The Fed’s attack on speculation in the Spring of 1994, in the guise of inflation fighting, should warn Congress and the White House that a thorough revamping of the Federal Reserve and our financial regulatory institutions is long overdue. We need a more powerful central bank, with tools that can effectively control money and credit whether its growth originates in the banks or other financial institutions. We need a separate, independent, consolidated financial regulatory agency that can blow the whistle on excessive speculation and other behavior that undermines productive investment, economic growth, price stability, and a stable financial system.
The Clinton Treasury proposal for revamping bank regulation offers an opportunity to join anti-inflationary monetary policy with bank regulation. It urges creation of a unified Federal Banking Commission to regulate the activities of banks and bank holding companies. The Federal Reserve stood in vehement opposition (see Greenspan, March 2, 1994, and Reinicke, 1994), joined en masse by the major commercial banks. The Fed’s less than exemplary regulatory role in the wave of bank crises since the late 1970s does not lend much support to its demand to retain its authority and power to regulate major banks, as a function complementary to, and supportive of, monetary policy.
Nonetheless, in an ideal world, I strongly believe that an effective central bank should have broad authority and effective power to regulate large banks and bank holding companies. It should intervene forcefully when those institutions are putting the safety and soundness of the money and credit system at risk. Only when armed with this authority and power to intervene forcefully in reining in the high-risk and speculative activities of huge multinational banks and financial institutions can the Fed effectively restrain money and credit growth in boom periods like the 1980s. But, with that authority and power must also go a heavy responsibility for open, public accountability of its intervention.
As the Federal Reserve is now constituted, along with the duplication of regulatory agencies, the great danger of the theoretical foundations of the Fed policy is that it completely abstracts from the concentrations of political and economic power in banks and financial institutions. The theory assumes competition among thousands of small banks, but the banking system diverges dramatically from that theoretical model. Restraining the growth of bank reserves, monetary aggregates, or nudging up money rates will have virtually no impact on the operations of huge multinational banks that easily manage their nondeposit liabilities in global markets as the Fed pushes the structure of market rates up and down.
This contemporary reality of concentrated power that has deeply eroded central bank monetary policy is never addressed in Congress, the White House, or at the Fed. Yet, increasingly, the power of multinational banks to evade national efforts to manage macroeconomic policy seriously undermines national goals (Kaufman, 1994). Once the huge multinational banks engage in financial speculation beyond the powers of the national central bank to control, the market itself does not impose much discipline. Moreover, since banks like Citicorp, Continental Illinois, and others have been deemed too large to be allowed to fail by policy makers in the Fed, the Treasury, and other government agencies, the banks really have boundless freedom. No longer can we talk about monetary policy in abstraction from bank regulatory policy. The two must go together.
We can now learn from a whole string of financial crises and banking failures in the past twenty years to form intelligent judgments about more effective oversight coupled with monetary policy restraint (Wolfson, 1994). In the late 1970s and the early 1980s, regulators at the Federal Reserve and the comptroller of the currency acted belatedly and timidly. Senior bank managements repeatedly evaded and resisted the Fed’s efforts to restrain highly risky activities.(8) Banks struggled to survive wave after wave of crisis stemming from bad loans to developing countries, energy credits, and real estate speculation. By 1984, for example, Chicago’s Continental Illinois Bank collapsed in the wake of its reckless expansion which the Federal Reserve and the comptroller of the currency failed to restrain. It led to the nationalization of that bank by the U.S. Treasury at taxpayer expense.
During the next ten years, the collapse of oil prices and the crash of the real estate boom sent shock waves from California to Texas to New York and New England. Nine of the ten largest banks in Texas failed. By 1990, New York’s Citibank was awash with bad real estate loans; it held more than any other bank in the country. Clearly, the federal regulators, including the Federal Reserve, failed to prevent problems from snowballing into systemic proportions.
Yet, in its monetary policy decisions, the Federal Reserve acted decisively to tighten the growth of money and credit, and to push up the structure of interest rates. Monetary restraint did not, however, prevent many banks from failing. To the contrary, higher interest rates (i.e., high costs of funds) simply pushed the banks into new and riskier businesses at higher rates. During the last half of the 1980s, nearly 900 commercial and savings banks failed; in 1991 and 1992 more than 100 banks failed each year. The number of “problem” banks on the Federal Reserve’s list of institutions requiring close scrutiny reached a peak of nearly 1,600 in 1987 and still remained at more than 1,000 as recently as 1991. According to Chairman Greenspan, “That 1991 figure was especially disturbing because, by then, it included some major institutions, which boosted the assets of problem banks to more than $600 billion” (Greenspan, September 22, 1994). Indeed, so extremely far did the big banks stretch their resources that, by 1992, the United States faced “an almost unprecedented situation with many of its largest banks operating on – or conceivably, over – the edge of insolvency” (Barth, 1992; p. xxi).
The significant improvement of individual banks and the whole industry since 1992 was in large part a result of the dramatic decline in interest rates and the rise in bond prices until early 1994. The Fed’s new cycle of high interest rates in 1994 virtually reversed that preceding decline in interest rates; some institutions no doubt suffered losses as bond prices declined in that process.
The lesson that emerges from these episodes of the 1980s and 1990s is that the Federal Reserve and other regulators have failed to prevent the problems of banks and other financial institutions from snowballing into systemic proportions. Given the huge social costs that the United States has suffered from both Federal Reserve monetary and regulatory policy, reining in central bank independence is long overdue.
Notes:
1 See Appendix Table B-6 from the Economic Report of the President, 1994.
2 See Appendix Tables B-40 and B-52 from the Economic Report of the President, 1994.
3 Economic Report of the President, 1994.
4 The Federal Reserve raised the Federal funds rate target on February 4, March 22, and April 18 (by 1/4 percentage point each time); May 17, August 16 (by 1/2 percentage point each time); November 15, 1994 (by 3/4 percentage point); and February 1, 1995 (by 1/2 percentage point each time), for a cumulative increase from 3.0 to 6.0 percent. It raised the discount rate by 1/2 percentage point on May 17 and August 16, 1994, by 3/4 percentage point on November 15, 1994, and by 1/2 percentage point on February 1, 1995, for a total increase from 3.0 percent to 5.25 percent.
5 See, for example, business and press criticism of Chairman Greenspan and Governor Wayne Angel in Newsweek, June 28, 1993, p. 44.
6 See, for example, the plunge in capacity utilization rates in appendix B-52 in the Economic Report of the President, 1994, for the years 1973-75 and 1981-82, along with the labor unemployment rates.
7 This important testimony is in Greenspan (1993).
8 See the detailed accounts of Federal Reserve Chairman Volcker’s efforts to compel senior management to change its strategies in order to prevent failure of the Continental Illinois Bank in 1984, described in Greider (1987), pp. 624-632.
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