Mort Zuckerman: Keep Congress Away From the Federal Reserve

When the professionals at the Federal Reserve Board review the epic diary of our economy, their lament must be “How soon they forget.” It has been 30 years since America was in the grip of double-digit inflation, with seemingly no hope of escape. The professionals look back with justifiable pride on the brave ac­tions of the Fed under Chairman Paul Volcker. Memorably, it raised interest rates to nearly 20 percent. Unemployment rose. The political firestorm was more turbulent than any­thing since the days of Herbert Hoover and the Great ­Depression. But the Fed’s extraordinary action broke the back of the “Great Inflation,” launching us into the “Great Moderation,” a 25-year pe­riod of high employment and prosperity with very limited inflation.

This was an exemplary illustration of Federal Reserve independence. Imagine if Congress had called the shots. Can anyone believe it would have acted with such reso­lution—and in an election year?

When the stock market crashed in 1987, the Fed restored confidence. It came to the rescue again after 9/11 created the financial ­disruption of 2001. How soon they forget! It has been only a year since our overleveraged system buck­led. Fear and panic paralyzed normal mar­ket functions. We were on the verge of en­during a freeze-up of the entire financial system that would have plunged our econ­omy into another Great Depression. What pulled us back from the chasm was the intervention of the Federal Reserve Bank.

The Fed led off by cutting ­interest rates aggressively, bringing them close to zero. That by itself didn’t do the trick. The Fed swiftly realized that the too-big-to-fail ­financial institutions, which account for roughly half of our banking, had seized up because their own financial assets had collapsed. The smaller banks didn’t have the means to bridge the gap. Understandably, households and busi­nesses cut their debt, so spending fell just when we needed to increase demand to prop up the economy. The Fed real­ized that unconventional policy tools were urgently need­ed to keep equity and debt capital flowing. It responded with great creativity and ingenuity through unique lending and asset purchase programs. It rebuilt confidence in the system through a series of “stress tests” that looked at which banks’ policies had gotten out of whack, lending too much on the basis of inadequate capital. The unprecedented mea­sures that the Fed took restored confidence and liquidity without provoking sharp increases in inflation. The rescue could not have happened without the Fed’s credibility and independ­ence from short-term political pressures.

In the process, the Fed has stoked public anger by bail­ing out, with billions of tax dollars, the same people and financial firms that got us into so much trouble in the first place. By bailing out individual firms, the Fed broke its long-standing policy of creating money completely separate from the decision of who benefited. It was necessary to do this because a general easing would not prevent the domino effect whereby one firm’s col­lapse would lead to runs on the others, thus threatening the health of the entire finan­cial system that lies at the core of our free-market economy.

As the chairman of the Fed, Ben Ber­nan­ke, put it, “That could have rivaled the Great Depression in length and severity.” The Fed’s choices were limited to allowing a major financial firm to fold, raising the pos­sibility of a systemic risk, or supporting the firm with taxpayer money. The choice of the latter course was even braver than the Fed’s assault on inflation in the 1980s.

These are but a few examples of why we must preserve the Federal Reserve’s ability to foster financial stability and promote economic recovery.

It could fairly be said that the Fed did not take timely steps to correct a generally ­unperceived structural transformation of the financial world. Money market funds emerged that undermined deposit ac­counts in banks; commercial paper trans­formed the business of short-term lending to big corpo­rations; high-yield bonds had the same effect on lending to smaller companies.

Then there were the many complex debt securities. Those in the financial world relied on third-party insurers who they believed would immunize them against failure mainly through so-called credit default swaps. When that proved illusory, the result was a panic that shattered confidence and raised the possibility of systemic failure. The financial world seemed so stable and predictable that it was a tremendous shock to find that we were living on top of the San Andreas Fault. Indeed, we now live with sec­ondary tremors because the imbalances that created the cri­sis, such as excessive leverage and collapsing asset values, have not yet disappeared (see Dubai). Huge potential vul­nerabilities remain.

