The Fed's fatal conceit.

• Author: Allison, John A.
• Position: Federal Reserve Board - Essay

I strongly believe that the recent financial crisis, ensuing recession, and slow recovery were primarily caused by government policy. The Federal Reserve made some very bad monetary decisions that created a bubble, i.e., a massive malinvestment. The bubble ended up being focused in the housing market largely because of government affordable housing policies--specifically, the actions of Freddie Mac and Fannie Mae, government-sponsored enterprises that would not exist in a free market. When Freddie and Fannie failed, they owed $5.5 trillion including $2 trillion in affordable housing (subprime) loans. It's true that a number of banks made serious mistakes, and I would have let them fail, but their mistakes were secondary and within the context of government policy.

I've known many people in the Federal Reserve, in monetary policy. They are very smart people. They are highly committed people. However, in my experience, they are guilty of what F. A. Hayek (1989) called "'the fatal conceit"--that is, the belief that smart people can do the impossible. I don't care how smart you are or how great your mathematical models are, you cannot coordinate the economic activity of seven billion people on this planet.

The real issue is: What does government policy incentivize real-world human beings to do? I'm going to share with you my own experiences in that regard and also my insights into the actions of other financial company CEOs.

The Federal Reserve: A Banker's Perspective

As a banker, I see the Fed as having three primary roles: (1) to control the payments system, (2) act as the number-one regulator, and, of course, (3) conduct monetary policy.

The Payments System

There is no private payments system in the United States. The payments system is controlled by the Fed and, ultimately, the so-called "shadow banking" system has to get back to the payments system. Troubles in the monetary economy, by definition, are caused by the Federal Reserve.

The Fed controls the clearing mechanism for the banks in the United States. The reason it does so is because the Fed subsidizes the banking business, especially small banks and nonbanks, who are inefficient providers. This arrangement has slowed technological advances in the banking industry because the big banks have to wait for the little banks and the nonbanks to be able to implement new technology. Furthermore, it has caused a lot of quality control problems because many nonbanks get a free ride into the payments system. Typically, privacy issues aren't created by banks--they are created by nonbanks using the Fed's operating system. It's a perfect analogy with the post office. You can compare the post office to FedEx and UPS. In fact, if you think the post office is a good thing, you ought to feel really good about the Fed controlling the clearing mechanism. The good news is that the post office is going to go out of business because of e-mail, and the Fed clearing system is going to basically go away largely because of electronic transactions.

Regulation

Regulation is a huge subject. It is 'also related to monetary policy and sometimes people disconnect the two and forget about the impact of the regulatory role on the Fed's effectiveness. First, the foundation for regulation in the banking industry is FDIC insurance. FDIC insurance is used as the excuse to justify many regulations because the banks are being "protected by the federal government." In my opinion, FDIC insurance is the third contributor to the recent financial crisis, after Fed monetary policy and government affordable housing policy. FDIC insurance destroys market discipline in the banking system. Golden West, Washington Mutual, Indy Mac, Country Wide, and other large financial institutions that failed, 'all financed their lending business using FDIC insured deposits. They absolutely could not have done that in the private market. And it became a vicious cycle: as Freddie and Fannie drove down the lending standards in the subprime business, these other private competitors had to be more aggressive, because they had to leverage their high-risk loan portfolio to pay for their high-cost certificates of deposit.

Bert Ely (1994) developed a private insurance model that absolutely would have worked. I believe if that model had been in place, the financial crisis would have been dramatically less than it was. The model was not implemented because of lobbying by large NYC banks and 'also community banks. If you ran the numbers that Ely was looking at, several of the large banks needed at least double and probably triple their capital or they weren't going to get into the private insurance pool. The Federal Reserve was allowing Citi, et al, to operate with very insufficient capital. Under private insurance standards, Citi, et al, would have significantly increased their capital and would not have failed.

Regulations contributed to the bubble and subprime market in a number of ways. "Fair lending" was supposed to eliminate racial discrimination in the banking business. I joined BB&T in 1971, and by that time there was no racial discrimination because every bank was trying to make money and you wanted to make all the good loans you could make. However, shortly before Bill Clinton got elected in 1999., the Federal Reserve of Boston did a research study that concluded there was a lot of racial discrimination in mortgage lending (Munnell et al. 1992) Turns out the study has been totally discredited (see, e.g., Liebowitz 1993, Zandi 199,3). I call it a "childish study"-it only looked at debt to income ratios and didn't consider the reliability of the income, collateral, past payment history, or character type issues. No mature banker would have made a loan based on the meager standards used in the Boston Fed study.

Of course, now the Fed itself has discredited the study. But when Clinton got elected, he was absolutely convinced there was racial discrimination. He had a huge political debt to the African American community that got him elected, and he was really energized about this--both for ethical and political reasons. So basically a dictate came out, and the theory was that the banking examiners had missed the racial discrimination: let's go find banks guilty. And they did that. I spoke to a number of CEOs who were found "guilty," and they all said, "No, we didn't engage in racial discrimination; however, it was easier just to pay the small fine, change processes, and then put out a press release that we were guilty of discrimination--and that made the politicians/regulators happy."

Well, the regulators came to BB&T and we didn't operate that way. They came to me and said...