Ben Bernanke’s speech in London this morning constitutes a clear overview of the various bullets that the Fed has fired into the onrushing crisis. But he starts off with a bold and puzzling claim:
I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn, even though the overnight federal funds rate cannot be reduced meaningfully further.
The natural response to this is simple: if you still have powerful tools at your disposal, why haven’t you used them already? And why did you enact that final rate cut to zero, which necessarily comes accompanied by all manner of nasty consequences in the repo markets and at money-market funds? That decision certainly made it seem as though the Fed believes a marginal further reduction in the Fed funds rate is still far more effective than any of its other policies.
Bernanke is of course a bank regulator as well as a setter of monetary policy, and so this kind of thing comes as no surprise:
Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.
I do wonder, though, whether the Fed is making enough of a distinction between the financial system, on the one hand, and the companies which comprise it, on the other. Can’t we build a strong financial system, perhaps through nationalizing failing institutions, in a way which doesn’t reward the people who screwed up the old one? Rather than spinning off bad banks, why not spin off good banks instead, and put them under new ownership and new management?
This, however, is the closest that Bernanke comes:
Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period. The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking.
I take this to mean that Goldman Sachs and Morgan Stanley aren’t going to be able to be freewheeling investment banks again, at least not for the foreseeable future: instead, they should expect "especially close regulatory scrutiny" — as should the large commercial banks. But who will be doing the scrutinizing? The New York Fed? The SEC? The OCC? The OTS? Treasury? A new and untested super-regulator?
Color me unconvinced, for the time being, that this will actually work, especially so long as the Fed chairman is generally chosen from the ranks of economists rather than regulators. After all, as Jeff Madrick says, the entire economics profession has garnered itself a big fat F during this crisis. Why should we trust the economists now — even ones from Princeton?