The Fed Was Wrong: Banks Got Screwed

and so did the American people….

Foreign Affairs quarterly recently ran a story by noted monetary policy guru, Scott Sumner (follow him @MoneyIllusion on Twitter) that pointed fingers at Fed policymakers for the financial crisis and subsequent Great Recession. When the noted banker, John Allison, was running the Cato Institute, I had the chance to interview him on the subject. His argument that the U.S. financial industry is the most regulated industry in the world, and therefore, a meltdown of any sort would have to be attributed to the misapplication of regulation, is convincing.

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U.S. Federal Reserve headquarters

John Allison is the former CEO of BB&T, the nation’s 12th-largest bank-holding company with $181 billion in assets, and recently retired president of the Washington, D.C. think tank, Cato Institute. He is the author of The Leadership Crisis and the Free Market Cure. (McGraw-Hill, 2013).

Interview with John Allison

The Dodd-Frank legislation doesn’t deal with most of the issues that caused the credit crisis, so it’s a misapplied remedy, not a cure. I would argue that the Federal Reserve is setting the stage for similar problems in the 2020s.

The topic, while a worthy one for economists, has nothing to do with her statutory role as chair of the Fed board of governors. In that role, she is charged to improve unemployment and stabilize interest rates, and today also to maintain the stability of our financial institutions. The irony is that her policies — and those of her predecessors, by the way — are killing the mom- and-pop saver who invests mainly in CDs and bank savings accounts, and the unintended consequence is that her policies benefit mostly the upper classes.

Yes, plainly speaking, the job is impossible especially when you take into account the politics. But, I would add, they’re not doing an impossible job very well. I think they’re all guilty of what’s called fatal conceit, the belief of smart people that they can do the impossible. Let’s start with the targeting of monetary rates. I have talked to numerous members of the Federal Reserve and asked them, could a group of experts in Washing- ton, D.C., set the price for automobiles? To a person, they all said absolutely not. And then I ask, what about setting the price of money, interest rates, which is the most complex commodity in the world? They just look at me. It’s a strange kind of hubris.

We just created the Cato Center for Monetary and Financial Alternatives, which will explore ways to discipline the Fed. At minimum, we think the Fed needs to be guided by fixed rules and proper over- sight. When you consider the Fed authority over our financial services, it is somewhat like having the government’s IT department that created the Obamacare website oversee Google.

Mark-to-market contributed to and worsened the financial crisis, because in an environment where the Federal Reserve is making arbitrary decisions, you don’t really have normal market prices. Assuming that everybody is going to liquidate everything in that kind of environment is an irrational way to evaluate assets. The result was tragic and predictable.

Our deficits would be $1 trillion a year larger than we are reporting because we don’t account for the fact that boomers are going to retire someday, and under Medicare they will spend 90 percent of their lifetime medical expenses in the last years of life. And we would have a negative net worth of $40 trillion.

I believe that the market needs to determine compensation. In financial services, the top tier of regulated companies has to cap compensation now. The result is that many of the best people are leaving firms like J.P. Morgan and Goldman Sachs, and ironically, this means the market will move to the unregulated companies that regulators were most concerned about during the financial crisis.

I think most boards tried their best, but there are structural and legacy issues that got in the way of better board performance. First, I don’t believe that boards effectively really self-regulated. The whole idea of independent directors is superficial, and has required companies to field boards that are inexpert in the company’s business.

What is really wanted are objective directors, but genuine objectivity requires a deep understanding of the business. If you put me on the board of a company I know very little about, I might not see the train coming despite the fact that I am a seasoned executive. I’m afraid boards that were overseeing some of our great financial failures lacked the right skills and, in some cases, the depth of experience.

Before I answer that question, let me pose one that precedes it: why in the world did they save Bear Stearns? Bear was not that big a player and would have easily been digested both because of its size and the timing. So the implication was they would have to save Lehman, because Lehman was much bigger, much more systemically important. That may be what impelled Lehman to double-up their bets on mortgage securities, and by doing so they quadrupled their losses. So, if Lehman had been liquidated the day Bear Sterns failed, the country might have avoided what the crisis became, the Great Recession.

Fair, certainly not, but rational, maybe.To understand that, you have to look at several issues that haven’t been given proper coverage by the media. The first is the never-ending myth that greed on Wall Street and deregulation caused the financial crisis, because the press and government believe so strongly in the power of regulation. Wall Street is the most regulated industry in our country, and the financial crisis could not have happened, ever, without regulation as a contributor. Now, we can get into why regulation didn’t work and why it was misapplied, but to blame bankers without blaming the authority they operated under is folly. In fact, government policy was the primary cause of the financial crisis. The subprime mortgage boom/bust was primarily caused by Freddie Mac and Fannie Mae, government-sponsored enterprises that would never have existed in a free market.

I argue that ethical principles that are appropriate for an individual — the idea of having a sense of purpose for making rational decisions based on facts, being honest, having integrity — are exactly the things that are appropriate for organizational behavior. One of my concerns is that we’re moving towards a compliance society, which is radically different than the ethical society. Companies comply, but that’s different than having the right ethical principles. In the long term, the lack of ethical principles will overwhelm whatever technical compliance a company or individual might employ. I think we can get back on track but it will take a change in leadership at many levels.

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Producer of Extraordinary Lives 2019 @TellyAwards for documentaries @; Author of Be Somebody @; ex-publisher @Forbes

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