Bernanke: Regulate or CYA?

Weak regulations for Wall Street, not low interest rates, caused the housing bubble, according to Federal Reserve Chairman Ben Bernanke.

In a speech to the annual meeting of the American Economic Association on January 3, Bernanke delivered a highly technical defense of the Fed's handling of events leading up to the housing and financial crisis. The cover-your-backside speech came as Bernanke battles to keep his job and preserve his agency's power.

The Federal Reserve, which Bernanke has headed for the past four years, has been accused of fostering the housing bubble through its policy of maintaining rock-bottom interest rates and by looking the other way as lenders and borrowers alike piled on risk.

Now, Bernanke is leading the parade on financial industry reform. He singled out "the increasing use of more exotic types of mortgages and the associated decline of underwriting standards," rather than monetary policy, as the underlying cause of the bubble, concluding that "the best response to the housing bubble would have been regulatory, not monetary."

A chastened Bernanke listed the Fed's attempts to regulate the housing bubble, which included issuing non-binding "guidance," but also admitted that more should have been done. "The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter," he said.

In his speech Bernanke laid out ideas for reforms that would strengthen his agency. The Fed should "move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole," he said. "Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets."

The Fed also wants to create a systemic risk council to keep a close eye on indicators such as leverage and liquidity across individual companies and the financial system as a whole.

Withe the regulatory moves, Bernanke hopes to fight off a Congressional proposal to create a new Consumer Protection Agency, which would take regulatory responsibility away from the Fed.

After four years as Fed chairman, presiding over the end of the housing boom and the bust that followed, Bernanke will face Senate hearings this month to decide whether he serves another four-year term. As Time Magazine's Man of the Year, credited in large part with pulling the financial system back from the brink of collapse, Bernanke has pretty good odds. But many lawmakers are still angry about the massive commitment of taxpayer dollars it took the prop up the system. It will be a tough hearing.

Congress is also considering other measures that would weaken Bernanke's agency. The House recently approved a proposal by Rep. Ron Paul (R-Texas) that would allow the Government Accountability Office, the investigative arm of Congress, to audit the Fed's moves on monetary policy.

Bernanke defended his agency and its decision to keep the Fed's benchmark interest rates low throughout the housing boom. He showed charts and graphs, recited theories and formulas. But the crux of his argument is that the Fed interest rate needed to be low for the sake of the economy as a whole. Sure, the housing bubble was inflated with easy money, but raising the Fed Rates would have been the wrong way to slow that flow of money. A Fed rate hike might have popped the housing bubble, but it also would have slowed the rest of a weak economy as well.

"Monetary policy is... a blunt tool," he said. "Interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established."

At the end of his speech, Bernanke issued his call for reform. Whether he is just covering his backside or truly embarking on smart regulatory reform is almost besides the point. What's important is that he is calling for reform. When the turf wars are settled, consumers can only hope that we emerge with tighter oversight.

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