Fed Chair

My pick for Fed chair below. I don't have much to say on the choice between Janet Yellen and Larry Summers. Both are worthy economists, with well-discussed pluses and minuses on which I have no particular insight.

So, this post is about who else one might want to look at, and much more importantly the broader question about what makes a good Fed chair.

The press mostly  wants a soothsayer, who will foresee events the market does not see and calm the waters -- in practice,  basically operating the worlds largest contrarian hedge fund, or the commissariat of macroeconomic central planning. Such people don't exist, so that's a self-defeating job description. Let's talk about reality.

The Fed chair will not just have to pick the right course, but will also have to wade through the cacophony of advice and pressure he or she will receive, from politicians, powerful banks and businesses, outside critics – people like me – and the crosswinds of contradictory advice from Fed board members, staff and regions. And then guide a headstrong committee and a ponderous bureaucracy to those ends.

To do that, a chair needs a clear intellectual framework and a core set of principles.

He or she must deeply understand modern macroeconomics, finance, and banking. Too many policy-oriented people are mired in simpleminded 1970-era Keynesian story-telling that they learned as undergraduates, and a similarly simplistic understanding of finance. Too many academic economists are too deep into modern work, take equations at face value and do not know how to distill and apply their essential lessons, and what lessons are robust from the inevitable simplifcations of all formal models. Too many bankers have little understanding at all of cause and effect. Long practical experience in a system produces little experience of how to guide that system.

The FOMC (Federal Open Market Committee) of bank presidents and governors is now as high-powered a group as you could imagine. The academics have taken over. They know their stuff, and so does their staff. When the staff brings in or a governor cites “unique locally bounded equilibria” of the latest "new-Keynesian DSGE model," or distills the tea leaves of interest rates in “three factor affine models,” a chair must find the nuggets of gold, the grains of salt, and the remains of horses. All three are present.

There is a tendency in many quarters, reflected well in the New York Times opinion pages, to dismiss modern macro as hogwash. (Except, of course, when particular equilibria of particular new-Keynesian models produce pleasing multipliers.) Dismissing all modern thinking is as dangerous as accepting it all uncritically. If for no other reason, this is the language the FOMC and its staff speak, so a chair who doesn't understand it will simply be bamboozled.

We are at a crossroads in monetary policy,  with deeply different intellectual frameworks bounding the discussion, from monetarists, old-fashioned IS-LM Keynesians, Minnesota/Chicago dynamic equilibrium, new-Keynesian DSGE all talking past each other in essentially different languages. And I haven't started on financial views, even more disparate. The chair must be literate! And this stuff is hard. Well, I think it's hard. It's going to be hard to find someone who has not been actively contributing to this thinking who really understands what's going on.

An ideal chair has the universal admiration and respect of all in the room -- they may disagree, but everyone knows the chair deeply understands all the modeling points of view. An ideal chair also has the rare talent to explain and apply modern macroeconomics, not just push the equations around correctly.

More deeply, the fundamentals of modern macro -- thinking intertemporally, thinking about expectations, rules, institutions, moral hazards, precommitment vs. discretion, not in static terms of this year's stimulus and this year's GDP, really are important guides to a successful central bank.

That intellectual framework should be broad as well as deep. Some people have one great idea and to Washington to  implement their pet idea. Such people do not often do well when asked to guide a large institution through, inevitably, uncharted waters. Great military theorists do not make great battlefield generals.

A great Fed chair also understands history, and the legal and institutional structure of the Federal Reserve and previous central banks. Too many academics, (I include myself, though I'm trying to repair the damage)  are steeped in theory and quantitative evidence, but pretty light on the simple facts of what happened in past crises.

Nobody can know everything, however, so the Fed chair needs a few core principles. Paul Volcker had them, when the cacophony of experts said we couldn’t stop inflation. Ronald Reagan had them, when he said “tear down this wall” over the cacophony of experts. And those principles need to be right.

So, a great Fed chair is not so much smart as wise. There is a big difference. Humility is a bedrock of wisdom. The chair needs clearly to understand the limits of our knowledge, how imperfectly we understand cause and effect of the Fed’s policy tools.  A wise chair remembers how much consensus views on those matters have changed in the past, and knows how much they will change in the future.  If the Chair does a good job, ideas will change in response to the slow accumulation of experience and not in the wake of some new disaster borne of overconfidence in wrong ideas.

Above all, a successful chair will avoid screwing up! The Fed is a defensive institution. Like oil in the car, you don't notice it when it's doing its job well, and it mainly is in the news when it fails. It is not an institution that succeeds by leading great charges to direct the economy.

The big past screwups came when old ideas met new events, as they did in the banking crises of the great depression and the unleashing of the great inflation of the 1970s, just as on the 1914 western front and Maginot line.

An ideal chair has thought a lot about issues which are likely to be the next great crisis. Ben Bernanke was one of the great scholars of the bank runs of the Great Depression, and in part as a result the Fed did not repeat many of the mistakes of that event.

But we never fight the last war, at least right away. The chance of us having another real estate boom, a huge increase in shadow banking, a run in short term debt linked to mortgages in the next 10 years is next to zero.  So what are the challenges going forward, and what special expertise would one want in a Fed chair?

