Fed's Kohn: Policymakers Complacent Before Meltdown

Thursday, 25 Mar 2010 07:26 AM

U.S. Federal Reserve Vice Chairman Donald Kohn said on Wednesday that top policymakers had been "a little complacent" about complex financial instruments that contributed to the global financial crisis.

The banking meltdown, which resulted in emergency measures by the U.S. central bank totaling well over $1 trillion, helped push the world economy into its first recession since World War II.

"The reality is that we didn't understand the economy as well as we thought we did," Kohn said in a speech at Davidson College in Davidson, N.C.

"Serious deficiencies with these securitizations — the associated derivative instruments, and the structures that evolved to hold securitized debt — were at the heart of the financial crisis."

Kohn, who announced earlier this month that he will step down from the No. 2 position at the Fed after a 40-year career at the U.S. central bank, said the meltdown showed the Fed needed to be able to lend freely — if at a penalty — to a broad array of firms in times of trouble.

"We need to retain the ability to lend against good collateral to certain groups of sound, regulated, nonblank financial firms," he said.

"I'm not suggesting that we establish permanent contingency liquidity facilities, just that the Federal Reserve retain the authority to create the tools necessary to meet liquidity needs," he said.

Still, Kohn credited the Fed's forceful actions for preventing a much worse economic outcome, such as an outright depression.

Even with interest rates near zero, the United States just recently emerged from its worst recession in more than 70 years.

The U.S. economy expanded 5.9 percent in the fourth quarter, though the spike was driven in large part by a rebuilding of inventories, which economists, including Kohn, don't see as sustainable.

"We're looking at a gradual recovery," Kohn said in response to questions at an academic conference here. "The results of the fourth quarter were kind of distorted."

As for preventing crises altogether, Kohn said the Fed must walk a fine line between doing too much and doing too little when it comes to managing apparent asset bubbles.

He reiterated the notion that regulation, not monetary policy, would be the best way to dampen sector-specific speculative activity, in housing or elsewhere.

Kohn, who is generally perceived as a monetary dove — meaning he is more worried about economic growth than about the threat of inflation — acknowledged that the Fed's unusual policies have driven up inflation expectations "among some observers."

He said officials remain mindful of this effect, but that it had not yet to translate into a broader — and potentially harmful — pick-up in general price expectations.

He also argued against raising the Fed's implicit inflation target to stimulate lending and economic activity.

As for the future, Kohn suggested officials charged with supervision cast a more skeptical eye on new financial products.

"The structures exposed the banking system to risks that neither participants in financial markets nor regulators fully appreciated," he said.

"Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis that resulted in very serious unemployment and loss of wealth around the world. We must learn from our experience."

© 2015 Thomson/Reuters. All rights reserved.

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