Simon Johnson, New York Times
Simon Johnson, the former chief economist at the International Monetary Fund, is an author of “13 Bankers.”
The Federal Reserve was created in 1913 to help limit the impact of financial panics. It took a while for the Fed to achieve that goal, but after World War II — with a great deal of help from other parts of the federal government — the Fed hit its stride. Today the Fed has not only lost that touch but, given the way our political and financial system currently operates, its own policies exacerbate the cycle of overexuberance and incautious lending that will bring on the next major crisis (and presumably another severe recession).
Sudden loss of confidence in the financial system was not uncommon toward the end of the 19th century, and while the private sector was able to stave off complete disaster largely by itself, the tide turned in 1907. In that instance J.P. Morgan could stand firm only because, behind the scenes, his team received a large loan from the United States Treasury (on this formative episode, see “The Panic of 1907: Lessons Learned From the Market’s Perfect Storm” by Robert F. Bruner and Sean D. Carr). Leaders of the banking system realized they needed help moving forward, and there was general agreement that the widespread collapse of financial intermediaries was not in the broader social interest. The question of the day naturally became: How much government oversight would bankers have to accept in return for the creation of a modern central bank?
The skeptics from the left — but also from the nonfinancial private sector (including those speaking on behalf of small-business people) — pointed out that the presence of a “lender of last resort” (of the kind already operational in Western Europe) was likely to encourage less care on the part of major financial institutions and the people who lent to them. The issue we now call “moral hazard” was front and center in the political discourse at the very founding of the Federal Reserve (although with different terminology).
Nevertheless, the original deal turned out to involve only a very light supervisory touch. In part this was about the individuals involved — the New York Fed was run by Benjamin Strong, a close associate of Morgan, until 1928. In part it was about the choice of organizational structure and internal rules — so the Federal Reserve Board in Washington had little de facto power relative to the New York Fed. But mostly the structural weakness was that the central bank was not designed to keep up with the pace of financial innovation.
Read more here: http://economix.blogs.nytimes.com/2010/09/23/the-fed-innovation-and-the-next-recession/
