Yalies Yellen, Hamada Put Tobin Twist Theory to Work in QE
When James Tobin joined President John F. Kennedy’s administration in 1961, the U.S. economy was struggling to recover from its third recession in seven years. As a member of Kennedy’s Council of Economic Advisers, the Yale University professor put his theoretical research on asset markets to work in fashioning a novel strategy -- nicknamed Operation Twist -- to reduce long-term interest rates.
Now, more than half a century later, two of Tobin’s Ph.D. students -- Janet Yellen, nominated to be the next chairman of the Federal Reserve, and Koichi Hamada, a special adviser to Japanese Prime Minister Shinzo Abe -- are applying some of those same concepts in their efforts to boost their respective countries’ economies.
Tobin’s work on asset markets with fellow Yale professor William Brainard “is essentially the backbone of quantitative easing,” said Edwin Truman, a former Fed official who taught at the school in New Haven, Connecticut, from 1967 to 1972.
The portfolio-balance theory found that policy makers had the ability to affect the prices of individual assets by altering their supply and demand in the financial markets. And that in turn would have an impact on the economy.
The research won Tobin the Nobel Prize in economics and formed the justification for the late economist’s strategy to twist the bond market’s yield curve in 1961 by selling shorter-dated securities and buying longer-term ones.
The aim was to support the dollar with higher short-term interest rates while bolstering the economy with lower long-term yields. The effort, which was smaller than the Fed and BOJ’s current quantitative easing, had a “moderate” impact on bonds, according to a 2011 study by Eric Swanson, a senior research adviser at the Federal Reserve Bank of San Francisco.
Fed Vice Chairman Yellen laid out what she called the “Yale macroeconomics paradigm” in a speech to a reunion of the economics department in April 1999.
“Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not,” said Yellen, then chairman of President Bill Clinton’s Council of Economic Advisers. “Do policy makers have the knowledge and ability to improve macroeconomic outcomes rather than make matters worse? Yes,” although there is “uncertainty with which to contend.”
That philosophy has put the 67-year-old Yellen at the forefront of moves by the Federal Open Market Committee to speed up growth, including initiating a third round of quantitative easing late last year and firming up a promise to keep short-term rates near zero.
Under QE3, the Fed is buying $85 billion of bonds a month in an effort to keep long-term interest rates down and encourage investors to hold more riskier assets, such as stocks, in their portfolios.
“Janet was a force -- perhaps ‘the’ force -- behind the FOMC’s decision to move to an even more accommodative policy last December,” said Laurence Meyer, a former Fed governor who is now a senior managing director at St. Louis-based Macroeconomic Advisers LLC.
Hamada, who retired from Yale this year after a 27-year tenure, also has been aggressive in pushing for more monetary stimulus in Japan, going so far as to publicly criticize his former star pupil Masaaki Shirakawa for not doing enough to lift growth when Shirakawa headed the central bank from 2008 to March of this year.
That was “a little bit of stepping out of the Japanese character,” said Richard Cooper, who taught Hamada at Yale and is now professor of international economics at Harvard University in Cambridge, Massachusetts. “It shows the American influence.”
The 77-year-old Hamada is one of the architects of the reflationary policies known as Abenomics and played a role in choosing Haruhiko Kuroda to replace Shirakawa as governor of the Bank of Japan. Under Kuroda, the BOJ is buying more than 7 trillion yen ($71.3 billion) in bonds a month in a bid to spur growth in the world’s third largest economy.
The central bank today maintained its unprecedented easing and forecast that inflation will reach its target, even as some board members cautioned the price outlook was too optimistic.
The BOJ program “is an extension of the Yale Tobin-Brainard approach,” Hamada said in an interview. The Japanese central bank is “enhancing activity in asset markets” to “activate the real, stagnated economy.”
Yale’s economics department was “particularly flourishing” when Hamada, who received his Ph.D. in 1965, and Yellen, who got hers in 1971, were there, said Joseph Stiglitz, who taught at the school from 1970 to 1974 and is now a professor at Columbia University in New York.
At least four future Nobel laureates were teaching at Yale then: Tobin, Stiglitz, Tjalling Koopmans and Edmund Phelps. So too was Henry Wallich, who served on the Fed board from 1974 to 1986, and Arthur Okun, originator of Okun’s law, which describes the link between economic growth and unemployment.
“This was a great period for economics at Yale,” said Brainard, who is now a professor emeritus at the university.
