I was on vacation last week (far from Jackson Hole) when Ben Bernanke gave his widely anticipated speech. The media (see the Times, for example) seemed to focus mainly on his criticisms of the political branches and economic policymaking, which were accurate enough. But in my opinion, Bernanke drew the wrong lessons from those observations.

He was very clear that the problem today is unemployment, not inflation:

“Recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed. Consequently, although we expect a moderate recovery to continue and indeed to strengthen over time, the Committee has marked down its outlook for the likely pace of growth over coming quarters. With commodity prices and other import prices moderating and with longer-term inflation expectations remaining stable, we expect inflation to settle, over coming quarters, at levels at or below the rate of 2 percent, or a bit less, that most Committee participants view as being consistent with our dual mandate.”

He even said that we are in a situation where economic would improve the economy’s long-term performance:

“Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view–the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.”

But what is Bernanke going to do about it? He declined to offer any new efforts to reduce unemployment, saying only that the Fed “is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” And mainly he relied on the political branches to solve the country’s problems, calling not only for “good, proactive housing policies” but also for policies that would improve K–12 education for underprivileged households and lower health care costs.

I don’t think it makes sense to criticize the political system for being dysfunctional and then rely on the political system to rescue the economy. I understand that traditional monetary policy tools don’t work that well in this environment: short-term rates can’t go any lower, and lowering long-term rates won’t make companies invest if they don’t think there is demand for their stuff. But there’s always, you know, dropping cash out of helicopters.

It’s true that, in the speech that gave Bernanke the nickname “helicopter Ben,” he was talking about a tax cut—in other words, fiscal policy. But there’s always the option of increasing the inflation target from 2 percent to 4 percent while simultaneously buying long-term bonds to keep nominal rates from rising too much (so real rates come down). If the Fed can actually generate more inflation, that would function like a transfers from creditors to debtors, which would help solve the household balance sheet problems that are weighing down the economy. And there’s nothing magical about the number two: both Ken Rogoff and Olivier Blanchard have argued for higher inflation, given current economic circumstances. As Blanchard says, “There was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.”

I’m not sure it would work; maybe even raising the inflation target wouldn’t actually increase inflation. But doing nothing is be the wrong policy conclusion to draw from Bernanke’s observations, which seem spot-on.

The Federal Reserve was created in 1913 to help limit the impact of financial panics. It took a while for the Fed to achieve that goal, but after World War II – with a great deal of help from other parts of the federal government – the Fed hit its stride. Today the Fed has not only lost that touch but, given the way our political and financial system currently operates, its own policies exacerbate the cycle of overexuberance and incautious lending that will bring on the next major crisis (and presumably another severe recession).

Sudden loss of confidence in the financial system was not uncommon toward the end of the 19th century, and while the private sector was able to stave off complete disaster largely by itself, the tide turned in 1907. In that instance J.P. Morgan could stand firm only because, behind the scenes, his team received a large loan from the United States Treasury (on this formative episode, see The Panic of 1907: Lessons Learned From the Market’s Perfect Storm by Robert F. Bruner and Sean D. Carr). Leaders of the banking system realized they needed help moving forward, and there was general agreement that the widespread collapse of financial intermediaries was not in the broader social interest. The question of the day naturally became: How much government oversight would bankers have to accept in return for the creation of a modern central bank?

The skeptics from the left – but also from the nonfinancial private sector (including those speaking on behalf of small business people) – pointed out that the presence of a “lender of last resort” (of the kind already operational in Western Europe), would be likely encourage less care on the part of major financial institutions and the people who lent to them. The issue we now call “moral hazard” was front and center in the political discourse at the very founding of the Federal Reserve (although with different terminology).

Nevertheless, the original deal turned out to involve only a very light supervisory touch. In part this was about the individuals involved – the New York Fed was run by Benjamin Strong, a close associate of Morgan, until 1928. In part it was about the choice of organizational structure and internal rules – so the Federal Reserve Board in Washington had little de facto power relative to the New York Fed. But mostly the structural weakness was that the central bank was not designed to keep up with the pace of financial innovation.

This innovation had an important feature then, just as it does now. While some new products were sensible, many seemingly good ideas turned out to be ways to disguise the true nature of risks being taken. (In the early 1930s, “what did they know?” and “when did they know it?” were big questions for leaders of the financial sector regarding the true risks involved; see Michael Perino’s The Hellhound of Wall Street: How Ferdinand Pecora’s Investigation of the Great Crash Forever Changed American Finance, to be published in October.)

If banks had remained as they were in 1913, the Fed might have had a fighting chance. But banks changed dramatically after the tight World War I controls were removed and entered rapidly into the business of selling and trading securities. The result was the financial shenanigans of the 1920s – with big banks front and center. The victims in that instance were middle-class investors lured with the promise of easy money – the parallels with the subprime craze are all too apparent. But the banks also damaged themselves thoroughly – as with subprime lending, because much of the ultimate risk ended up on banks’ balance sheets, presumably much more than the top bankers intended.

