Illustration by Mark Todd
Handicapping the Contenders to Replace Bernanke
Over the past four years, the Federal Reserve has become the most important branch of government. It has acquired unprecedented powers over almost all aspects of American life. It has also become much more politicized than at any time in living memory. Expect further attacks on its independence and integrity at election time. The spirit of Andrew Jackson lives on.
And now we see clear signals that the Fed is likely to have a new chairman soon. Who will run the central bank and what does the choice of top leadership mean for the country?
The recent expansion of the Fed’s powers is ironic, because the decade before 2008 was hardly the organization’s most glorious. Monetary policy was arguably too loose for too long after the dot-com bust and the Sept. 11 attacks. The Fed’s light-touch approach to financial regulation failed completely. And the regulator drank the Kool-Aid of the Basel II international banking rules -- believing in the “advanced approaches” that let banks design their own model-based capital levels, which turned out to be woefully inadequate.
The Fed also failed to protect consumers and homeowners from rapacious practices in parts of the financial sector. And it spectacularly neglected to consider systemic risk and the ways a real-estate price boom could lead to overborrowing that would bring down the macroeconomy. (Amir Kermani, a doctoral student at the Massachusetts Institute of Technology, has an excellent new paper that is relevant for understanding these kinds of dynamics.)
In fact, it is hard to find an aspect of the Fed’s activities that went well during the credit boom. Yet the central bank is now more powerful than ever. How did this happen?
The explanation lies partly in the extraordinary measures taken by Chairman Ben Bernanke and his colleagues -- both as the crisis manifested itself in the fall of 2008 and as the economy staggered along beginning in 2009. (For more on what happened and why, I recommend David Wessel’s book, “In Fed We Trust.”)
Harvey Rosenblum and Richard Fisher of the Dallas Fed write about the “blob that ate monetary policy,” by which they mean that undercapitalized megabanks became so badly broken that the ordinary transmission mechanisms of monetary policy no longer worked. It wasn’t enough to cut short-term interest rates; if the Fed wanted to help the economy, it needed to take more- dramatic steps.
Fast-forward to early 2013: Through its current and expected asset purchases, the Fed controls almost the entire yield curve, meaning the benchmark “risk-free” interest rates paid on Treasury debt of all maturities (certainly up to the 10- year bond and arguably beyond).
But the change in Fed operating doctrine is much more profound. In principle, as a result of the Humphrey-Hawkins legislation in the 1970s, the Fed cared about unemployment as well as inflation. In practice, the Fed was much more focused on inflation. Now, however, we have an explicit unemployment target for the first time.
And the Fed has also assumed greater powers vis-a-vis the financial system. It’s true that the Dodd-Frank reform legislation also empowered the Federal Deposit Insurance Corporation to handle the failure of financial institutions. And now there is a Financial Stability Oversight Council, headed by the Treasury secretary.
In reality, though, the Fed controls key parameters regarding the safety of big banks -- including how much equity funding they have and the structure of their debt. It is also in charge of determining whether banks have viable “living wills” that would allow any potential failure to be handled through bankruptcy. And the Fed is very much involved in deciding whether any nonbank financial institutions should be regarded as “systemic” and thus subject to tighter regulation. Don’t hold your breath for serious progress on any of these missions.
The Fed is powerful today for two reasons. On the macro side, there is no alternative. Fiscal policy is off the table as an instrument for stimulating the economy: You might be for or against, but nothing is going to happen. You might think monetary policy is too loose or too tight, but there is no denying that these decisions are currently of paramount importance.
On the regulatory side, all the other regulators have problems. The Office of Thrift Supervision was abolished, thankfully, by Dodd-Frank. The Office of the Comptroller of the Currency may be improving under new leadership but it has a tawdry history of being captured by big banks. And the Securities and Exchange Commission has become a sad shadow of its former self.
The FDIC did have a relatively good crisis, but it remains focused on deposit insurance -- and has been handed the difficult, messy business of potentially “resolving” failing megabanks.
Politicians on both left and right feel increasingly uncomfortable about decision making at the Federal Reserve -- calling now for an audit of the interest-rate-setting process in the Federal Open Market Committee.
The Fed is full of smart people with a great deal of integrity. But some parts of the system have become too close to powerful interests on Wall Street, undermining the political legitimacy of the more independent parts.
Bernanke will probably step down when his term as chairman of the Board of Governors expires in early 2014. He could stay, but the main lesson from the cult of former Chairman Alan Greenspan is that more than two terms isn’t healthy for the organization or the country. Future chairmen should be limited to eight years in office.
There are three plausible candidates to take over.
Janet Yellen, the current vice chairman, must be considered the front-runner. Support her if you like the current trajectory of the Fed with expansionary macro policy and a go-slow approach to regulation. Yellen is a very accomplished economist. But should the Fed continue to disregard the risks of inflation and understate the danger of too-big-to-fail banks? Most of the history of central banking -- including the first 100 years of Fed experience -- suggests that this can become a toxic combination of mistakes.
Timothy Geithner, who is stepping down as Treasury secretary, wants the job of Fed chairman. Yet he was head of the New York Fed during the disastrous boom phase and remains closely associated with the Robert Rubin-Citigroup wing of the Democratic Party. His doctrine of “overwhelming force” over the past four years can be translated into plain English as “unconditional bailouts for big banks.” This is unlikely to fly on Capitol Hill.
Fisher of the Dallas Fed represents a different view, more concerned about the potential resurgence of inflation and pressing for tougher action on the dangerous megabanks. Everyone should read his latest speech on how to reform the banking system.
Fisher warrants serious consideration for the position of chairman of the world’s most powerful central bank.
(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)
To contact the writer of this article: Simon Johnson at firstname.lastname@example.org
To contact the editor responsible for this article: Max Berley at email@example.com