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Jim Jubak

Jubak's Journal12/19/2008 12:01 AM ET

5 reasons the Fed is obsolete

Over the past decade, the history-bound central bank has stumbled repeatedly, threatening US leadership in the quest for a new global financial system.

By Jim Jubak
MSN Money

Over the past decade, the Federal Reserve has demonstrated it isn't up to the challenges of the financial markets of the 21st century.

The Federal Reserve had the regulatory power to head off the worst excesses of the markets in 1999 and 2006, but it chose not to act. Why not? Why didn't the Fed take even the easiest steps to head off not one but two bubbles?

Here's the simplest explanation: The Federal Reserve stayed rooted to the sidelines because the Fed, while still capable of technical innovation, is bound by its history and its very DNA to the financial world of the past.

That wouldn't be so bad, except that the world is facing the need to invent a new global financial system. And it needs the help and leadership of the United States.

In this column, I'm going to tell you why I believe the Fed isn't up to the job. Make up your own mind. If I'm right, I don't think the solution to the crisis is to give the Federal Reserve more regulatory power. Something much more revolutionary than a tweak here and an expansion of authority there is needed if we want to avoid a replay of today's financial crisis in five years or so.

  • Watch the video on the right to hear Steve Forbes' views.

(This is the third column in a three-part series on how to reform the financial system. You can find the first two columns, "Fake inflation numbers masked crisis" and "3 fixes for the credit crisis enablers," by clicking on these links.)

5 Fed failures

Here are the five reasons the Federal Reserve needs a revolutionary overhaul:

  • The Fed failed to use its power to set margin rates for stock trading in the run-up to the bursting of the 2000 bubble. Granted, it might not have stopped the bubble, but it would have been a good place to start. And requiring buyers to put up more cash to purchase shares would have sent a message to the stock market more clearly than then-Chairman Alan Greenspan's musings about whether it was better for the Fed to deflate a bubble or clean up afterward. Unlike raising interest rates across the board, raising rates on stock market margin loans wouldn't have tanked the general economy either.

  • The Fed failed to use its power to raise reserve requirements for banks in the run-up to the bursting of the bubble in 2007. That would have taken money out of the market for mortgage-backed securities and other derivatives based on buyout loans, commercial real estate, etc. At the least, an increase in reserve levels would have meant that banks such as Wachovia (WB, news, msgs) would have gone into the bust with more capital. The Fed also could have moved to restrict or ban the off-balance-sheet financial vehicles that still threaten to take down Citigroup (C, news, msgs). By letting banks claim that these vehicles for loading up on debt weren't really part of the bank itself, the Fed let banks load up on leverage.

  • The Fed appears to play favorites. The Fed is supposed to care more about the soundness of the system as a whole than about picking winners and losers. But court papers in the Lehman Bros. (LEHMQ, news, msgs) bankruptcy case show that on Sept. 15 and 16, after declining to rescue Lehman, the Fed lent a Lehman subsidiary $138 billion so that the subsidiary, Lehman's broker-dealer business, could wind down tens of thousands of trades with other Wall Street companies in an orderly fashion. Odd, since at the time both the Treasury and the Fed were saying publicly that they didn't have legal authority to lend money to Lehman on exactly the same kind of collateral that backed the loan to the subsidiary. It appears that the Fed found it could move when the profits of other Wall Street companies were at stake. The Fed is supposed to be an impartial regulator of the financial markets, not a covert protector of strong institutions at the expense of weak ones. By compromising its impartiality, the Fed is also compromising its ability to lead an effort to build a new global financial system.

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The Fed's next move
What will the Federal Reserve do to fight the recession now that interest rates are at 0%? It will print so much money that banks have to lend, says Jim Jubak, which will mean big inflation in '10.

  • The Fed let other central banks take the lead on innovative regulation. Contrast the Federal Reserve's do-nothing approach to the latest financial bubble with the actions taken by the central bank of Spain. First, the Bank of Spain made it so expensive for Spanish banks to set up off-balance-sheet leverage vehicles that few Spanish banks did. As a result, Spanish banks went into this crisis with less leverage. Second, the Bank of Spain required banks to put aside extra reserves during good years. By raising reserve requirements when profits were high and bad loans were low, the central bank got Spain's banks in position for the down cycle. The two actions have helped Spain weather this crisis better than most countries. That's remarkable considering that Spain experienced its own runaway speculative housing boom.

  • The Fed has become a fixture of the status quo. Even the most zealous government regulatory agencies, U.S. history shows, are captured over time by the industries they were designed to regulate. The Federal Reserve Act of 1913 was based on a plan worked out by such Wall Street powers as J.P. Morgan's bank and what is now Citigroup to head off a repeat of the string of panics that rocked the financial system early in the last century. The act established that private bankers would run the 12 regional reserve banks, overseen by a Federal Reserve Board appointed by the president. What strikes me about the members of the Fed board and the heads of the 12 Federal Reserve banks isn't how many came from Wall Street -- I count only four out of 17 with past employment at banks such as Wachovia, Morgan Stanley (MS, news, msgs) and Citigroup -- but how many are Federal Reserve lifers. What this all adds up to in my arithmetic is an institution that talks mostly to itself. Whatever else the Fed may be, it's surely not a cauldron of new thinking and different points of view.

Continued: Opportunity may pass the US by

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