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Rebuild the Fed From the Bottom Up

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.
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The presidency of Donald Trump will present the opportunity to reshape the Federal Reserve from the outside in.

Though many proposals have been floated in recent years, the call to eradicate the Fed altogether is neither reasonable nor wise. That would only deny the risks inherent in globalized financial markets, leaving the U.S. economy open to attack. At the same time, simply auditing the Fed’s monetary policy-making methodologies also comes up short.

It is the individuals who make an institution. At the Fed, it is those same individuals, as well-intentioned as many of them may be, who have doubled down on their broken economic theories despite their pernicious effects. If anything, the Fed has only institutionalized its errant ways in the years since the 2008 financial crisis, rendering the economy and markets all the more fragile.

The first thing an engaged Congress can do is prevent future missteps on the Fed’s part.

In November 1977, the Federal Reserve Act was revised to expand the central bank’s mandate to maximize employment in addition to maintaining price stability. No doubt, the debilitating stagflation of the day, manifest in both high inflation and unemployment, suggested that fiscal policy had reached its outer bound in offering relief. Still, some 30 years on, the evidence is clear: Interest rates are the wrong tool to produce both maximum employment and stable prices.

In fact, extraordinarily low interest rates can be counterproductive if they facilitate inaction or worse, and give Congress license to enact legislation that effectively encourages the unemployed to remain outside the workforce. (This was the case with the Obama administration’s expansion of qualifiers for disability insurance, to cite an example.)

Congress should immediately remove the employment maximization mandate that necessarily conflicts with the Fed’s other mandate, the minimization of inflation. The single mandate would ensure that the Fed is less intrusive than it’s been in recent years.

Once the Fed’s mission has been simplified, the real work begins. In a 1993 Reuters interview, Milton Friedman observed that, “The Fed’s relatively enhanced standing among the public has been aided by the fact that Fed has always paid a great deal of attention to soothing the people in the media and buying up its most likely critics.” He explained that the Fed employed half the monetary economists in the U.S. and created visiting appointments for two-thirds of the rest. For Friedman, the risk was that the economics profession would be hard-pressed to ever criticize the Fed. 

His prescience was remarkable. Today the institution of the Fed is as intellectually entrenched as it has ever been. It has become the largest employer of people with doctorates in economics. It has hired or contracted with more than 1,000 of these economists, who actively endeavor to validate, rather than question, orthodox theories and policies. The pipeline of talent filling new positions at the Fed is sourced from the same stagnant academic pool that produced the current leadership. Is it any wonder criticism within the Fed has been quashed?

Now the door is open for an outsider to bring the outside world back into the Fed. The last time that all seven governor positions on the Federal Reserve Board were occupied was in 2013. Trump can expeditiously fill these seats, but, more important, he can remake the culture inside the Fed.

Armies of consultants have presumably been busy making a list of potential board nominees. If these advisers have the interests of those who voted for Trump at heart, they will look for individuals who have been on the receiving end of monetary policy and therefore understand it.

They will find CEOs who would rather have invested in the future of their companies, thus creating more jobs and opportunities, rather than be pressured to buy back their shares with cheap debt because of regulatory uncertainty. They will seek out the handful of pension fund managers who have insisted on using assumptions for lower rates of return, to better reflect the reality of lower returns on fixed-income securities, and who resisted the siren call of inappropriate investments to offset the dearth of options in a low-interest-rate world. They will seek rational critics of Fed policy who empathize with, not roundly dismiss, the plight of savers in this environment.

Once a full complement of possible nominees is in place, the new administration can concentrate on redrawing the institution to reflect the tremendous change the U.S. economy has undergone in the more than 100 years since the Fed first came into being.

Right now, there are 12 Fed districts. Some regions of the U.S. have become more economically powerful over the years. California is the largest economy followed by Texas. They should have their own Fed districts. A third one could encompass most of the rest of the West.

At the same time, the regions that have become less economically relevant should be consolidated. For example, Missouri no longer merits two Feds. St. Louis can be incorporated into the Chicago Fed, along with Cleveland. New York is the third-largest state economy. It seems economically reasonable, from Philadelphia north, to have two Fed districts rather than three.

Then give the presidents of the 10 districts that remain permanent votes on the Federal Open Market Committee. This is a necessary act to begin dismantling the over-concentration of power at the board in Washington and at the New York Fed.

While the reformers are taking on the task of reducing the waste in having so many regional Fed operations, they can slash the economics departments throughout the system. Then they can hire practitioners -- M.A.s in accounting who can read a balance sheet, for example; Ph.D.s in finance who can decipher the implications of complicated investment vehicles, and securities attorneys who can measure the liability to which regulated entities are exposed.

The economists who remain should be professionals who can gauge the impact of Fed policy actions before the fact, not after. They should not be academic types whose main aim is to get articles placed in journals that appeal to others with Ph.D.s in economics.

By transforming the central bank, the Trump administration can help the U.S. avert another financial crisis, which is something that four more years of misguided Fed policy would create. In the Obama administration, the Federal Reserve let the 2008 crisis go to waste, failing to understand its lessons. In the next four years, we have a chance to address these lessons without a crisis precipitating the call to action.

Danielle DiMartino Booth, a former adviser to the president of the Federal Reserve Bank of Dallas, is the author of “Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad for America” (Portfolio: February 2017). She is the founder of Money Strong LLC, an economic consulting firm.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Danielle DiMartino Booth at Danielle@dimartinobooth.com

To contact the editor responsible for this story:
Katy Roberts at kroberts29@bloomberg.net