Wall Street gets an F

Still, Cole's overall argument is hard to disagree with. When analysts treat retail clients differently from institutional investors, the playing field becomes unequal. The team with the most money wins, while smaller investors suffer.

And when correct information is absorbed by only part of the market -- when the general public trusts biased advice from supposed experts -- the market works inefficiently. The exact conflict-of-interest pitfalls that Congress tried to avoid with the Glass-Steagall Act become more common. Bubbles and busts become more extreme. The entire economy -- as evidenced by the present economic slump -- becomes more fragile.

Enter the Fed, the single most important institution entrusted with the job of easing the pain of downturns and catalyzing upticks in the market. But can the Fed work its magic again?

Not necessarily, argues Martin Mayer. The veteran financial journalist picks up where Cole leaves off. Although written in impenetrable prose, "The Fed" makes a strong case for skepticism -- providing a welcome antidote to previous paeans to Alan Greenspan's leadership of the economy.

Mayer starts by showing that the Fed has steadily grown more powerful over the past century, relentlessly claiming ever more jurisdiction, independence and political clout. Although the Treasury and the Office of the Comptroller of the Currency (OCC) formerly competed for primacy on several occasions, today, says Mayer, the Fed is the undisputed "cock of the walk in American financial regulation." The 1999 Gramm-Leach-Bliley bill, which made the Fed an "umbrella advisor" to the banking securities and insurance industries, simply legitimized the institution's rise to prominence.

But the central bank suffers from at least two dangerous weaknesses. First, the Fed's expertise lies with traditional banking. And since banks are on the decline (they once controlled 60 percent of the country's commercial and industrial financing, but now manage only about 20 percent), the Fed's influence has also dipped.

Monetary policy, adding or subtracting from the money supply, garners its power from the demand for bank loans. When interest rates are low, the theory goes, more people will borrow; adding cash to the economy. When they're high, people will trim their spending. But now, when people can get cash from credit cards, home equity loans, stock and other financial instruments, the Fed's power over liquidity "will not necessarily go where you want it to go when you need it to go there," Mayer writes.

"Now the 'new economy' is financed by 'venture capitalists' and underwriters who push initial public offerings, and the movement of a few basis points in short-term interest rates matters nothing to them unless the result is a noticeable change in the valuation of -- one hesitates to say it -- stocks."

In order to affect the economy, the Fed must influence the markets. But this is getting harder and harder.

"Do we really understand the long-term consequences of the technologically driven disintermediation of payment flows away from credit-sensitive financial institutions [or traditional banks]?" asks E. Gerald Corrigan, former president of the New York Fed.

"No," Mayer answers, "we don't."

The Fed in particular "knows relatively little about securities, and even less about insurance," Mayer argues. And the institution may not be ready to learn either.

In fact, the Fed's second weakness lies with its penchant for secrecy and aversion to change. Unlike the SEC, which has a reputation for encouraging openness, according to Mayer the Fed tends to be managed with a closed, top-down form of efficiency. Bank examiners aren't allowed to publish their findings, even if a bank is about to fail, and all staffers report to the chairman. Even Federal Reserve bank governors are rarely allowed to voice opinions that differ from the official stance.

"The Fed has never believed in sunshine as a disinfectant," Mayer writes. And yet, now more than ever, disclosure matters. The Asian crisis might have been avoided if banks in Thailand and Malaysia had publicly revealed their risky investments before collapse was imminent. Damage from the real estate fallout of the '80s and the savings and loan scandal could have been minimized, Mayer argues, if the institutions were forced to regularly divulge their finances. Greenspan has opened up the Fed more than other chairmen, but in Mayer's view, the Fed needs to go much further if it wants to ensure stability.

Mayer, who once acted as an advisor to President Reagan, stops just short of asking for legislation that would actually mandate openness. Like Cole, he seems to believe that the onus is on investors, who must learn for themselves that the markets and the economy are far more fragile than they may believe. But the dangers that these books identify offer hints into what could become a changing cultural mood. Through the '90s, when the markets and the Fed could do no wrong, regulation resembled an unnecessary burden. But if the economy continues its downward spiral, government may look less like a villain -- and more like a white knight.

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