Focus On The Fed

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Divining the Regulatory Goals of Fed Rivals

By BINYAMIN APPELBAUM


WASHINGTON — Lawrence H. Summers, as Treasury secretary, presided over the group of senior Clinton administration officials who reached the fateful decision in the late 1990s that there was no need to regulate a new family of financial transactions known as over-the-counter derivatives. Janet Yellen attended some of those meetings, too, as chairwoman of President Clinton’s Council of Economic Advisers. But she did not speak.

Mr. Summers and Ms. Yellen are now the leading candidates to head the Federal Reserve, and the winner is likely to spend far more time on financial regulation than previous Fed chairmen. Congress has greatly expanded the Fed’s regulatory purview; moreover, the central bank’s basic responsibility to try to keep the economy on an even keel, experts say, will require a much greater focus on ensuring the stability of the financial system.

The two candidates share similar views on many regulatory issues, according to a review of their public statements and interviews with friends and colleagues. Both forged academic careers as members of the economics counterculture that attacked the dogma of efficient markets. Both say they believe that markets require regulation to prevent abuses, ensure fair competition and prevent disruptions of economic growth.

But those meetings 15 years ago highlight a basic difficulty in predicting what kind of regulators they would be. Ms. Yellen, during her two decades in prominent public roles, has left few footprints on the era’s debates about the government’s role in the markets. Mr. Summers, in helping to shape the regulatory policies of two administrations, has taken positions that critics say amounted to not following his own advice.

For supporters of stronger regulation, it comes down to a choice between someone they do not know and someone they do not trust.

The overhaul of financial regulation that Congress passed in 2010 — known as the Dodd-Frank law after its two principal authors, Senator Christopher J. Dodd and Representative Barney Frank (both since retired from Congress) — amounted to an instruction manual for the creation of a new system. The construction process remains substantially incomplete.

The next head of the Fed faces controversial decisions, in particular, about what safeguards to impose on the largest financial institutions to make it credible that if they falter, they will be allowed to fail.

“There’s a huge plate of unfinished business where the Fed has lead — if not sole — authority and the next chairman could derail a lot of that, or water it down,” said Sheila Bair, who was chairwoman of the Federal Deposit Insurance Corporation during the financial crisis. “That’s why it’s important for the next Fed chairman to have a good focus on regulation.”

President Obama has said that he intends to nominate a successor this fall for the current Fed chairman, Ben S. Bernanke. The White House has said he is also considering a third candidate, Donald L. Kohn, who was Ms. Yellen’s predecessor as Fed vice chairman. While past Fed chairmen have been selected almost exclusively for their views on monetary policy, this time the White House is focused on the fact that it is picking a financial regulator, too.

Mr. Summers and Ms. Yellen declined to comment for this article. Both, however, have spoken in recent months about the need for stronger regulation. Ms. Yellen, in a June speech, detailed areas where she believed stronger regulation was required. Mr. Summers, in an April interview, made a similar point, although he did not discuss specific proposals.

“The world is moving in the right direction,” he told Maclean’s, a Canadian newsmagazine. “Whether it is moving rapidly enough, and aggressively enough, is a judgment we will have to make in the next several years.”

Mr. Summers and Ms. Yellen were academic stars before entering public service. Menzie Chinn, an economist and professor of public affairs at the University of Wisconsin, said that both were “at the forefront” of research undermining the idea that markets were self-correcting. By contrast, the former Fed chairman Alan Greenspan frequently argued that government regulation did more harm than good.

Mr. Summers is known for perhaps the most efficient rejoinder to the efficient-markets theory. “THERE ARE IDIOTS. Look around,” he famously wrote in an unpublished paper. Professor Chinn said that Ms. Yellen’s work showed an even clearer pattern of viewing markets as inherently flawed.

“She and her husband were thinking about how to model the economy in a realistic fashion,” said Professor Chinn, referring to Ms. Yellen’s husband and his own former teacher, the economist and Nobel laureate George Akerlof. “The willingness to do that took a little bit of courage.”

In keeping with this worldview, both Mr. Summers and Ms. Yellen have long argued that government must protect people from abuses.

As Treasury secretary in 2000, Mr. Summers joined with the Department of Housing and Urban Development to produce an exposé of predatory lending practices. The report recommended modest changes in federal law but Congress, then controlled by Republicans, made none. The Fed and other banking regulators also ignored the findings. Years later, however, it was a source for elements of Dodd-Frank.

As President Obama’s chief economic adviser in the wake of the crisis, Mr. Summers advocated the creation of a regulatory agency, the Consumer Financial Protection Bureau, arguing that the Fed could not be trusted to retain that role.

Mr. Summers also was an architect of the administration’s broader approach to overhauling financial regulation; he and the Treasury secretary, Timothy F. Geithner, oversaw the staff that hammered out the details. At the time, he described it as an effort to ensure that participants in the financial system, like drivers, wear seat belts and carry insurance, and submit their cars to regular inspections, to limit the chances and the consequences of crashes.

