The Real Threat to Fed Independence

Unless we shrink large financial conglomerates, we will end up with a socialized banking system.

By HENRY KAUFMAN

The Federal Reserve in coming years will probably become highly politicized and thus lose its quasi-independent status. This is because of past shortcomings in its policies and, more importantly, of difficult decisions that face it in the year just ahead.
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.
Still, past presidents have hardly been effective at controlling their Fed chairmen. Bill Martin, who served as Fed chairman from 1951 to 1970, was called a "traitor" by Harry Truman when U.S. Treasury financing costs increased as a result of measures supported by Martin allowing Treasury obligations to be traded at market-determined levels.
In 1965, after the Fed raised rates, Martin was summoned to Lyndon Johnson's Texas ranch where the disgruntled president reportedly said to him, among other things, "You took advantage of me and I just want you to know that it's a despicable thing to do." Journalists referred to this episode as "a trip to the woodshed."
One of the most striking examples of Fed chairman nonpartisan independence was Paul Volcker's eventful tenure during the Jimmy Carter administration. I doubt the Democratic president fully anticipated how Mr. Volcker would wring hyperinflation out of the economy by raising interest rates to unprecedented heights. It was a correct and effective action, but it earned Mr. Volcker few friends within the business and financial community.
On the other hand, Mr. Volcker's successor, Alan Greenspan, who was initially appointed by a conservative Republican president, Ronald Reagan, has been widely criticized for keeping interest rates too low for too long in the early years of this decade, helping to fuel the growing asset bubble that eventually led to our current financial mess.
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.

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Today, with interest rates near zero and the stock market booming, increased political pressure will be put on the Fed when it begins to shift away from its current posture of quantitative easing. What will most inspire a shift toward tightening? The inflation rate? Better employment numbers or a housing recovery? That's hard to say.

Even harder to say is how the Fed will deal with the speculative fervor now fomenting in the financial markets, i.e., the increase in the carry trade (borrowing dollars to buy assets) and the run-up of many stock and commodity prices. Will the Fed ignore these developments and wait until the economy gains full traction to raise rates?
The current economic situation suggests continued substantial monetary ease, but developments in the financial markets do not.
Closely related to the this conundrum is another one: How will the Fed reduce its bloated balance sheet—which has reached $2.2 trillion, compared with $919 billion in mid 2008? Fed holdings now include more than $1 trillion of obligations involving largely longer-dated mortgage-related securities.
The Fed's unwinding of non-U.S.-government obligations will be monitored carefully by the market. But the disposition of these obligations is very sensitive politically. Many of these securities are mortgage-related. Their liquidation will put upward pressure on interest rates, which will not be welcomed by Washington, and even less by the housing industry. The Fed's holdings of mortgage-related securities dominate some sectors of this market.
Moreover, the central bank has announced that its mortgage-related purchases probably will end next March. The Fed might attempt to mitigate the impact of this change on financial markets by purchasing U.S. government bonds of comparable maturity. But to neutralize pressure on the mortgage market, these purchases might well need to be considerably larger than the size of the mortgage liquidation.
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.
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.
A much better approach would be to prohibit any financial institution from remaining or becoming too big to fail. This would require that regulators downsize large financial conglomerates. In this process, the prime targets for divestiture should be financial activities that pose risk to the stability of the deposit function as well as operations that pose conflicts of interest.
Our financial system is at a crossroads. We can either succumb to the forces that are shifting markets toward greater government back-stopping and socialization. Or we can create a structure in which no institution is too big to fail, and a financial system that is supervised effectively by a modernized central bank.
Mr. Kaufman is president of Henry Kaufman & Company Inc. and author of "The Road to Financial Reformation: Warnings, Consequences, Reforms" (Wiley, 2009).