Lecturing Bernanke The Fed chairmans old teacher worries that Washington isn't fixing the too-big-to-fail issue

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Economist Stanley Fischer was Ben Bernanke's thesis advisor at MIT; he knew better than most that his former student had the right stuff to avert a depression. Bernanke was an "expert" at injecting liquidity into a sinking economy, Fischer said last year before the markets took their frightening plunge. Fischer had no doubt that Ben would do what it took (Ben did, earning himself a second term as Fed chairman this week). But serious questions remain in the minds of Fischer and other critics whether the most serious problem of the financial crisis—the too-big-to-fail issue—is proving too big for Bernanke and Washington's power elites to handle.

Fischer was not only Bernanke's teacher; he was also one of the preeminent economic officials of the '90s, the era of the "Washington consensus" bias in favor of deregulation. After leaving the IMF he became vice chairman of Citigroup—the corporate embodiment of the too-big-to-fail problem. So it was all the more remarkable to hear Fischer apparently jumping to the other side of the issue and chiding his former student at the annual Jackson Hole, Wyo., conference for central bankers last week. Fischer also seemed to take aim at his former allies from the deregulatory '90s, Larry Summers and Tim Geithner. "We seem to be taking it for granted that we should go back to the structure of the financial system as it was on the eve of the crisis," said Fischer, who is now the governor of the Bank of Israel.

This is still the central pathology of our economic era. We have a free-market system dominated by institutions so huge and "systemically important" that they don't have to play by free-market rules. Excessive risk-taking is built into the system because bailouts are; the promise of the latter begets the former. And as The Washington Post reported Friday, the problem is getting worse rather than better: nurtured by government bailouts and a hands-off approach to their size, the biggest banks are getting even bigger and, therefore, harder to control. Both Bernanke and the Obama administration are acutely aware of this "moral hazard" problem and have sought to address it. But the biggest undercurrent of worry at Jackson Hole was that reform efforts were getting bogged down in political bickering, and nothing would happen this year. With each passing month—it's nearly the first anniversary of the Lehman Brothers collapse—the memory of how close we came to the abyss recedes and the impetus for radical change loses force. "I think the concern was that the administration was focusing on too many different things at once and [regulatory reform] was getting pushed to the bottom," says Mark Gertler of New York University, Bernanke's longtime academic collaborator.

A Treasury Department spokesman, asked to comment, says the administration still believes financial-reform legislation will pass by the end of the year. But many at Jackson Hole talked about resistance on Capitol Hill, which is particularly susceptible to Wall Street lobbying. Treasury Secretary Tim Geithner has also been embroiled in an angry dispute with regulators, especially FDIC chair Sheila Bair, over whether the Fed should play the role of systemic risk regulator or that more of that task should fall to a council of regulators. Geithner wants the Fed to do it, but Bernanke has pushed back against taking on the whole job. He sometimes seems to side more with Bair and SEC chairwoman Mary Schapiro, along with Gary Gensler, chair of the Commodity Futures Trading Commission, who all want a piece of the regulatory action.

It's a major mess, in other words, and Fischer has reason to worry. He's hardly alone. It is no accident, perhaps, that Fischer has been a member of the Group of Thirty, the financial advisory panel chaired by Paul Volcker. And Volcker, the former Fed chairman, has also been trying to push the Obamaites and Bernanke in the direction of more fundamental reform. Among other things, Volcker wants to bar federally insured commercial banks from proprietary trading so that the Citigroups and Bank of Americas of the future cannot again become the systemic risks they have been. But he, too, has been ignored, even though he gets to talk to Barack Obama on occasion as head of the president's largely cosmetic financial-recovery advisory board.

Oddly enough, the too-big-to-fail problem is one of the very few in Washington that seems to unite the left and right sides of the political spectrum. Renowned economist Joseph Stiglitz, who has been the left's most prominent voice since the '90s, has criticized the administration's proposals as too meek. Rather than breaking up the big banks that failed, "the Obama administration has actually expanded the notion of 'too big to fail,' " Stiglitz told me in June. Now giant institutions like Citigroup, he says, are considered "too big to be financially restructured." On the other side of the aisle, Nicole Gelinas of the Manhattan Institute recently complained that the administration's June financial-regulatory proposal actually "formalizes" the too-big-to-fail pathology by providing loans, purchasing assets, guaranteeing liabilities, and making equity investments in faltering giant firms. She says the proposal does nothing about making sure that bondholders and other uninsured lenders take losses.

Bernanke believes that an expanded "resolution authority," of the kind the FDIC now has to take over and break up troublesome firms, will be effective in restraining them. Perhaps he's right. But Congress still has to say yes to such new powers—whoever it is that eventually wields them. Bernanke himself has undergone something of a battlefield conversion. Once an devotee of Milton Friedman's free-market economics who was expected to follow in Alan Greenspan's footsteps, he was praised by Obama on Monday for his "bold, persistent experimentation"—the quote is from FDR in 1933—in saving the economy from a depression. The president also said the Fed would help to lay the "foundation" for the future, and that "part of that foundation has to be a financial regulatory system that ensures we never face a crisis like this again." But with the administration now bogged down in so many different issues—health care being only the latest—is that foundation really getting put in place?

China Deploys Rare Earth Metals For Strategic Leverage

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As I've previously noted, China has cornered well over 90% of the market for rare earth metals, which are essential in various high-tech products.

The Telegraph ran an article on August 24th pointing out that China is now deploying these resources to gain strategic advantage:

Beijing is drawing up plans to prohibit or restrict exports of rare earth metals that are produced only in China and play a vital role in cutting edge technology, from hybrid cars and catalytic converters, to superconductors, and precision-guided weapons.

