Yesterday's excellent Washington Post piece on the failures of the Fed has inspired a number of responses (Felix Salmon, Noam Scheiber, Kevin Drum, Ezra Klein), and it's certainly a must read. The Fed's sheer inability to fulfill its regulatory responsibilities was caused in large part by an ideologically driven refusal to learn what was happening: See Alan Greenspan's conviction, based on his own free-market prejudices and bad management, that regulators can't keep up and that "self-regulation" by companies is the right solution. More self-aware officials might question their decision-making and strategy. Reading this, Ezra agrees with Greenspan that regulations will always fail, and decides the answer is less discretion:
I think it's all evidence that regulators can't be trusted and we need more automatic safeguards. The FDIC's insurance of bank deposits, for instance, prevents bank runs whether or not the FDIC thinks there's a problem in the market. Muscular capital requirements could conceivably do the same thing, keeping banks from threatening the whole system even when regulators are sure that the awesome innovation the banks just developed is totally kosher, now and forever, amen. After all, there's not much we can confidently say about the next bubble or financial crisis, but the one thing we can say is that the Federal Reserve will miss it, as that's pretty much the definition of these things. What the Federal Reserve can see, it can generally stop. But the Federal Reserve will miss the boat again, and we need some failsafes that will work when they do.
I don't think this is entirely right -- Greenspan was his own self-fulfilling prophecy. One important thing we need to do is appoint people who aren't free market ideologues to these positions, and get more lawyers and fewer economists in the supervision departments. Appointments are half the battle in regulatory reform.
But, conceding that regulatory discretion does give a lot of opening for failures of this nature, the real automatic safeguards we need are robust dissolution powers. (Regular readers saw that coming.) The "ultimate market discipline," as Elizabeth Warren calls it, is for large financial institutions to know they will be liquidated by regulators if they become insolvent due to insane risk-taking. Like the FDIC's authority to dismantle smaller banks, this happens more-or-less automatically as a bank fails and doesn't rely on regulators deciding what behaviors were permissible or not.
-- Tim Fernholz