As a result of that experience and the ensuing financial disaster, during the 1930s the Fed received more regulatory powers, became a tougher-minded supervisor and was supplemented by a range of powerful agencies – including the Securities and Exchange Commission. The tougher rules included the Glass-Steagall Act of 1933, which separated commercial banking from the world of investment (and speculation). Yet none of this was anti-business: the Federal Reserve plus tough regulation oversaw the post-World War II boom in which the United States managed to combine the kind of investing and risk-taking that supports nonfinancial innovation – pushing forward the technological frontier while maintaining high real-wage growth – all the while avoiding significant financial crises.

But effective oversight and constraint on financial-sector innovation was dismantled, starting in the 1980s and culminating when Congress in 1999 tore down (what little was left of) the Glass-Steagall wall with the Gramm-Leach-Bliley Act. And it was not reimposed or updated by the Dodd-Frank financial regulations of 2010. The Federal Reserve is again set to support a financial system within which “innovation” is not effectively constrained (at least this is my reading of Perry Mehrling’s The New Lombard Street: How the Fed Became the Dealer of Last Resort, forthcoming in January). As a result we face again the prospect of a 1920s-type roller-coaster.

Regulation remains largely ineffective (in fact, the industry has managed to demonize the word), the big banks are too important to fail, and interest rates are low across the yield curve. The Fed provides downside protection and there is no effective limit on the amount or nature of risks that the private financial sector can take. This is a recipe not for stagnation but rather for a metaboom in which we will receive warnings, including painful recessions – but consistently ignore them.

The 1920s opened with an 18-month recession, an eerie parallel to the 2007-9 experience. It ended with the Great Crash of 1929.

An edited version of this post appears this morning on the NYT.com Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Bernie Sanders’s “audit the Fed” amendment, which expands the ability of the Government Accountability Office to review Federal Reserve operations, seems to be gaining some momentum. Opponents, including the Obama administration and Fed chair Ben Bernanke, are mounting a defensive effort. There are two main arguments that I have heard.

The first is that publicizing which banks take advantage of Fed lending facilities will stigmatize those banks and could increase panic in the midst of a financial crisis. I’m not particularly convinced by this argument, since most supporters of the amendment are fine with releasing such information with a delay. Section 1152(a)(2) of the amendment eliminates the provision in 31 U.S.C. 714(b) that shields from audit monetary policy decision-making and financial transactions by Federal Reserve banks, but replaces it with this:

“Audits of the Federal Reserve Board and Federal reserve banks shall not include unreleased transcripts or minutes of meetings of the Board of Governors or of the Federal Open Market Committee. To the extent that an audit deals with individual market actions, records related to such actions shall only be released by the Comptroller General after 180 days have elapsed following the effective date of such actions.”

Transparency is supposed to be good for markets, because it gives parties in the market the information they need in order to make rational decisions. I understand the concern that immediate disclosure could make banks avoid using Fed lending facilities in a crisis, which could be bad. But I don’t see why the 180-day delay doesn’t solve this problem. Let’s say (for argument’s sake) that Goldman Sachs borrowed money from a Fed liquidity program in May 2008. If they can’t bear the market receiving this news in November 2008, doesn’t that imply that they really are in big trouble, and the market should know about it? In other words, Goldman and the Fed have six months to solve whatever problem Goldman had. If they can’t solve it by then, then Goldman is no longer worth protecting.

The second argument is that increased GAO oversight will unduly “politicize” or “interfere with” monetary policy. On its face, this objection doesn’t seem to apply, since the amendment would explicitly not bring to light transcripts or minutes of meetings that the Fed had not itself already released.

More fundamentally, though, this objection rests on a disturbing view of how government should operate. Equating information with politicization or interference is a misleading way to justify undemocratic processes. In general, government agencies are supposed to be overseen by Congress (of which the GAO is an arm). As a basic principle, it’s good that the people’s elected representatives have visibility into what the other arms of the government are doing, so that they can make better decisions about, for example, whether heads of regulatory agencies should be reconfirmed, or whether the statutes governing those agencies should be modified. We even have Congressional oversight over deeply secretive operations, such as our intelligence operations. If “politics” means accountability to officials who are actually accountable to the people, then that’s a good thing.

There is a lot of skepticism about Congress these days, and that skepticism is justified. But the alternative — allowing government agencies to operate in secret because we think our Congressional representatives are bozos — is worse.

But the Fed is different, people say. Monetary policy is so technical, and so hard to explain to the public, and so dependent on the credibility of the central bank, that any exposure to politics would be dangerous.

The idea that monetary policy is too technical for Congress to understand, and therefore should be done in secret, I don’t buy. So is, say, climate policy. That’s a complex scientific topic, of crucial importance to the future of our nation (and the human race), that is clearly beyond the ability of Congress to understand and discuss responsibly. But we don’t exempt the EPA from Congressional oversight.

