Fed’s ability to handle risks is put to the test

Under the Bush administration’s plan to restructure our financial system it is the Federal Reserve that gets most of the new responsibilities.

From a structural standpoint, there are good reasons for this. The Fed already has a responsibility to ensure orderly markets and it exerts considerable force over our commercial banking system and government debt markets. It also uses persuasion, access to sizeable government funds and its guarantee authority to stabilize markets when major participants appear to be sinking.

The most obvious reason, though, is not likely to be noticed, and even less likely to be discussed: The Fed is one of the least politicized organizational units in the entire federal government.

The Fed is also self-funded and not dependent on Congress for its daily bread. This establishes a different relationship for Congressional hearings and oversight; one that over the years has generally been healthier and more informative than the usual script-and-sound-bite circus that other agencies are put through.

There is a saying that “you can get a buffalo to do anything he wants to do,” and it has often seemed that the buffalo should be the symbol of the Federal Reserve. Not even presidents can get the Fed to do something it doesn’t want to do — just ask former president George Bush, who couldn’t get the lower interest rates he wanted to stave off a recession and win re-election.

This is not to say that all of the other financial regulatory organizations are dens of corrupt political influence. That is far from the case, and most of them do a pretty decent job.

But there is an inherent imperfection in the regulatory process, a level of interdependence between regulator and regulated that is hazardous to begin with and not always improved by each having its own separate relationship to Congress. When banks and other financial institutions are lobbyists and major campaign contributors, for example, it is almost certain to affect congressional perspective on regulatory agencies.

We have a need, then, for an organization that can operate with some independence from both the financial industry and Congress. For the most part, the Federal Reserve has done that well.

One of the good things about the administration’s restructuring plan is that it preserves the independent character of the Fed. Whether the new and improved Federal Reserve will have the right balance of responsibility and authority, though, is not really apparent. The administration plan expands the ability of the Fed to poke its nose into all sorts of businesses — examining records and accounting reports — but exactly what it could or should do with the information it obtains isn’t very clear.

The positive side of the Fed’s expanded role is that it will be the risk analyst and risk manager for our financial system as a whole. This is something that we have needed for some years, and the Fed has exactly the kind of expertise and the independence to take on that responsibility.

That is not to say it will be an easy task. Most of us tend to think of our financial system in fairly simple terms — maybe a little more complicated than Jimmy Stewart’s Bailey Building &Loan in Bedford Falls, but not much. Actually, though, it is a lot different.

To get a perspective on the change, think of a company such as Boeing. It makes airplanes and sells them to airlines around the world. The design, engineering and manufacturing process has become more complex, but managing the whole thing is still something that ordinary mortals can grasp, at least in theory. Maybe it’s not so easy that a caveman could do it, but most of us can at least understand what is involved.

Now suppose that Boeing’s customers, the airlines, were concerned about their risk of not needing the airplane when it is delivered, and so they sell options on it — first to other airlines and then to anybody who wants to speculate in aircraft futures. Then, Boeing suppliers start taking similar actions so that eventually the ownership and delivery schedule of every sub-assembly and part has been divided, optioned out and sold to individuals and groups around the world.

At that point, the management of Boeing would become very complex. If everything goes according to schedule, of course, there is no problem. But a disruption of any sort could cause a collapse of critical portions of the assembly process.

Our financial system has become vulnerable to disruptions because its complexity has concealed risk, especially the kind of systemic risk that affects our financial structure. Whatever merits or faults the overall administration plan has, they got the risk management part right — and they picked the right buffalo to do the job.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.