Obama's recent nomination of Jeremy Stein and Jerome Powell to the Board of Governors of the Federal Reserve System raises an important question: How should the Senate treat nominations whose terms are likely to run beyond the term of the current president? If confirmed, Stein could serve until 2018 and Powell until 2014. Of course this pales in comparison to current governor Janet Yellen, whose term runs until 2024. With or without Stein and Powell, Obama nominations will have control of the Federal Reserve for years to come.
The long terms of Federal Reserve governors are meant to insulate them from political pressure. But that's after they've been confirmed. This structure tells us little about how to handle such appointments during their nomination phase.
In the absence of strong policy or theoretical rationales, we often look to precedent. In this case we have at least one. In December of 2007, almost a year before the November 2008 election, then Senate Banking Committee chair Chris Dodd (D-CT) said, in relation to the nomination of Randall Kroszner to the Federal Reserve, "We're frankly getting down to less than a year away from the election. On nominations of that length, I'm fairly reluctant." Senator Dodd acted (or rather failed to act) on that reluctance, and blocked the nomination of Professor Kroszner. His nomination was not an exception, as the nominations of Larry Klane to the Federal Reserve and a couple of nominations to the Securities Investor Protection Corporation were also blocked, for apparently this same reason. Dodd also delayed nominations to the President's Council of Economic Advisers, although those positions would have ended with the term of President Bush. Also worth noting is that these important economic policy positions were being blocked in the middle of a recession and financial crisis, when one would think you need "all hands on deck."
Is this "Dodd rule" the correct position? It's hard to know. I can say I didn't think it was appropriate at the time. And I am usually not one to believe that "two wrongs make a right." The correct solution, in my view, would be to have the Senate decide upon the appropriate length of time before a presidential election that it will no longer consider nominations that run beyond the president's term and incorporate that decision into the Senate rules. Until then operating under the "Dodd Rule" strikes me as fair enough.
Tomorrow the Senate Banking Committee will likely hold a vote on President Obama's recent nominations to the Federal Reserve Board, Harvard professor Jeremy Stein and former investment banker and Treasury official Jerome Powell. I've written elsewhere on how these two fail to meet the statutory requirements for board membership, as it relates to geography. But there is another issue that continues to bother me about these nominations. That is the unwritten assumption that Wall Street gets a seat on the Federal Reserve Board.
As Bloomberg reports Powell "would bring expertise on financial markets to the Fed’s board, filling a void left by Kevin Warsh, a former Morgan Stanley banker." But this overlooks the fact that the New York Federal Reserve President, currently former Goldman Exec William Dudley, is a permanent member of the Fed's Federal Open Market Committee (FOMC). As an institutional matter, the Fed already has a line from Wall Street via the New York Fed, where's the need for another?
The Federal Reserve Act requires the president, when making nominations to the Fed, to give "due regard to a fair representation of the financial, agricultural, industrial, and commercial interests." As far as I can tell there is zero representation on the Board for "agricultural, industrial and commercial interests" and already one former banker (Duke) on the Board. How is that "fair?" While this "fairness" requirement is not as black and white as the geography issue, I do believe it is one fundamental to the functioning of the Fed. Is this a Fed that represents all sectors and interests in the economy, or is this a Fed that mainly represents Wall Street (and academia, which is never mentioned in the Federal Reserve Act)?
While I do not personally know Mr. Powell, and I have no reason to suspect he is anything other than an honorable and well-intended man, I think we all have reason to believe that the last thing the Fed needs is another New York investment banker.
You might have heard of Peter Diamond, he recently won the Nobel Prize in Economics and earlier this week withdrew his nomination to the Federal Reserve Board. But maybe you have not heard of Paul Pate.
Mr. Pate, former Republican mayor of Cedar Rapids, Iowa was nominated by President Bush in 2003 to fill a seat on the board of the National Institute of Building Sciences. I remember it well, as I handled that nomination as staff for the Senate Banking Committee.
So what exactly do Mr. Diamond and Mr. Pate have in common? They were both nominated for positions they could not legally hold. I've written elsewhere about Mr. Diamond's situation. Mr. Pate was barred from serving on the NIBS board due to an ownership interest he had in an asphalt company.