The idea that monetary policy, to work at all, must be sealed off from political interference has a little more merit to it. The idea (to simplify) is that elected politicians always want to lower interest rates in order to boost growth and jobs; in order to maintain inflation-fighting credibility, central banks have to be completely apolitical, and the markets have to believe that they are apolitical. But from there to the idea that there must be a blanket of secrecy over all decision-making is much too large a leap.

Ryan Grim’s article discussing Federal Reserve transcripts from 2004 is especially instructive in this context. The article focuses on a meeting of the Open Market Committee at which there was debate about whether there was an unsustainable housing bubble. The minutes of that meeting, released the same year, whitewashed the debate. More revealingly, the recently-released transcript includes this gem from Alan Greenspan:

“We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.”

That is the money quote of this whole debate about the Fed, and I’m sorry I buried it 750 words into this post. (I’m not a news reporter, as you no doubt know.) The Fed and its defenders think that monetary policy should be entirely up to them — which it is — and that no one else should even participate in the debate. They are so concerned about this prerogative that they react violently even to suggestions that Fed policy-making should be reviewed after the fact.

This goes hand-in-hand with the idea that the Fed chair is a de facto dictator and that even questioning him is economic treason. We saw this during the Bernanke reconfirmation debate, when supposed experts and Wall Street insiders claimed that, were Bernanke to be voted down, the markets would collapse. I think this claim is almost certainly false, but if it were true that would be even worse: how can it be a good thing that our economy is held hostage to the health of a fifty-six-year-old man? (And Greenspan was seventy-nine when he stepped down.)

Look, we all know there are debates about monetary policy. Intelligent economists have them all the time in public, and Federal Reserve bank presidents have them as well through their public appearances (though in somewhat measured tones). We all know what the arguments on the various sides of those debates are. What we gain by trying to hide them and pretending they don’t exist — except for increasing the dangerous mythology of the omniscient Fed chair — is beyond me.

Monetary policy is important. It is also somewhat technical. It should not be decided by vote of Congress every six weeks. That’s why we entrust it to a committee of twelve people, seven of whom are presidential appointees confirmed by the Senate and five of whom are bank presidents chosen by boards of directors themselves chosen (in a majority) by private banks. Their actions (raising or lowering key rates) are announced the same day that they meet, and commentators jump all over them immediately. The idea that Ben Bernanke would do something he thought was bad for the economy because he was afraid of what a GAO report might say about his decision-making process (remember, the decision is public immediately) is both preposterous and, frankly, insulting to Ben Bernanke.

I don’t actually think auditing the Fed is the most important step we need to take to fix our financial system. And I am open to considering alternatives to the Sanders amendment, if any serious ones were to be put forward. But hiding behind the idea that the Fed is so magical that it has to be hidden from the people it serves is about as undemocratic as it gets.

PS: In Chapter 6 of their forthcoming Crisis Economics (I got a free advance copy from Roubini Global Economics), Nouriel Roubini and Stephen Mihm dicsuss how the Fed’s role changed during the recent crisis — from a traditional “lender of last resort” model to an “investor of last resort” model in which the Fed bought up all kinds of non-traditional assets (e.g., long-term Treasuries, agency bonds) in an attempt to stop the economic downturn. Roubini and Mihm are generally positive about the short-term impact of these policies. But, they argue, by taking the Fed far afield from its traditional scope of action, they raise the issue of democratic accountability:

“The Fed has instead stepped into the financial system and effective subsidized its operations, potentially incurring losses that could ultimately fall on the shoulders of taxpayers. Put differently, it’s engaging in monetary policies that bleed imperceptibly into the traditional domain of fiscal policy — namely, government’s power to tax and spend. Those are prerogatives of the legislative branch, but in this crisis Bernanke’s policies have blurred that line.”

In another passage, they refer to this as “an end run around the legislative process.” This, it seems to me, strengthens the argument that increased oversight of the Fed is warranted.

PPS: Brad DeLong has an argument against the Sanders amendment. But his argument seems to be that the Sanders amendment does not solve the real problems with the Fed:

“I do not think that the Federal Reserve is working reasonably well. I do not think that the dominant views of monetary policy in the FOMC right now are informed by American values and a reality-based assessment of the state of the economy. That a good many of the people speaking and voting in the FOMC are the wrong people to do so did not matter (much) when the Federal Reserve was dominated by the incredibly charismatic (yes, I mean that) philosopher-central banker-princes of William McChesney Martin, Arthur Burns, Paul Volcker, and Alan Greenspan, but it matters now.”

I’m not sure DeLong makes a strong case in his post that the Sanders amendment is actually bad — just that the Fed’s problems go deeper than those that will be solved by greater oversight.

Donald Kohn recently announced that he is resigning as vice chair of the Federal Reserve Board of Governors, after forty years in the Federal Reserve system, most of it in Washington. Articles about Kohn have generally been positive, like this one in The Wall Street Journal. The picture you get is of a dedicated, competent civil servant who has been a crucial player, primarily behind the scenes, in the operation of the Fed.

