After revering Alan Greenspan as the greatest central banker ever, it has now become fashionable to look for scapegoats in the current financial turmoil.  And Alan Greenspan has become a prime target  Is it because of his supposed embracing of competitive markets, his concern about over regulation, his alleged lack of interest in protecting consumers or his overblown fears of deflation following the 9/11 attack and subsequent recession?  Is it his pursuit of low interest rates that caused the sub prime crisis?  

While not a defender nor an opponent of Greenspan, I do think we need to recognize that there are always two sides to a story.  It is particularly important now to understand both the successes and mistakes, and why they may have occurred.  This is necessary now because the risks of rushing to “fix a problem” can often generate legislation and other responses that may have unintended consequences, a risk which always looms large during and in the aftermath of a financial crisis.  This list of such “fixes” is long beginning with Glass-Steagall and ending with Sarbanes-Oxley.  I would like to offer four points that hopefully transcend the blame game.

First, those who are attacking Greenspan on the consumer regulation front are misguided.  They are arguing that the Fed should have pursued consumer protection regulation more vigorously, especially in the mortgage area.  They even suggest that the Federal Reserve should have expanded its policing activities far outside the class of institutions that it had the legal authority to regulate or supervise. 

The Fed’s three main responsibilities are, in order of importance, monetary policy, protecting the integrity and functioning of the payments system, and banking supervision.  The Fed’s responsibilities for consumer protection including Truth-in-Lending, Truth-in-Savings and the Home Mortgage Disclosure Act (HMDA) are examples of add-ons to the Fed’s main responsibilities that have crept in over time. 

In my view, these are examples of mission creep, and aren’t, nor should they be, pivotal concerns of a nation’s central bank.  Many of these functions were bestowed on the Fed because of the regulatory failures of other agencies or the perceived policy and regulatory competence of the Fed.  I don’t believe, nor can most make cogent arguments that it should be a central bank’s job to police contracts between private parties.  Nor should the Fed be put in the position of having to substitute its judgment for what is in the best interest of a given citizen.  This is what many are arguing the Fed should have done in the consumer protection area.  The right to make those individual decisions –whatever the consequences - is the essence of democracy.   

Second, the place where criticism of Greenspan’s tenure is justified is in continuing the Fed’s historic approach to banking regulation, and in particular its approach to capital adequacy.  The Fed bought into the idea that US banks were at an unfair competitive disadvantage with investment banks and other banks in the rest of the world who had less capital.  First, it was the inability to compete with Japanese banks, and later it was Europe’s universal banks. 

That view just didn’t square with the facts.  Banks with higher capital are more profitable and better able to weather adversity than those institutions with greater leverage.  Unfortunately, the Fed let itself get embroiled in supporting the developments and negotiations over the misplaced Basel II and Basel I approach to capital adequacy rather than embracing prompt corrective action and early intervention policies contained in Federal Deposit Insurance Corporation Improvement Act of 1991.  That is, the Fed should be worrying about whether capital is measured correctly and in assuring that banking failures (now investment bank failures) are isolated events. 

The best way to do this is to close troubled institutions before their net worth goes to zero.  Instead of pursuing arbitrary methods of allocating capital in healthy institutions (the Basel approach with extreme reliance upon internal models) and buying into the outsourcing of risk assessment (by relying upon the rating agencies) the Fed should have been focusing on how to unwind a failed institution to minimize the spillover effects to counter parties.  Rather than bailing out Bear Stearns, the result might have been different had the Fed understood, ex ante, the counter party risks. 

If it had, the Fed could have provided temporary liquidly to counter parties if it were needed to unwind positions.  That’s the way to deal with systemic risk without creating moral hazard.  The truth is that the Fed’s role in international capital regulation was first delegated to the Federal Reserve Bank of New York and then passed around to a sequence of Governors who were not equipped to deal with the issues.

Third, going back to consumer protection, that responsibility was always considered a nuisance add-on that conflicted with the Fed’s main missions dealing with monetary policy, banking supervision and payment systems.  In particular, banking supervision was for the longest time a largely consultative activity (especially for smaller institutions that lacked certain management expertise).  When Truth-in-Lending came along, regulation became more costly and burdensome.  Charges of over-regulation began to take hold, even though some of this was the result of requests from banks for rules and procedures that gave them safe harbor from law suits.  To the extent that the added costs adversely impacted banks’ ability to compete, there were conflicts between the Fed’s missions.  After all, higher costs meant lower profits, which in turn meant less protection for bank depositors and higher risks of failure.   

My work with a colleague at the Atlanta Fed suggests that when an agency is given multiple responsibilities that might be perceived as conflicting, those conflicts will be resolved internally, and weighted in favor of the responsibilities deemed to be primary responsibilities.  In the case of the Fed, this meant that resolution of conflicts between threats to bank soundness and consumer protection would be tilted towards bank soundness. 

The alternative to assigning an agency multiple goals is to segment regulatory responsibilities into separate agencies, where inter-agency goal conflicts can be externalized and resolved in the public arena.  Note that there is no theory that says that external versus internal resolution of goal conflicts is better.  But the results can differ and require one to balance efficiency and enforcement costs against the consequences of a goal conflict resolution that may differ from what the public may desire. 

I might add that these deeper issues seem to have been lost on the framers of the Paulson report which simply attempted to create a neat desk without any concern about regulatory incentives or how things might work over time or in a crisis.

Finally, I perceive that Chairman Greenspan saw his main responsibility as being monetary policy, and much of the other responsibilities either took time away from that activity or conflicted with that concern.  Hence, he delegated and deferred to others on those issues.  Was that a misuse of his time?  Clearly, it was not.  To be sure there were some rough patches, but there were also prolonged periods of prosperity and declining inflation. 

But before one suggests that the Fed be taken out of all supervision and regulation, it is important to understand what the connections are between the activity to be reassigned and the Fed’s macro-systemic risk responsibilities.  If you don’t have a window into how institutions function, how can you unwind or deal with spillover effects of a failure of a major institution to others?  

There clearly is no need for the Fed to be involved in the supervision and regulation of small banks.  It is also apparent that the split of supervisory responsibilities for different bank subsidiaries within a holding company makes no sense.

Should the Fed have supervisory responsibility for firms with access to the discount window?  Certainly.  Does the Fed have a special interest or does it need to be involved in consumer protection?  I believe that the answer is no.  Could the same agency that regulates and supervises disclosures of mutual funds and stocks also deal with truth-in-lending and truth-in-savings? Perhaps.  The point is that we need to think deeply about the issues and how we want decisions and tradeoffs to be made when it comes to regulatory design rather than simply instituting change for its own sake. 

How does all this relate to the Greenspan legacy?  It is always easy to second guess past policies, especially when one isn’t fully informed.  Moreover, it is also the case that our understanding of the economy is clearly imperfect.  To be sure, mistakes were made.  But if I may be allowed some personal observations from the perspective of someone who spent a substantial part of his career at the Federal Reserve and served under every chairman since WW II except Mariner Eccles, (which includes Chairmen Martin, Burns, Volcker, Miller, Greenspan and Bernanke), it is also the case that that no chairman has presided over as many financial disruptions – be it the breakdown in 1987, the LTCM problems, or the 9/11 attacks - or been associated with the incidence of fewer or milder recessions or as long a period of declining inflation as has Chairman Greenspan.  Much of the current criticism centers on ex post disagreements with some of the tradeoffs he made when it came to balancing the competing objectives and responsibilities that have been thrust upon the central banks.  Were the priorities misplaced?  I think they were not.  But the decisions deserve more in depth scrutiny so they don’t happen again.