Calling on Yellen: Time for a Modest, Dull Fed

Most of the news accounts of Obama’s nomination of Janet Yellen as the next Federal Reserve Chairman focused either on what type of monetary stance she was likely to take or on biographical details.

But some writers have used the upcoming changing of the guard at the Fed to look at the bigger question of the Fed’s role, particularly now that it has continues to intervene in financial markets to an unprecedented degree, a full four years after the worst of the financial crisis had passed.

Two particularly commentaries, one from a progressive stance, the other a much more conservative position, call for a more modest Fed, one more focused on the nuts and bolts of banking regulation and less bedazzled by the power of monetary policy.

The desire for a different Fed than we’ve had in recent years reflect deep, underlying discomfort with the lack of accountability of the central bank. It has fetishized “independence.” Central bank defenders contend that in a democracy, the monetary authority might capitulate to pressure to stimulate the economy by setting rates too low. But the problem with that argument is that in the US, before the Fed was created, our central banking functions were handled for over 70 years by the Treasury, and banking interests look to have dominated over popular ones then as now (deflationary policies in the late 19th century followed by adoption of the gold standard in 1900).

And the Fed in the Greenspan and Bernanke era has wanted to have its cake and eat it too, invoking its independence to beat back calls for more supervision, yet meddling in policy debates in a way that would have been unthinkable in the era of William McChesney Martin. Consider a few examples: Greenspan’s loud and active support of deregulation, his approval of the Bush plan to privatize Social Security, as well as advocating cuts in Social Security and Medicare, his urging mortgage borrowers to use adjustable-rate mortgages. Bernanke was arguing for deficit reduction in 2011 (again, not the place of an independent Fed) while still engaged in QE.

Dan Kervick, who most readers know well from his writing at New Economic Perspectives on MMT and economic policy, wants a Fed that will stick to bank supervision and take a much less interventionist approach to monetary policy:

We need to end the barmy “maestro” system that has transformed Fed Chairs into rock stars, and turned every inadvertent nose-scratching by the Fed chief into a Page One story feeding hyper-reflexive and erratic market responses to real or imagined Fed signals. The maestro system, with its cult of superstitious fawning and slack-jawed wonderment at the Banker-In-Chief, has veered into extreme depths of perversity lately, as too-clever-by-half market practitioners attempt to outthink themselves at every turn, neglecting fundamentals and clinging to dotty theories about quantitative easing that turn good news into bad news and bad news into good news. The markets sometimes seem to have become nothing but free-floating postmodern casinos driven by arbitrary assignments of importance to Fed policy statements – and that’s a very dangerous thing for our economy..

I sincerely hope that five years from now hardly anyone pays attention to the news from the Fed, and that we hear little from our central bank other than some occasional inside page stories along the lines of “Banks Grumble about Tightening of Lending Rules”, “Fed Agrees with FDIC and OCC on Capital Rules Adjustments”….

The Fed is a bank, and serves as the organizing hub of our centralized banking system….The Fed is also charged with supplying an elastic currency to the US economy. In carrying out this function, it broadly accommodates the expansion or contraction of money and credit in our economy, an endogenous process that is driven primarily by economic factors and government policies external to the banking system, and that the Fed helps stabilize, but no means directs or controls….

Somewhere along the ways and byways of economic theory, an unromantic grasp of the sober institutional reality just described was transformed into fantastical monetarist-inflected theories portraying the central bank as the omnipotent controller of the money supply, the guarantor of full employment and the driver of aggregate demand. A credulous tilt toward these extreme theories was even written into our laws during a period when monetarism was in the first flush of enthusiastic ascendancy, and a whole generation of economists and pundits has since been raised on them, and taught to look to the central bank to steer and power our economies. There is now a rather substantial cottage industry of influential economic pundits and policy economists who are personally and intellectually invested in central bank-oriented monetarism, and who have placed career bets on its continued thriving. So it may be hard to break the hold of these outworn and frequently failed theories on the public imagination.

Direction of macroeconomic policy in a democracy belongs with the political branches of government, not the central bank. The Fed should be a pliant accommodator of government policy, applying an unobtrusive stabilizing rudder as the ship of government pushes onward in whatever direction the people choose to sail it. The persistent magnification of central bank importance has helped lead to a generation of Congressional and Presidential buck-passing, and is in part responsible for the grossly inadequate and immoral response of government policy-makers to the crisis of 2008.

Amar Bhidé, a professor at Tufts, manages to annoy the right and left. He invokes the Hayekian preference for decentralization to argue for bank regulation, albeit of a very different type than we’ve seen of late, which has increased concentration in the banking system. Bhidé prefers smaller institutions that aren’t hostage to simple-minded rules, like using FICO as a primary tool for evaluating mortgage borrowers, but can also use local market knowledge to make lending decisions. That’s similar to the stance of Andrew Haldane, executive director of financial stability of the Bank of England, who has, among other things, looked at biological systems to see which are more robust. Needless to say, ones with a dominant species aren’t very stable.

As Bhidé writes in Project Syndicate:

America’s system of government imposes particularly strict constraints on officials’ actions, reflecting a deep-rooted skepticism of philosopher-kings….

Today, enormous power is concentrated in the hands of the 12-member Federal Open Market Committee, which sets interest rates and regulates the money supply behind closed doors – decisions that are not subject to review or challenge. Retirees can sue if their homes are seized for urban renewal, but not if the Fed’s financial suppression deprives them of a return on their savings.

The Fed’s seemingly unchecked authority, like the National Security Agency’s warrantless surveillance, undermines ordinary Americans’ faith in their government…A more decentralized monetary authority would align better with America’s democratic traditions and economic reality.

As it happens, governments directly provide only a thin “base” layer of money; most money is created by banks extending credit. Such a “loan-by-loan” process usually allocates money and credit effectively; however, it can over-lend, stoking inflation and even triggering economic collapse.

But centralized, one-size-fits-all monetary policies cannot counteract booms or busts reliably, and often have unintended consequences. For example, while raising interest rates may help to curb inflation and possibly even avert a credit bubble, doing so curtails both sound and unsound lending alike.

A better approach would be to regulate individual banks, branches, and even loans, while limiting the Fed’s interventions to those that serve its original purpose of ensuring an adequate monetary base and acting as lender of last resort during panics, like the 2008 financial crisis.

A return to monetary decentralization would require radical policy changes, including the implementation of 1930’s-style laws enabling regulators to monitor banks, ensure that deposit insurance is credible and comprehensive, and halt off-balance-sheet financial activities…

Furthermore, Congress would have to relieve the Fed of unrealistic mandates for ensuring low unemployment and controlling inflation. While the Fed should be responsible for forestalling the monetary instability that can trigger intolerable inflation or mass unemployment, its policies cannot account for the many cross-currents that buffet prices and jobs. In the rapids, it is best to concentrate on keeping the canoe from capsizing, rather than worrying about maintaining a straight course…Amid heated debates over whether monetary policy is too tight or too loose, a more grounded approach based on the “do no harm” principle has received little attention.

Sadly, it’s in the nature of institutions to accept mission creep, sometimes because the incumbents like wielding more power, but at least as often to take up a duty that seems related to its mission, even it results in overreach or conflicting objectives. While the Audit the Fed push in Congress did lead to some modest increases in the central bank’s transparency, the leadership of the Fed was unwilling to entertain discussion of whether its role was suitable and whether it had adequate governance mechanisms. Unfortunately, I don’t see Yellen as the sort to raise such fundamental questions, let alone push for a markedly different role for the central bank. But it would sure be nice to be surprised.

This piece is cross-posted from Naked Capitalism with permission.