Tobin was engaged in a public debate with another Nobel laureate, Milton Friedman at the University of Chicago, about economics, particularly monetary policy, said Cooper, who was at Yale from 1963 to 1977.
Friedman argued that the Fed lacked the ability to manage the ups and downs of the economy and instead wanted the central bank to focus on controlling inflation through steady growth of the money supply, according to Cooper. Tobin thought otherwise.
“Tobin was a life-long sparring partner of Friedman,” said Willem Buiter, the chief economist for Citigroup Inc. in New York, who received his Ph.D. from Yale in 1975.
Cooper said Tobin was a “curious combination. He was a theorist with a very strong interest in issues of contemporary policy.” He also was a “very modest man” who was “somewhat shy” and “did not have a big ego.”
When Kennedy asked Tobin to join his administration, the Yale professor demurred, saying he was an ivory-tower economist, Cooper said, recounting a story frequently told by Tobin’s intimates. Kennedy responded that didn’t matter: He was an ivory-tower president.
In the classroom, Tobin was a “very exacting teacher” who was rigorous in his thinking, Cooper added.
“He encouraged his students to do work that was about something,” Yellen told the Yale Daily News after Tobin died in 2002. “Work that would not only meet a high intellectual standard but would improve the well-being of mankind.”
As a teaching assistant, Yellen was so meticulous in taking notes during Tobin’s macroeconomic class that they ended up as the unofficial textbook for future graduate students.
“I learned my macroeconomics from Janet Yellen’s lecture notes,” Buiter recalled. “It was handwritten incredibly clearly and it went through the whole Tobin canon.”
Tobin also made a big impact on Hamada. When the professor approved his doctoral thesis on international capital movements, Hamada told Tobin he would look at related research on the subject. Tobin said he shouldn’t do that right away and instead should think seriously himself about the issue he was tackling, Hamada recalled.
“From that moment, I felt I was emancipated as an independent scholar,” he wrote in the book “Exemplary Economists: Europe, Asia, and Australasia,” published in 2000.
Tobin even “corrected my poor English” sometimes, Hamada said in the interview.
“Everybody who worked for him or with him had the sense of the importance of clarity,” Buiter said. “When I handed in the manuscript of my thesis, it came back completely red and at the end he wrote, ‘Delete every other word and I will accept it.’”
Tobin and his wife Betty’s New Haven home “was for many decades a magnet and refuge not only for friends and colleagues, but also for legions of students,” Buiter wrote in an obituary in The Independent newspaper in 2002. “A large number of cats and dogs also frequented the premises and sometimes appeared to run the place,” including a three-legged feline.
The period when Yellen was at Yale was a “time of great social and political turmoil,” Buiter said in an interview. New Haven was rocked in 1970 and 1971 by successive trials involving members of the Black Panthers revolutionary group for the killing of an alleged informant.
Regular protests were held across the city, and some spilled over onto the Yale campus. University President Kingman Brewster Jr. said he was “appalled and ashamed” and voiced skepticism that the Panthers could receive a “fair trial anywhere in the U.S.”
“The campus was torn apart by that,” Buiter said.
The lessons Yellen and Hamada learned from Tobin back then aren’t producing the intended results today, said Brendan Brown, who attended the University of Chicago in the 1970s and is now executive director of Mitsubishi UFJ Securities in London.
Echoing some of Friedman’s skepticism, Brown argues the Fed’s effort to boost bond and stock prices artificially won’t help the economy because investors and companies realize the run-up won’t last and so will hold back on spending.
Rather than stepping up capital investment, companies are responding to the rise in stock prices by buying back shares or increasing dividends, he said. Orders for U.S. equipment such as computers and machinery fell 1.1 percent in September, according to the Commerce Department in Washington.
“QE is not working,” said Brown, author of “The Global Curse of the Federal Reserve.”
Former central bank official Joseph Gagnon takes issue with that assessment. He supports the Fed’s actions and said the economy has been restrained by households paying off debts, the on-again off-again crisis in the euro region and a “massive” fiscal squeeze.
Gagnon, who is now a senior fellow at the Peterson Institute for International Economics in Washington, sees economic growth topping 3 percent next year as those headwinds dissipate. Since the end of the recession in June 2009, gross domestic product has risen by an average annual 2.2 percent.
“This is just Operation Twist redone,” said Gagnon, who taught at the University of California’s Haas School of Business in Berkeley in 1990 and 1991 when Yellen was a professor there. “And what we now know is that Operation Twist did work. They just needed to do more.”
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