Second-Guessing the Fed

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Alex Wong / Getty

Federal Reserve Chairman Ben Bernanke

The race for the Great Fed Second Guess of 2008 is now well under way: First out of the blocks was former Federal Reserve chairman Paul Volcker, who worried aloud in April that forcing and partially financing the takeover of ailing investment bank Bear Stearns had taken the Fed to "the very edge of its lawful and implied powers."

Next came William Poole, a few weeks after retiring from the presidency of the Federal Reserve Bank of St. Louis, declaring in May that the Fed's actions — which, along with the Bear rescue, have included hundreds of billions of dollars in unconventional loans to banks — had created an "appalling" state of affairs.

On Thursday, two current members of the Fed hierarchy, Philadelphia Fed President Charles Plosser and his Richmond counterpart Jeffrey Lacker, joined the fray. In a speech at New York University, Plosser argued —without mentioning the seat-of-the-pants Bear Stearns rescue by name — that Fed actions ought to follow explicit rules. "Discretion in lending practices runs the risk of exacerbating moral hazard and encouraging financial institutions to take excessive amounts of risk," he said.

Lacker, speaking at the European Economics and Financial Centre in London, did mention Bear Stearns, warning, "The danger is that the effect of recent credit extension on the incentives of financial market participants might induce greater risk taking, which in turn could give rise to more frequent crises."

Regional Federal Reserve Bank presidents such as Plosser, a former dean of the University of Rochester's Simon School of Business, and Lacker, a veteran Richmond Fed economist, are not at the center of the Fed hierarchy. They serve on a rotating basis on the Federal Open Market Committee, which sets short-term interest rates, but neither was directly involved in the partially Fed-financed takeover of Bear Stearns by J.P. Morgan Chase. That deal was mainly the work of Timothy Geithner — who as president of the Federal Reserve Bank of New York, is the Fed's designated financial-crisis firefighter — with the approval of Fed chairman Ben Bernanke and the rest of the Federal Reserve Board in Washington.

Geithner and Bernanke defended their actions as necessary to fend off a collapse of the global financial system — and few in official Washington or the Federal Reserve System disagreed at the time. But as the crisis atmosphere of early this year has given way to calmer times, second thoughts are increasingly coming out into the open.

The likely result of the debate is stricter rules on exactly when and how the Fed can intervene in the affairs of banks and brokerage firms. The basic conundrum faced by the Fed will probably never be resolved, though: If banks and brokerages are never allowed to fail, lenders and investors have no incentive to monitor the risks they're taking. But in a crisis, otherwise perfectly sound institutions — and with them the entire financial system — can go under unless the Fed steps in.