently stated, “I think this is a case where Fannie and Freddie are fundamentally sound, that they are not in danger of going under… I think they are in good shape going forward.”

The historical track record of federal regulators being able to uncover a financial crisis in the making suggests the council is headed for failure. It may well be able to prevent the last crisis from repeating itself. Indeed, regulators can watch for similar warning signs and react to those. But there’s no way to predict what the next, new crisis will be. And there will be another one.

Oh, and in related news, Bernie Madoff has been named the new chairman of the Securities and Exchange Commission.

This article was originally published by on August 3, 2010: This is the second in a series of commentaries on the Dodd-Frank Act.