(This article was originally published on January 14, 2010 and submitted to the Wall Street Journal as an Op-Ed piece. There is reason to believe that the article was removed without my knowledge by illegally accessing my email and WordPress accounts because it is a potential exhibit in my grievance against the Federal Reserve submitted to Senator Barbara Mikulski of Maryland for suppressing dissent within the Fed against the Fed’s official position on the matter of financial regulatory reform.).
The Federal Reserve has published its official case for a role in financial regulation amidst the bold legislative outcry to strip it of all financial regulatory powers. That case has been well anticipated because it has been aired by the members of the Fed Board on several occasions both in front of Congress in earlier public testimonies and in public speeches.
The Fed’s public case to keep its banking supervisory and regulatory function deserves a necessary public rebuttal, especially in the wake of the bold proposals to reform the financial system in the Congress. In a democracy, only rarely is such boldness seen. And when it surfaces, it does so for good reason. The reasons are all too well known: a Wall Street insulated from the business cycle that affects every other American, an unemployment rate in double digits, wage and income uncertainty and high average debt burdens with no clarity from the government as to how the country is going to extricate itself from the despondence. It would be irresponsible on the part of the Fed to not work with the Congress to overhaul financial regulations and institutions, setting its own bureaucratic turf aside.
The Fed, under current public law, regulates its member banks. It also supplies money to the same banks. This is a core conflict of interest in the functions of the institution. This legal conflict of interest, the absence of checks and balances, presents an avenue for moral hazard, largely leaving it to the Fed’s judgment to stay honest. In our system of government, all derivative institutional structure flows from the most fundamental arrangement of the separation of powers under the United States Constitution. Institutions are designed to act as a check and balance on each other. The Fed cannot be allowed to regulate the banks it is charged with supplying money to because doing so could be potentially unconstitutional, let alone supervising banks in a manner that is completely non-transparent.
The United States Congress had passed the Federal Reserve Act (FRA) in a manner that creates the conflict of interest of the Fed supplying money to the banks its regulates and through private financial institutions that are almost entirely outside government reach, with the Fed’s statutory independence since the Treasury-Federal Reserve Accord of 1951 which effectively keeps it outside the scrutiny of both the Executive Branch and the Supreme Court of the United States.
The Fed says that it needs the financial markets supervision function, at least all of the current function it is currently performing, because it has expertise. True. However, the presence of expertise in one government institution does not preclude the Congress from transferring it to another by simply moving the bureaucracy to another government institution, just as it has already done with consumer protection.
The Fed says that its direct supervision of the financial markets, as it has done under extraordinary circumstances during this crisis with some Wall Street corporations which it had not regulated before, will help it react nimbly with monetary policy to changes in the health of the markets. True, but to react nimbly the Fed need not collect the supervisory data also just as the Fed also does not collect the data for the nation’s gross domestic product (GDP) and inflation (or the change in the consumer price index), the most essential data for it to do its job. The Bureau of Economic Analysis (BEA) and the Bureau of Labor Statistics (BLS), two executive branch agencies, provide that data which is the best in quality compared to anywhere else in the world (though there is always room for improvement). The Fed indeed reacts nimbly to changing economic circumstances. Therefore, so can it if another government agency provides similar data about the health of the financial markets as often as BEA and BLS produce output and inflation data.
The Fed says the financial markets data is critical to make monetary policy. True, and unequivocally so. But the Fed is not the Fed bureaucracy (which includes its current banking supervision and regulation and payments systems bureaucracies, both of which it wants to keep). The Fed is the Federal Open Market Committee (FOMC). The FOMC must have an important role to only fully take into account, but not either supervise or regulate, the health of the financial markets to set interest rates.
For the Fed to have that role, similar but at the same time unlike the European Central Bank (ECB) which the Fed cites in its case, whichever new agency is charged with supervising and regulating the financial markets and to collect data must have a permanent vote on the FOMC. That agency must be asked to provide a detailed analysis of financial market conditions based on its supervision and regulation functions that spans the entire breadth of the financial markets, 8 times in year to the FOMC for each rate setting meeting. The Fed economist bureaucracy around the country currently does the same for economic conditions in the form of the Beige Book, Greenbook and the Bluebook. The Fed needs a similar book to describe the health of financial markets.
It would be best if the Congress gives the Department of the Treasury the full financial markets supervision and regulation authority and lets the Treasury determine whom to send to participate in the FOMC deliberations. Further, the Treasury also issues coins and notes, the nation’s currency, and surveils the financial system. Therefore, the Fed’s Payment Systems function can also be shifted to the Treasury. Then, what the Congress would be doing would be no different from what the Congress has already intended to do in the case of consumer protection.
How the nation supplies its money must be purged of conflicts of interest, because most elementally, the very institutions through which the Fed regulates money supply, its primary dealers, have been operating outside all regulatory reach since the inception of the Fed in 1913 (besides some limited role for the Securities and Exchange Commission and a smattering of other government agencies). A list of the Fed’s primary dealers can be found at http://www.newyorkfed.org/markets/pridealers_current.html.
The Fed has no case.