Of all the villains responsible for the Great Economic Wipeout, the Federal Reserve is pretty far down the list.
It's certainly behind members of Congress who deregulated the banks in 1999, allowing once-staid institutions to gamble recklessly. Then there are notorious CEOs such as Martin Sullivan of American International Group (AIG, news, msgs), Angelo Mozilo of Countrywide Financial and Richard Fuld of Lehman Brothers, whose greed and hubris wrecked their companies. Crooked mortgage brokers, rapacious Wall Street traders and millions of irresponsible homeowners were key supporting actors in the revolting drama, too.
The Federal Reserve made one unambiguous mistake: It kept interest rates too low for too long after the 2001 recession, in the forlorn belief that Wall Street money hounds would exercise restraint instead of getting drunk on cheap money and heading to the casino.
The Fed also could have spotted the housing bubble sooner than it did and acted more quickly to deflate it. And once the financial system was in full meltdown in 2008, the Fed arguably could have done a better job managing the collateral damage.
But the punishment proposed by critics of the Fed is far out of proportion to the crime. Fed basher Rep. Ron Paul, a Texas Republican, wants to conduct regular audits of the Fed, allow Congress to get involved in decisions on monetary policy and eventually eliminate the Fed altogether -- as if politicians would be better economic stewards than the Fed's gray-suited bankers.
Democratic Sen. Chris Dodd of Connecticut, chairman of the Senate Banking Committee, wants to strip the Fed of its power to regulate banks, entrusting those duties to some other agency that would presumably do a better job because . . . it's not the Fed.
As Congress debates how to reregulate the financial industry, the next few months could be the most fateful for the Fed since it was revamped in the 1930s.
Video: Bernanke pushes back on audits
The Fed certainly needs several reforms, and Chairman Ben Bernanke has proposed a few good ones himself. But wholesale overhaul, political meddling and burden-shifting to some other agency seem like overkill.
Some better ideas come from the recent report on the AIG bailout by Neil Barofsky, the special inspector general auditing the Treasury Department's bailout regime. The AIG bailout was effectively a joint venture by Treasury and the Fed, and Barofsky did his report to answer one of the most unsettling questions of the entire fiasco: Why did AIG use taxpayer money to redeem billions of dollars in contracts with trading partners like Goldman Sachs (GS, news, msgs), Merrill Lynch and four other sophisticated banks -- at full value, with no discounts mandated by AIG's financial distress?
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In September 2008, when it became clear that AIG was on the verge of failing, the Fed tried to organize a group of private banks to bail out AIG, as Wall Street has done before. But the private banks, worried that they'd lose money at a time of crisis when they needed it most, essentially chickened out, leaving the Fed to either step in or let AIG fail.
Lehman Brothers had just collapsed, the financial markets were in a free fall and Fed economists feared a 1930s-style financial seizure if such a huge conglomerate went down -- a judgment that seems generally sound more than a year later. So the Fed crafted a hasty AIG takeover plan involving an $85 billion loan to the company, following some of the guidelines the private bankers had come up with and leaving other important details to be worked out later.
Under the circumstances, there's probably no way such a complex, chaotic bailout could have gone smoothly, but in retrospect, the Fed made a couple of big mistakes it probably could have avoided.
Continued: Secrecy for a reason
