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Insider Joins Critics of the Fed,
Faulting Credit-Crisis Programs

In a striking insider's critique, a Federal Reserve policy maker said lending programs the central bank has created to combat the credit crisis distort private markets, encourage risky behavior and could endanger the Fed's independence.

Federal Reserve Bank of Richmond President Jeffrey Lacker's remarks, made Thursday in a speech in London and amplified in an interview, show that concerns that outsiders, including former Fed Chairman Paul Volcker, have raised about the Fed's actions -- in particular its rescue of the investment bank Bear Stearns Cos. -- are shared by some inside the Fed.

Those people, including presidents of some of the 12 regional Fed banks, remain a minority. Nonetheless, their views will matter in the months ahead as the Fed, the Bush administration and Congress grapple with the implications of the Fed's unprecedented actions.

"The danger is that the effect of recent credit extension on the incentives of financial-market participants might induce greater risk taking," a phenomenon called moral hazard, "which in turn could give rise to more frequent crises, in which case it might be difficult to resist further expanding the scope of central-bank lending," Mr. Lacker said, according to a text of his remarks. (Read the full speech.¹)

In an interview, Mr. Lacker said that "before this recent episode, there [were] well-understood and well-articulated boundaries around when we would lend": to manage short-term interest rates, to help banks deal with temporary shortages of cash, or to facilitate the closure of a bank taken over by regulators.

"The innovative credit programs and other things we've done have gone beyond previously accepted boundaries. We'll be wrestling with the consequences." The new program could put the Fed's independence at risk, he said. "It crosses a line into what is essentially fiscal policy to direct credit to particular sectors, creating expectations of similar treatment."

Fed officials are debating how quickly, if at all, they should withdraw some of the lending programs they have created to stabilize markets. If some of those programs become permanent, they might entail the Fed expanding its oversight of the financial system. Federal Reserve Bank of New York President Timothy Geithner, who helped arrange the Bear Stearns rescue, is to address its implications for the country's regulatory structure in a speech Monday.

Since August, the Fed has taken numerous unconventional steps to improve conditions in credit markets, including vastly expanding loans to banks. Separately, it has temporarily lent safe Treasurys from its own portfolio to investment banks in exchange for their riskier securities. Most controversially, it lent $29 billion to Bear Stearns and opened its discount window to investment banks for the first time.

In a separate Thursday speech, Charles Plosser, president of the Federal Reserve Bank of Philadelphia, made points similar to Mr. Lacker's, highlighting to the possibility that a central bank's actions can distort markets and prices and "effectively subsidize risk-taking by systemically important financial institutions."

"Policy interventions in financial markets run the risks of increasing moral hazard and inhibiting efficient price discovery," he told the Society for Financial Econometrics in New York. "Moreover, interventions intended to quell instability can, by creating moral hazard, actually make instability more severe in the long run." Mr. Plosser suggested policymakers outline in advance conditions under which they would lend to financial institutions and commit "to act in a systematic way" consistent with those guidelines. Mr. Plosser, former dean of the William E. Simon Graduate School of Business Administration at the University of Rochester, became president of the Philadelphia Fed in August.

In a speech scheduled for delivery to the European Economics and Financial Center in London, Mr. Lacker said the Fed should lend more when a sudden demand for, or shortfall of, cash drives short-term rates higher. But he said the past year's credit crisis results from something different: Investors are fundamentally reassessing the creditworthiness and appeal of many types of securities and institutions.

When a central bank makes loans to such institutions or accepts their debt as collateral, it "distorts economic allocations by artificially supporting the prices of some assets and the liabilities of some market participants."

Mr. Bernanke considers concerns raised by Mr. Lacker to be valid, but he has argued that the problems involved in the Bear Stearns loan were preferable to the chaos and disorder that would have resulted from the firm's bankruptcy.

As for the Fed's other steps, officials have argued that they represent a more effective use of the Fed's existing authority rather than an expansion of that authority and that they are similar to tools in use by the European Central Bank.

Asked if he approved of the Bear Stearns deal, Mr. Lacker said: "It was an excruciating choice. I wasn't close to all the data they had...so I'm not going to second-guess it."

Still, he said that because of the Fed's $29 billion loan to Bear, it is "going to be natural for firms to ask for what they view as similar accommodation."

Mr. Lacker said the Fed has already "gotten questions from firms saying, 'I'd like to take over this other firm. Can you help like you helped with Bear?'" He declined to name or describe the firms, adding, "We've turned them down" because helping them "wasn't appropriate."

To convince the markets that it won't routinely prop up troubled firms, the Fed eventually will have to let fail some institutions that lie beyond its stated boundaries for intervention, Mr. Lacker said.

Those boundaries "are going to be more credible if we take actions, and those actions are going to be more credible the more costly they are" in terms of disruptions to the market.

Mr. Lacker, who holds a doctorate in economics from the University of Wisconsin, joined the staff of the Richmond Fed in 1989 and has been its president since August 2004. He regularly dissented in votes on interest-rate decisions in 2006, favoring higher rates. He isn't currently one of the five regional Fed bank presidents with a vote on rates.

Write to Greg Ip at greg.ip@wsj.com²

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