cognitive regulatory capture

michecon · Apr 2, 2009

This is from a paper from William Buiter. The original paper is in pdf and is prepared for the FED conference in May. Here's a part may interest DnD:

Cognitive regulatory capture of the Fed by vested interests

In each of the instances where the Fed maximised moral hazard and adverse selection, obviously superior alternatives were available – and not just with the benefit of hindsight. Why did the Fed not choose these alternatives? I believe a key reason is that the Fed listens to Wall Street and believes what it hears, or at any rate, acts as if it believes what Wall Street tells it. Wall Street tells the Fed about its pain, what its pain means for the economy at large and what the Fed ought to do about it. Wall Street’s pain was indeed great – deservedly so in most cases. Wall Street engaged in special pleading by exaggerating the impact on the wider economy of the rapid deleveraging (contraction of the size of the balance sheets) that was taking place. Wall Street wanted large rate cuts fast so as to improve its solvency, not its
liquidity, and Wall Street wanted the provision of ample liquidity against overvalued collateral.

Why did Wall Street get what it wanted?
Throughout the ten months of the crisis, it is difficult to avoid the impression that the Fed is too close to the financial markets and leading financial institutions, and too responsive to their special pleadings, to make the right decisions for the economy as a whole. Historically, the same behaviour has characterised the Greenspan Fed. It came as something of a surprise
to me that the Bernanke Fed, if not quite a clone of the Greenspan Fed, displays the same excess sensitivity to Wall Street concerns.

The main evidence to me of Fed excess sensitivity to Wall Street concerns are (1) the two cuts in the primary discount rate; (2) the decision to let the clearing bank acting for the primary dealer price the collateral offered by the primary dealer to the Fed in both the TSLF and the PDCF; (3) the modalities of the Bear Stearns rescue, and especially the roads nottaken; (4) the proposal that interest be paid on reserves without making this conditional on
interest not being paid on required reserves; and (5) the aggressive interest rate cuts since August 2007, and especially the 75 basis points cut on January 21/22 2008. It seems that the only news that could have prompted this cut was high-frequency movement in stock prices and the palpable fear in the financial sector, that the stock market rout in Europe on Monday 21th January 2008 (a US stock market holiday) and at the end of the previous week, would spill over into the US markets. As regards the cuts in the Federal Funds target rate, some of them are difficult to rationalise
even with a Fed interpretation of its mandate that gives priority to the real economy over the maintenance of price stability. Instead they provide support for what used to be called the ‘Greenspan put’ hypothesis, but should now be called the ‘Greenspan-Bernanke put’ or ‘Fed put’ hypothesis.14 I find it hard to rationalise in any other way the decision on 21 January,
2008 to implement a Federal Funds target rate cut of 75 bps, at an unscheduled meeting, and the announcement of that cut of normal working hours the next day.

A complete definition of the ‘Greenspan-Bernanke put’ is as follows: it is the aggressive response of the official monetary policy rate to a sharp decline in asset prices (especiallystock prices), even when the asset price falls (a) are unlikely to cause future economic activity to decline by more than required to meet the Fed’s mandate and (b) do not convey new information about future economic activity or inflation that would warrant interest rate
cuts of the magnitude actually implemented.

Mr Greenspan and many other ‘put deniers’ are correct in drawing attention to the identification problems associated with establishing the occurrence of a ‘Greenspan- Bernanke put’ with a reasonable degree of confidence. The mere fact that a cut in the policy rates supports the stock market does not mean that the value of the stock market is of any inherent concern to the policy maker. This is because of the causal and predictive roles of
asset price changes already alluded to.

Nevertheless, looking at the available data as a historian, and constructing plausible counterfactuals as a laboratory economist, it seems pretty evident to me, that the Fed under both Greenspan and Bernanke has responded more vigorously with rate cuts to sharp falls in stock prices than can be rationalised with the causal effects of stock prices on household
spending and private investment or with the predictive content of unexpected changes in stock prices.

To me, both the LTCM and January 21/22, 2008 episodes suggest that the Fed has been coopted by Wall Street - that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception of reality is unhealthy and dangerous. It can be called cognitive regulatory capture (or cognitive state capture), because it is not
achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator, like the Fed, but instead through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate
and supervise in the public interest instead.

The literature on regulatory capture, and its big brother, state capture, is vast (see e.g. Stigler(1971), Levine and Forrence (1990), Laffont and Tirole (1991), Hellman et. al. (2000) and Hanson and Yosifon (2003)). Capture occurs when bureaucrats, regulators, judges or politicians instead of serving the public interest as they are mandated to do, end up acting
systematically to favour specific vested interests – often the very interests they were supposed to control or restrain in the public interest. The phenomenon is theoretically plausible and empirically well documented. Its application to the Fed is also not new.

There is a long-standing debate as to whether the behaviour of the Fed during the 1930s can be explained as the result of regulatory capture (see e.g. Epstein and Ferguson (1984) and Philip et. al. (1991)). The conventional choice-theoretic public choice approach to regulatory capture stresses the
importance of collective action and free rider considerations in explaining regulatory capture (see Olsen (1965)). Vested interests have a concentrated financial stake in the outcomes of the decisions of the regulator. The general public individually have less at stake and are harder to organise. I prefer a more social-psychological, small group behaviour-based explanation of the phenomenon. Whatever the mechanism, few regulators have succeeded in
escaping in a lasting manner their capture by the regulated industry.

I consider the hypothesis that there has been regulatory capture of the Fed by Wall Street during the Greenspan years, and that this is continuing into the present to be consistent with the observed facts. There is little room for doubt, in my view, that the Fed under Greenspan treated the stability,
well-being and profitability of the financial sector as an objective in its own right, regardless of whether this contributed to the Fed’s legal triple mandate of maximum employment, stable prices and moderate long-term interest rates. While the Bernanke Fed has but a short track record, its rather panicky reactions and actions since August suggest that it too may have a
distorted and exaggerated view of the importance of the financial sector for macroeconomic stability.
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cognitive regulatory capture

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