It seems obvious to me that sovereign debt, sovereign promises, an emerging period of sclerotic growth (rather than "lack of demand" recession) and how monetary policy is fundamentally affected by this set of circumstances is going to be a big issue for the Fed going forward. A chair who relies only on rules of thumb or correlations that held in a time of high trend growth and small sovereign debts is going to be taken by surprise.

An ideal Fed chair has spent a lot of time thinking about, and surveying the wide historical and cross-country experience on, the link between monetary policy, sovereign finances, and large-scale economic fluctuations. When California and Illinois default, Spain can't roll its debts, Germany refuses to recapitalize the ECB, and US long rates spike, a chair armed only with shifting around IS and LM curves and bailing out creditors will fall flat.

It also seems obvious to me that financial regulation, the temptations to financial micromanagement, and the forces of capture by the financial industry, are going to fill the Fed's plate as much or more than the mundane question of whether to raise or lower short term interest rates by a few basis points.

Financial regulation is even more about moral hazard, rules, institutions and perceptions than regular monetary policy. Chair William McChesney Martin, referring to rising interest rates, once sad the job of the Federal Reserve was to take away the punch bowl just as the party gets going. Now that the Fed is managing "financial stability,"  the chair’s job is to more to stop putting out fires soon enough that the underbrush burns out, people don’t build their houses too close to trees, and keep their own fire extinguishers loaded. At some point, you  let Bear Stearns go to send a message to Lehman Brothers.  A Fed chair that spends a lot of his time clarifying what the Fed's role will be in the next crisis rather than one who just ammasses larger and larger discretionary power, will weather that crisis much better.

Resisting capture will be a full time job. When billions of dollars are on the line for powerful Wall Street firms, the chair needs to be someone who can say no -- and who everyone knows will say no. From before the Fed’s inception, people have wanted to manipulate monetary policy and financial regulation to their ends.  They will steer subsidies and protection their way, they will use regulation to block competition, and they will steer credit their way.

We didn't have a central bank for a century, mostly because of this fear. The argument over having a central bank at all focused on the concentration of financial power and its marriage to political power, not inflation and unemployment. Now that the Fed is squarely running the financial system, and not just setting interest rates, we will start that discussion again.

Ideally it would not matter at all who the Fed chair is. Our government works well when the institutions work, not when we await the right benevolent aristocrat to run things with great power and no accountability. So a wise central banker is not one in the news every day, spouting a frenzy of new ideas. The wise central banker works within and buttresses well codified rules of behavior, thinks hard about what those rules should be, and slowly moves them over time.

Oh, and politics matter. Pick a Democrat.

So who fills that bill? I've pretty much described Tom Sargent. If you want a taste, go to his website. His latest paper "Fiscal discrimination in three wars" with George Hall is just what I would want a Fed Chair to be thinking about with state and local defaults looming. His Nobel Prize speech "US Then, Europe now" is one of the wisest set of thoughts on the Euro crisis I've seen. Some of my favorite classics: "The macroeconomics of the French Revolution" with Francois Velde. There you see how Tom can put modern macro into action, to understand real-world events. Of course his studies of the fiscal roots of hyperinflations are fundamental. He knows macroeconomic theory of all stripes inside and out. He knows the history and institutions inside and out.  He is one guy who could command hushed awe in the FOMC.

There are a few other candidates who fit the bill similarly. I don't want to get too deep in to personalities, it's the job posting that counts. You could make a similar case for, among others Ken Rogoff, David Romer, John Taylor, Mike Woodford, Greg Mankiw, and many others. (Just examples; I don't mean to insult anyone by omission). The interesting observation is that none of these are on the agenda reported in the papers.

There is perhaps two good reasons why such candidates are not on the table. First,  the Fed chair runs a large organization. The talents of corralling a bureaucracy, herding the opinionated cats on the board of governors, keeping the staff in line, working within the legal and institutional structure of the Fed, keeping one’s mouth shut so as not to roil markets and cause scandals, (or perhaps talking so much that markets stop paying attention? That's what would happen if I were Fed chair!) while furthering the Fed’s admirable quest of transparency are crucial.

Second, the chair has to make hard decisions in real time. This is incredibly hard.

Most academics don't have these skills. I don't know if Tom does. Perhaps some trial of running a large organization is a needed requirement.

And of course, the chair needs to persuade one person he or she will be good at the job, the president. Ben Bernanke served on George Bush's council of economic advisers, and undoubtedly impressed Bush. Tom impresses me, but I'm not in charge.

You may object that I'm thinking too narrowly. I'm a university academic, so I'm pushing other university academics. But in this case, I think that's warranted. The academics really have thought long and hard about central banking, and they have taken over from the bankers. The FOMC is a great debating club of monetary and financial policy. An industry economist or banker will get eaten alive.

By the way, I think when the dust has settled, history will be kind to Ben Bernanke. He fits most of my job description. Inflation is stuck at 2%, the world did not melt down, and we’re all gradually coming to the realization that if $2 trillion bucks of stimulus and zero interest rates didn’t bring our economy out of the doldrums, there really is nothing more that a central bank could do. The Phillips curve has been screaming "this is supply, not demand" for a few years now. Like any great general, we can argue with specific decisions, and much of the direction of Fed policy, and I have. But we have not lost the war.

Yet. The next chair could easily make Mr. Bernanke’s term look even better.