Tuesday, November 25, 2014

The Changing of the Monetary Guard

NEW YORK – With leadership transitions at many central banks either under way or coming soon, many of those who were partly responsible for creating the global economic crisis that erupted in 2008 – before taking strong action to prevent the worst – are departing to mixed reviews. The main question now is the extent to which those reviews will influence their successors’ behavior.

Many financial-market players are grateful for the regulatory laxity that allowed them to reap enormous profits before the crisis, and for the generous bailouts that helped them to recapitalize – and often to walk off with mega-bonuses – even as they brought the global economy to near-ruin. True, easy money did help to restore equity prices, but it might also have created new asset bubbles.

Meanwhile, GDP in many European countries remains markedly below pre-crisis levels. In the United States, despite GDP growth, most citizens are worse-off today than they were before the crisis, because income gains since then have gone almost entirely to those at the top.

In short, many central bankers who served in the heady pre-crisis years have much to answer for. Given their excessive belief in unfettered markets, they turned a blind eye to palpable abuses, including predatory lending, and denied the existence of an obvious bubble. Instead, central bankers focused single-mindedly on price stability, though the costs of somewhat higher inflation would have been miniscule compared to the havoc wrought by the financial excesses that they allowed, if not encouraged. The world has paid dearly for their lack of understanding of the risks of securitization, and, more broadly, their failure to focus on leverage and the shadow banking system.

Of course, not all central bankers are to blame. It was no accident that countries like Australia, Brazil, Canada, China, India, and Turkey avoided financial crisis; their central bankers had learned from experience – their own or others’ – that unfettered markets are not always efficient or self-regulating.

For example, when Malaysia’s central-bank governor supported the imposition of capital controls during the East Asian crisis of 1997-1998, the policy was scorned, but the former governor has since been vindicated. Malaysia had a shorter downturn, and emerged from the crisis with a smaller legacy of debt. Even the International Monetary Fund now recognizes that capital controls may be useful, especially in times of crisis.

Such lessons are most obviously relevant to the current competition to succeed Ben Bernanke as Chair of the US Federal Reserve Board, the world’s most powerful monetary authority.

The Fed has two main responsibilities: macro-level regulation aimed at ensuring full employment, output growth, and price and financial stability; and micro-level regulation aimed at financial markets. The two are intimately connected: micro-level regulation affects the supply and allocation of credit – a crucial determinant of macroeconomic activity. The Fed’s failure to fulfill its responsibilities for micro-level regulation has much to do with its failure to meet macro-level goals.

Any serious candidate for Fed chairman should understand the importance of good regulation and the need to return the US banking system to the business of providing credit, especially to ordinary Americans and small and medium-size businesses (that is, those who cannot raise money on capital markets).

Sound economic judgment and discretion are required as well, given the need to weigh the risks of alternative policies and the ease with which financial markets can be roiled. (That said, the US cannot afford a Fed chairman who is overly supportive of the financial sector and unwilling to regulate it.)

Given the certainty of divisions among officials on the relative importance of inflation and unemployment, a successful Fed chairman must also be able to work well with people of diverse perspectives. But the next leader of the Fed should be committed to ensuring that America’s unemployment rate falls below its current unacceptably high level; an unemployment rate of 7% – or even 6% – should not be viewed as inevitable.

Some people argue that what America needs most is a central banker who has “experienced” crises firsthand. But what matters is not just “being there” during a crisis, but showing good judgment in managing it.

Those in the US Treasury who were responsible for managing the East Asian crisis performed miserably, converting downturns into recessions and recessions into depressions. So, too, those responsible for managing the 2008 crisis cannot be credited with creating a robust, inclusive recovery. Botched efforts at mortgage restructuring, failure to restore credit to small and medium-size enterprises, and the mishandling of bank bailouts have all been well documented, as have major flaws in forecasting both output and unemployment as the economy went into free-fall.

Even more important for a central banker managing a crisis is a commitment to measures that make another crisis less likely. By contrast, a laissez-faire approach would make another crisis all but inevitable.

A top contender to succeed Bernanke is Fed Vice Chair Janet Yellen, one of my best students when I taught at Yale. She is an economist of great intellect, with a strong ability to forge consensus, and she has proved her mettle as Chair of the President’s Council of Economic Advisers, President of the San Francisco Fed, and in her current role.

