Tuesday, June 10, 2008

Expanding the Fed

Here's a good speech by one of the the PIMCO boys about the way the Fed works and what effect the recent changes might have on it. He's pretty sanguine about the whole works, and goes so far as to see a sliver lining in all this:

Post opening the discount window to the investment banks, regulatory arrangements will ineluctably change – it is simply untenable for the Fed to lend to someone that it doesn’t regulate. The Fed knows this and Congress knows it, too. Thus, while the Fed may have less independence over the composition and size of its balance sheet, the Fed will have greater leverage at this watershed moment to demand and get sensible regulatory reform, aimed at counter-cyclical, rather than pro-cyclical, constraints on leverage in the financial system.

And, in fact, I think there actually may be a silver lining in the Fed’s making more loans and holding less U.S. Treasury securities on the asset side of its balance sheet, even if Congress is given to more meddling. More loans will, by definition, give the Fed more power to shape the activities of those to whom it loans, similar to the relationship between Bank of Dad and my 19-year old son.

I am much less certain. Just look at the bit of rhetoric here. The government is the Bank of Dad. Call me a right wing nut-case, but that's exactly what got us into this whole bloody mess! What on earth would make you happy about putting the fox in charge of closing the barn door after all the chickens got out? Sorry, couldn't resist that one.

Anyhow, there is a really easily identifiable pattern in American history. First, you have some crisis. It can be purely financial, more broadly economic, one of security or health and safety and retirement, whatever ... it makes no difference because the crisis is just the MacGuffin, as Hitchcock used to put it. The crisis is always an excuse for the government to come in and take over "for the benefit of everyone". This inevitably seems totally plausible at the time, and sage people will nod their heads in agreement and talk about how it was sadly necessary. Once the government gets its foot in the door it will never leave. Temporary measures needed in the crisis become permanent almost without exception. At first, the new regulation looks great -- after all its wisdom and measure just saved us from the foolishness and greed that precipitated the crisis.

But pretty soon, people start to realize that some of these new regulations have all kinds of undesirable consequences that nobody saw right at first. To begin with, these regulations are overseen by a bunch of bureaucrats whose primary goal in life is not looking to the benefit of "the people" (who, like all other abstract nouns, are after all not to be found anywhere in particular) but to keeping their jobs. So the primary goal of all regulation is more regulation. On top of that, these bureaucrats have to come up with their brilliant regulatory schemes somehow, and they ain't getting any help here from the luminaries in congress, so the natural people to consult are those whose businesses you are regulating, and the natural place to hire people to do this regulating is from the ranks those very businesses. And don't forget that when these people stop regulating, they can always go back to those companies and make many many times more money. So now businesses are back regulating themselves again, except this time not through a free and transparent market, but through a backroom lobbying setup that only the biggest businesses have access to. Unsurprisingly, monopolistic self-regulation is not effective, and sets the stage for another period of stupidity and another crisis, which of course, requires even more regulation to solve.

That little allegory applies equally to finance, defense, the FDA, and just about every other aspect of government I can think of. It doesn't require any conspiracy theory or any terrible plot by the government or by "big business". It's just a simple mechanism that forms a predictable and well defined feedback loop. Government makes more government. Centralization and regulation propagate. When other countries begin to imitate, they reproduce.

I have honestly gotten to the point where I'm almost unable to understand why this is so difficult for people to see. The Bank of Dad is clearly one of the greatest myths of all time.

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