Why doesn't the Fed stop crises?

The revelations of Carmen Segarra, the former New York Federal Reserve bank examiner who made secret tapes of her bosses timidly urging her not to challenge big banks on risky deals and other questionable moves in 2011 -- after the Fed was supposed to have learned its latest lessons on making it tougher for big banks to blow themselves up – supports an argument that Fed-watchers have made and the Fed has acknowledged for years: the nation's central bank fails to use its powers to identify and act on crises, even when its people collects lots of warnings.

Fed critiques and self-critiques after the last several crises read like the 9/11 Commission's report on how the FBI, CIA and local police, by not sharing, missed chances to stop the bombers. Why does this keep happening?

In a study of Fed meeting minutes and pronouncements going back to 2008, Swarthmore College economist Steve Golub and two colleagues, political scientist Aysa Kaya and sociologist Mike Reay, found top policymakers tended to talk a lot to each other about subprime mortgages and financial derivatives only after the damage was done -- a backward-looking approach that seems to ignore the warnings the Fed's policymakers, economists and bank examiners had separately collected. Read the paper at http://www.voxeu.org/article/federal-reserve-run-global-crisis

Golub points out that, in posting Segarra's transcripts at ProPublica.org, reporter Jake Bernstein cited a detailed 2009 report by Columbia University professor David Beim -- paid for by the New York Fed and mostly ignored -- that recognized the Fed's failure to recognize the crisis and act on it in time and recommended specific steps to put the Fed's many sources of information and its policy powers together faster.

Golub also cites University of Chicago economist (and now Indian central bank head) Raghuram Rajan's famous 2005 speech to central bankers warning (quite accurately) about the fragility of the financial system, and how it provoked rejection from American policymakers led by Larry Summers and Donald Kohn. Why wouldn't our policymakers review his arguments in detail before getting so defensive?

At the time, the Fed acknowledged its own failure to anticipate the 1998 near-collapse of hedge-fund Long Term Capital Management (LTCM), which could have blown up the financial system, and then organized a bailout by banks; but the Fed then forgot about LTCM, Golub says.

In an article published in the July Review of International Political Economy and summarized in the VoxEU blog (Golub says he knows it's popular because it got 6,000 views, which is a lot at this level), Golub and his coauthors reviews familiar criticisms that the Fed has been "captured" by the banks it's supposed to regulate, or by an anti-regulatory, "freemarket ideology," or an overly-abstract academic approach, or by a too-narrow focus on fighting inflation -- and says the problem goes still deeper, to the way the Fed is set up: groups of smart and conscientious people studying small pieces of large problems in isolation. Policymakers, researchers and regulators don't communicate enough.

And the structure of key Fed meetings does not encourage discussion and dissent.  Fed bank examiners -- Segarra's former colleagues -- "tend to look at individual banks and see how risky they are," says Golub. "But you need also to see the larger picture. How many banks is this a problem for?"

Isn't that something the Fed's hundreds of economists are hard at work studying? I asked? No, says Golub: "The research people don't talk to the regulatory people. Everybody's doing their own thing. The research people want to publish in academic journals. The regulatory people looks at individual banks." (It doesn't help that there are still several rival agencies in Washington policing different kinds of financial institutions.)

Bank deregulation at the end of the 1990s confirmed the Greenspan Fed in charge of "systemic" financial  regulation. But the bank never seems to have developed management practices for sharing information, drawing broad conclusions or acting on them, Golub says.

Also, Fed economic models, in line with academic trends, considered only a limited role for financial markets. "And Fed policymakers were confident that they did not need to regulate because they always thought they could fix everything later by expanding the money supply if the economy got in trouble,"  Golub told me. That worked reasonably well after the dot-com bubble of 2001 but did not account for the high level of risky debt created in 2003-2007 during the housing bubble.  While the Fed's bailouts prevented another depression, the costs to the economy have still been enormous."

What about the policymakers at the top? "The Fed, despite having a lot of capable people in there, is very rigid. Beim said private organizations try to overcome those by creating more fluidity. The research people have to talk to the regulatory people to find out what the problems are. The research people can help the regulatory people determine what practices are a danger to the economy as a whole.  The policymakers have to issue warnings and take preemptive measures when these risks get too big."

I noted there are obvious roadblocks: It's illegal for anyone to make public a confidential bank examination. Also, the Fed has existential critics, some in Congress; admitting mistakes gives the crazies ammo.

Golub says economists in general need to focus more on basic analysis of the copious financial reports the government and banks generate. "But that's not the kind of thing research economists like to do. The Fed 20 years ago decided to make their research more academic. rather than do the humdrum policy stuff. At the New York Fed you got promoted based on academic articles. That's not a terrible thing. But the economists weren't motivated to really get down and dirty in the data. It's just not what we do. We want a data set you can enter into a computer easily and run some statistical packages on. Rather than say, 'What's happening here?'"

Who does better? "Anthropologists. Economists have to be a little more like anthropologists to be successful. Policymakers, the economists and the regulators have to talk -- and connect the dots."