The Fed has suffered disrepute in Washington because of the central bank’s failure to recognize the significance of the structural changes. It also underestimated the risk of maintaining the federal funds rate at 1 percent in 2003 and 2004, which contributed to the orgy of excessive debt. Most critically, the Fed’s focus on the safety and soundness of ­individual institutions was paralleled by the lack of clear responsibility for preventing a systemic risk to the entire financial world.

The result has been legislative proposals before Congress that would significantly reduce the capac­ity of the Fed to perform its core function, all fueled by populist anger at the fact that Wall Street seems to be flourishing from the re­cession while the nation is not. In the Senate, there is a proposal to strip the Fed of its role and powers vis-à-vis the regu­lation of banks. In the House, there is a proposal that would repeal a 1978 provision meant to pro­vide the confidentiality to guard monetary policy from political influences.

The sponsors of the legislation discount how much the Fed has done to reduce the risks. The Fed has toughened the rules. It now requires banks to hold more equity capital and liquidity, and it is seeking to structure compensation packages in ways that limit excessive risk-taking by bankers.

Since giant financial firms will inevitably be a part of our future, the Fed is can­vassing new regulations and tougher over­sight of large, complex firms. As Bernanke put it, we are going to have to develop “a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system.”

None of the measures already taken would have been possible without the Fed’s unparalleled expertise and authority derived from its role as bank supervi­sor. It’s an expertise critical to overseeing complex fi­nancial firms and their interactions with others and the market. But Congress is in a dangerously fretful mood.

The House proposal seeks to have the Government Ac­countability Office audit all Fed operations, including emergency lending programs, interactions with foreign central banks, assistance to major financial institutions, and the Fed’s ability to push down interest rates by in­tervening in bond markets. In effect, the sponsors want to audit all the Fed’s monetary policy. The idea sounds in­nocuous, but it isn’t. Increasing the perceived influence of Congress on monetary policy decisions would alone un­dermine the confidence not only of the public but also of the financial markets at home and abroad. We would then be witnessing after the fact opinions by the GAO on whether a certain monetary policy is correct or incorrect, which would dramatically constrain the deliberations of the Federal Open Market Committee in making these judgments. And should the Fed be taken out of bank su­pervision, it would be crippled in its ability to prevent and manage crises. Without being able to gather information through bank supervision, it is hard to believe that the Fed, or anybody else, would know enough about the risks.

There is another situation coming to a boil. Banking reserves that determine the capacity to create money have increased by a multiple of nearly 500, from $2 billion or less before the crisis to $1 trillion today. It is not a strat­egy that can last for long, but deciding when to exit is a tough call. Squeeze too soon and the recovery will die; too late and inflation will come back. Forestalling the inflation risk will very likely mean raising interest rates at a time when unemployment has not fallen much, if at all. This is a quintes­sential judgment call for the Fed but will hardly go over well with a hostile Congress. But the politics seem to be going against the Fed, with two thirds of the House back­ing new constraints.

The Fed just has to be protected. If glob­al financial markets came to believe that political pressure was determining mone­tary policy, there would be dangerous con­sequences. The markets would reckon that inflation in the United States would lead to higher interest rates. There would be greater downward pressure on the dollar—and given the deficit we are facing, a run on the dollar would be disastrous.

All this would be a high price for con­gressional amnesia. It is not as if the Fed is unscrutinized. It gets plenty of attention from both the financial markets and the media. The chairman of the Fed and other Fed officials are constantly testifying before congressional committees. But a congres­sional audit of monetary policy through the GAO is a dif­ferent matter altogether.

An independent monetary policy designed and executed by the Fed is one of our enduring achievements. It has for decades brought us relatively low inflation and has been ad­mired and imitated by many other countries. As Sen. Jim DeMint of South Carolina put it, “If there’s anything worse than a secret Federal Reserve, it’s Congress controlling it.”

We must preserve the Fed’s historic and crucial insula­tion. Sen. Judd Gregg of New Hampshire sums it up aptly: “Congress has demonstrated time and again its inability to manage the nation’s fiscal policy, illustrated by our stag­gering national debt in excess of $12 trillion, so how could anyone think that its involvement in monetary policy would be good for the country?”

When we fell off the cliff, the Fed threw us a rope. While we are being hauled back up, along comes a busybody who says, “Give me the rope . . .” No thanks!

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