Bush's Office of Presidential Personnel didn't catch that problem because they, like Obama's same Office, don't appear to actually read the statutory qualifications for nominations. I will admit, I didn't catch this problem either. It was brought to my attention by the staff of former senator Paul Sarbanes (D-MD). When I verified Sarbanes's objection, we immediately told Mr. Pate and the Bush White House that then Committee Chair Richard Shelby would not move Mr. Pate's nomination (despite Mr. Pate's personal friendship with Sen. Grassley (R-IA)).
Both Mr. Diamond and Mr. Pate were, in part, the victim of circumstances beyond their control. They had done nothing wrong. Yet the law was the law. While I don't equate NIBS with the Fed, that shouldn't matter. We should respect the law regardless of the viewed relative importance of the position. In fact, I believe the more important the position, the greater need for respecting the law.
Unfortunately there is a lot Mr. Diamond and Mr. Pate do not have in common. Rather than accept his bad luck, Mr. Diamond offers in the New York Times the rant of a spoiled brat. Mr. Pate, in contrast, accepted his bad luck with integrity and grace.
An insightful op-ed in yesterday's Financial Times by Raghu Rajan (who will be presenting his latest book soon here at Cato), apparently was too much for Paul Krugman to bear. What was Rajan's great crime that so upset Krugman? Rajan, correctly, pointed out that US policies, such as Fannie Mae and the Community Re-investment Act, were direct contributors to the financial crisis and that bankers shouldn't be blamed for simply reacting to perverse government incentives.
Now Krugman cannot bear to see CRA and Fannie questioned. He claims that Rajan is relying on some blind faith that has been disproven by all thinking people. Krugman offers two points (his supposed "facts") that prove Fannie Mae and CRA are innocent.
First, he argues that the bad lending was done not by banks covered by CRA, but by non-banks that were exempt from CRA. Now in Krugman's defense, there is a grain of truth to this. For instance, up until its purchase of a thrift, Countrywide, the largest subprime player, was not covered by CRA. However, comparing Countrywide to say Bank of America, which was covered by CRA, misses a crucial point: these non-CRA lenders were selling their loans to Fannie and Freddie, who were getting housing goal credit for those loans. For instance, 25% of Fannie's whole loan purchases were from Countrywide. So rather than, as Paul claims that CRA didn't matter, what the comparison shows is that the GSE housing goals were more damaging than CRA.
Krugman tries to cover this base by claiming that Fannie and Freddie were "sidelined by Congress" during the worst years of the boom. As someone who spent the boom years as staff on the Senate Banking Committee, I found that claim to be insane. For every Senator Shelby who tried to sideline the GSE's, there was 10 Senators Sarbanes, Dodd and Schumer who pushed the GSEs to do more. Krugman needs to move past empty assertions and offer some, any, evidence that Congress sidelined Fannie and Freddie.
What evidence he does offer is to show that during the boom, the percent of the market that was securitized by Fannie/Freddie fell, while the percent securitized by the private-label market increased. Krugman has that fact correct, yet he misses a critical point. That increase in private-label securities was being funded/purchased by Fannie and Freddie.
As my chart illustrates, the more involved were Fannie and Freddie in purchasing subprime MBS, the more the subprime market grew. During the bubble years, Fannie and Freddie were the largest single source of liquidity for the subprime market. And the chart doesn't even take into account all the subprime whole loans being purchased by the GSEs.
Sadly Krugman has his facts on CRA wrong as well. I point the reader to Ed Pinto's work in this area, as well as my post on CRA from a few months ago.
We have little hope of avoiding a future financial crisis if we do not undo all the perverse government incentives for irresponsible lending. Krugman's presentation of selective and misleading data only makes true and meaningful reform all the more difficult.
When it comes to banking policy, there are few people I respect more than Jonathan Macey and Arnold Kling; so when these two, independently, argue that we should be breaking up the largest banks, it is idea that merits consideration. Yet I still have my doubts.
First, lets start with what we are fairly certain of. There is a large empirical literature that suggest most US mega-banks are beyond their efficient size. There is a good survey of the literature by former Fed Economist Allen Berger . So, at a minimum, the academic literature suggests the largest banks are beyond a size that is justified by the social benefits.