Yellen brings to bear an understanding not just of financial markets and monetary policy, but also of labor markets – which is essential in an era when unemployment and wage stagnation are primary concerns. (A classic article that she co-authored remains, many years later, on my list of required reading for Ph.D. students.)

Given the fragile economic recovery and the need for continuity in policy – as well as for confidence in the Fed’s leadership and global cooperation based on mutual understanding and respect – Yellen’s steady hand is precisely what US policy making requires. President Barack Obama is supposed to appoint senior officials with the “advice and consent” of the US Senate. Roughly one-third of Democratic senators have reportedly written to Obama in support of Yellen. He should heed their counsel.

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    1. CommentedVan Poppel charles

      sir, you write: "the next fed leader should be committed to ensuring that america's unemployment rate falls below its current unacceptably level"; I read in L'Echo 3/12/2013 (belgian financial paper) that Apple is producing in gale force iPhones in ZHENGZHOU - China occuping nearly 250000 people using USA technology; How the FED can avoid this situation?ch Van poppel;

    2. CommentedLuis de Agustin

      From the start, Janet Yellen has been an outspoken supporter of Ben Bernanke’s radical monetary experiments, particularly zero interest rates and quantitative easing. Dr. Yellen advocates vigorous government intervention in the economy. That’s a tragedy, says David Ranson, head of research for Wainwright Economics, because there is a strong empirical case for skepticism, especially with respect to the Fed’s power to stimulate credit and employment. Debt monetization has been used on a moderate scale throughout the past, and its effects (confirmed in analysis published by Ranson’s shop) can be evaluated by comparing the growth of the monetary base with the growth of the economy. In the evidence, Wainwright’s research finds an inverse relationship over the half century prior to the crisis and the post-crisis that shows quantitative easing inflates but does not stimulate. The best choice for the Fed chair should be someone who is doubtful that the enormous expansion in the Fed’s size, reach and powers has produced economic benefits, says Dr. Ranson. Yellen is an ardent advocate of expansionary fiscal policy, and supporter of increasing the Fed’s powers. Those who are skeptical about the role of government, and who are relegated by politics to the margins of this debate cannot be happy with the Janet Yellen, that is, Bernanke redux. Luis de Agustin

    3. Commentedcaptainjohann Samuhanand

      In India the Central bank Governor Subba rao who retired did not succumb to the FII Media and corrupt politicians but now we have an IMF Governor who is also a US citizens of Indian origin, one cannot say that any more.

    4. CommentedJoshua Ioji Konov

      Enhancing Markets (i.e. Economies) Transmissionability to Optimize Monetary Policies’ Effect
      Joshua Ioji Konov
      Monetary Policies of expanding liquidity through bottom low interest rate; stimulus packages, quantitative easing, etc should be transmissible to the entire market (i.e. economy) for best performance. However, current markets (i.e. economies) do not posses enough market security to provide the transmissionability to reach adequate market development (i.e. economic growth). This paper theoreticizes that by mitigating of 1) the shady business practices of 2) vague personal corporate liability and 3) contract laws, 4) vague insurance and bonding laws, 5) inadequate 1) intellectual property laws, 2) environmental protection and 3) consumer protection laws, etc market marginalization in fact will enhance the market security, and improve the transmissionability and the effectiveness of the monetary policies to boost market development (i.e. economic growth).

      JEL Codes: A1, D01, D5, P48, K0

    5. CommentedGeoff Walker

      Changing the guard means NOTHING unless you change the regulators.The failure happened because the regulators let the thieves (banks and ratings agencies) do anything they liked. Every American is still paying because the Fed. is printing billions of dollars of new paper money. This erodes the savings of the citizens. America is finished as fiscal power because it has shuffled debt and paper.It does not CREATE wealth.

    6. CommentedRichard Todd Sorenson

      Professor, aren't the leaders to which you refer just fronts for the powers that truly control the central banks? If we continue believing changing leadership will make a difference aren't we fooling ourselves?

      Might have created new asset bubbles? With real unemployment still very high, isn't what we are witnessing in equity prices likely an illusion if the same folks who controlled the leadership then, control the new leadership now?

    7. CommentedTheStudent Economist

      Absolutely right! What we need is the Neil Armstrong of economic crisis management. Neil was known as the guy you wanted on ship when things went wrong.

