Arguably Ripping into the Federal Reserve from Within

Via Google Alerts, I receive periodic e-mails notifying me of online publications (many of them respectable economics and finance blogs) citing Robert Higgs‘s analysis of “regime uncertainty” during the years of the New Deal. (His article “Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” first appeared in the Spring 1997 issue of The Independent Review, and a revised version appears in his superb recent book, Depression, War, and Cold War: Challenging the Myths of Conflict and Prosperity.)

However, it was not by Google Alerts but by sheer dumb luck (or rather via the U.S. Postal Service, which arguably amounts to the same thing) that I happened recently upon a reference to Higgs’s analysis of “regime uncertainty” from an unexpected source: the lead article in the 2008 Annual Report of the Federal Reserve Bank of Richmond.

How do government functionaries make use of criticisms of past government policies? Very carefully. Consider the passage in the article in which the authors, Richmond Fed employees Aaron Steelman and John A. Weinberg, reference Higgs:

Through the [current] crisis, the Fed’s approach has evolved and changed in numerous directions, including the direction of credit to particular market segments and institutions. Beyond winding down its many new lending vehicles, the Fed will need to make it clear to all market participants which principles it will follow during future crises.... Public policies by all agencies must be well articulated and time consistent so that market actors can make rational plans regarding their financial and other business affairs. Arguably, such policy uncertainty did much to prolong the Great Depression in the United States (pp. 16-17) [footnote to Higgs (1997)].

Note the wording in the last sentence. “Arguably” can function like a weasel word: its use allows a writer to confer a measure of respectability on a particular conclusion, without the writer having to publicly endorse that conclusion. (At least “arguably” is arguably like a weasel word. Its use is perfectly justified, of course, when one finds an explanation plausible but inconclusive—or when it’s employed to keep the mail carrier on semi-cordial terms, as in paragraph 2 above.)

I don’t chastise Steelman and Weinberg for employing that term, however. Space limitations and other legitimate concerns may have prevented them from doing anything more than to note Higgs’s piece. And even if their use of the term was “strategic” (in the weasel-word sense), their efforts to critique other Federal Reserve policies—from within the belly of the beast itself!—should be lauded.

On p. 10 of their report, Steelman and Weinberg employ the “regime uncertainty” concept (and give it a different name) while they offer explanations for why the banks finally became cautious about lending and why investors became cautious about banks:

Third, there is policy uncertainty. After the onset of the crisis, the Federal Reserve and the Treasury took several actions to help stabilize the financial sector. However, these actions appeared to evolve on a case-by-case basis. Some institutions received support, while others did not, making it more difficult for market participants to discern the governing principles and to make predictions about future policy moves. These institutions were already facing an uncertain economic environment, which contributed to relatively sparse lending opportunities. Coupled with an uncertain public policy environment, it is not surprising that many have been hesitant to lend and that many have had trouble raising private capital.

It’s nice to see the authors allude to the harmfulness of “policy uncertainty”—i.e., a policy of waffling. However, the article is marred by (arguably more) instances of the authors’ own annoying waffling:

In hindsight, private lenders and borrowers may have made some imprudent decisions.... Also, the Federal Reserve kept interest rates low for a long period, which may have encouraged additional lending that exacerbated the crisis. (p. 12, emphasis added.)

Such mistakes may have been made? Is there any basis for doubt?

On the plus side, however, Steelman and Weinberg resist calling for more and stronger doses of government intervention:

[T]here is also a strong case to be made that the function of market discipline can be improved by constraining some forms of government intervention, especially those that dampen incentives by protecting private creditors from losses (p.5).... However, additional regulation of financial markets would likely hamper innovation in that industry. An alternative approach is to seek to reduce the scope of explicit safety net protection—as well as creditors’ expectations of implicit protection of firms deemed too big to fail (p.11).

Even more interesting are Steelman and Weinberg’s other thinly veiled criticisms of Federal Reserve policy during the recent crisis:

The Fed could benefit from heeding the advice of two classical economists, Henry Thornton and Walter Bagehot, who considered how the Bank of England could act effectively as the lender of last resort. The Thornton-Bagehot framework stress six key points:

• Protecting the aggregate money stock, not individual institutions
• Letting insolvent institutions fail
• Accommodating only sound institutions
• Charging penalty rates
• Requiring good collateral
• Preannouncing these conditions well in advance of any crisis so that the market would know what to expect.

Current Federal Reserve credit policy has deviated from most if not all of these principles.

Just in case Steelman and Weinberg’s article is too transparently critical of policies proposed by Federal Reserve H.Q., however, their author-i.d. line is followed by the standard bureaucratic disclaimer:

“The views expressed are those of the authors and not necessarily those of the Federal Reserve System.”

Arguably, therein lies a problem.