However, there is also a small literature that suggests more concentrated banking systems are more stable, and less prone to crisis. Some of this literature has grown out of research efforts by the World Bank. While this literature is largely cross-country comparisons, recalling our own banking history gives several examples - the savings & loan crisis, the mass of small banks failures in the 1920s and 1930s, and current day Georgia - where lots of small bank failures have been associated with significant economic damage. So, at minimum, there is some question of whether breaking up the largest banks would give us a more stable, less crisis-prone system. In fact, there is considerable evidence to suggest that breaking up the banks would make our financial system more fragile.
To some extent, the debate over breaking up the large banks is about reducing political power. The argument is that, because of their vast resources, these large banks unduly influence and capture our political system. Undoubtedly, I believe the largest banks have substantial influence over both our legislative and regulatory systems. However, so do smaller banks. From my seven years as staff on the Senate Banking Committee, I would definitely argue that the Independent Community Banks Association (ICBA), as a group, has far more pull than does say Bank of America, as a single company. One need only witness the various exemptions for small banks in the Dodd bill, for instance from the consumer protection bureau, to illustrate the lobbying power of small bankers. One could also argue that the economic history of progressive era legislation, like the Sherman Act, is one of smaller, organized interests winning against larger sized firms. Despite its appeal, the assertion that bigger is always better in politics is just an assertion. Yet this is at heart an empirical argument, and perhaps one that can be tested. Until then, I still have my doubts.
Today Paul Volcker appears before the Senate Banking Committee to argue for the separation of proprietary trading and commercial banking. In Mr. Volcker’s own works “what we plainly need are authority and methods to minimize the occurrence of those failures that threaten the basic fabric of financial markets.”
Using his own test, the Volcker Rule fails miserably. Had this rule been in place say five or even ten years ago, we’d most likely be in the same place we are today. It would have not avoided the crisis, and may potentially have made it worse.
First of all the proposal ignores the fact that those institutions at the heart of the crisis, Bear, Lehman, Fannie, Freddie, AIG, were not commercial banks. They were not using federally insured deposits to gamble in our financial markets. Those commercial banks with proprietary trading activities that did fail, such as Wachovia, were sunk not by proprietary trading, but by bad mortgage lending.
Mr. Volcker is correct in arguing for a change in assumptions that institutions and their creditors will not be bailed out. He errs in believing that the House passed financial “reform” bill achieves that. One has to wonder if he’s bother to even read the bill. The House bill explicitly allows for rescuing creditors. The House bill does not reduce the chance of bailouts, it increases them.
While the Obama Administration may have changed the face of its reforms, sadly the substance of its proposals continue to bear little relation to the actual causes of our financial crisis. Nowhere in the President’s proposals do we see any efforts at avoiding future housing bubbles. Perhaps this should come as no surprise given Washington’s continued attempts to re-inflate the last housing bubble.
Fed Chairman Bernanke’s term as Chair ends in January 2010. So far President Obama has offered Bernanke praise for his performance, but little else. After last week’s House Oversight Committee hearing focusing on Bernanke’s role in Bank of America’s purchase of Merrill Lynch, it is now readily apparent that the Chairman has few supporters on Capitol Hill. While his nomination will not be subject to the approval of the House of Representatives, or any of its Committees, the Senate Banking Committee’s reaction to Treasury Secretary Geithner’s plan to extend the Fed’s power serves as a useful proxy in gauging that Committee’s view of the Fed’s recent performance.
Several recent polls show President Obama to be broadly popular with the American public, while the public holds some concern over the scope and cost of his policies. His policy that garners the least support has been his bailout and support for the auto industry. It is no secret that the American public was not enthusiastic about the bailouts at the time, and is even less so now. With Hank Paulson having left the stage, Bernanke is now the public face of corporate bailouts. While having Bernanke around may offer President Obama a convenient target for the public’s anger over bailouts, re-appointing Bernanke would finally force Obama’s hand -- so far he’s managed to support the bailouts with little fallout, as Bush and others have taken the blame. Re-appointing Bernanke makes him Obama’s pick.
In addition to political risk to President Obama, one can assume that many Senate Democrats are not looking forward to having to vote for the man who bailed out AIG. It is a fair bet that many Republican Senators would not vote for Bernanke’s re-appointment, leaving it up to the Democrats to secure his re-appointment.
Whatever the merits, or flaws, in his performance as Federal Reserve Chair, support for Bernanke’s re-appointment is becoming a proxy for one’s support, or opposition, to corporate bailouts.