It’s a bit interesting that Kohn is generally getting the soft touch given that he was the right-hand man of both Alan Greenspan and Ben Bernanke. Here are some passages from the WSJ article:

“‘Don was my first mentor at the Fed,’ Mr. Greenspan says. Mr. Kohn told Mr. Greenspan how to run his first Federal Open Market Committee meeting, the forum at which the Fed sets interest rates. He became one of Mr. Greenspan’s closest advisers and defender of Mr. Greenspan’s policies.”

“Mr. Kohn has spent the past 18 months helping to remake the central bank on the fly as Chairman Ben Bernanke’s loyal No. 2 and primary troubleshooter.”

“Mr. Kohn has been at Mr. Bernanke’s side for nearly every critical decision during the crisis. He also has been asked to solve some of Mr. Bernanke’s biggest challenges — from finding a way to melt frozen commercial-paper markets to keeping peace among occasionally warring factions inside the Fed.”

Let’s not mince words. Kohn was one of the leading cheerleaders for the Greenspan Doctrine. Here’s one example. In 2005, Raghuram Rajan gave a now-famous paper at the Fed’s Jackson Hole conference warning of the impending financial crisis. Kohn gave a response, which we describe this way in 13 Bankers:

“Fed vice chair Donald Kohn responded by restating what he called the ‘Greenspan doctrine.’ Kohn argued that self-regulation is preferable to government regulation (“the actions of private parties to protect themselves . . . are generally quite effective. Government regulation risks undermining private regulation and financial stability”); financial innovation reduces risk (“As a consequence of greater diversification of risks and of sources of funds, problems in the financial sector are less likely to intensify shocks hitting the economy and financial market”); and Greenspan’s monetary policy resulted in a safer world (“To the extent that these policy strategies reduce the amplitude of fluctuations in output and prices and contain financial crises, risks are genuinely lower”). Kohn’s conclusion reflected the prevailing view of Greenspan at the time: “such policies [recommended by Rajan] would result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person whose era we are examining at this conference.”

(Emphasis added.) Now this does not mean that Donald Kohn is a bad person; it just means that he was wrong, along with Alan Greenspan and Ben Bernanke. If recent accounts are to be believed, he, like Bernanke, was relatively quick to shift gears when the crisis exploded and figure out effective responses, for which he deserves credit. (He also oversaw the stress tests, for better or worse.) But from where I’m sitting, the fewer members of the old guard, the better.

So now the question is, who will fill Kohn’s seat — and the other two empty seats on the Board of Governors? The Board is supposed to have seven members, and they matter because they have seven of the twelve seats on the Open Market Committee, which sets the fed funds rate. Business Week says that the search is being led by Tim Geithner and Larry Summers, and that the likely goal is to find people to back Bernanke.

This confuses me for a few reasons.

First, it’s not clear what Bernanke stands for. He was a Greenspan clone for about two years; then he turned into a pragmatic firefighter; and recently he’s been avoiding taking positions on issues, except to say that he’s against anything that reduces the power of the Fed (like an independent CFPA). So even if you wanted to find three mini-Bens, how would you even identify them? For starters, is he an inflation hawk or a dove?

Second, why is the Democratic establishment uniting behind Bernanke? Bernanke was a Bush appointee to the board, a chair of the Bush Council of Economic Advisers, and then Bush’s pick to replace Greenspan. He’s a Republican whose main selling point to Obama was that he was already in the job and accepted by “the markets,” and he was the clear choice of Wall Street this winter. Does this mean that Obama is going to appoint three centrists who follow the (recent) central banking orthodoxy of putting inflation control over economic growth, and who oppose tighter regulation of banks? For anyone who thinks that there is such a thing as a coherent Democratic economic policy, that seems like shooting yourself in the foot.

Finally, and I know I’m in the minority here, why are we trying to increase the power of the Fed chair — especially a Fed chair from the opposite party? Leaving aside policy questions, I think the deification of the Fed chair in the past two decades has been a decidedly bad thing. The sensitivity of the markets to one man’s pronouncements (and, just imagine, his health) is a bad thing; the fact that an unelected person is widely considered the second-most powerful person in the country is a bad thing; and if our economic fate actually depends on one person’s wisdom, that’s also a bad thing. The point of a committee is to have differing views, arguments, and a vote — not to have a bunch of suck-ups and yes men. If we put some real progressives on the board, then that’s what you would have — diversity of opinion and meaningful votes. (Including Bernanke, three of the four current members are Bush appointees, including a former investment banker and a former chair of the ABA.)

I know people will say I don’t understand, and if we had debate on the board the markets would be spooked. I think that effectively amounts to saying that dictatorship is good for the markets, so we should have a dictator.

* If you’re wondering why I begin so many posts with “The Importance of . . .,” it’s something I picked up from The French Laundry Cookbook by Thomas Keller.

