NCPA - National Center for Policy Analysis


October 30, 2009

Although Federal Reserve analysts will doubtless continue research on the causes of asset price bubbles, they would be foolish to accept formal responsibilities for pre-emptively containing asset price surges and becoming financial super-regulators, says Jagadeesh Gokhale, a senior fellow at the Cato Institute.

Economists have long lamented problems in assessing whether asset price increases constitute bubbles and in predicting the timing of asset price bubble bursts, says Gokhale:

  • Setting capital standards and ancillary regulatory frameworks for financial institutions is more art than science.
  • Given economists' poor predictive ability in evaluating macroeconomic risks and setting appropriate capital buffers for financial institutions, the Fed is bound to eventually (and spectacularly) fail at preventing asset price bubble bursts followed by severe financial disruptions.
  • Then calls for congressional investigations and oversight on monetary policy would threaten the Fed's independence.

Indeed, making the Fed a financial super regulator would only provide formal sanction to policies that have increased moral hazard effects in the first place, says Gokhale:

  • Once the current recession is over and the Fed has withdrawn its extra-normal initiatives to restore credit markets, the correct policy approach may be to do the exact opposite -- to signal that there will be no super regulator for financial institutions and to formally prohibit the Fed from engaging in bailouts of non-bank financial firms.
  • Such a formal stance by Congress on financial regulatory policy is the best bet for developing mechanisms for sustained and effective self-regulation by market participants.

Fed officials are probably well aware of the dangers of accepting responsibility for setting financial regulatory standards and using monetary policy to prick asset price bubbles.  The dangers are in setting anti-bubble policies that are so draconian they reduce the economy's long-term growth potential and eventually fail to protect financial institutions and the economy from a large macroeconomic shock.  Such failures could permanently compromise the Fed's independence in monetary policymaking, says Gokhale.

Source: Jagadeesh Gokhale, "A Financial Super-Regulator,", October 29, 2009.

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