Willam Poole: How the Fed violated the constitution


William Poole has been published recently in the Financial Analysts Journal by the CFA Institute. was the eleventh chief executive of the Federal Reserve Bank of St. Louis. He took office on March 23, 1998 and began serving his full term on March 1, 2001. In 2007, he served as a voting member of the Federal Open Market Committee, bringing his District's perspective to policy discussions in Washington. Poole stepped down from the Fed on March 31, 2008.

Poole is Senior Fellow at the Cato Institute, Senior Advisor to Merk Investments and, as of fall 2008, Distinguished Scholar in Residence at the University of Delaware. We will go over his thoughts in greater detail later, but for now we will focus on the solution that he brought about the financial crisis.

You can read his comments below. He is very pessimistic on what the Fed and Congress are doing right now. He hates too big to fail. He despised hte bailout and thinks that the Fed has violated the consititution by purchasing Mortgage Backed Securities without a direct mandate.
It is important to distinguish two aspects of Fed activity during the financial crisis: the credit market policies and the monetary policies. The credit market policies whereby the Fed purchased large quantities of nonbank obligations, it seems to me, ought not ever to have been done by the Fed. This activity should have been done, if done at all, through congressional authorization and administered by the U.S. Treasury or some other department of our government. The U.S. Constitution is very clear on this point. It says that the President does not have the authority to spend public money. Expenditure requires an act of Congress, an appropriation.

Yet, the Fed has purchased $1.25 trillion in mortgage-backed obligations. At its peak, the commercial paper funding facility lent around $350 billion to corporations through purchases of commercial paper. Thus, the Fed has been exercising powers in the credit markets to commit public funds—powers that were not authorized by Congress. No legislation authorizes these programs. These are powers that the President himself does not have. I also believe this abuse of power explains why the Fed has found itself so embroiled in political disputes.

These disputes have also been partly over the Fed’s reluctance to disclose its activities. The Fed has not disclosed, for example, the companies from which it bought commercial paper. Historically, federal credit programs authorized by Congress have come with provisions requiring disclosure and provisions about program eligibility. These are fundamentally political decisions and fall under the purview of the legislative branch of government. The Fed, however, made expenditure decisions unilaterally. They may have been good decisions; they may not have been good decisions. But I believe that they exceeded the authority and proper role of the Fed.
For a concrete permanent solution to the financial crisis he wrote:
I suggested that what ought to be done is to insist that every firm with a bank charter—a bank holding company or a commercial bank charter—be required as a condition of that charter to maintain a substantial block of longterm subordinated debt in its capital structure. The subdebt proposal has been around a long time; in my version, subordinated debt would be equal to 10 percent of total liabilities.

Financial stability requires that there be a large block of long-term debt that cannot run. Deposits can run, so at the first hint of a problem, the depositors and other short maturity claimants disappear, and that will bring the company down. That creates a financial crisis. So, we need a big cushion, and that is the purpose of having long-term debt.

Second, because the bank has to refinance those long-term bonds—a 10-year maturity, perhaps—it produces a tremendous amount of market discipline, which is going to be far more successful in the long run in constraining the risk taking of these large firms. There is no other way of doing it, really—to simultaneously create market discipline and the stability of long-term, relatively permanent capital that cannot run. 
...these are 10-year bonds, so a tenth of them are maturing every year. The bank must roll them over to stay in business at that scale. If the bank cannot roll them over because the market is unreceptive, the bank is forced to shrink. It is much better that the bank be forced by market discipline to manage its own restructuring than to have the restructuring managed by the federal authorities. So, that is a big advantage. One other part of this plan is that the subordinated debt would be convertible to equity, at the option of the bank, when it matures. That means the bank is able to conserve cash when needed. The bank does not have to pay it out; it can convert the subdebt into equity. The bank would still be forced to shrink because it would not have the required amount of subordinated debt outstanding. So, subordinated debt would be a very useful adjunct—or maybe even the major aspect creating market discipline, in addition to equity capital.
When asked if his ideas had any traction to them, he responded:
I do not think that any of  the reform proposals in either the Senate Committee on Banking, Housing, and Urban Affairs or the House Financial Services Committee include this idea. I also do not see my idea being advocated by the Fed or by the Treasury. So, it does not appear to have any traction. 
Read the full article below.  Click on Full Page to ge a better read of the document. 
Ending Moral Hazard by William Poole

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