Like much but not all error, there is a grain of truth to this point. Thanks to John Maynard Keynes (whom Samuelson cites), George Akerlof, Robert Shiller, and any number of economics experiments, we know that confidence has an effect on behavior and hence on the economy. Too much overconfidence can fuel a bubble and too much pessimism can exacerbate a slowdown.

But to leap from there to the conclusion that the job of the chair of the Federal Reserve is to increase confidence–”Ben Bernanke has, or ought to have, a very simple agenda: improve confidence”–is just silly.

The Federal Reserve has two important jobs: (1) set monetary policy and (2) regulate bank holding companies and enforce financial consumer protection statutes. These affect the real economy in very concrete ways, not just via their impact on confidence. Saying that the objective of bank regulation should be to improve confidence is not just silly, it’s destructive. If your goal were to improve confidence, you would never restrict predatory lending practices (since they are good for banks and for asset prices) or crack down on undercapitalized banks (since that would reduce confidence in the banking system). I would submit that the first item on Ben Bernanke’s agenda should be doing the job mandated by Congress.

Equally quarter-baked is the idea that Bernanke should go out and talk up the economy. Even if we agree that too much or too little confidence can be a bad thing, how do we know that the current level of confidence is too low? Samuelson says that 47% of Americans rated the economy as “poor” in mid-January–with unemployment at 10% (now 9.7%), I’d say that seems low if anything. Is it really a good thing for people to be more optimistic than the economic fundamentals warrant? That’s not a rhetorical question–think back over the past decade.

If Samuelson’s point is that Bernanke should do a good job because that will make people feel more confident in the Federal Reserve, then that’s virtually a tautology, and certainly not worth writing eight hundred words about. If his point is that Bernanke should seek to improve confidence as an independent objective (implied by everything in the article itself), then that’s nutty.

Then there are the additional bits of silliness, like this one: “The administration’s decision to push health-care legislation was a blunder. It sowed conflict and was so time-consuming that it paralyzed action on other issues. Business planning and the willingness to expand have suffered, because companies find it harder to predict their costs and returns.” Businesses are one of the major interest groups supporting health care reform, because they bear the brunt of increasing health care costs, and they face the tough choice every year between increasing their personnel costs and cutting back on health care benefits. Most companies would like nothing better than the development of a viable alternative to the employer-based health care system. And what data could possibly exist that would back up the assertion that businesses have expanded slower because of health care reform, as opposed to, say, reduced availability of credit?

But I’ve already given Samuelson’s column more time than it’s worth.

By James Kwak

I don’t think he’s right about the latter; or, more precisely, I don’t think it matters. The FOMC is, on paper, a democratic body: they vote. There is a tradition that the votes are generally unanimous because of the perceived importance of demonstrating consensus. I don’t know how old this tradition is; it was certainly in place under Greenspan. But everyone knows that the members of the FOMC disagree about many things; that’s why the various bank president members go around giving speeches objecting (not in so many words) to the FOMC’s decisions. Given that we all know there are debates involved, how important is this fiction of consensus?

Put another way, I think it would actually be good if we had a non-unanimous FOMC and even a FOMC that voted against its chair now and then. That would help get us away from this ideology of the all-knowing, all-powerful Fed chair, which is clearly wrong and certainly dangerous. So if Krugman couldn’t get everyone on the committee to back him, who cares? He’s a smart man, and by being on the committee he will move it in his direction, even if not all the way there. As I’ve said before, the job of Fed chair should be a little more like being chief justice of the Supreme Court and less like being Dictator of All Economic and Monetary Policy, which is what it almost was under Greenspan. That’s why I think the administration can be very open-minded about this job. We want to get away from depending on one person, which means we have to stop acting like the Fed chair has to be a demigod.

More important, is this a serious “I don’t want to be considered,” or is it the Bob Kelly variety? Bob Kelly, CEO of Bank of New York Mellon, said he wasn’t interested in being CEO of Bank of America on November 4. Then on December 11, it turned out he was talking to Bank of America about being CEO. What changed in the meantime? Bank of America paid back its TARP money, eliminating restrictions on . . . executive compensation.

Unfortunately, I think Krugman is serious. I mean, why would anyone in his or her right mind want to be Fed chair?

Update: StatsGuy nominates Michael Woodford.

By James Kwak

Whom would I pick? I certainly don’t know the candidates well enough to make a good choice. But the first thing I would say is that the Federal Reserve chair does not need to be Superman. The Federal Reserve Board of Governors is a board, and while the chair is important, he or she should really be the first among equals. You want someone who will push the Board in a certain direction, but the chair can draw on the experience and skills of the other board members and the staff, who are technically very competent. The idea that the chair must be Superman seems to be a product of the Greenspan era, and we project it back onto Volcker because of his success in fighting inflation in the early 1980s. And it’s a bad idea, just like searching for a savior CEO. In this context, I think it’s limiting to insist that the nominee have experience on the board, or have government experience, or be a prominent academic, or anything in particular.

