Bernanke Takes On Monday Morning Quarterbacks

More Prudent Regulation Would Have Helped

While I agree that the Fed's interest rate moves were a minor contributor to the crisis, I think it is hard to argue that lax regulation, of which the Fed played a part, was not major cause.

Of course, the Fed, the rest of the regulators, and the general market (myself included), all fell for the same fallacy that "this time was different": financial innovation, by spreading risk around to those who could bear it, had made the financial system safer. In order to prevent this regulatory capture of the Fed, I think we need to change the way we view, and regulate, financial innovation.

As a capitalist society, we tend to view all innovation as a good thing. And I think in most industries, other than finance, this is generally correct.

During the dot com bubble, innovation was rampant. Many of the new businesses and websites were redundant, unnecessary, or unwanted, and as a result many of them failed. But no bailouts were necessary. Pets.com didn’t require government funds. And the fallout from the failure of start-ups didn’t take the rest of the economy down with them. The ideas, business, and jobs that grew out of the dot com bubble were beneficial after the dust settled. Thus, I think it is fair to say that innovation deserves the benefit of the doubt in most industries.

However, this crisis showed that in finance, innovation should not be given the same free pass.

Many people who blindly support innovation in finance cite the correlation between economic growth and growth in the finance sector throughout history as proof. And in fact, I support this claim, but only up to a point. I don’t think it is clear that the relationship is linear. It might be, but there also may be diminishing returns, where once we get to a point, each subsequent innovation may be worth very little. Also, not all innovation is clearly beneficial. Innovation that increases transparency (decreases the level of asymmetric information) and avoids moral hazard and tail risk is usually a good thing. But of course, this kind of innovation is much less profitable than the innovations that take advantage of asymmetric information and moral hazard.

My conclusion then, is we, as a society, should be skeptical of financial innovations. Our regulators need to switch the burden of proof to the finance industry, and make them show that each individual innovation increases transparency and avoids moral hazard and tail risk before it is allowed to be implemented.

Nice Post.

I fully agree with your assessment, and many many large wirehouse economists agree with your assessment. It's quite difficult though for policymakers and the general public to even come close to understanding the complexity that does into some of the decisions the FOMC and Bernanke make. You specifically named just one tool. Ironically, the Taylor Rule has now "hit the mainstream" as Larry Kudlow yesterday evening was using the term in his contempt for Bernanke. If you asked him how to calculate the Taylor...or even the Stone & McCarthy Model, or the Deutche Bank model, his head may explode.

That said Bernanke is 100% correct. Monetary policy in the 2000's, while not accomidating to the restraint of transactions, had a much smaller role than the lack of regulation, lack of personal, corporate, and political responsibility, and the increase in exotic securitized products used worldwide.

For politicians...it's simply easier to get re-elected blaming the Fed (which I've heard is a new subject for a Dan Brown book), than it is to accept their own shortfalls.