Should Fed chairmen go around kissing babies?

Central bank governors should serve one non-renewable term

Central bank governors should be appointed for one fixed, non-renewable term.  The ECB got that one right.  Members of the Board, including the President, serve for one, non-renewable eight-year term.  The Bank of England’s arrangements are deficient in this regard.  The governor is appointed for a five-year term but can be re-appointed as many times as the Chancellor of the Exchequer sees fit.

The Fed’s arrangements for appointments to the Board are also flawed. From the Fed’s website, Board appointments following the following set of rules: “The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate. The full term of a Board member is fourteen years, …. After serving a full term, a Board member may not be reappointed. …

The Chairman and the Vice Chairman of the Board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board. The terms for these positions are four years.”

The chairman of the Federal Reserve Board can therefore at most serve three consecutive full terms as chairman, followed by one two-year term.  This would exhaust the maximum 14 year stint on the Board. [Addition on 29th July 2009: a reader of this blog (yes, I still have some) writes: "If a Board member is initially appointed to fill the remaining term of a member who has departed early, he can then be reappointed for a full term.  So, potentially, one could serve almost 28 years, and be chairman the whole time." ]

Why is the possibility of re-appointing the chairman of the Fed, and indeed the re-appointment of the governor of any central bank, a bad thing?  Clearly, it undermines the appearance and possibly the substance of independence of the chairman.  The incentive to suck up to/please the power(s) that can reappoint you may be difficult to resist.  It is not necessarily the case that the actions and policies most likely to secure the re-appointment of the chairman are the actions and policies that are best from the perspective of the central bank’s mandate – price stability or macroeconomic stability, and financial stability.

The problem of lack of independence is always present at the initial appointment stage.  This is unavoidable.  Unless we choose the chairman of the Fed at random from among the adult population of the US (which would not necessarily be such a bad idea), we just have to live with it.  It may also not be too problematic, because prior to the initial appointment, the candidate chairman does not have access to the regulatory and monetary instruments of the Fed.  Any implicit or explicit commitments made or understandings reached with the appointing party (the nominating President and the confirming Senate) concerning future policy actions are unenforceable in any  case and can be broken at will, as long as there is no possibility of re-appointment.  What is avoidable and ought to be avoided is the potential corruption of the independence of the chairman at the re-appointment stage.  At that stage the leverage of withholding nomination for a further term or of denying confirmation can be used to influence the actions of the chairman seeking reappointment.  A single, non-renewable term of, say, 7 or 8 years would be the simple solution to this problem.

Self-regulation and self-supervision by the Federal Reserve System

If the possibility of reappointment is a flaw in the governance design of the Federal Reserve Board, the appointment process for the presidents of the 12 regional Reserve Banks in the US is a ludicrous anomaly.  The president of the Federal Reserve Bank of New York is always a member of the 12-member Federal Open Market Committee – the committee that takes the key decisions (including setting the target for the Federal Funds rate) affecting the cost and availability of money and credit in the economy.  The remaining four slots on the FOMC are taken by the other regional Federal Reserve Bank presidents, who serve one-year terms on a rotating basis.

Each president of a Federal Reserve Bank is appointed by the board of directors of that Bank, for a renewable five-year term, subject to the approval of the Board of Governors of the Federal Reserve System.  Each of the twelve regional Federal Reserve Banks is separately incorporated with its own board of directors. In each Reserve District, commercial banks that are members of the Federal Reserve System own the stock of their District’s Reserve Bank and elect six out of the nine members of that Reserve Bank’s board of directors; the other three directors are appointed by the Federal Reserve Board.

This arrangement amounts to one where a regulated industry, the US banks regulated and supervised by the Fed, elect their own supervisors and regulators.  Regulatory capture is made inevitable with this institutional arrangement.  Indeed, the governance structure of the regional Federal Reserve Banks, including the way in which they elect their Presidents, seems designed to ensure capture of the regulator/supervisor by the industry he is supposed to regulate and supervise in the wider public interest.  It is an unbelievable and utterly insane arrangement from the point of view of the common good.  It is a wonderful arrangement from the perspective of the US banking industry.

Surely it must be possible to design a governance structure that permits the regulators and supervisors to be aware of the views and interests of the industry they regulate and supervise that falls short of granting the industry the power to appoint or elect its own regulators and supervisors.  When the inmates of the prison elect the warden, society’s purpose for the prison is likely to be ill-served.

Kissing babies

Chairman Ben Bernanke is running for re-appointment. The open way in which he does this is, at least to me, toe-curlingly embarrassing.  James Pethokoukis has a rather nice piece on it here.  In case you believe I am making this up (I wish I were), the Federal Reserve Board provides you with  a video record of much of the  Punch-and-Judy-show here.  The Fed itself calls it a town-hall meeting (a “Town hall event with Chairman Bernanke . View video excerpts from the town hall event with Chairman Bernanke at the Federal Reserve Bank of Kansas City on July 26, 2009“).