For a rough parallel, think of John Roberts. When he joined the Supreme Court, he was by definition the least experienced of the bunch–yet President Bush made him chief justice, and no one objected that he was not competent enough for the job (the objections were over his anticipated policies). In short, the nominee must have intellectual heft and people skills, but otherwise President Obama should feel free to pick someone on the basis of his policies. It’s no accident that Ronald Reagan picked an ardent free marketer back in 1987.

My other observation is that the bench on the progressive side is pretty thin, because there has been a de facto consensus around central banking in the past two decades. That is, everyone seems to think that inflation is more important than full employment, and most people at the Fed have shared the pro-innovation/anti-regulation stance of Greenspan and Bernanke, and hence the emphasis on monetary policy as opposed to regulation. (I’m not an experienced Fed watcher, so I’m sure I’m overlooking someone in those generalizations.) But if Obama wanted a progressive choice (which he doesn’t, but just as a hypothetical), there doesn’t seem to be an obvious one.

But anyway, after all that lead-up, what about Paul Krugman? I think he’s said he doesn’t want the job (or was it Treasury Secretary that he didn’t want?), but I’m sure Obama is a hard person to say no to. Or Brad DeLong? He’s clearly smart and knowledgeable, and I like what he says about inflation and deficits. Whether either of them has the people skills to be chair of the Fed I have no idea. But I don’t think we should be confining ourselves to previous board members, especially since this is a fruitless intellectual exercise, because Bernanke will be confirmed sooner or later.

By James Kwak

In October, Ben Bernanke named Patrick Parkinson director of the Division of Bank Supervision and Regulation. Who is Patrick Parkinson?

EB at Zero Hedge has the history in ten years of extended quotations. Here’s one example from 2005:

“[Transactions between institutions and other eligible counterparties in over-the-counter financial derivatives and foreign currency] are not readily susceptible to manipulation and eligible counterparties can and should be expected to protect themselves against fraud and counterparty credit losses.”

Here’s another from July:

“One of the main reasons the credit derivatives market and other OTC markets have grown so rapidly is that market participants have seen substantial benefit to customizing contract terms to meet their individual risk-management needs.  They must continue to be allowed to bilaterally negotiate customized contracts where they see benefits to doing so.”

Now, it’s plausible that the benefits to parties of certain types of transactions may outweigh the costs of those transactions to society at large. But to say that parties must be allowed to negotiate customized contrasts simply because they want to is frivolous. (Insert analogy to illegal drug sales here.)

So Parkinson was another mini-Greenspan–what’s wrong with that? Nothing, really–except that Bernanke promoted him, now when we need someone new to take bank supervision seriously.

Where’s the change?

By James Kwak

Paul Krugman’s speaking notes are here. Ben Bernanke’s are here.

Bernanke’s speech is largely a defense of the Federal Reserve’s monetary policy in the past decade, and therefore of the old Greenspan Doctrine dating back to the 1996 “irrational exuberance” speech–the idea that monetary policy is not the right tool for fighting bubbles. The Fed has gotten a lot of criticism saying that cheap money earlier this decade created the housing bubble, and I think it certainly played a role.

But I actually agree with Bernanke here:

“[T]he most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”

(Note that the purpose of stronger regulation, according to Bernanke, is to constrain the housing bubble that he denied existed at the time–not to protect consumers.)

The problem, for the Greenspan-Bernanke legacy at least, is that the Fed is also the chief regulator of the financial system, with jurisdiction over all bank holding companies and primary responsibility for consumer protection statutes applying to all financial institutions. Here Bernanke makes a partial attempt at an apology:

“The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.”

In other words, we did nothing until 2005, and then we didn’t do much. [Also see Update 2 below.]

I don’t really care about apologies. The more important question is what Bernanke and the Fed will do in the future. On that front, he has this to say:

“The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.”

There are basically only two things in this paragraph, one of which is disingenuous at best. Bernanke claims that he is getting serious about consumer protection, yet he has lobbied against the Consumer Financial Protection Agency, which everyone who is serious about consumer protection wants. I’m disappointed that Bernanke would stoop to this kind of misleading rhetoric.

The other thing is a lot of talk about systemic risk. Yes, systemic risk is important. But all the words I hear about it, and the fact that the importance of systemic risk is one of the few things that everyone can agree on, are making me start to worry. Specifically, I wonder if a lot of regulatory apparatus aimed at systemic risk will serve as a distraction from old-fashioned regulation of individual institutions. Yes, it’s true that the thing that hit us in 2008 was systemic risk. But it’s also true that regulators already had the power to supervise Citigroup, Bank of America, Wachovia, Washington Mutual, Lehman Brothers, Bear Stearns, and Countrywide and force them to pare back their risky activities–and didn’t. Talking about systemic risk is a way of passing the buck–of excusing regulatory failure by saying that regulators didn’t have the authority to look at systemic risk. But the fact remains that someone looked at Citigroup’s range of businesses and its asset portfolio and decided it was a healthy bank.That was at least as big a problem.

