What Janet Yellen must do at Federal Reserve

According to Janet Yellen, President Obama’s nominee to head the Federal Reserve, anyone who bought into the housing market in the years before it crashed in 2008 had “an exceptionally benign view of the underlying risks.”

But all the home buyers, mortgage brokers, and bankers who rode that housing bubble were not the only naive ones. Ms. Yellen points out that the Federal Reserve itself, which regulates the money supply and interest rates, was also “behind the curve.”

“We missed some of the risky developments that were unfolding,” she said, noting the Fed’s role in keeping interest rates too low for too long while Americans believed house prices were “on an ever-upward march.”

Her humility about the Fed’s misplaced optimism, even if in hindsight, will serve her well if the Senate confirms the Yale-trained economist as the first woman to head the world’s most powerful central bank.

The Fed’s many economists do not usually steer the American economy by dint of virtues such as humility. Yellen herself is better known for an excellence in data crunching than asking questions like why nearly 70 percent of people who defaulted on their mortgages between 1997 and 2006 lied on their original applications.

Yet virtue, or each person’s ability to make prudent and just choices, needs more attention from the Fed after the Great Recession.

The profound failure of character that helped cause the financial crisis – from “liar loans” to misleading assurances by mortgage brokers – will not be remedied alone by new rules on risk-taking or more diligence by regulators such as the Fed. Even the many federal watchdogs may still have an “overconfidence bias,” or the tendency to overestimate their effective oversight of the industry and its consumers.

The outgoing Fed chief, Ben Bernanke, often says the aim of the new rules, such as the 2010 Dodd-Frank law aimed at reforming Wall Street, is to instill “market discipline.” That is code for having financial players bring such qualities as trust, caution, humility, foresight, and honesty to their dealings.

Such virtues were once ensured mainly by private stakeholders, such as bank depositors, shareholders, creditors, and borrowers. But with increased regulation, the financial industry and its clients may assume government will protect them from too much risk-taking or fraud. A corporate and consumer complacency, called “moral hazard,” could easily set in.

The Fed, as the top financial regulator, needs to find a balance between healthy, transparent competition in which players learn from their bad choices and a regulatory environment that prevents abuse and avoids financial meltdown.

During her Senate confirmation hearings, Yellen will likely be quizzed about her views on balancing the Fed’s twin challenges of boosting job creation and preventing high inflation. (She has a decent regard for achieving both.) She will also likely be asked to explain how fast the Fed will reel in the trillions of dollars it has pumped into the economy since 2008.

But lawmakers should also delve into what she has learned from the Great Recession about how a market economy can be better virtue-driven and not only data-driven.

Financial rules should take moral behavior into account. “Laws are always unsteady when unsupported by mores; mores are the only tough and durable power in a nation,” wrote Alexis de Tocqueville, the French observer of the United States.