The Fed's New Job Description

Robert Shiller says changes in the institutional structure of the financial system such as the breakdown of the traditional lines between what is and what isn't a bank require the Fed to reevaluate and expand its role in managing the economy. I agree, and I also agree that Ben Bernanke is well-suited to the role of leading the Fed through this change:

The Fed Gets a New Job Description, by Robert Shiller, Economic Scene, NY Times: The plan of Treasury Secretary Henry M. Paulson Jr. to overhaul the financial system includes a crucial proposal: it would officially transform the Federal Reserve into a “market stability regulator” rather than merely a banker’s bank.

This aspect of the Treasury plan is a natural step in a historical trend. The Fed is no longer just a regulatory agency presiding over a narrow group of businesses called banks. Rather, its mission increasingly is to maintain macro confidence — confidence that the entire financial system is functioning well as part of the whole economy.

In contrast, traditional securities regulators like the Securities and Exchange Commission have as their primary mission the maintenance of micro confidence — confidence that individual firms are disclosing the truth about their own internal operations and are not manipulating information. But as the current financial crisis attests, it is macro confidence that requires the most subtle attention. ...

[T]he nature of financial institutions is changing... In the new financial order, in fact, we do not clearly know what is or is not a bank, so a narrow definition of the mission of the central bank is no longer appropriate. ...

The Fed has been taking an expansive view of its own powers recently, for the most part with considerable public approval. Witness its decision to give a $29 billion line of credit to JPMorgan Chase to encourage the purchase and rescue of Bear Stearns. There was very little criticism of this move because so many people rightly feared the systemic effects on financial institutions if the Fed did not act. ...[T]he whole financial house of cards could have collapsed.

Because we sense that maintaining confidence in our financial system is so important, we are permitting the Fed to expand its role. ... Two of the Fed’s most important innovations were internationally coordinated measures. These were the establishment of the Term Auction Facility in December, ... and the creation last month of the Term Securities Lending Facility...

It has been said that Ben S. Bernanke chose an awful time to become chairman of the Federal Reserve — ... just as the economy was about to enter its worst financial crisis since the 1930s. But it was also the perfect time, because it presented him with challenges for which he had a lifetime of preparation. His most famous academic work concerned the crisis of the Great Depression, and he has thought deeply about systemic economic problems.

Mr. Bernanke’s own analysis of history, as well as that of other economists, emphasizes the essential importance of confidence in financial institutions and the subtlety of the issues involved in promoting such confidence. ...

Confidence is too complex for the consumer confidence indexes — which are based on surveys of ordinary people — to measure adequately. It has to do with confidence in specific institutions — confidence that they will behave properly and that the leaders who are trying to promote others’ confidence will act in a constructive way.

Formalizing the Fed’s transformation into a market stability regulator makes sense. The Fed has already begun to play this role. And by doing so, it is taking a significant step toward reducing the fundamental instability of our economy.