A striking characteristic of economic experience in the United States is the repeated occurrence of financial crises—crises that usher in deep depressions and periods of low-level economic stagnation.
—Hyman Minsky, economist, Washington University, 1970
The Federal Reserve has hit a rough patch. Last week, The U.S. central bank managed to confuse everyone about its monetary policy intentions. Fed chairman Ben Bernanke surprised investors by passing up a consensus moment to announce the start of tapering its $85 billion a month asset purchase program (so-called quantitative easing). The judgment to stay the course was right, considering the deepening fiscal impasse in Washington, but the policy message was badly botched.
The White House hasn’t done the Fed any favors. The Obama administration has bungled the process for nominating Bernanke’s replacement when his term expires early next year. The high-stakes drama between supporters of leading candidates Larry Summers and Janet Yellen went on far too long before Summers withdrew on September 15th.
That said, the tempest should quiet down. No one really doubts that the Fed is committed to engineering a withdrawal from quantitative easing when the economic tea leaves are less murky and the latest fiscal crisis resolved. Fed vice-chair Yellen is widely acknowledged to be superbly qualified to lead the Fed, assuming she gets an official nod from President Obama. (Even in the unlikely event the White House fails to back her, alternatives such as former Fed Governor Donald Kohn and former Israeli central bank head Stanley Fisher are good, too.)
Certainly, the next Fed chair faces no easy tasks: Manage the end of quantitative easing, reduce the Fed’s bloated balance sheet, and at the same time, keep fears of higher inflation at bay. While daunting, none of this is outside the Fed’s expertise. In recent decades the Fed, aided by a vast ecology of monetary economists housed in academia, think tanks, and global financial institutions, has developed a rich intellectual edifice for combating inflation.
The Fed also loathes inflation. Even now, with the personal consumption expenditure price index running at 1.4 percent over the past 12 months—well below its target range of 2 percent—Fed governors and presidents have never stopped publically worrying about the risks of rising prices. “The commitment to keeping inflation down is strong,” says Varadarajan V. Chari, economist at the University of Minnesota and senior research officer and economic adviser at the Federal Reserve Bank of Minneapolis. “We understand the problem quite well.”
The real economic problem confronting the next Fed chair is how best to deal with booms, not inflation. Modern capitalist economies are prone to excess. “It turns out that the fundamental instability of a capitalist economy is a tendency to explode—to enter into a boom or ‘euphoric’ state,” wrote the late economist Hyman Minsky. As John Maynard Keynes famously put it, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”
The traditional answer is that the Fed should take the punchbowl away—tighten monetary policy—when the party gets fun. Problem is, booms are welcome and monetary policy is a blunt instrument. Booms are when new technologies and new ways of doing business are funded. Confidence runs high and the future is bright. The animal spirits of capitalism are unleashed. It’s always difficult to say when legitimate enthusiasm transforms into mass delusion.
“In any case, the animal spirits of enterprise, risk-taking, and innovation will always breed booms rather than sleepy and stable environments. Without a punch bowl to enjoy, there will be no innovation, no technological change, no rise in living standards, no dreams of a brighter future—which include a home of one’s own,” observed Peter Bernstein, the late finance historian.
The next head of the Fed will eventually face the challenge of a boom, with much of the activity financed on credit. Before the next boom emerges (fingers crossed, soon) and grows old (hopefully a long time off), the Fed and its vast economic fraternity need to focus brainpower on nitty gritty financial regulation and worry less about macroeconomic affairs. Fed economists have always preferred researching monetary policy and the macroeconomy, but regulatory design and the economy should take priority. The Dodd-Frank financial regulations bill is only a starting point—and an unsatisfying one at that. Far more important are proliferating conversations about much higher capital requirements and tough leverage standards for financial institutions.
Much more work needs to be done. For example, University of Minnesota’s Chari and colleague Christopher Phelan make a case for requiring financial institutions to hold large capital cushions against publicly traded assets and smaller sums against more illiquid loans—the opposite of current thinking. They surmise that financial institutions in times of trouble can easily dump publicly traded assets, exacerbating the downturn and the odds that a bailout will be needed. Such a policy might encourage financial institutions to fund smaller businesses that lack access to public markets, too.
Similarly, economists are debating the proposal of their colleagues, Anat Admati and Martin Hellwig, authors of The Bankers’ New Clothes, for 30 percent capital ratios—a substantial multiple over current thinking. Perhaps most intriguing are questions over how to regulate the massive, opaque “shadow banking” system of hedge funds and similar financial gunslingers.
The politics of regulation are incredibly difficult, of course. Nevertheless, greater intellectual coherence about what kind of financial regulation will allow for booms and minimize downside risks will help the Fed marshal its arguments and allies. It’s job No. 1 for the next Fed chair.