Bernanke to Reinhart:"Et tu, Brute?"

Vincent Reinhart, former director of the Division of Monetary Affairs at the Federal Reserve and coauthor with Ben Bernanke on several papers, had an article in the Wall Street Journal titled "Our Overextended Fed." In this piece, Reinhart takes to task his former colleagues at the Fed for setting moral hazard-creating precedents as well sending panic signals to investors. His frank rebuke of the Fed's actions are surprising for a former high-ranking Fed official.

Our Overextended Fed

In the past few weeks, the Federal Reserve has fundamentally redefined the role of a central bank in a market economy.

Almost one-half of our nation's central bank balance sheet -- more than $400 billion -- is exposed to credit risk through new lending facilities. It has also entered an open-ended commitment to use its discount window to back stop major securities firms. Those efforts will influence the depth of the recession that the U.S. economy has likely already entered, and will leave a durable imprint on the financial landscape for many years to come.

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The desire on the part of policy makers to draw a line defending the existing structure of the financial system is understandable. But one can wonder if the trenches the Federal Reserve has dug are this generation's Maginot Line -- ineffective in defense and costly in the long run.

The Federal Reserve put its balance sheet in harm's way to give assurance to Bear Stearns's creditors and extended that protection to the other primary dealers. In doing so, the Board of Governors of the Federal Reserve had to determine unanimously (since they only had five members at the time) that these were "unusual and exigent" circumstance and that failure to lend to Bear would have adverse consequences for the U.S. economy. The signaling aspect of that decision cannot help but have adverse consequences for investors' willingness to take on risk.

Moreover, the implicit declaration that a midsize investment bank was systematically important puts any firm at least as big as Bear in the cross-hairs of speculators. In coming days, how can the Federal Reserve turn away another like-sized entity, whether primary dealer or not, that is suddenly in the marketplace's disfavor for having used leverage to borrow at short-term maturities to fund longer-term obligations?

In such circumstances, the Federal Reserve's $900 billion balance sheet will not look that big. And the Federal Reserve will have ceded control of its balance sheet to the needs of private-sector entities.

More seriously, the Federal Reserve's action can only be viewed as rewarding bad behavior. Remember that Bear opened this financial crisis when it revealed problems at its sponsored hedge funds last June. That it did not spend the next nine months resolving its problematic positions and getting sufficient capital did not prevent it from getting a "get out of jail free" card from the Federal Reserve.

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