Jerome Powell, the Fed and Regulation

08/25/2021 12:00am

Most progressives who have been pressuring the Fed to be more supportive of full employment, and less concerned about inflation, would be very happy to see Powell reappointed as Fed chair. He has led the Fed in a complete reversal of its priorities. He shifted it away from its obsession with inflation, which often meant raising rates and throwing people out of work, even when there was no clear evidence of accelerating. Instead, he wants the Fed to target full employment and only raise rates once we see the sort of unemployment rates we had before the pandemic.

This is hugely important, not only because it can mean that millions of additional workers get jobs, but also because high unemployment has been a major factor contributing to inequality over the last four decades. When the unemployment rate rises, it is disproportionately the most disadvantaged workers who lose their jobs. This means Blacks and Hispanics, workers without a high school degree, disabled workers, and workers with a criminal record.

Not only does a rise in the unemployment rate prevent these workers from getting jobs, it also puts downward pressure on the pay of workers at the bottom of the wage ladder. When we have sustained periods of low unemployment, such as the late 1990s and the four years before the pandemic, workers in the bottom half of the wage distribution were able to secure pay increases that outpaced inflation, and those at the tenth percentile saw the largest gains.

For these reasons, progressive economists who have been pushing the Fed to pay more attention to full employment have been very happy with Powell’s reversal of past Fed policy. However, some progressives have objected to Powell because he has supported the weakening of the regulations that were put in place by the Dodd-Frank financial reform bill.

Powell’s record on regulation is bad, and this is a problem. However, the Fed’s policy on regulation can likely be shifted by appointing new members who are committed to a stronger regulatory framework. The rumored selection of Sarah Bloom Raskin, a former Fed Board member, and deputy Treasury Secretary, as Vice-Chair for Supervision, would go far towards this end.

But apart from the question of how much Biden can shift the Fed’s regulatory orientation, there is also the question of its relative importance. There has been a tendency to overstate the importance of regulation because many people believe that it was regulatory failures that led to the Great Recession, as opposed to the Fed’s ignoring a housing bubble that was driving the economy.

The distinction is important because the issue here was a huge bubble not bad regulation per se. Bubbles are not necessarily the result of regulatory failures. The 1990s stock bubble, whose collapse gave us a recession in 2001, and the longest period without job growth since the Great Depression (until the Great Recession), was not the result of any obvious regulatory failure.

As Alan Greenspan famously commented at the time, the bubble was the result of “irrational exuberance,” the widely held belief that stock prices would always rise and that investing in the market carried little or no risk. The bubble made it easier to hide financial fraud of various types, such as the Enron or WorldCom scams, but it was not driven in any important way by these scams.

Fraudulent loans and their securitization did play a more important role in the housing bubble, but it was really only necessary to see the bubble, which was pretty much impossible to miss than to see the financial edifice that was helping it to grow. Although as a practical matter, when mortgage issuers were boasting about their negative amortization loans, it wasn’t too easy to miss the bad loans either.

The point here is that we will not see another recession because the Fed was failing to monitor the books of a future AIG or ignoring fraudulent loans in a major sector of the economy. We got the Great Recession because the Fed ignored a huge housing bubble that was driving the economy. Seeing that bubble didn’t require a regulatory microscope, all that was needed was someone who paid attention to the quarterly GDP data and could examine the fundamentals in the housing market, which was clearly driving the economy from 2002 to 2007.    

Financial Regulation is Important

Having said this, I would argue it is still important to keep a tight leash on the financial sector, for three reasons. First, the financial industry is a major source of inefficiency in the economy. Finance is an intermediate good like trucking. We need it to allocate capital and make payments, just as we need trucking to get goods from one place to another, but unlike items like health care or housing, it does not directly provide benefits to people.

For this reason, an efficient financial sector is a small financial sector. Unfortunately, the financial sector has exploded as a share of the economy in the last half century. The narrow securities and commodities trading sector has nearly quintupled relative to the size of the economy over this period. This would be comparable to a situation where we needed five times as many trucks and drivers, relative to the size of the economy, as we did in 1971.

If we had something to show for the explosion of the financial sector, say in better capital allocation or more secure savings, then perhaps we could justify the increase in its size. But, it would be very hard to make that case. Instead, we have people working in finance who could be productively employed in health care, construction, or other sectors that actually provide goods and services that people value.

The second reason that we need to have tighter regulation of finance is that it is a major source of inequality. Many of the richest people in the country got their wealth from running hedge funds, private equity funds, or other financial institutions.

There is at least an argument for extreme wealth when it is associated with important innovations that benefit society, like electric cars or an efficient on-line retail system. There is not much of a case when the wealth comes from financial engineering that left workers, landlords, and/or other investors worse off.

The last reason why it is important to regulate finance is that unregulated finance will often turn to predatory practices that prey on lower income households, and especially Blacks and Hispanics. A well-educated lawyer or accountant, who devotes themselves to the task, can find ways to design deceptive contracts that will take advantage of their customers. If we greenlight such practices, effectively allowing people to make large amounts of money by ripping off their customers, then we can be very sure that many people will go into the business of ripping off customers.

We need the government to limit abusive practices in the financial sector. As Senator Elizabeth Warren famously argued in her push to get the Consumer Financial Protection Bureau established, we wouldn’t let a company sell toasters that blow up in people’s kitchens, we shouldn’t let financial institutions sell products that blow up in the faces of the people who buy them.

The Net Story on Financial Regulation and the Fed

Having argued the case for the importance of regulating finance (see also Rigged chapter 4 [it’s free]), let me say that I still see it as very much a secondary consideration in the selection of the Fed chair. First, the Fed’s ability to control the amount of employment in the economy, through its monetary policy, is incredibly important in determining the economic well-being of tens of millions of people, especially those who are disadvantaged in the labor market and society.

Second, we have other regulatory bodies, such as the Consumer Financial Protection Bureau, the Securities and Exchange Commission, and Comptroller of the Currency, and several more. Good appointees at these agencies can go far towards ensuring that the financial system is well-regulated.

Finally, if Biden makes good picks for the currently vacant position at the Fed and for the Vice-Chair for Supervision, and the spot that will open up in the winter, he can likely change the Fed’s course on regulation.

But at the end of the day, it’s hard to see the Fed’s regulatory stance as being anywhere close in importance to its position on monetary policy. Firing Powell because he has not been good on regulation would be like dumping the great pitcher Bob Gibson from the team because he wasn’t a good base runner.

We need a Fed that is firmly committed to full employment. For the first time in seventy years, we have that with Jerome Powell. Biden would be taking a huge risk by going with a different chair.[1]

[1] It is also worth mentioning that Powell, unlike almost anyone else should have an easy confirmation. Many Republican senators will almost certainly vote for him. After all, he was picked originally as chair by Trump. (Obama appointed him as a Fed board member.) It is very possible that any other Biden pick will face 50 no votes from Republican senators. That means that Biden would need to make sure that Manchin, Sinema, and other centrists were on board. These centrists would then effectively have veto power over the success of Biden’s presidency.    

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