I’ve been on the fence about Bernanke’s confirmation, mainly because I’m not so optimistic we’ll get anyone better from a policy standpoint, and we could certainly get someone worse from the standpoint of intelligence, knowledge, thoughtfulness, and work ethic. But now that I’ve read this speech, I’m against confirmation.

Update: I should clarify one thing. I am sure there are better people out there. I’m less confident about whomever Obama and his advisers would pick. This is a deeply centrist administration, at least on economic issues, and one that is absolutely not going to make a major policy shift anytime soon; whether or not we agree with them, their current message is that they have done a good job fixing the financial system and running the economy. So I think that if Bernanke by some miracle were not confirmed, Obama would take pains to appoint someone with the same policy positions.

Update 2: Mike Konczal at Rortybomb points out what Bernanke left out of Bernanke’s defense of the Fed: the fact that the Fed actively ignored warnings going back to 1998. Funny how a factually correct statement can be deeply misleading.

By James Kwak

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do. But I digress again.

This is what Duy sees:

• Kevin Warsh of the board of governors: “If ‘whatever it takes’ was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed’s institutional credibility.”
• Richmond Fed president Jeffrey Lacker, from Bloomberg: “The Federal Reserve will need to raise interest rates when the economic recovery is ‘firmly’ in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.”
• Philadelphia Fed president Charles Plosser: “[J]ust as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. …  The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.”

Can you feel the testosterone?

Duy argues that all this manliness is misplaced. The Fed hawks’ basic argument seems to be that, because it acted so aggressively to stimulate the economy last year, it will have to act equally aggressively to dampen growth at some point — just to send a message. And to send that message, they need to be willing to raise interest rates while unemployment is still 10% (Lacker) or “well before unemployment rates and other measures of resource utilization have returned to acceptable levels” (Plosser).

Now, there may be something to this. Duy points out that the hawks seem to be worried about recreating the debt bubble of the last decade through too much cheap money. If cheap money is going to flow straight into overvalued houses, then that’s a problem. But Duy says that that is a failure of regulation. Low rates are supposed to stimulate capital investment by businesses, which is what long-term economic growth depends on. But earlier this decade, despite low rates, capital investment never returned to 1990s levels, because all the cheap money was flowing into housing instead — for reasons we know.

“Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade’s debt bubble? …

“With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.”

The solution, then, is better regulation to protect against misallocation of credit to the next asset bubble. Simply raising rates will choke off an asset bubble, but it will also choke off real investment by businesses.

This goes back to what StatsGuy said in a post here:

“In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). …

“But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.”

In other words, if you’re going to throw in the towel on regulation, then there is no place for cheap money to go except the next asset bubble. You might as well try to prevent that, but then you are consigning the real economy to a long, slow decline since you have no way of getting monetary stimulus where you need it (factories, not new condo towers).

So there seem to be two possible futures. If we repeat the Greenspan policy of low rates during a boom, we’ll just create a bubble all over again, since none of the underlying factors (weak consumer protection, weak bank regulation, etc.) have changed. Or if the hawks win (both in the Fed and in Congress, which controls fiscal stimulus), we’ll have high unemployment for a long, long time, since no one will have the guts to risk higher inflation. Being a “hawk” has become the safe, comfortable choice — even in a week when monthly job losses were up and weekly new unemployment claims were up.

By James Kwak

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?

Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).

The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.

In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.

So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive.  By contrast, quietly moving a bill through Congress might be a better option.

But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.

That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.

It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).

*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

– Dennis Lockhart, President, Atlanta Fed, August 2008

By StatsGuy

I find both of the Fed’s arguments weak.

I agree that immediate revelation of who is borrowing at the discount window (the Fed’s facility for lending to banks directly) could make creditors worry about a bank, triggering the modern version of a bank run. (Traditional bank runs shouldn’t happen because of FDIC insurance.) But we’re talking about things that happened last year, and the government has done everything it can to convince the public that the banking system is sound again. Even if Citigroup borrowed at the discount window last September, the ample bailouts it has received since then should convince any jittery investors that Citigroup isn’t going anywhere.

That is also something that apparently Barney Frank and Ron Paul agree on – any Fed disclosure should be delayed by several months.

The second Fed argument is interesting. Basically it says that if banks need to be bailed out in time of crisis, we want the ability to bail them out in secret. This only weakens the incentives for bank managers to run their companies prudently. Knowing that the Fed will bail me out in times of trouble already creates moral hazard. Knowing that they will bail me out without even my shareholders ever knowing only increases the moral hazard. Where does this stop?

* I know you can argue about whether Fed lending counts as “taxpayer money,” since the Fed is arguably an independent entity. The argument on the other side is that when the Fed lends money to dodgy institutions, the ultimate downside risk is taken either by the taxpayer, or by anyone who has dollar-denominated assets that would be hurt by inflation.

