Thursday, November 12, 2009

More Confusing Financial Rhetoric From Henry Kaufman

One-time Salomon Brothers economist Henry Kaufman wrote a typically-muddled editorial in yesterday's Wall Street Journal entitled "The Real Threat to Fed Independence."

Is it just me, or is Kaufman really getting to the point where he can no longer even focus on his topics anymore, and, thus, contradicts himself, while also wandering somewhat aimlessly among not-always-related topics?

Regarding the title and, thus, putative topic of Kaufman's latest diatribe, I think he's too late. Though omitted from his article, the Humphrey-Hawkins Full Employment Act of 1978 pretty much gutted independence for the average Fed Chairman, as I noted in this post from February of this year. True, Paul Volcker managed to ignore it, as he and it were both newly-minted at about the same time.

Kaufman begins his piece by writing,

"To be sure, the Fed has never been fully independent of the political process, and it shouldn't be. The president appoints the chairman and the governors of the Federal Reserve Board, and Congress must approve these appointments. With the chairman serving a four-year term, presidents at their discretion can change the Fed's leadership. While Fed governors serve a 14-year term, most of them step down well before the end of their terms."

Already, I disagree with him, and side with the venerable Milton Friedman. Find a way to put the growth of the monetary base on autopilot, and save a lot of angst and money for Fed Governors, Chairman and such. Keep the data-collection, operations and related reporting elements. Transfer regulatory oversight to the OCC or the FDIC.

Kaufman goes on to contend,

"So, why should we be concerned that the Fed will become highly politicized now? First, there is the Fed's legacy of its inability to limit past financial excesses. By failing to be an effective guardian of our financial system, it has lost credibility.

During the Greenspan years (1987-2006), the Fed clearly failed to recognize the significance of the many structural changes in the financial markets—such as the rapid growth of securitization and derivatives—on economic and financial behavior and thus for its monetary policy. The Fed also failed to foresee how the 1999 repeal of the Glass-Steagall Act, which had separated commercial from investment banking since 1933, would sharply accelerate financial concentration through mergers and acquisitions and thus contribute to the "too-big-to-fail" phenomenon."

Gee, Henry, why stop at 1987? Didn't the Fed fail to foresee the effects of removing Korean War-era regulations on installment credit, checking accounts, etc.? And, then, in the 1960s, with the despised withholding tax, the creation of the Eurobond market? And so on?

When has the Fed ever gotten ahead of any financial innovation?

But Henry gets to the heart of his argument about two-thirds of the way through his editorial,

"From my perspective, the most important issue confronting the Fed will be its proposals for reforming our financial system, especially the question of what should be done with institutions that are deemed "too big to fail." It is clear from the last few years that these large financial conglomerates have not been an anchor of stability. To the contrary. All of these institutions—including Citigroup and even J.P. Morgan Chase—would have failed if the federal government had not provided enormous amounts for direct and indirect support in key markets.

From what I could gather from a speech given by Fed Chairman Ben Bernanke at a conference sponsored by the Federal Reserve Bank of Boston a few weeks ago, the Fed favors constraining giant institutions to the point where they would become, in effect, financial public utilities. They might be required to increase equity capital and to limit their activities in proprietary trading and other risky activities."

So far, I actually agree with Kaufman. In fact, my good friend and sometime-business partner, B, was the first persion to my knowledge, back in 1996, to coin the phrase "financial utilities" to describe the current crop of super-sized commercial banks- Chase, Citigroup, BofA- minus their riskier activities.

I've written quite a few pieces about this phenomenon, discussing how the government would force divestiture of activities which couldn't reasonably be covered by FDIC protection.

Kaufman continues,

"But under this arrangement, these large institutions nevertheless would still command a vast amount of private-sector credit. And when markets became unstable in the future, other financial institutions would merge in order to come under the government's protective too-big-to-fail umbrella.

If an overwhelming proportion of our financial institutions are deemed too big to fail, monetary restraint would fall heavily on institutions that are not. Pressure would sharply intensify on smaller institutions that mainly service local communities. Further consolidation would result, which in turn would reduce credit-market competition. At the same time, with increasing financial concentration, market volatility would increase.

All of this would narrow the gap between the Federal Reserve and the political arena. Taken to its logical conclusion, our market-based system of credit allocation would be replaced by a socialized financial system, and the Federal Reserve would become part of it."

Here's where Kaufman forgets his prior position. First, he posits something that is far from necessarily true, i.e., that plain vanilla financial utilities will get into trouble with risky loans. Or that other, riskier financial services entities won't be created to offer riskier credit via better risk management.

Then, he magically equates the Fed and the "political arena," but without any explanation of what this means, or how it actually transpires.

But, right now, by the mid-2009, with government-directed mortgage loan forgiveness in Fannie and Freddie portfolios, we already have socialized finance. Congress has been doing this for over a decade.

Where were you while this was happening, Henry?

But if the financial utilities can't do risky activities, how, then, will they get into trouble and come to account for even more banking? Won't the risky activities already be in smaller, newer entities, which won't be rescued?

This is what I mean by Kaufman forgetting his own position just a few paragraphs earlier.

However, the real punchline here is that the phenomenon about which Kaufman warns in the future is already here.

How else do you describe government loan forgiveness in its own portfolios, and coercion of private entities to join a mortgage foreclosure moratorium?

Or allow Fannie and Freddie to become so bloated, but poorly-managed, as to destroy the former, parallel, private conduit systems?

Or forcibly inject federal capital into banks, then refuse to take selected repayments, requiring some banks to be treated as government-owned financial entities?

None of which actually involves Fed independence. That's a completely different topic, Henry.

Rather than regulatory forces conspiring to bring all financial activity under the Fed's oversight, and then calling this 'socialized' finance, I believe the non-Federal Reserve government entities have done a pretty thorough job socializing finance apart from the Fed, which has contributed to the efforts, as well.

Socialized finance won't be thrust upon the Fed. The Fed has already been moving, with the GSEs, FDIC, Treasury,, in this direction for years.

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