Letter to Ben Bernanke

Dear Ben,

By now you have realized that Federal Reserve policy has become highly politicized. While the media is placing you squarely in the middle of that development, I realize that the shift has been occurring since long before you were appointed Chair, and even Governor, as the Federal Reserve has found it worthwhile and expedient in the past two decades to work directly with Congress and the various Administrations on a number of key issues, ranging from housing policy to addressing financial markets hiccups to maintaining steady economic growth. Unfortunately, that era is over and the Federal Reserve will be responsible for some tough decisions.

You, as well as I, realize that Congress and the Administration are rudderless on many of the key issues necessary for recovery. Below I mention three, along with the obvious remedies that the Federal Reserve is in some cases providing and in other cases is premature, but all of which are crucially necessary to demonstrate Federal Reserve independence and promote recovery.

BHC/FHC Regulation

The current crisis is due primarily to two interrelated factors: poor bank lending practices and interbank (and intra-bank holding company) funding relationships.

The first is the classic cause of most banking crises. Poorly underwritten loans cannot support real economic growth. Regardless of who is to blame, there was an obvious bubble in housing markets. It is unrealistic and incredibly risky to try to reinflate that bubble. Hence, the economy will move forward with reduced credit availability.

Part of the source of cheap funding for the bubble was bank funding relationships, which at the peak were sometimes merely other entities within the same bank (or financial services) holding company. While occasionally pieces of securitizations that funded loose bank lending were sold outside the holding company, often they stayed within the holding company structure in order to arbitrage Basel capital rules at preferred rates. As a result, while the loans left the bank, they never left the holding company. With the bank in a sound condition and without holding company resolution authority, there was little a regulator could do.

Resolution authority obviously needs to be fixed, but the stumbling block remains too-big-to-fail. While the chief reason not to fail a big firm (from a monetarist’s perspective) is the risk of a sudden credit disruption, once the market gets past the sudden revelation of asset value shocks the disruption has already occurred. Hence, mopping up the mess requires failure of the too-big-to-fail institution after markets have been stabilized. In short, bank policy decisions (colloquially called bailouts) can allow policymakers to choose the moment of closure to smooth the economic effects of the insolvency, but cannot avoid the insolvency, itself, without substantial moral hazard problems.

Now, while I realize that the political ramifications of closing or severely restricting a large holding company on the eve of a Senate confirmation are dire, I also realize that you have been placing restrictions on several holding companies and muscling them to slim their operations for some time now. Publicize this good work. The strategy will make a valuable contribution to Congressional proposals, because it is a reasonable paradigm for holding company resolution authority.

Monetary Policy

While the goals of monetary policy primarily remain consistent over time, the means of achieving those goals changes along with financial sector innovation. It is hard to argue that recent innovation has not substantially affected today’s financial sector. It should be obvious, therefore, that tools and targets will need to evolve.

You, yourself, realized this early in your tenure largely as a result of your academic work. Early on in your tenure, you encouraged research into various monetary policy tools and targets that could stand in for Fed funds policy, and you have sought to apply those techniques to some effect. Those efforts – whether one likes the particular choices or not – are noteworthy and worthwhile.

The issue now, however, is that we are probably not going back to the same old tools and targets and need to continue to evolve money theory and application in a new institutional environment, including the “shadow” banking system and holding company relationships that got us to this point. There is nothing wrong with this stage of development. We have seen it before, with the advent of Eurodollar deposits in the 1970s, the necessary deregulation of interest rates, the rise of mutual and money market funds, and the monetary policy developments necessary to continue to influence economic growth in light of each significant change.

The important point is how you handle the shift. While I realize that you do not want to either disrupt markets with proposed changes nor telegraph directly your intentions, both economic growth and monetary economics might be better served with an open approach toward examining new alternatives. The institutional environment will not revert back to the 1990s, devoid of securitization and the shadow banking sector, any more than it will revert to the pre-1970s, before institutional developments rendered reserves targeting meaningless.

Fertilize monetary economics so that it grows, debating the impacts of new targets and tools before they are implemented. Continue the research you sponsored early in your tenure, with the intent of remaining prepared for change. Most importantly, be proud of your own creativity and help spawn that dynamic view in monetary economists throughout the discipline. Monetary economics is no more dead than it is understandable to the vast majority of Senators weighing on your confirmation. In fact, these are the environments when the field of monetary economics is most alive, when new theories need to be developed and implemented to address previous unknowns that can no longer be ignored.

Future of Housing Policy

The perceived problem that gave rise to contemporary homeownership policies was that, “From 1940 to 1980, the national homeownership rate rose from 43.6 percent of all households to 65.6 percent. Since 1980, the overall ownership rate has declined to a current rate of about 64 percent. While this rate has been increasing in the past 2 years, the Nation’s homeownership rate is still well below its historic peak.” Hence, it was perceived that after decades of financial and economic difficulties as well as a demographic bubble of young adults in the economy, a coordinated plan was necessary to “restore” homeownership to levels beyond historic highs from a postwar boom era. (US Department of Housing and Urban Development, “The National Homeownership Strategy: Partners in the American Dream,” Chapter 1, July 11, 2000, obtained from http://web.archive.org/web/20010106203500/www.huduser.org/publications/affhsg/homeown/chap1.html.)

The Federal Reserve, to my knowledge, never signed on to the National Homeownership Strategy that tried achieve record-high homeownership rates by pushing homes on people who, “lack… cash available to accumulate the required down payment and closing costs,” or “do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms.” The Strategy’s unbridled pursuit of “Financing strategies, fueled by the creativity and resources of the private and public sectors, [to] address both of these financial barriers to homeownership,” actively promoted the practices that expanded poor mortgage underwriting and servicing practices to those that contributed to the crisis (US Department of Housing and Urban Development, “The National Homeownership Strategy: Partners in the American Dream,” Chapter 4, July 11, 2000, obtained from http://web.archive.org/web/20010106230700/www.huduser.org/publications/affhsg/homeown/chap4.html.).

Someone is going to eventually have to tell Congress that the policy has reached its end, and it is probably going to have to be you – after confirmation. Moreover, Congress is going to have to accept that adjustable-rate mortgage reference rates cannot be held a zero to twenty-five basis points forever, and that increased rates result in greater adjustable-rate mortgage defaults.

Just as in the 1970s we were forced to admit that there exists a natural rate of unemployment that cannot be reduced without perverse economic dynamics, so we also need to admit that homeownership rate policy goals are not one hundred percent, but a similar “natural rate” that cannot be expanded without similar perverse dynamics.

I am sure you will ease the economy out of the bubble, but that is going to require hard policy stances that will inevitably pit you against Congress in a way that only policy independence will support.

At the end of the day, Ben, I realize you have to get reappointed to make and continue the tough policy decisions enumerated above. Realize that Congress itself, however, is between a rock and a hard place. If they reappoint you, they risk being derided for maintaining ineffective monetary and regulatory policy. If they do not, they risk uncertainty in confirming a replacement, most candidates for which will be from private sector employment sources that are currently unpopular. Moreover, with Donald Kohn – the vice-chair’s – term, expiring in June 2010, even reliance upon an acting designation will only be a short term alternative for the Senate in order to maintain some semblance of order in monetary policy.

Ben, Congress and the American public need you, even if they are loath to admit it. But first, they need to get past a momentary susceptibility toward instability so that you can secure the nomination for another four years. I realize that only then will you be able to take a truly independent stance on both monetary and regulatory policy, leading the economy toward economic growth.

Best Regards,

Joe