Dodd-Frank’s Achilles’ heel

By Robert J. Samuelson

Four years after Dodd-Frank became law, the question being asked is whether the country is safe from another financial crisis. It’s the wrong question. It presumes that major financial crises are routine events. They’re not. What happened in 2008-2009 was the first in the United States since World War II. This sort of calamity requires much stupidity, incompetence and bad luck. With or without the Dodd-Frank financial overhaul, the next one might be many years or decades away. The right question is: When a crisis occurs — as it probably will — does Dodd-Frank better prepare us to handle it?

Unfortunately, no. It may even make us more vulnerable. To see why, you need to understand Section 13(3) of the Federal Reserve Act and its role in the last crisis. It’s the sleeper issue in judging Dodd-Frank.

By their nature, financial crises are unexpected, fast-moving and chaotic. Government’s goal is to defeat panic: the terror-driven rush to sell stocks and bonds or withdraw funds from financial institutions and markets. Panic becomes self-fulfilling. Less wealth and more fear depress spending and raise unemployment. In 2008-2009, the Fed — aided by the Treasury and the Federal Deposit Insurance Corp. — arrested panic by lending huge amounts to besieged markets and institutions. At its peak, the Fed’s loans totaled about $1.5 trillion.

Much of this lending couldn’t have occurred without Section 13(3). Normally, the Fed lends only to deposit-taking commercial banks. In the crisis, it also lent to or supported money-market funds, commercial paper markets, investment banks and a major insurance company (AIG). It could do so because Section 13(3), enacted in 1932, said that “in unusual and exigent circumstances” the Fed could lend to almost anyone — individuals, industrial companies, non-bank financial institutions.

Section 13(3) enabled the Fed to serve as a true “lender of last resort.” Many economists believe that this may have prevented a second Great Depression. And how did Congress, via Dodd-Frank, reward the Fed’s good deeds? It handcuffed (maybe gutted) 13(3).

Dodd-Frank’s restrictions on 13(3) loans include: (1) the treasury secretary must approve any lending; (2) loans can’t be focused on an individual firm (example: a wobbly money-market fund) but must be open to a broad class of borrowers; (3) the names of borrowers must be disclosed to Congress within a week; and (4) there are stricter standards for loan collateral. “I’m concerned that the restrictions . . . limit more than is wise,” Donald Kohn, the Fed’s vice chairman during the crisis, said at a recent Brookings Institution conference. Other commentators agreed.

It’s easy to see why. Suppose that temporarily propping up that one wobbly ­money-market fund might prevent a general panic affecting all money-market funds. Shouldn’t the Fed have the power to do that? Under Dodd-Frank, it doesn’t.

The curbs on the Fed reflect a general resentment that the Fed could deploy so much money without first getting approval from Congress, which controls the government’s purse strings. But creating money is what modern central banks do. If Congress objects, it should revert to the gold standard. In a crisis, the Fed’s ability to respond quickly is what gives it the potential to stop a panic. (Note: Most of the Fed’s loans have been repaidwith interest.) The insistence on detailed oversight would, if applied to the military, require generals during wars to clear every tactical change with Congress. This sounds impractical because it is.

The anti-Fed backlash also stems from the belief that it is an agent of the “too big to fail” doctrine — protecting the big financial institutions that caused the meltdown. These institutions, the theory goes, took big risks because they would reap big profits if they succeeded and would be rescued by the government if they failed. With this implicit government guarantee, they could borrow more cheaply than rivals to finance their speculative investing.

This beguiling theory fails on the facts. Yes, some big financial institutions (AIG, Citigroup) were protected. But many failed or were forced to sell out at low share prices: Lehman Brothers, Bear Stearns, Merrill Lynch, Wachovia, Washington Mutual. There was no blanket protection for “big” players. Nor was their interest-rate advantage large. Studies suggest that it averaged about 15 basis points, reports the International Monetary Fund. That’s a difference between 4 percent and 4.15 percent — a slim margin on which to hang the entire financial crisis.

The crisis ultimately originated in an orgy of optimism, reflecting a quarter-century of solid economic growth, which spawned reckless lending and borrowing. No one plans a financial collapse. Dodd-Frank’s provisions, even if they work as hoped, can’t permanently shield us from unforeseen problems. In a crisis, we need a competent first responder. The Fed, though hardly infallible, is the best choice. A farsighted and wise Congress — not now in evidence — would restore its flexibility.