Is it really necessary to defend the institution of the Fed, and what remains of its independence (independence from Congress that is; independence from the Executive went out of the window long ago), by making statements like the following:”The best way to have a strong dollar is to have a strong economy”, ”I don’t think the American people want Congress running monetary policy”; ”I was not going to be the Federal Reserve Chairman who presided over the second Great Depression” or ”When the elephant falls down, all the grass gets crushed as well”?  The first of these statements is utter nonsense, although US politicians use it all the time.  As regards the second statement, I wish it were true but I am not so sure.  As regards the third statement, I will take chairman Bernanke’s word for it.  He has, however, apparently decided to go down in history as the Federal Reserve chairman who presided over the creation of the biggest moral hazard machine ever.  As regards the fourth, this is obviously incorrect if you make sure the elephant is in a place where there is no grass.

This “Town Hall Event with Chairman Bernanke” politicises the Fed even more.  It does not serve the institution, but demeans it.  It may serve  chairman Bernanke’s re-appointment.

And the runners are…

The race for the top job at the Fed thus far appears to have three runners: the incumbent, Ben Bernanke, Larry Summers, the current director of the NEC and Janet Yellen, president of the Federal Reserve Bank of San Francisco .  Both Bernanke and Yellen are qualified for the job.  Summers is not.

There are several reasons why Summers would be an inappropriate choice as chairman of the Fed.  Let’s start with Fed-relevant knowledge and expertise.  Summers is not a monetary economist or macroeconomist. He has never shown any serious interest in researching and understanding the workings of the kind of complex, interdependent dynamic systems that represent the environment a central bank operates in.  He is the arch-typical quick and dirty partial equilibrium man, full of clever isolated micro-insights, but incapable of grasping the whole.  His macroeconomics stalled at the Keynesian cross.  As a monetary economist he has never seen a Federal Funds rate target so low he did not want it just a bit lower.

As regards the regulatory and supervisory functions of the Fed, Summers would be a disaster.  During his time in the Clinton administration, culminating in his stint as Treasury Secretary, he was, with Greenspan, the main official apostle of full-speed ahead financial sector deregulation.  The same naive trust in  self-regulation and market discipline that has tarnished Greenspan’s reputation has been a trademark of Summers in action, both at home and abroad.   Summers remains cognitively captured by old Wall Street and a prisoner of its culture and views.

Even before Summers went to the US Treasury, his approach to financial crises (in emerging markets and developing countries) never got beyond the putting out of immediate fires.  The impact of the bail-outs and rescue efforts advocated and promoted by Summers on the likelihood and severity of future crises was either not considered or not given any weight.

The only time Summers mentions moral hazard is when he asserts that now is not the time to worry about it.  And of course, it is always now.  Well, now is always the time to worry about moral hazard.  There is always more than one way of skinning the cat, and different ways will have different implications for moral hazard.  Just one example.  Bank of America and Citigroup did have an effective special resolution regime (administered by the FDIC) throughout the crisis.  Why was the tax payer called on to recapitalise the banks when it was perfectly feasible to make the unsecured creditors pay instead?

Once the immediate crisis is over, the highest priority should be attached to designing and creating institutional arrangements and incentive structures that will minimize the likelihood and severity of future systemic crises.  Summers has never shown any interest in creating institutions that enable policy makers (in the Fed, in the Treasury and in the regulatory agencies) to make credible, long-term commitments.  He invariable favours opportunistic discretion over rule-bound flexibility.  The last thing the US needs today is a chairman of the Fed with the long-term perspective and attention span of a fruit fly.

Janet Yellen is an outstanding monetary and macroeconomist.  I have known this for a long time, because when I came to Yale as a PhD student in 1971, we all passed our Comprehensive Examinations (Comps) in macroeconomics thanks to the ‘Yellen notes’, the wonderful collection of ‘augmented’ lecture notes from James Tobin’s lectures, created by Janet Yellen as Tobin’s teaching assistant.  She was a professor at Berkeley for many years, a member of the Board of Governors of the Federal Reserve System from 1994 to 1997 and chair of the President’s Council of Economic Advisors from 1997 till 1999.  Her abilities as a regulator and supervisor have not, as far as I know, been tested.  These are, of course, at least as important for a chairman of the Fed as his or her command of the conventional monetary policy tools.  Her ability to stand up to the populists in the Congress and the relentless lobbying efforts of Wall Street and the rest of the financial establishment are also unknown.  But at least we can hope.

With Ben Bernanke we know what we would get.  An eminent monetary economist with a pretty good record managing interest rates, quantitative easing and credit easing from the perspective of mitigating the immediate financial crisis and the contraction that followed it; a dreadful regulator/supervisor who ‘did not see it coming’ at all; a fully-signed up contributor to the biggest explosion of moral hazard in US financial history; and the man who allowed the Fed to be turned into an off-budget, off-balance sheet subsidiary of the US Treasury.

In the field of regulation and supervision, I prefer untried and untested to tried, tested and failed.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website