The Federal Reserve’s Escape from New York..

Prof Simon Johnson’s recent piece is on governance at Federal Reserve. In his typical style, he lambasts what has been going on at Fed esp. at NY Fed.

The US Federal Reserve System is the world’s most important central bank. Its decisions about interest rates and financial regulation reverberate through global markets and affect millions of lives. Yet its governance structure is of another age – antiquated, increasingly problematic, and urgently in need of sensible reform.

The Fed made major mistakes in the run-up to the global economic crisis of 2007-08, most notably by adopting a lax approach to the supervision of key financial institutions, and by allowing some very large banks to become extremely fragile. In one of the great ironies of modern American politics, the post-crisis Dodd-Frank financial reforms of 2010 actually gave more power to the Fed, mostly because other US regulatory agencies were regarded as having done a worse job.

In view of the Fed’s decidedly mixed track record since the Dodd-Frank reforms, some officials evidently regarded that default by Congress as a mandate to conduct business as usual. Recent press reports have highlighted lapses in supervision, particularly in and around the Federal Reserve Bank of New York – one of 12 regional banks in the Fed System, which also has a Board of Governors in Washington, DC.

This regional structure is the result of legislative compromise in 1913, when the Fed was created, and again in the mid-1930s, when its governance was last overhauled. Whereas members of the Fed’s Washington-based Board of Governors are nominated by the US president, subject to Senate confirmation, the presidents of the regional Federal Reserve banks are appointed by local boards.

In reality, the New York Fed has always had disproportionate sway; not all regional Fed presidents are created equal. The president of the New York Fed is a permanent voting member and vice chairman of the Federal Open Market Committee, which sets interest rates, whereas other regional Fed presidents are voting members only on a rotating basis.

The New York Fed also has a particularly important role in bank supervision – most of America’s “too big to fail” banks are located in its jurisdiction (and most global banks have a presence there). And the New York Fed has long been the Fed System’s eyes and ears on Wall Street.

Or perhaps it has become the other way around. At least over the past decade, senior New York Fed officials have consistently sided with the interests of very large banks. (To be clear, I also know many Fed officials who are outstanding public servants). Though Wall Street interests have long been well represented on the board of the New York Fed, under Timothy Geithner, its president from 2003 to 2009, the big players became even more powerful – with some rather unfortunate consequences for the rest of us.

How times change. There was a time when NY Fed was “the model”. Experts said for mon policy to work it has to hear what banks say and be closer to financial markets. It made sense for the central bank to be located at the financial markets centre of their respective countries. Fed at Washington was seen as fuddy/duddy whereas at the NY one was seen as cool and hep.

What is the way going forward for central banks? As mon pol transmission deals with banks/fin system, they shall always be close to the banks. Central banking policy only works if the banks follow what the central bank has to say. On its own, central banks do not mean much as banks are carriers of their policy.

In that sense central banks are a weird kind of regulator. Other regulators do not care and can be really tough on the players. But central banks apart from regulation also do monetary policy where they have to work along with the banking system. Just because of this these two activities were seperated in countries like UK, EZ etc with central banks only supposed to do mon pol.  But now after the crisis, regulating activities are again being added to their respective central banks.

The world would be a much better place if central banks are seen as part of overall economic policy. Currently it is like central bankers and the rest. This is leading to all kinds of problems..

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