A column by David Leonhardt in today's New York Times seems to be getting a lot of notice in the blogosphere. In it, Leonhardt asks the question: if the Fed missed the real estate bubble, how can we expect it to see the next one? I sort of addressed this question on Monday, when I called into question the theory that the Fed needs more power to prevent such future failures. Leonhardt argues something different, and I disagree.
He buys into the idea that the Fed should get more regulatory power because it has the best resources to spot bubbles. Essentially, he's calling for an apology and an explanation. In other words, he thinks the Fed can better spot bubbles if it's a little more humble and introspective. I'm not convinced.
Specifically, Leonhardt calls for a sort of commission, charged by Congress, to investigate how bubbles were missed, saying:
In the future, a review process like this could become a standard response to a financial crisis. Andrew Lo, an M.I.T. economist, has proposed a financial version of the National Transportation Safety Board -- an independent body to issue a fact-finding report after a crash or a bust. If such a board had existed after the savings and loan crisis, notes Paul Romer, the Stanford economist and expert on economic growth, it might have done some good.
Spotting bubbles is a really hard business. Imagine, for example, if such a report was issued after the tech bubble pop a decade ago. We might have learned how to prevent another tech bubble exactly like the one that formed, under exactly the same initial conditions. Of course, such a scenario would almost certainly never happen again anyway.
And the report certainly wouldn't have helped with the real estate bubble, which was completely different. No other such report which might have been issued resulting from bubbles throughout the history of the U.S. would have helped either, because we had never experienced a real estate bubble leading to such disastrous consequences. Such reports won't prevent new, unforeseen kinds of bubbles -- which are precisely what we're trying to avoid. The problem with unexpected systemic risk is that it's, well, unexpected.
Stopping bubbles once they've started is also very difficult -- both logistically and politically. This is particularly true for the Fed, whose mission statement includes keeping unemployment as low as possible. Even if the Fed had seen statistics indicating that a dangerous housing bubble might be forming in 2005 and decided to take action -- can you imagine the political fallout if it caused a recession resulting in a few percentage points rise in unemployment?
Washington would have gone crazy. Most Americans would have too. How did the Fed know a bubble was forming? What if it was wrong and it hurt the economy for no reason?
I think the only way to ever hope to prevent systemic risk and bubbles -- which might simply be impossible anyway -- would be through a new, independent agency charged with exactly that task. It should be completely devoid of conflicts of interest. Its sole focus should be mitigating systemic risk. And if it's also the non-bank resolution authority, then it would have the vested interest to do so, as its insurance fund used to wind-down institutions would suffer if it screws up.
I've never accepted the argument that the Fed should be systemic risk regulator just because it's the most easily equip to do so. There are conflicts of interest that I've explained before that could prevent it from excelling in this responsibility. Frankly, even the FDIC would be a better choice to house this new regulator, if it weren't a separate new agency altogether. Unfortunately, looking at the House's financial regulation bill, which is likely to resemble whatever becomes law, the Fed will likely get this power anyway.