Sunday, September 27, 2009

Still Not Convinced the Fed Shouldn't be the Systemic Risk Regulator?

I argued against the Fed taking such a role in this blog entry earlier this month. Among my five points was this:
The Fed doesn't have the regulatory chops.

And what do you know? The Washington Post now does a detailed autopsy on how the Fed failed to rein in the mortgage lenders who abused subprime borrowers: As Subprime Lending Crisis Unfolded, Watchdog Fed Didn't Bother Barking. Consumer finance companies sprang up in an unregulated space, and as they boomed, established banking companies jumped in to create their own mortgage-lending units and grab a chunk of the profits. Throughout this period, the Fed decided not to get involved.

The takeaway points: (1) The Fed didn't just regulate lightly. It turned its back on this sector altogether, while these predatory lenders grew like weeds. (2) The Fed was being warned about these lenders as early as 1998, about a decade before everything fell apart. (3) When the Fed declined to supervise them, that left a vacuum, because the Fed alone was in a position to handle the job, according to a 1999 report by the General Accounting Office. (4) Possible reasons for the Fed's indifference: under Greenspan it didn't believe much in regulation anyway (surprise, surprise!) and had an "affinity" for the financial industry (5) The article suggests the Fed is a place full of navel gazers who like to deep-think about the economy and not muck around with anecdotal details. As the Post tells us:
The Fed also minimized repeated warnings about mortgage lending abuses in part because it was an institution dominated by big-picture economists focused on the health of the broader economy rather than the problems faced by individual borrowers.
This brings me back to a simple yet common-sense point: The Fed is full of Phd academic economists, from what I can tell. By temperament, these kinds of guys are NOT good regulators. Imagine putting the Princeton economics department in squad cars and having them patrol the city for crime. First night, they'd all be gathered around a stoplight, sipping lattes and debating whether the length of the interval between green and red light signals encouraged risk-taking behaviors and what kind of model could best capture the expected increase in traffic violations.

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