The Changing of the Monetary Guard

Many financial-market players are grateful for the regulatory laxity that allowed them to reap enormous profits before the crisis, and for the generous bailouts that helped them to recapitalize – and often to walk off with mega-bonuses – even as they brought the global economy to near-ruin. True, easy money did help to restore equity prices, but it might also have created new asset bubbles.

Meanwhile, GDP in many European countries remains markedly below pre-crisis levels. In the United States, despite GDP growth, most citizens are worse-off today than they were before the crisis, because income gains since then have gone almost entirely to those at the top. 

In short, many central bankers who served in the heady pre-crisis years have much to answer for. Given their excessive belief in unfettered markets, they turned a blind eye to palpable abuses, including predatory lending, and denied the existence of an obvious bubble. Instead, central bankers focused single-mindedly on price stability, though the costs of somewhat higher inflation would have been miniscule compared to the havoc wrought by the financial excesses that they allowed, if not encouraged. The world has paid dearly for their lack of understanding of the risks of securitization, and, more broadly, their failure to focus on leverage and the shadow banking system.

Of course, not all central bankers are to blame. It was no accident that countries like Australia, Brazil, Canada, China, India, and Turkey avoided financial crisis; their central bankers had learned from experience – their own or others’ – that unfettered markets are not always efficient or self-regulating.

For example, when Malaysia’s central-bank governor supported the imposition of capital controls during the East Asian crisis of 1997-1998, the policy was scorned, but the former governor has since been vindicated. Malaysia had a shorter downturn, and emerged from the crisis with a smaller legacy of debt. Even the International Monetary Fund now recognizes that capital controls may be useful, especially in times of crisis. 

Such lessons are most obviously relevant to the current competition to succeed Ben Bernanke as Chair of the US Federal Reserve Board, the world’s most powerful monetary authority.

The Fed has two main responsibilities: macro-level regulation aimed at ensuring full employment, output growth, and price and financial stability; and micro-level regulation aimed at financial markets. The two are intimately connected: micro-level regulation affects the supply and allocation of credit – a crucial determinant of macroeconomic activity. The Fed’s failure to fulfill its responsibilities for micro-level regulation has much to do with its failure to meet macro-level goals. 

Any serious candidate for Fed chairman should understand the importance of good regulation and the need to return the US banking system to the business of providing credit, especially to ordinary Americans and small and medium-size businesses (that is, those who cannot raise money on capital markets).

Sound economic judgment and discretion are required as well, given the need to weigh the risks of alternative policies and the ease with which financial markets can be roiled. (That said, the US cannot afford a Fed chairman who is overly supportive of the financial sector and unwilling to regulate it.)

Given the certainty of divisions among officials on the relative importance of inflation and unemployment, a successful Fed chairman must also be able to work well with people of diverse perspectives. But the next leader of the Fed should be committed to ensuring that America’s unemployment rate falls below its current unacceptably high level; an unemployment rate of 7% – or even 6% – should not be viewed as inevitable. 

Some people argue that what America needs most is a central banker who has “experienced” crises firsthand. But what matters is not just “being there” during a crisis, but showing good judgment in managing it.

Those in the US Treasury who were responsible for managing the East Asian crisis performed miserably, converting downturns into recessions and recessions into depressions. So, too, those responsible for managing the 2008 crisis cannot be credited with creating a robust, inclusive recovery. Botched efforts at mortgage restructuring, failure to restore credit to small and medium-size enterprises, and the mishandling of bank bailouts have all been well documented, as have major flaws in forecasting both output and unemployment as the economy went into free-fall. 

Even more important for a central banker managing a crisis is a commitment to measures that make another crisis less likely. By contrast, a laissez-faire approach would make another crisis all but inevitable.

A top contender to succeed Bernanke is Fed Vice Chair Janet Yellen, one of my best students when I taught at Yale. She is an economist of great intellect, with a strong ability to forge consensus, and she has proved her mettle as Chair of the President’s Council of Economic Advisers, President of the San Francisco Fed, and in her current role. 

Yellen brings to bear an understanding not just of financial markets and monetary policy, but also of labor markets – which is essential in an era when unemployment and wage stagnation are primary concerns. (A classic article that she co-authored remains, many years later, on my list of required reading for Ph.D. students.)

Given the fragile economic recovery and the need for continuity in policy – as well as for confidence in the Fed’s leadership and global cooperation based on mutual understanding and respect – Yellen’s steady hand is precisely what US policy making requires. President Barack Obama is supposed to appoint senior officials with the “advice and consent” of the US Senate. Roughly one-third of Democratic senators have reportedly written to Obama in support of Yellen. He should heed their counsel.

Copyright: Project Syndicate, 2013.
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