By Dan Kervick
President Obama will soon name a successor to Ben Bernanke for the position of Chair of the Federal Reserve’s Board of Governors, and Brad Delong recently offered his views on what qualifies someone as a strong candidate for that position:
To be good choices for Federal Reserve chair, candidates must pass three tests. They must have experience at a similar job: this is not something to throw somebody into and expect them to swim. They must fear high inflation as they fear a tornado, and feel in their bones the pain of the unemployed. And they must understand and properly weight the different models of how the economy might behave. Right now, this third means that a good Federal Reserve chair must give a relatively high weight to the Keynesian model, which has been so successful at describing and forecasting the economy over the last six years.
DeLong then goes on to argue that this proposed collection of qualifications narrows down the candidate list significantly:
Janet Yellen has a proven record of being able to build consensus inside the Fed. Larry Summers is the least likely to bind himself to an institutional consensus past its sell-by date. Only five potential candidates pass this threefold test: Larry Summers, Janet Yellen, Christy Romer, Alan Blinder and Laura Tyson. They are all, in my view, superior by far to others whose names have been mentioned.
And DeLong then opts gingerly for Summers, his former boss and a man with whom he has co-authored several papers in the past. But DeLong’s analysis leaves out what to my mind should be the most important factor among the qualifications for the Fed Chair position: central bank experience.
Let’s start with a simple question: What is the Fed anyway? The short answer is that the Federal Reserve is the central bank of the United States. But what does that mean?
In the US we have a highly integrated, hierarchical and centralized banking system. People and businesses – including some state-chartered banks that are not themselves Fed member banks – hold their deposits at the Fed member banks. Those Fed member banks in turn hold their deposits at the twelve regional Federal Reserve banks. And those regional banks are governed by the Board of Governors, which develops and implements the regulations governing the entire system, as well as deciding on certain aspects of monetary policy that lie under its control. The regional banks also elect some of their Presidents to sit on the Fed’s Open Market Committee, a twelve-person body that formulates and implements much of Fed monetary policy, but is itself dominated by the seven members of Board of Governors who are automatically members of the committee.
Although the direction of our financial system is increasingly subject to the actions of a “shadow” banking system of financial institutions that are not directly governed by the Fed, the Federal Reserve System still constitutes the most vital part of the financial machinery and infrastructure of our economy. Among other important aspects of that machinery is the Fedwire payment system which processes trillions of dollars worth of interbank payments each day, either directly or in conjunction with the Clearing House Interbank Payments System (CHIPS) that itself holds a Fed account through which its start-of-day and end-of-day transactions with participating banks are processed. These payments systems are in effect the financial circulatory system of our economy, and the Fed oversees them to preserve their smooth functioning.
So the Board of Governors, all seven members of which are appointed by the President of the United States, sits at the apex of the nation’s integrated banking structure and governs this vast and economically fundamental system. When the financial system fails – as it did in 2007 and 2008 – the results can be economically catastrophic, as we all now well know. So, effective Fed oversight and regulation of our market-based financial system, a system that history shows is perpetually prone to bouts of fragility and crisis, is a governmental chore of the highest possible priority. The Chair of the Board of Governors is the active executive of the system who directs that board, coordinates its activities and decisions, and communicates those decisions to the public. The Fed Chair thus occupies a position of immense power and systemic responsibility.
The whole system is a large and complex financial machine, and so the people running it had better know how the machine works at a fairly fine level of detail. This is the kind of robust and detailed knowledge people generally acquire not simply by thinking, but by long experience in doing. To my mind, then, the number one qualification for the job of Fed Chief is that the candidate have some high-level hands-on experience in banking and finance, preferably central banking. (And by hands-on experience, I don’t mean just sitting on the board of a bank, a token sinecure that is bestowed on many well-connected individuals to build alliances and as a reward for services rendered.) The Fed Chair should also be someone who shows a knack for, and enthusiastic appreciation of, vigorous financial regulation.
By these criteria, Janet Yellen is the only person on DeLong’s list who qualifies since she has been at the central banking game since the mid-90’s, when she was first named to the Board of Governors. Yellen also served for six years as President of the San Francisco Fed. She is an established, very experienced and by all accounts highly competent and professional central banker, who has had hands-on, day-to-day responsibility for Fed governance and policy formation during the intense and politically high-pressured recent period of the Great Recession.
The fact that Yellen’s actual experience in the central banking system is not often pointed to as the key qualification distinguishing Yellen from among all of the candidates for succeeding Ben Bernanke has been somewhat mysterious to me, but I think I know part of the solution to the mystery. There is a distorted view of the Fed that is widely popular in some quarters of the popular press, the blogosphere and among some economists that seems blithely ignorant of the fact that the Fed is primarily a bank: the bank of all banks that backstops, regulates and holds the deposits of its members, while also running the interbank payment systems. This impoverished popular picture of the Fed leaves out great quantities of important operational facts and constraints, and treats them as though they merely irrelevant details. For example, pundits frequently ignore the facts that when the Fed issues money to purchase financial assets, those financial assets and their associated cash flows are thus removed from the private economy as a result, and so the total sum of net financial asset value is little affected. They also ignore the fact that the so-called “reserves” of Fed member banks are mainly just the deposits in these banks’ accounts at the Fed that they are required to hold in order to settle their daily interbank payment obligations via the Fed’s payment system. There is also widespread ignorance of the fact that, with the exception of small fluctuations in the quantity of physical currency held by banks, bank reserves in the aggregate do not move “out” of the reserve accounts of commercial banks when those banks make loans. They only move from bank to bank.
