What Do You Want in a New Fed Chair?

I was recently asked by an interviewer who’s going to replace Chairman Bernanke. I declined to predict because I don’t do horseraces. You’d have to be inside the beltway to understand which way President Obama is leaning. There’s not much doubt that Wall Street is pulling for one of its own, Larry Summers, and Wall Street usually gets what it wants.

Let me turn to what we should want in a central banker, rather than trying to pick the winner of the contest. To understand the qualities desired, we need to know what central bankers should be able to do. There is a lot of misconception over the role played by the Fed in our economy.

The power of the central bank is substantially less than usually imagined, or at least what influence it has is not in the areas usually identified. It has little direct impact on inflation, unemployment, economic growth, or exchange rates. It does set the overnight interest rate, but there is no plausible theory nor evidence that this matters very much. The “interest rate channel” is weak — normally the Fed is raising rates in a boom, when everyone is enthusiastically borrowing and spending, so higher rates do not diminish optimism. In a slump, when the Fed normally lowers rates, it is too late — pessimism has already taken hold.

The way that raising rates actually can work is by causing insolvency of those already heavily indebted — by pushing payments on floating rate debt above what can be afforded. There is no smooth relation between borrowing and interest rates that can be exploited by policymakers. Rather, they can cause a financial crisis if they are willing to do a “Volcker”: push rates so high that defaults snowball through the economy.

Over the past three decades, where the Chairman’s influence has been significant has been in the area of regulation and supervision of the financial sector. Unfortunately, three successive Chairmen have failed to pursue the public interest preferring instead to promote Wall Street’s interest. This has been disastrous.

Obviously Chairman Greenspan was the worst. From his glowing endorsement of the worst S&L crook, Charles Keating, to his testimony in favor of prohibiting regulation of credit default swaps, Greenspan always took the side of de-regulation and de-supervision of financial institutions on the belief that they could “self-supervise.” Greenspan is ground zero when it comes to the GFC.

From this it becomes obvious that the foremost expertise and quality that one would look for in a good central banker would be knowledge and expertise of bank regulation and supervision. One would also want a predisposition to actually do the regulation and supervision that is necessary.

I’d take Elizabeth Warren. Her instincts are right. She understands financial institutions. She wants to regulate and supervise their behavior. She’s not enamored with silly macro models that shed no light on the way our economy actually operates. But I know there’s no chance she’ll get the nod. Heck, Wall Street raised such a fuss that she couldn’t even head the darned consumer protection agency that she created. They will never let her get her hands on regulating them.

Forget the Fed. We won’t get anyone who will do what needs to be done. We’ll carry on with the ridiculous belief that the Fed exerts significant control over the macro economy through its judicious interest rate changes, and by stroking the expectations fairy to align views of the future. Like the toddler with the plastic steering wheel attached to her car seat, the Fed Chairperson will think she/he is driving the car. Fortunately, what is usually classified as monetary policy doesn’t matter much. Otherwise we’d be deep in the poo. Yes, we already are. We’d be deeper.

What does matter is getting the Vampire Squid under control. That will not come from the Fed or Treasury. It must come from our elected representatives. Before you write in to call that naïve, let me say that I know that’s a task for Sisyphus.

What can a progressive do? Support Elizabeth Warren’s attempts to protect us from Wall Street. Demand greater transparency at the Fed. Push elected representatives to push for more accountability. The arguments for Fed secrecy and independence do not stand up to scrutiny. Much of what the Fed (and Treasury) did in the aftermath of the GFC is truly horrifying. It was done behind closed doors. It was not necessary. It propped up Wall Street and allowed the banksters to return to all of the practices that created the GFC.

We will crash again. That will open up an opportunity to get it right. We have to prevent the Fed (and Treasury) from a repeat performance in the coming next great crash.