How Obama Should Pick the Next Fed Chairman
(Corrects description of Tim Geithner in second paragraph.)
Ben Bernanke has repeatedly said that he wants to leave his post as Federal Reserve chairman once his term ends early next year. The consensus among economists and journalists is that Janet Yellen, the Fed's current vice chairman, will get the nod. She has years of monetary policymaking experience from her time as a Fed governor in the 1990s and as president of the Federal Reserve Bank of San Francisco in the 2000s.
Among those under consideration -- rumors suggest that former Treasury Secretaries Tim Geithner and Larry Summers are also on the short list -- Yellen is almost certainly the best choice. Her chances of being confirmed by the Senate are good, while her experience and personality should also make it easier for her to build consensus among her colleagues. These qualities are helpful in a Fed nominee, but they are insignificant compared to what we should really care about: Does she know what she's doing?
We don't actually have a very good way of answering this question. Yesterday, my colleague Justin Wolfers pointed to a 2004 paper by Christina Romer and David Romer that seemed like it could be useful. Unfortunately, their recommendation isn't helpful for the elected politicians entrusted with nominating, vetting and confirming the next Fed chairman:
The way to choose a good Federal Reserve chair is to read what candidates have said about how the economy operates and ask them about their economic beliefs. If what a candidate says is unrealistic or poorly reasoned, move on to another candidate or risk a replay of the 1930s or the 1970s.
Unfortunately, the Romers never really defined what they call "a sensible economic framework." Moreover, it isn't clear why we should trust whatever any mainstream academic has to say on the subject. Jesse Eisinger made this point well in his latest DealBook column, which discusses the intense dislike that many investment managers seem to have for Ben Bernanke:
What these investors are expressing should trouble all of us: they have almost no confidence in the Federal Reserve or the economics profession. And for good reason. It's impressive that the Fed and many economists have successfully predicted the path of interest rates and inflation in the wake of the worst financial crisis in a generation. But neither the central bank nor academicians managed to predict or prevent the crisis in the first place. The failure dwarfs the accomplishment.
This failure should have ruined many academics' careers, yet most establishment macroeconomists act as if the crisis never happened. Others prefer to focus on the best ways to respond to the downturn while dismissing its causes as unimportant. It's a striking contrast to the profession's response to the "stagflation" of the 1970s. How can the test devised by the Romers be put to good use when the overwhelming majority of the profession is unwilling to examine where it went wrong?
It's not as if it was that difficult to see what was happening. Anyone who bothered to study the data in the 2000s would have seen that leverage was soaring. Many mainstream macroeconomists simply chose not to look, or ignored those who did. Claudio Borio and William White warned of the potential dangers as far back in 2003. Raghuram Rajan reinforced the argument two years later. When Oscar Jorda, Moritz Schularick and Alan Taylor studied every business cycle in 14 rich countries from 1870 through 2008, they found that excessive private credit growth always led to deeper downturns and slower recoveries, even in the absence of an acute financial crisis. Why weren't more people paying attention?
Yes, some scholars are trying to learn from experience and advance our knowledge by incorporating the financial sector into their models of the economy and monetary policy. Many of those same scholars are also trying to improve how we measure systemic risk. Others are using new computational techniques to explain why we endure cycles of growth and contraction. These reformers and revolutionaries are in the minority, however. I suspect that we'll have to wait until the retirement of the old guard before we experience real progress. Maybe then we will be able to assess whether a candidate to run the Fed would actually be good at the job.
I do have one general suggestion while we wait: Let's have more people setting monetary policy who understand how the financial system works. Getting Jeremy Stein, the Harvard economist and finance expert, on the Federal Reserve Board was a good start -- more like him would be better. George Soros would be a great Fed chairman. More realistically, President Barack Obama should see if a top Fed job might lure former Pimco managing director Paul McCulley out of retirement. There are also several good options within academia, including Markus Brunnermeier, John Geanakoplos, Hyun Song Shin and Amir Sufi. Let's think outside the box.
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Matthew C Klein