    8. CommentedTim Nevins

      Let's hope a changing of the guarding facilitates more fresh ideas than in the UK when the new governor of the Bank of England could only manage a rehashing of forward guidance which does not instil much confidence. For more, see http://yourneighbourhoodeconomist.blogspot.co.uk/2013/08/same-low-interest-rates-but-for-longer.html

    9. CommentedChee-Heong Quah

      Even after so many failed central bankers and failed doctoring of the economy, these extreme Keynesians still don't learn.

      Just abolish the Fed. The problem lies in the system. Not the person.

      Two suggestions:

      1) Revert to pure gold standard, or
      2) Free banking, that is, let banks fail and let depositors choose. Free to choose.

      quah, chee heong

    10. CommentedLuca Gemmi

      "That said, the US cannot afford a Fed chairman who is overly supportive of the financial sector and unwilling to regulate it."

      This is the very reason that why Larry Summers is completely unsuitable to the chair of the Fed. First of all, cause of his work with Citigroup, the hedge fund D.E. Shaw and a venture capital society like Andreessen-Horowitz.

      (Italian article about it http://tagli.me/2013/08/01/linfelice-scelta-di-larry-summers-alla-federal-reserve/)

    11. Portrait of Christopher T. Mahoney

      CommentedChristopher T. Mahoney

      Does Yellen have a cogent explanation why a quadrupling of MB had almost no impact on M2? Does she have a plan to get inflation and nominal growth up to the required levels? Is she happy with 7.4% unemployment? I consider her a hawk. I would prefer Summers because he is not a consensus-seeker. 7.4% unemployment and 3.8% nominal growth just doesn't deliver what the masses need.

    12. CommentedMariano Cusi

      In 2009 Joseph Stiglitz praised Spain for its excellent regulatory system. The Banc of Spain, as it turns out, didn't allow the purchases of American Toxic assets. Then Spain collapsed and mysteriously, Spain disappeared from Stiglitz's analysis.

      Spain is exactly what is wrong with the argument that financial markets should be better regulated. Neither the regulators nor the Nobel-Prize-winning-oppinionated-analists like Joseph Stiglitz have any idea of what the next shock will come from. And as Spain's collapse was not foreseen by Stiglitz, the next financial crisis will not be prevented by any amount of smart regulations.

    13. CommentedCarol Maczinsky

      "Many financial-market players are grateful for the regulatory laxity that allowed them to reap enormous profits before the crisis"

      They should take the full responsibility and bankrupters should go in rags, be stripped off their pensions.

    14. CommentedStephen R. Ganns

      There was an excellent article by Joe Queenan entitled “Second Thoughts About Second Chances”WSJ June 15, 2013— which brilliantly implies that those who badly “bungle the job” should not be heavily rewarded with a largess of second chances.

      Larry Summers is known for his altercations with others in his previous job incarnations. He was part of the group that steamrolled the CFTC in the 90’s and firmly entrenched the world in an unregulated OTC derivatives market—which played a pivotal role in bringing down the U.S. and global economies—promoting hyper-excessive leverage in the financial system. He was an advocate for the repeal of Glass-Steagall--which removed the risk management firewall in the banking sector.

      There are two other very viable candidates mentioned as of late: Janet Yellen and Roger Ferguson Jr.

      Ms. Yellen is extremely smart, a distinguished professor, a straight arrow, an experienced monetarist, former CEO of the San Francisco Fed, Vice-Chair of the current Fed Board of Governors—but most importantly, she was a strong advocate of risk management in the banking system early on.

      Roger Ferguson, Jr. is brilliant, an experienced risk manger hailing from both the private and public sectors: as former CEO of Swiss Re (re-insurance) and as the current CEO of TIAA-CREF, the $350B pension entity. He was formerly Vice-Chair of the Fed’s Board of Governors and has recently been diligently involved in researching and publishing work aimed at stabilizing the banking system.

      So: in this most important decision: who would be, in Mr. Queenan's parlance, the least likely to “bungle the job”?

    15. CommentedTim Nevins

      I think the changing of the guard is a good time to look at the inadequacies of current monetary policy in terms of a blind focus on inflation while ignoring other things such as asset price bubbles as referred to here in this article. For more analysis, please have a look at http://yourneighbourhoodeconomist.blogspot.co.uk/2013/07/time-to-rethink-inflation.html