Posted by Joseph Y. Calhoun, III

Ben Bernanke’s speech at the Council on Foreign Relations on March 10th somehow escaped my attention at the time, but it is a masterful speech that deflects the blame for our economic problems onto just about everyone except the Federal Reserve. Bernanke starts by laying out what he sees as the causes of the crisis. All of them, in my opinion can be laid at the doorstep of the Fed or Treasury:

In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

Could the Fed’s policy of holding interest artificially low for most of the last 20 years have anything to do with the low savings rate? Based on my simple supply/demand analysis, if you hold interest rates too low, ignite first a stock bubble and then a housing bubble, people are not going to see the need or incentive to save. And the commodity exporters wouldn’t have had all those excess dollars if the Fed hadn’t printed them and the Treasury hadn’t incessantly talked down the dollar.

However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States. The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets.

Again, we find the Fed’s fingerprints. If banks and other financial institutions hadn’t believed that the Fed would bail them out of every bad decision, maybe they would have been a little more prudent about investing their capital. Furthermore, the capital was misdirected because the Fed distorted the money market by manipulating interest rates.

Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort. In that regard, the Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn. Moreover, we have reiterated the U.S. government’s determination to ensure that systemically important financial institutions continue to be able to meet their commitments.

Stabilizing the financial system requires allowing failed institutions to fail. The Fed and the Treasury are the ones blocking recovery. And with a now more explicit guarantee, what are the chances that these large institutions will make more poor investment decisions?

Today, I would like to talk about four key elements of such a strategy. First, we must address the problem of financial institutions that are deemed too big–or perhaps too interconnected–to fail. Second, we must strengthen what I will call the financial infrastructure–the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets–to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality–that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing. My discussion today will focus on the principles that should guide regulatory reform, leaving aside important questions concerning how the current regulatory structure might be reworked to reduce balkanization and overlap and increase effectiveness. I also will not say much about the international dimensions of the issue but will take as self-evident that, in light of the global nature of financial institutions and markets, the reform of financial regulation and supervision should be coordinated internationally to the greatest extent possible.

Who will man this agency charged with “monitoring and addressing systemic risks”? Would that be the Fed? In fact, doesn’t the Fed already have some oversight functions that should have prevented some of these problems? Why didn’t they enforce the existing rules? Coordinate regulation and supervision internationally? Isn’t that, at least in part, what Basel II was all about? That didn’t work out too well did it?

Bernanke, like so many in DC, sees the current crisis as a lack of regulation and therefore sees the solution in more. We already have the OTS, OCC, FDIC, SEC, Federal Reserve and Treasury Department. How many more regulators can we possibly need? The financial crisis of 2008 was caused primarily by the Federal Reserve and if we want to avoid future ones, that is the institution that needs reform. It is the Fed’s meddling in markets which got us here and their current meddling will likely cause the next crisis. We don’t need a super regulator. We need the Fed to do what it was designed to do - maintain the value of our money and act as lender of last resort. They have failed miserably in the first and have overstepped their bounds on the second. If the Fed can’t accomplish those goals - and I don’t care who is Chairman, I don’t believe it can - it should be abolished and we should return to the gold standard. It wasn’t perfect, but it was a hell of a lot better than the Fed.

As for all the other alphabet agencies, they need to enforce the rules that already exist. Every agency charged with oversight failed in this mess. They didn’t fail because there weren’t sufficient rules. They failed because they didn’t enforce the rules that already exist. Yes, some changes are necessary and we should review the system but some simple changes would go a long ways toward preventing this from happening again. The one simple thing that would help prevent future crises is to raise - dramatically - the capital requirements for banks and enforce them strictly. No off balance sheet shenanigans. Higher capital requirements would probably have to be phased in over time but it has to happen. Over lending by banks for speculative activities has been at the center of every major financial crisis in the history of the US. How many times does this have to happen before we finally do something about it?