04 April 2008

Federal Reserve's Moves Calm Markets, Create Controversy

Unusual action in unregulated area may redefine central bank’s role

Traders at the New York Stock Exchange monitor share fluctuations, following the Federal Reserve’s March actions. (© AP Images)

By Andrzej Zwaniecki
Staff Writer

This article is the second in a three-part series on the turmoil in the U.S. financial markets and efforts to address it.

Washington -- Unorthodox steps taken by the U.S. Federal Reserve have calmed the troubled capital markets but have brought on a debate about the central bank’s future role, according to experts.

In mid-March, the central bank took the most dramatic action since the housing and related credit crises erupted in 2007. It facilitated a takeover of Bear, Stearns and Company Inc. -- a faltering Wall Street investment firm -- and at an emergency meeting cut the interest rate on direct loans to banks. Also, for the first time since the 1930s, the central bank provided access to short-term borrowing through its “discount window” to investment houses it does not regulate. (See "U.S. Central Bank Takes Sweeping Action to Avert Financial Crisis.")

The plan, executed by the Federal Reserve in unison with the U.S. Treasury Department, has restored a measure of confidence to world financial markets.

President Bush called the plan “strong and decisive,” and some congressional leaders and experts cautiously praised it.

However, by setting the stage for deeper involvement in lightly regulated areas, central bankers entered an uncharted territory where they face a greater risk, according to some experts.

Former Federal Reserve Chairman Paul Volcker and economist Joseph Mason are uncertain whether the benefits of stretching the bank’s authority “to the limit,” as Volcker put it, outweigh the risks.

Mason, a finance professor at Drexel University, believes that the central bank risks its most precious asset -- credibility.

The credibility is particularly important in challenging times, he told America.gov, because it is crucial to the bank’s ability to control inflation and facilitate government borrowing at low rates. Mason and some other economists see a real threat of a surge in inflation.

Edwin Truman, a resident scholar at the Peterson Institute for International Economics, is not among them. The former Federal Reserve official told America.gov that any risk to the central bank’s credibility is minimal, “as long as it is very clear that [it is] not rescuing any particular institutions or individuals but trying to stabilize the financial system.”

The Federal Reserve has broader responsibilities than other central banks, which focus primarily on inflation, Truman said. These responsibilities include promoting economic growth and financial stability.

Federal Reserve Chairman Ben Bernanke defended the bank’s action in April 2 testimony before the congressional Joint Economic Committee.

"Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain," he said.

Some experts and lawmakers argue, however, that the Federal Reserve could have acted in a way that would have ensured continued, smooth functioning of the financial system without putting taxpayers’ money at risk or, at least, without creating a moral hazard. To facilitate the acquisition of Bear Stearns by another large investment firm, the central bank agreed to guarantee close to $30 billion in Bear Stearns’ hard-to-value securities. The concern is that the central bank not only could lose money on those securities but also could encourage Wall Street firms to take even more risks in expectation of a future government rescue.

Truman said that the Federal Reserve’s move was in no way a “bailout” of Bear Stearns, as some have called it. The firm lost its independence, and its equity was wiped out, leaving its shareholders, who include Bear Stearns employees and executives, no winners at all, he said.

As to the risky assets, Truman said, the scenario that the Bear Stearns securities would generate profits rather than losses for the Federal Reserve cannot be excluded.

In any case, Treasury Secretary Henry Paulson said the central bank’s recent actions should be viewed as a precedent only for unusual periods of turmoil. Investment houses and other important financial institutions having temporary access to the bank’s discount window should be subject to certain disclosure and transparency requirements, he said. Paulson also said that the temporary arrangement is a learning experience for the U.S. government and will “inform a path forward.”

Mason is unpersuaded. He said the Federal Reserve and the government should have let the market work through the Bear Stearns insolvency problem, which likely would have led to the firm’s collapse. Having trusted market discipline in the past, the Federal Reserve and the government should do so in the future if another major financial institution finds itself near bankruptcy, he added.

But others point to Japan as an example of the failure of a hands-off approach. In the late 1980s, when Japanese banks accumulated large amounts of bad debt following the bursting of a real-estate bubble, financial authorities waited years for the market to clear the mess. This produced a decade-long economic malaise that ended only after the government began injecting huge amounts of public funds into the troubled banks.

The full texts of Paulson’s prepared remarks and Bernanke’s prepared statement are available respectively at the Treasury Department’s Web site and the Federal Reserve Web site.