Much of the controversy over financial regulatory reform has swirled around the proposal for a consumer financial protection agency. But what I find most controversial in the bill that Senator Chris Dodd drafted and that the Senate Banking Committee recently reported out on a party-line vote is the provision for a new financial oversight council that would oversee the Federal Reserve and other agencies. It’s not just unnecessary. It could also have a pernicious effect on regulation. It is a Trojan Horse for the status quo.
The proposed nine-person council—dubbed a “Financial Stability Oversight Council”—would be chaired by the Secretary of Treasury and consist primarily of officials drawn from the Securities and Exchange Commission and other federal agencies. Dodd’s council appears to go beyond the similar body that was part of the House bill that was passed last December. The House’s Financial Services Oversight Council would advise the Federal Reserve and Congress on threats to stability and issue “formal recommendations” to take action when a financial company is in distress. But the Finance Committee’s Oversight Council would also approve and devise regulations and have the right of approval or disapproval over key regulatory decisions that the Fed makes.
Whenever an agency doesn’t do its job in Washington, the temptation is to create still another agency to oversee it. That was the proposed solution for the intelligence failures of the Central Intelligence Agency and Federal Bureau of Investigation. And now it’s Washington’s solution to the failures of the Federal Reserve. But this council wouldn’t address the principal reasons for the failure of the Fed from 1997 or so through 2007, when it pressed for further financial deregulation and ignored or downplayed the warning signs of the dot-com and housing bubbles. We know what happened next.
Many liberals now blame the ideological propensities of Federal Reserve Chairman Alan Greenspan, a former Ayn Rand disciple, for the deregulatory excesses of the period—but the real problem was the “Dow 35,000” boom psychology that afflicted liberals and conservatives alike and that led them to oppose any measures that would restrain market growth. Secretary of the Treasury Robert Rubin and his successor Lawrence Summers joined Greenspan in opposing the regulation of derivatives and in backing the repeal of the Glass-Steagall Act, which had walled off commercial from investment banking. Bill Clinton reappointed Greenspan twice—in 1995 and again in 2000.
Would an oversight council have halted these measures and instilled financial sobriety? The question answers itself. Rubin and then Summers would have chaired the council. Or take the Bush years. Federal Reserve chair (and before that Bush economic advisor) Benjamin Bernanke has not really explained why he downplayed, or just plain missed, the housing bubble, but his judgement was probably clouded by a fear of taking steps that would imperil a tenuous recovery. Would Secretary of the Treasury John Snow and SEC chair Christopher Cox have advised Bernanke to put on the brakes—or would they, as is more likely, have either acquiesced in what Bernanke wanted to do or urged even worse steps to be taken?
The other reason for the Fed’s failure from 1997 to 2007 was probably its proximity to the people and institutions it was supposed to regulate. Sandy Weill of Citigroup had more access to Greenspan or to the chairman of the New York Federal Reserve—the second most powerful Fed official—than a labor leader or consumer advocate. When the interests of the banking community coincide roughly with the national interest—as they did when the Federal Reserve was founded in 1913—that’s no problem. But when Wall Street has special interests in deregulation that don’t coincide with the national interest, its influence becomes problematic. Would a council address this problem? Was the financial community less likely to influence Snow or Cox than it was Bernanke? Is the current Secretary of the Treasury more likely to listen to Goldman Sachs’ Lloyd Blankfein or to Mark Cooper of the Consumer Federation of America?
There are several obvious lessons that most economists and policy-makers outside the University of Chicago have drawn from this financial crisis: first, the need to include “non-bank” financial companies like AIG in the purview of the government’s financial regulatory agencies; second, the need to break up, when necessary, giant financial corporations whose failure could pose a systemic risk to the system; third, the need to prohibit commercial banks and non-bank financial institutions from engaging in proprietary trading and investing in hedge funds and private equity funds. The latter is currently referred to as “the Volcker rule.”
If you look at Dodd’s proposal, what you discover is that all of these measures are not written into law, but are to be carried out at the discretion of—you guessed it—the Financial Stability Oversight Council. If the Fed wants to break up a “large complex company [that] poses a grave threat to the financial stability of the United States,” it will have to obtain a two-thirds vote of the council. If it wants to regulate a non-bank financial company, it has to obtain a two-thirds approval of the council. And the Volcker rule will or will not be implemented depending upon the “recommendations” from a “study by the Financial Stability Oversight Council.”
In other words, Dodd’s council could not only rubber-stamp bad decisions by the Fed, but it could also block good ones. Think again of who would have populated the council during the George W. Bush administration or even of the current squabbling among the Fed, the Federal Deposit Insurance Commission, and other financial regulatory agencies over who is in charge of what. Washington policy-makers need to listen for once to the wise advice of William of Ockham: “Entities must not be multiplied beyond necessity.” William, of course, was talking about Platonic forms, but his advice could easily apply to the proposal for a financial oversight council.
What is a solution to the failures of the Fed? It should be clear that there is no lasting remedy to the boom psychology that affected Rubin and Summers as well as Greenspan—but we can enact laws that make speculative booms less likely. To be sure, laws can be repealed, but it is much more difficult to repeal a law than to ignore advice. It took more than two decades for bank lobbyists to get rid of Glass-Steagall, after all. When Virginia Democrat Mark Warner said of the Volcker rule, “I don’t necessarily think itneeds to be a mandate,” he got it exactly wrong. In fact, if Congress wants the Volcker Rule, it has to make it a mandate.
There is also no lasting remedy to the power lobbies have over government policy. But every effort should be made to insulate the Federal Reserve and other financial regulatory agencies from the influence of those whom it is supposed to regulate. The Fed, of course, was created as a semi-private agency. The officers of the regional banks, including the powerful New York branch, were appointed by the bankers who served on their boards of directors and who in turn were chosen by the banks. The head of the New York Fed had a permanent seat on the Open Market Committee that made decisions over federal monetary policy. These arrangements institutionalized the influence of the banks over their regulators.
To Dodd’s credit, his bill does address the problem of the financial industry’s influence over the Fed and other regulatory bodies. Dodd is proposing that the head of the New York Fed be appointed by the president and confirmed by the Senate. He suggests that the companies the Fed supervises no longer be allowed to vote for the directors of regional banks, and that the bankers themselves (like Morgan’s Jaime Dimon, who is a director of the New York Fed) no longer be allowed to serve on regional banks’ boards of directors. Unlike the proposal for an oversight council, these provisions of the bill might actually do some good.
John B. Judis is a senior editor of The New Republic and a visiting scholar at the Carnegie Endowment for International Peace.