"Independent Does Not Mean Unaccountable"

As you might guess given my recent posts defending Fed independence, I agree with this:

The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating... Understandably, many people are calling for change. ... As a nation, our challenge is to design a system of financial oversight that will ... provide a robust framework for preventing future crises...

I am concerned ... that ... some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures ... would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation. ...

The proposed measures are at least in part the product of public anger over ... the rescues of some individual financial firms. The government's actions... -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity...

Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

The Federal Reserve ... did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems. ... There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks...

This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.

Of course, the ... ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance...

Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities... Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation. ...

 Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

While I agree on the independence and regulation statements, one thing I do wonder about is why there is such widespread acceptance of the idea that we have to live with institutions that are so big that their failure is a threat to the financial system and the economy. The notion seems to be that large, dangerous firms are inevitable, so we need special procedures in place that we hope will allow them to fail without the problems spreading and creating a devastating domino effect. The concern seems to be mainly about having the procedures and authority to allow orderly dissolution of large, dangerous firms rather than preventing these firms from getting too large and too interconnected to begin with.

We need procedures for orderly dissolution in any case -- we didn't think firms were systemically important before the crash, so we need to be ready (e.g., recall the many, many statements that the crisis would be "contained"). But what is the minimum efficient scale (MES) for financial firms? That is, what is the smallest size at which economies of scale and economies of scope are fully realized?

There has been some discussion of this (e.g. Economics of Contempt versus The Baseline Scenario), but it doesn't seem to me that this question is very close to being settled. I want to know how the MES relates to the minimum size where a bank becomes systemically important. If the MES is smaller than the size where banks become systemically dangerous, break them up - their size adds nothing but risk. But if the MES is greater than the minimum dangerous size, then we have a tradeoff to make -- safety for efficiency -- and we may or may not want to force firms to reduce their size and connectedness. It depends upon the tradeoff.

But until we know what these tradeoffs are -- and I don't think we have a good sense of this -- it's very difficult to determine if the costs of breaking up banks and reducing their connectedness are greater than the benefits. I suspect that if the MES is greater than the minimum safe size, then the extra safety from reducing bank size and connectedness would be worth the loss of efficiency, and I'd like to push that position much more than I have to date. But without knowing the MES, the minimum threatening size, the minimum threatening degree of connectedness, and the costs and benefits of reducing size and connectedness, it's hard to do so with confidence.