“I think Larry looked at the financial market and had the basic view that it was broken,” said Michael Barr, a member of the group.

But the administration’s initial proposal in June 2009 was a disappointment to many Congressional Democrats, who added or significantly strengthened some of the key provisions — sometimes in conflict with the White House — before passing a bill in 2010.

“Everything in that original working paper was marginal change to the existing regulatory structure,” said Jeff Connaughton, then an aide to Senator Ted Kaufman, a Delaware Democrat who became one of the most persistent voices for making more fundamental changes.

Critics of Mr. Summers say that he has a record of showing too much trust in financial markets to regulate themselves. And the most important example concerns over-the-counter derivatives — basically, customized bets on the movements of other prices, which could be used as insurance or, just as easily, to magnify risk-taking.

Mr. Summers, as a senior Treasury official in the late 1990s, played a leading role in the suppression of an effort by the head of the Commodity Futures Trading Commission to establish oversight of these customized derivatives, whose misuse already had contributed to financial catastrophes, including the bankruptcy of Orange County, Calif., and the collapse of a ballyhooed hedge fund, Long-Term Capital Management.

At the time, Mr. Summers emphasized that he wanted to maintain the status quo to preserve the stability of domestic markets, and to avoid pushing the business overseas. In July 1998, he told Congress that he also saw no reason for regulation because “the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves.”

The Clinton administration subsequently agreed with Congressional Republicans to formalize the lack of regulation, allowing the market to grow in the dark. That helps explain why regulators were blindsided a decade later when the world’s largest derivatives gambler, the American International Group, nearly brought down the financial system.

More than a decade later, in 2010, President Clinton said on ABC’s “This Week” that he had been wrong to listen to his advisers. “Sometimes people with a lot of money make stupid decisions and make it without transparency,” Mr. Clinton said.

Mr. Summers, too, changed his mind in the aftermath of the crisis. “By 2008, our regulatory framework with respect to derivatives was manifestly inadequate,” he told the Financial Crisis Inquiry Commission. But he and his supporters have maintained that the failure occurred because the use of derivatives changed over a decade in ways that they did not anticipate.

Michael Greenberger, a senior official at the futures trading commission in the late 1990s, said that did not explain the reluctance to establish safeguards. The problem, he said, was not the failure to predict the specific problem but the willingness to trust that there would be none. “I don’t think that required 20/20 foresight,” he said.

Lewis A. Sachs, a senior Treasury official in the late 1990s, said that Mr. Summers backed him in his bid to increase the transparency of derivatives by requiring them to be processed through clearinghouses, but that he was unable to win the support of Mr. Greenspan or Senate Republicans, so the idea was dropped.

Mr. Sachs, whose private investment firm now pays Mr. Summers as an outside adviser, noted that the administration’s report called for the regulators to revisit the derivatives market as it grew. The Bush administration failed to do so, he said.

Some of Mr. Summers’s supporters also argue that better oversight of derivatives would not have prevented or significantly diminished the crisis.

Ms. Yellen found a ringside seat in the years before the financial crisis. She was named president of the Federal Reserve Bank of San Francisco in 2004 and, the next year, she became one of the first officials to describe the rise in housing prices as a bubble.

Over the next few years, in public speeches and meetings of the Fed’s monetary policy committee, she spoke with growing concern about the potential for broad economic damage when the bubble burst. But the San Francisco Fed, which oversaw the nation’s largest mortgage lender, Countrywide Financial, did not move to check its increasingly indiscriminate lending. The regional banks take their marching orders from Washington, which had adopted a hands-off policy.

Ms. Yellen told the Financial Crisis Inquiry Commission in 2010 that she and other San Francisco Fed officials pressed Washington for new guidance, sharing the problems they were seeing. But Ms. Yellen did not raise those concerns publicly, and she said that she had not explored the San Francisco Fed’s ability to act unilaterally, taking the view that it had to do what Washington said.

“For my own part,” Ms. Yellen said, “I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the S.I.V.’s — I didn’t see any of that coming until it happened.” Her startled interviewers noted that almost none of the officials who testified had offered a similar acknowledgment of an almost universal failure.

Chastened by the financial crisis, Ms. Yellen now favors stricter regulation. “This experience,” she told the commission, “has strongly inclined me toward tougher standards and built-in rules that will kick into effect automatically when things like this happen, that make tightening up a less discretionary matter.”

Mr. Summers’s supporters contrast his long experience on regulatory issues with Ms. Yellen’s more limited record to argue that he would be more effective in carrying forward a set of reforms that he helped to shape. Ms. Yellen’s supporters draw a different lesson from the same contrast.

“Between the two of them,” said Mr. Connaughton, the former Democratic Senate aide, “I would rather roll the dice on her than get the known quantity of Larry Summers.”

http://www.nytimes.com/2013/08/14/business/economy/careers-of-2-fed-contenders-reveal-little-on-regulatory-approach.html?ref=business&pagewanted=print