An enthusiastic core of Fed fanboys in the punditry seem to view the Fed as some kind of sulking and reticent macroeconomic superhero that inexplicably refuses to use its superpowers to restore demand, production and full employment throughout the land. This style of discussion, treating the Fed as a nearly omnipotent macroeconomic titan and potential messiah, has undermined political pressure for economic policy action from other directions, and has helped spread an unhealthy press culture of obsessive Fed-watching and neurosis. The enthusiasts for the superhero picture first promote outlandish obsessions over the Fed’s role, and then recommend policies based on exploiting these obsessions by attempting to behaviorally manage them. They seem to see the Fed as running a vast game of macroeconomic Simon Says that can coordinate almost every kind of economic behavior and manage demand throughout the economy. But despite the intensity of these discussions among the zealots, the number of economic agents who are paying very close and minute attention to the Fed and its precise statements is actually relatively small.
The superhero conception of the central bank also tends to ignore the fact that the primary channels through which the Fed does influence broader economic activity – when it can influence that activity – run through the banking and credit system. Boosters of greater Fed activism seem to think the role of the Fed is to drop money or demand into the “economy” from some serene aerie poised high above it all. But the Fed interacts with the real economy through the banking sector and through its regulation of the conditions of bank lending. It doesn’t have helicopters; it doesn’t have ways of reaching out and touching non-financial businesses, households and individuals to turn us into greater “demanders”. Its statements might have this kind of psychological effect on some participants in the economy, but this is a highly subjective and variable business that depends on that agent’s background understanding of the Fed’s role, and the behavioral impact on these varying understandings can thus cut in several conflicting directions at once.
Now certainly Fed governors should have a great deal of economic knowledge as well as institutional experience, and Yellen has also maintained an ongoing and distinguished academic career while attending to her institutional responsibilities at the Fed. But the Fed is not really a good place for academic macroeconomists to try out their theories and models in a complex institutional setting in which they have no real experience operating. That would be like putting a lifetime academic nuclear physicist in charge of a nuclear power plant. The scientist might be brilliant and the intellectual background is certainly highly relevant to the job, but there is no reason to think the knowledge of pure physics would make a person a competent executor of the very different engineering responsibilities of running a power plant. Nor, as bright as the scientist might be, could the community that depends of the safe functioning of the plant afford to wait many months as the new appointee learns all the ropes about how the machinery works.
The Fed Chief does not go to work each day and manipulate the nation’s aggregate demand curve and aggregate supply curves on some godlike control screen. The Fed is not the all-purpose Department of Macroeconomic Control, and its chair is not the Czar of the Macroeconomy.
Recent commentary on the Fed Chair position has been heavily focused on monetary policy, and the various fads and flights of monetarist fancy that tend to drive discussion of the Fed in the press and academia. But during the next phase of the Fed’s history, overseeing the regulatory role of the Fed will likely be the most important job for its chief. Among other things, the Fed will be involved in implementing the modified Basel III capital requirement rules and the provisions of the Dodd-Frank Act. Many observers think these new rules are too weak to address the fundamental sources of instability in the system. But as with any system of broad rules, whether they work or not often depends on how aggressively they are implemented.
Consider a story that we all became aware of a couple of weeks ago. A little noted change in Fed regulations in 2003 has allowed big investment banks like Goldman Sachs and J.P. Morgan to become major players in warehousing physical commodities like aluminum and copper. So far the actual impact on consumers has been minimal, but it could be very risky if these “systemically important” financial firms eventually become Too Big To Fail in the commodities world, just as they are already in the financial world. We could be on the way to re-creating the old gilded age system of vertically integrated and oligopolistically coordinated trusts. Dismantling that system was the chief concern and achievement of the progressive era in US history. This is the kind of thing that we need the Fed to keep a very close watch on.
And on that score, one final thing needs mentioning: The Fed governorship is not a job for a political crony; it’s not a job for a person with a track record of old boy friendliness to The Street and its taste for reckless, high-rolling and systemically destabilizing money-making; it’s not a job for a regulatory softie who is plugged into the political networks of money guys, boosters and campaign funders, a person who might have trouble saying “no” to insiders and donor cliques who run and prop up political parties. One hopes that the President has not settled for a shallow partisan diagnosis of the crisis of 2008 and has advisers who actually understand the roots of the crisis lie in three decades of bipartisan zeal for deregulation, desupervision, decriminalization and misguided enthusiasm for the self-sufficiency of markets. The key economic architects of that failed order should not be rewarded now with the opportunity to put their flawed judgment to work again in a setting where it might prove devastating.