“Who shall guard the guardians?”
– Juvenal
I gave a speech in New Orleans last week to a group of commercial bankers. My subject was the Panic of 1907 and the current financial crisis. In 1907 the U.S. did not have a central bank; J. P. Morgan filled the role of central banker. This detail leads to one of the most frequent questions I get at these lectures: do we really need the Fed today?
The events of 1907—and the more recent events—perhaps suggest not. Certainly, the Presidential candidate, Ron Paul, doesn’t think so. Ben Bernanke, Alan Greenspan, and the Federal Reserve System have taken quite a few lumps in the past nine months. When commercial bankers—people of the economic mainstream who are tied tightly to the Fed—start asking this question, the rest of us should take serious notice.
Of course, the Fed isn’t the only government entity in the pillories. This weekend, Barron’s published an article by Jonathan Laing that positively blisters Fannie Mae for its past practices and current poor health—Laing predicts that Fannie Mae will need a government bailout. The International Monetary Fund is running a deficit and is in the midst of a major identity crisis. Then too, the entire U.S. Government is running a large deficit, which, given that it is tax time, makes it an inviting target for political candidates of all stripes. Did the Fed promote a liquidity glut? Some analysts say yes; others point to the dearth of evidence that interest rates were inappropriately low. Did Fannie, Freddie, Sallie, and other entities stoke speculative activity? Again, both sides of the question will likely find evidence in support.
Misery loves company. The private sector warrants scrutiny as well. In the years to come, analysts will consider the potentially adverse effects of aggressive lending, financial innovation, and lax risk-management. By now, no one doubts that there was a pandemic of adverse credit-creation in the U.S. capital markets in recent years.
I replied to the bankers in New Orleans that we need some person or agency to mobilize collective action. Markets during a crisis reflect the classic “prisoner’s dilemma” problem, where people take actions that are individually good but jointly bad. The bad outcome of the prisoner’s dilemma occurs because the two prisoners do not collaborate. The job of the Fed today is to organize collective action to prevent bad outcomes. Given the immense complexity of financial markets today, I doubt that the task of mobilizing collective action could be performed adequately by private parties. Thus, my reply to the bankers was yes, we need the Fed.
I quickly added that the better question is, What should we do differently in the future? The Fed is only part of an elaborate system of defenses against disaster. Managers and boards of directors are the first line of defense; but in some prominent instances, they failed. We might hope in a Congress, free press and academy to keep an eye on things—except that they tend to speak up when it is too late. Some pundits foresee in 2009 a large reaction to the present crisis, a re-regulation of American business and finance on the order of Franklin D. Roosevelt’s first 100 days in 1933.
The Roman poet, Juvenal, reported that a jealous husband locked his wife in a guarded house to prevent her adulteries. But then, he asked, who shall guard the guardians? However we improve the defenses against financial disaster, let us hope that such improvements simply don’t add more layers of overseers.
Stephen Hawking told a story about a scientist lecturing on the origins of the universe. A lady interrupted the scientist and said “What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise” Hawking said that the scientist asked her, “What is the tortoise standing on?” “You’re very clever, young man, very clever,” said the lady. “But it’s turtles all the way down!””
We need the turtles, or guardians, or government agencies to organize collective action and monitor one another. The question is how high the stack of turtles must be to deal effectively with financial crises.
Posted by Robert Bruner at 03/09/2008 10:53:59 PM