Why the Federal Reserve Needs an Overhaul
The Fed’s Dilemma
In the early months of 2007, on the eve of catastrophe, most members of the Federal Open Market Committee seemed oblivious to the crisis about to seize the financial system. In March of that year, Fed chair Ben Bernanke said he was “puzzled” that financial markets were roiled by the collapsing value of subprime mortgages. After all, he told FOMC members, “the actual money at risk is on the order of $50 billion from defaults on subprimes, which is very small compared with the capitalization of the stock market. It looks as though a lot of the problem is coming from bad underwriting as opposed to some fundamentals in the economy.”
Bernanke’s remarks show that he did not grasp the nature of the threat or understand how the interconnections of modern finance would swiftly spread the panic from one troubled credit market to others. The Fed chair was not embarrassed by this ignorance because his remarks were made behind closed doors, at the FOMC meetings that set monetary policy. The transcripts of those 2007 meetings were not made public until five years later—long after the disclosures could have had an impact on financial markets or public opinion. The Fed’s narrow-gauge thinking and its fallibility were, as usual, protected from timely public scrutiny.
Some of Bernanke’s colleagues voiced similar complacency. “We don’t see the current situation as precipitating a cyclical downturn in aggregate activity,” said David Stockton, the director of Fed research, in reporting the staff forecast in March 2007.
Jeffrey Lacker, president of the Richmond Federal Reserve Bank, seconded this overconfident view. “My overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies,” he said at the same meeting. “Realization of that risk seems to be playing out in a fairly orderly way so far.”
Michael Moskow, president of the Chicago Fed, also grossly misjudged reality. “Given the ample liquidity in financial markets, it seems unlikely that the subprime problem will cause major changes in overall credit availability or pricing,” he said.
The transcripts of the 2007 policy meetings quoted here destroy the Fed’s popular reputation as economic soothsayer. Some FOMC members worried about inflation or oil prices or the home-building industry; others clung to business-as-usual optimism, even as the market news got more disturbing, with Bear Stearns and Countrywide and others sliding toward their fatal reckoning. It took six or eight months, and more violent market disturbances, for the FOMC to wake up, despite prodding and pleading from a few strong voices.
One such voice was Janet Yellen, who recently began her tenure as the new Fed chair. In March of 2007, she was the first to warn that financial stability could be threatened. By August, she sounded a bit impatient with slow-moving colleagues. “We seem to be repeatedly surprised with the depth and duration of the deterioration in these markets,” Yellen observed, “and the financial fallout from developments in the subprime markets, which I now perceive to be spreading beyond that sector, is a source of appreciable angst.”
As the pace quickened, William Dudley, manager of the open-market desk at the New York Fed (and now its president), was a levelheaded sentinel and tutor, warning about “a danger of forced liquidation” and trying to educate FOMC members on the complexities of collateralized debt obligations and other Wall Street exotica. “The magic of structured finance and the corporate rating agencies,” Dudley explained, had been used to convert low-rated debt paper into triple-A investments. Now the investors who had bought the stuff were discovering that the assurances were false. As they started dumping failed investments, they began to wonder what else was phony, and the panic spread.
The question arose in the FOMC’s meetings: What should it tell the people? This is always the fundamental dilemma for a central bank used to deliberating in private. Does a public institution that sees a threatening storm have an obligation to inform the public at large—that is, give citizens fair warning of what’s about to happen to them? Or would that only make things worse? To put it another way, in a public-private institution, who gets to know the secrets? As events darkened in 2007, the dilemma nagged policy-makers.
“I am worried that we will be asked publicly at different intervals and perhaps starting now what our opinions and perspectives are,” Richard Fisher, president of the Dallas Fed, said in August. “I’m also worried about giving the wrong answer.”