By James Kwak

Friends and contacts who work in the financial sector freely discuss their participation in activities they now regret.  But where is the mea culpa, of any kind, from a public figure – our “leadership”?

I suggest we divide the competition into three classes.

1. Policymakers who now admit that any of their actions or inactions contributed to the Great Credit Bubble.  Blaming China gets a person negative points; this may hurt Fed officials.
2. Private sector executives who concede they made mistakes or misjudged the situation so as to lose a lot of Other People’s Money.  Blaming Hank Paulson also earns negative points (too obvious).
3. Anyone charged with safeguarding consumers, in either public or private sector capacity, who now says that they or their organization did a completely miserable job.  My guess is that you will find precisely no one in this category.

You can award points for style, timing, and extent of the apology or near-apology.

Feel free to suggest other categories or to propose additional scoring rules.

By Simon Johnson

The Fed is a well-regarded institution in general and Bernanke is currently riding a wave of personal popularity and prestige, but are these claims vis-à-vis consumers plausible?

Not really.

The heart of the problem here lies with the Federal Reserve Act.  As it currently stands, the all-important Section 2A reads, “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

This is what the Fed does – in practice by trying to keep unemployment down (ideally around the 4-5% mark, although that can change over time) and inflation low (no more than 2%, roughly).

Formal objectives matter for central banks because they have to weigh trade-offs – “if we try to lower unemployment, what will that do to inflation?” etc – carefully in deciding where to set short-term interest rates and other dimensions of their support to the credit system.

Consumer protection is not in this mix and you can tell.  No one can seriously tell you what a great job the Fed has done protecting consumers.   For example, the Fed has dragged its feet for years on coming up with a sensible definition of the Annual Percentage Rate on loans, i.e., a measure that includes all costs.  As a result, many borrowers have been misled effectively by lenders.

More broadly, Alan Greenspan famously stood by despite being warned by his colleagues about the housing bubble and the associated abuses of consumers.  As the housing frenzy developed in 2003 and low income people got sucked in and – many of them – suckered, Ben Bernanke argued for a further lowering of interest rates on the basis of short-run macroeconomic considerations; apparently he was oblivious to the dangers that implied to consumer-as-borrowers.

As Rep. Barney Frank (D-Mass.) said at the height of the housing madness in 2007, “If I was going to list the top 87 entities in Washington in order of the history of their efforts on consumer protection, the Fed would not make it.”

What would happen if you tried to add formal protection of consumers to the top level of Fed priorities and to make it central to Bernanke’s job?

This would surely require amending the Federal Reserve Act, otherwise consumer protection would remain a second class citizen at the Fed.  The Fed is not a government department, it’s an independent entity.  If you don’t give the Fed specific legislative direction and detailed reporting requirements for a particular task, it won’t get done.

And even that may not be enough.  The Fed has plenty of powers to help consumers, but it just hasn’t used them.  The American Banker (subscription required) quotes Barney Frank on this also, “One of the greatest unused examples of power were the consumer protection powers we’ve given the Fed.”

Why? Again, Frank – as chair of the House Financial Services Committee – should know, “If you look at the Fed governors, their focus has been on the safety and soundness of the banking system, not consumers.”

The tip off here is that banks of all kinds want enforcement of consumer protection laws to stay with existing bank regulators where, John C. Dugan, Comptroller of the Currency claimed recently “it works well.” But he doesn’t mean that this arrangement protects consumers.  He means that it protects banks and the banking system – whenever necessary (like now) consumers can be squeezed to improve the banks’ bottom line.

The Federal Reserve never has and never will put consumers first.

By Simon Johnson

A slightly different version of this post originally appeared on the NYT.com’s Economix blog.  It is reproduced here with permission.  If you wish to repost this material in its entirety, please contact the New York Times. 

The question seems to be whether the Fed will be able to tighten monetary policy fast enough when necessary to dampen the potential inflationary effect of its current expansive monetary policy (Fed funds rate at zero, buying long-term securities, etc.). My read on the situation is as follows:

1. Almost everyone agrees that expansive monetary policy has been appropriate during the crisis and recession to date.
2. Everyone agrees that at some point monetary policy will have to be tightened.
3. No one knows when that will happen.
4. Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.
5. Everyone agrees more or less on what tools will be available to the Fed.
6. No one is certain the Fed will or will not be successful, because there are no relevant datapoints to compare it to.
7. No matter what Bernanke actually thought, he would still have to say exactly what he is saying this week.

I don’t see much in there worth arguing about.

As Catherine Rampell says, a more interesting question is when the Fed will start tightening policy. This is the kind of thing that can set the Fed against the administration, as stereotypically one focuses on inflation and the other on unemployment. But since most people think it is too early to start now, that debate would be purely speculative at the moment.

* He does need a grammar checker, though. His first sentence – “The depth and breadth of the global recession has required a highly accommodative monetary policy” – contains an error in subject-verb agreement.

By James Kwak