Financial Reform: How We Should Choose the Regulators

Last Updated Sep 22, 2009 6:56 PM EDT

Editor's Note: Economist Mark Thoma is guest-blogging for The Macro View this week.
With all the talk of financial reform lately, one area I don't think is receiving enough attention is how the regulators who will oversee the financial system will be chosen. I will use the Federal Reserve as an example, but the comments below apply to whomever the principal regulator of the financial system winds up being, whether it's the Fed or another agency.

As explained here, at its inception the Federal Reserve System had features ensuring that public, business, banking, and government interests all had a strong voice in policy decisions, and that different geographic interests also had a voice at the table. Thus, the system had mechanisms in place to allow all societal interests to be represented in policy and regulatory decisions.

This shared power arrangement changed after the Great Depression when monetary authorities failed to respond adequately to crisis conditions. The problem, or at least so it seemed at the time, was that the deliberative and democratic nature of the institution prevented it from taking quick, decisive action when such action was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances, or to regulate the banking system.

The solution was to concentrate power into the hands of the central bank so that should a crisis occur, it could act quickly, and to considerably enhance the Fed's regulatory authority. There are risks, of course, to concentrating power so narrowly, but in the aftermath of the Depression we were quite willing to take that risk if it helped to avoid another catastrophe. Thus, the Fed has evolved from what was initially a very democratic, shared power arrangement to one where it functions, for all intents and purposes, as a single bank in Washington, D.C., with twelve branches spread across the U.S.

A lack of dissent
While some concentration of power was necessary in order to allow a faster response in times of crisis, in my view this concentration has gone too far. For example, monetary policy is set by the Federal Open Market Committee. The FOMC consists of the seven members of the Board of Governors and five of the twelve Federal Reserve District Banks on a rotating basis.

In theory, the District Bank presidents should represent the interests of their region in FOMC deliberations and votes on policy, but in practice, they mostly follow the lead of the Board of Governors. To the extent that there is any dissent, it largely comes from the District Bank presidents, but there is rarely any substantive disagreement on monetary policy and most votes are unanimous. This may be because the Board of Governors, whose members are appointed by the President with the advice and consent of the Senate, has considerable influence over the choice of who becomes a District Bank president.

There is also a problem in the way the Board of Governors is chosen. A Federal Reserve Board member serves a 14 year, non-renewable term (the non-renewable term is meant to reduce the temptation for a Board member to change policy to please the President and get reappointed, and the length of the term allows Board members to survive the President who appointed them). If all works as planned and each Board member serves their full term, one Board member is replaced every two years and no single President should be able to unduly affect policy by stacking the Board even if they are serve for a full eight years. But in reality, most Board members have not served even close to their full terms, and that has meant that each President has had the opportunity to replace enough Board members to dominate the Board. For example, every current Board member was chosen by former President Bush.

That is not how it is supposed to work. Unlike Supreme Court members who pay close attention to the makeup of the court and retire strategically if they can, members of the Board of Governors do not seem to feel honor-bound to serve out their terms or to consider the makeup of the Board in their decision about whether to continue their appointment.

I have no doubt that the members of the Board of Governors and the District Bank presidents have the best interests of the nation at heart when they make their decisions, but that doesn't mean there can't be disagreements over how to best serve the nation's needs. For example, there can be differences over how to respond to the competing goals of low inflation and high employment based upon differences in the macroeconomic models that are used for analysis.

A problem of perception
Even if policymakers are properly representing the various societal interests, there is a problem with perception. Rightly or wrongly, the public believes that the bank bailouts mainly served the interests of Wall Street, not Main Street. They believe policymakers are largely captured by the vast wealth of Wall Street, and that the needs of ordinary households have taken a back seat to banking interests (I believe many of the calls to take away some of the Fed's independence arise from this belief).

This perception needs to change, and the way to do that is to ensure that there is a selection process for regulators and policymakers that makes it very clear that the interests of the typical working class household are represented when important decisions are made. There could be, for example, two slots on the Federal Reserve Board that would be filled by a national vote during presidential election years. Whatever procedure is used the important thing is that the public feels it is represented.

Public support of policy is critical to its success, and right now policymakers do not have the full confidence of the public behind them. I believe that changing the selection process so that it's abundantly clear that the public has a voice at the table is an important part of policy reform that is, unfortunately, receiving little if any attention.