R
R
egrettably, every time a hedge fund's problems make the news, political
pressure to regulate the industry mounts. Hedge funds are both risk
takers and very large, the thinking goes—doesn't that prove they are dangerous?
Shouldn't the government rein them in? Leaving aside the undermining
of market liquidity that such actions could induce, the benefit of more
government regulation eludes me. Hedge funds change their holdings so
rapidly that last night's balance sheet is probably of little use by 11 a.m.—
so regulators would have to scrutinize the funds practically minute by minute.
Any governmental restrictions on fund investment behavior (that's
what regulation does) would curtail the risk taking that is integral to the
contributions of hedge funds to the global economy, and especially to the
economy of the United States. Why do we wish to inhibit the pollinating
bees of Wall Street?
I say this having served as a regulator myself for eighteen years. When I
accepted President Reagan's nomination to become chairman of the Fed,
what drew me was the challenge of applying what I had learned about the
economy and monetary policy over nearly four decades. Yet I knew that the
Federal Reserve was also a major bank regulator and the overseer of America's
payments systems. Avid defender though I was of letting markets function
unencumbered, I knew that as chairman I would also be responsible for the
Fed's vast regulatory apparatus. Could I reconcile that duty with my beliefs?
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GLOBALIZATION AND REGULATION
In fact; I had crossed that Rubicon long before, during my stint as chairman
of President Ford's Council of Economic Advisors. Although the primary
job of the CEA was to shoot down harebrained fiscal policy schemes,
I did on occasion accept increased regulation—when it appeared to be the
least bad of the options politically available to the administration. As Fed
chairman, I decided, my personal views on regulation would have to be set
aside. After all, I would take an oath of office that would commit me to uphold
the Constitution of the United States and those laws whose enforcement
falls under the purview of the Federal Reserve. Since I was an outlier
in my libertarian opposition to most regulation, I planned to be largely passive
in such matters and allow other Federal Reserve governors to take the
lead.
Taking office, I was in for a pleasant surprise. I had known from my
contact with Fed staff members, during the Ford administration especially,
how extraordinarily qualified they were. What I had not known about was the
staff's free-market orientation, which I now discovered characterized even
the Division of Bank Supervision and Regulation. (Its chief, Bill Taylor, was
a likable, thoroughly professional regulator. President Bush, the father, later
appointed him to head the Federal Deposit Insurance Corporation, and his
premature death in 1992 was a great blow to his colleagues and the nation.)
So while the staff recommendations at the Federal Reserve Board
were directed to implementing congressional mandates, they were always
formulated with a view toward fostering competition and letting markets
work. There was less emphasis on "thou shalt not" and more on management
accountability and disclosure that would enable markets to function
more effectively. The staff also fully recognized the power of counterparty
surveillance as the first line of protection against overextended or inappropriate
credit.
This view of regulation was no doubt influenced by the economists in the
institution and on the Board. They were generally sensitive to the need to
buttress the competitive market forces that the financial safety net of the
United States tends to impair. This safety net—which includes such safeguards
as deposit insurance, bank access to the Fed's discount facilities, and
access to the Fed's vast electronic payments system—reduces the importance
of reputation as a constraint on excessive debt creation. Nonetheless, manag
373
THE AGE OF TURBULENCE
ers' efforts to protect their reputations are important in all businesses but
especially so in banking, where reputation is key to the overall soundness
of a bank's operations. If a bank's loan portfolio or its employees are suspect,
depositors disappear, often very quickly. But when the deposits are
insured in some way, a run is less likely.
Studying the damage caused by Depression-era bank runs had led me to
conclude that, on balance, deposit insurance is a positive.* Nonetheless, the
presence of a government financial safety net undoubtedly fosters "moral
hazard," the term used in the insurance business to describe why customers
take actions they would not so readily consider were they not insured
against the adverse consequences of their behavior. Regulations on lending
and deposit taking hence must be carefully designed to minimize the moral
hazard they inevitably create. Democracy requires trade-offs.
I was delighted that being a regulator was not the burden I had feared.
Of the hundreds of Board votes on regulation during my tenure, I found
myself in the minority just once. (I argued that a consumer law requiring
disclosure of an interest rate relied on a method of calculation that was
faulty—scarcely a major point of philosophical debate.) While I never
shared the fervor of some for discussing the appropriate wording of a rule,
I settled down to a comfortable role in which I asserted myself only on issues
that I saw as important to the functioning of the Federal Reserve or to
the financial system as a whole.
Over the years I learned a great deal about what kind of regulation
produces the least interference. Three rules of thumb:
1.
Regulation approved in a crisis must subsequently be fine-
tuned. The Sarbanes-Oxley Act, rushed through Congress in
the wake of the Enron and WorldCom bankruptcies and mandating
greater financial disclosure by corporations, is today's
prime candidate for revision.
*I had always thought the payment system should be wholly private, but I found that Fedwire,
the electronic funds-transfer system operated by the Federal Reserve, does offer something no
private bank can: riskless final settlements. The Fed's discount window serves as a lender of last
resort, a function the private sector cannot provide without impairing a bank shareholder's
value.
3 74
GLOBALIZATION AND REGULATION
2.
Sometimes several regulators are better than one. The solitary
regulator becomes risk averse; he or she tries to guard against
all imaginable negative outcomes, creating a crushing compliance
burden. In the financial industries, where the Fed shares
regulatory jurisdiction with the Comptroller of the Currency,
the Securities and Exchange Commission, and other authorities,
we tended to keep one another in check.
3.