A draft report by China’s Ministry of Industry and Information Technology has called for a total ban on foreign shipments of terbium, dysprosium, yttrium, thulium, and lutetium. Other metals such as neodymium, europium, cerium, and lanthanum will be restricted to a combined export quota of 35,000 tonnes a year, far below global needs.

China mines over 95pc of the world’s rare earth minerals, mostly in Inner Mongolia [My note: Mongolia is not part of China, but is an independent nation]. The move to hoard reserves is the clearest sign to date that the global struggle for diminishing resources is shifting into a new phase. Countries may find it hard to obtain key materials at any price...

No replacement has been found for neodymium that enhances the power of magnets at high heat and is crucial for hard-disk drives, wind turbines, and the electric motors of hybrid cars. Each Toyota Prius uses 25 pounds of rare earth elements. Cerium and lanthanum are used in catalytic converters for diesel engines. Europium is used in lasers.

Blackberries, iPods, mobile phones, plasma TVs, navigation systems, and air defence missiles all use a sprinkling of rare earth metals. They are used to filter viruses and bacteria from water, and cleaning up Sarin gas and VX nerve agents...

New uses are emerging all the time, and some promise quantum leaps in efficiency. The Tokyo Institute of Technology has made a breakthrough in superconductivity using rare earth metals that lower the friction on power lines and could slash electricity leakage.

The Telegraph points out that Japan is also taking steps to secure a supply of rare earths, but the West has not:

The Japanese government has drawn up a “Strategy for Ensuring Stable Supplies of Rare Metals”. It calls for 'stockpiling' and plans for “securing overseas resources’. The West has yet to stir.

The Telegraph also notes that China is not necessarily using its near-monopoly of rare earths to dominate the world, and that other countries may be able to extract more rare earths after slowly ramping up production:

Alistair Stephens, from Australia’s rare metals group Arafura, said ... “This isn’t about the China holding the world to ransom. They are saying we need these resources to develop our own economy and achieve energy efficiency, so go find your own supplies”...

It will take years for fresh supply to come on stream from deposits in Australia, North America, and South Africa.

The bottom line is that the West has been asleep while China has amassed tremendous control over scarce resources which are vital for both technological innovation and security. China's deployment of its dollar reserve holdings (which may lose value) to purchase these key strategic assets is very clever, indeed.

Rep. Frank eyes Fed audit, emergency lending curbs

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WASHINGTON (Reuters) - Rep. Barney Frank, the chairman of the U.S. House of Representatives Financial Services Committee, said he plans legislation to restrict the Federal Reserve's emergency lending powers and subject the central bank to a "complete audit."

At a recent town hall meeting, Frank said the House would pass a bill to use an audit to crack open the central bank's books more widely, but in a way that will not encroach on the central bank's monetary policy independence.

In addition, he said the House would move to rein in the authority that allows the Fed to lend to a wide range of non-bank firms in "unusual and exigent circumstances."

A bill sponsored by Texas Republican Rep. Ron Paul that would allow the Government Accountability Office, a federal watchdog agency, to audit Fed interest-rate decisions has won the co-sponsorship of more than half of the House.

Fed Chairman Ben Bernanke has warned that the bill would compromise the U.S. central bank's policy-making independence and could undermine financial markets and the economy.

Frank said he has been working with Paul on compromise language. "He agrees that we don't want to have the audit appear as if it is influencing monetary policy because that would be inflationary," Frank told constituents. A video of his remarks was posted on the popular video file-sharing website YouTube athttp://www.youtube.com/watch?v=J2DX9Iu4wNo

Steven Adamske, a spokesman for Frank, told Reuters compromise language had not yet been written. He provided no further details. A spokesman for Paul could not be reached.

OCTOBER TARGET

Frank said the audit and emergency lending provisions would be incorporated in broader legislation to revamp U.S. financial regulation that would likely pass the House in October. By seeking a compromise with Paul, Frank could strengthen the broader legislation's chance at passage.

As chairman of the House Financial Services Committee, Frank is a key player in the effort to overhaul U.S. financial regulation.

The Obama administration has proposed giving the Fed responsibility for overseeing firms whose collapse could endanger the entire financial system. At the same time, it wants to strip the central bank of its consumer protection function, and invest that authority in a new agency.

Frank expressed unease at what he called the Fed's power to "lend money to anybody they want" in emergency circumstances. "We are going to curtail that lending power. We are going to put some restraints on it," he said.

Since the financial crisis struck two years, the Fed has used this emergency authority to prop up a number of non-bank financial firms with billions of dollars in loans, including insurer American International Group.

The Fed's actions have angered many lawmakers who are concerned the central bank has put taxpayer money at risk. Fed officials have defended their actions as necessary to prevent a deeper credit crisis and widespread damage to the economy.

Bernanke, who President Barack Obama nominated this week to serve a second four-year term at the helm of the central bank, told lawmakers in July that the Fed understands the need to be accountable to taxpayers but that monetary policy decisions needed to be shielded from political interference.

In congressional testimony on July 22, he signaled a willingness to work toward a middle ground. "We are quite willing to work with Congress to try to figure out exactly where the line should be," he said.

Frank said the House legislation would pave the way for an audit to look into what the central bank "buys and sells," but he said the data would be released after a period of several months to avoid impacting financial markets.

Bernanke is widely expected to win needed Senate backing for a new term as Fed chairman, but the central bank's aggressive efforts to stem the financial crisis have stirred controversy that is likely to color his re-nomination hearing.

His current term expires on January 31, 2010.