Regulations outlive their usefulness and should be renewed
periodically. I learned this lesson watching Virgil Mattingly, the
longtime chief of the Federal Reserve Board's legal staff He
took very seriously the statutory requirement to review each
Federal Reserve regulation every five years; any regulation that
was judged to be obsolete was unceremoniously scrapped.
An area in which more rather than less government involvement is
needed, in my judgment, is the rooting out of fraud. It is the bane of any
market system.* Indeed, Washington would do well to divert resources
from creating new regulations to greatly stepping up the enforcement of
anti-fraud and anti-racketeering laws.
It is not uncommon to see legislators and regulators rush to promulgate
new laws and rules in response to market breakdowns, and the mistakes
that result often take decades to correct. I had long argued that the Glass-
Steagall Act, which in 1933 separated the business of securities underwriting
from commercial banking, was based on faulty history. Testimony before
Congress in 1933 was filled with anecdotes that gave the impression that
inappropriate use by banks of their securities affiliates was undermining
overall soundness. Only after World War II, when computers made it possible
to evaluate the banking system as a whole, did it become evident that
banks with securities affiliates had weathered the 1930s crisis better than
those without affiliates. A few months before I took up my duties at the
Fed, the Board introduced a proposal that would again allow banks to sell
securities through affiliates, under very restrictive conditions. The Board
*Fraud is a destroyer of the market process itself because market participants need to rely on
the veracity of other market participants.
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THE AGE OF TURBULENCE
continued to encourage easing of the restrictions, and I testified many times
for legislative change. It took until 1999 for Glass-Steagall to be repealed
by the Gramm-Leach-Bliley Act. Fortunately Gramm-Leach-Bliley which
restored sorely needed flexibility to the financial industries, is no aberration.
Awareness of the detrimental effects of excessive regulation and the
need for economic adaptability has advanced substantially in recent years.
We dare not go back.
G
G
lobalization, the extension of capitalism to world markets, like capi
talism itself, is the object of intense criticism from those who see only
the destructive side of creative destruction. Yet all credible evidence indi
cates that the benefits of globalization far exceed its costs, even beyond
the realm of economics. For example, economist Barry Eichengreen and
political scientist David Leblang, in a paper delivered in late 2006, found
"evidence [during the 130-year span from 1870 to 2000] of positive rela
tionships running in both directions between globalization and democracy."
They found "that trade openness promotes democracy ... The impact of
financial openness on democracy [is] not as strong but still point[s] in the
same direction [and] .. . democracies are more likely to remove capital
controls."
Accordingly, we should focus on addressing and assuaging the fears induced
by the dark side of creative destruction rather than imposing limits
on the economic edifice on which worldwide prosperity depends. Innovation
is as important to our global financial marketplace as it is to technology,
consumer products, or health care. As globalization expands and
ultimately begins to slow, our financial system will need to retain its flexibility.
Protectionism, whatever its guise, whether political or economic,
whether it affects trade or finance, is a prescription for economic stagnation
and political authoritarianism. We can do better than that. Indeed, we must.
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TWENTY
THE "CONUNDRUM"
W
W
hat is going on?" I complained in June 2004 to Vincent Reinhart,
director of the Division of Monetary Affairs at the Federal
Reserve Board. I was perturbed because we had increased
the federal funds rate, and not only had yields on ten-year treasury notes
failed to rise, they'd actually declined. It was a pattern we were accustomed
to seeing only late in a credit-tightening cycle, when long-term interest
rates began to fully reflect the lowered inflationary expectations that were
the consequence of the Fed tightening.* Seeing yields decline at the beginning
of a tightening cycle was extremely unusual.
This tightening cycle had barely even begun. I'd signaled its commencement
less than two months earlier, when in testimony before the Joint Economic
Committee of Congress I'd delivered a clear signal of the Fed's
intention to raise rates: "The federal funds rate must rise at some point to
prevent pressures on price inflation from eventually emerging.... The Federal
Reserve recognizes that sustained prosperity requires the maintenance
*More typical was the pattern of long-term interest rates in 1994, for example. In February and
the ensuing months, we raised the federal funds rate a total of 175 basis points with the aim of
defusing an incipient rise in inflation expectations. The yield on the treasury long-term note
rose. Only at the end of 1994, after we raised the federal funds rate an additional 75 basis
points, did the yield decline.
THE AGE OF TURBULENCE
of price stability and will act, as necessary, to ensure that outcome." Our
hope was to raise mortgage rates to levels that would defuse the boom in
housing, which by then was producing an unwelcome froth.
The response from the market was immediate. Anticipating the increase
in bond yields usually associated with an initial rise in the federal
funds rate, market participants built large short positions in long-term debt
instruments. Yields on ten-year treasury notes rose about 1 percentage
point during the next several weeks. Our tightening program seemed to be
right on track. But by June, market pressures seemingly coming out of nowhere
drove long-term rates back down. Thinking we must be witnessing
an aberration, I was both perplexed and intrigued.
Unexplainable market episodes are something Fed policymakers have
to deal with all the time. One many an occasion I have been able to ferret
out the causes of some pecularity in market pricing after a month or two of
watching the anomaly play out. On other occasions, the aberration has remained
a mystery. Price changes, of course, result from a shift in balance
between supply and demand. But analysts can observe only the price consequences
of the shift. Short of psychoanalyzing all market participants to
determine what led them to act as they did, we may never be able to explain
certain episodes. The stock-market crash of October 1987 is one such
instance. To this day, there are competing hypotheses about what set off
that record one-day plunge. The explanations range from strained relations
with Germany to high interest rates. We certainly experienced the fact that
