Six Warnings for Ben Bernanke's Replacement

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DEALBREAKERS JULY 19, 2013

Six Warnings for Ben Bernanke's Replacement

With Ben Bernanke’s term as Federal Reserve chair near expiration, virtually every economic policy pundit in good standing has thrown out their list of who should replace him. Some favor the aggressive regime shift of a Christina Romer. Others prefer the continuity of a Janet Yellen. And Larry Summers thinks very highly of an obscure economist named Larry Summers.

You can come up with your own names; heck, you can even put down money in the Irish betting markets on your prediction. But rather than taking a whack at who should become the next Fed chair, I thought it would be more fruitful to offer some advice. Here are five examples of people that Ben Bernanke’s successor shouldn’t emulate under any circumstances:

Ben Bernanke, circa May 22, 2013. As Strother Martin said to Paul Newman in Cool Hand Luke, “What we’ve got here is a failure to communicate.” That’s been the big problem with the Fed over the last two months. For some reason, the Fed governors got it in their heads that they had to signal an end to the latest round of quantitative easing, the monthly purchase of $85 billion in mortgage backed securities. So Ben Bernanke used Congressional testimony on May 22 to say that “If we see continued improvement (in the economy)… then we could in the next few meetings ... take a step down in our pace of purchases.” This became known as the taper, and it predictably led to premature expectations of monetary tightening, and a rapid rise in interest rates throughout May and June.

This had the most immediate impact on mortgage rates, which soared well over a full point. There are indications that this has stunted the growth of the housing recovery, as buyers shy away from more expensive home financing. Moreover, rising interest rates have made investor purchases of foreclosed properties less profitable, and those investors fled the market, depressing housing in the distressed communities they targeted. This week’s retail sales numbers showed that building materials purchases dropped sharply in June, and housing starts in June fell to their lowest level in a year, perhaps due to the impact of rising mortgage rates.

The interest rate explosion calmed after Bernanke reassured investors that the taper would not take place until economic conditions merited it (in fact, this week, Bernanke tried to re-establish control by telling Congress that, if needed, the Fed would increase their quantitative easing purchases). But the episode is an example of the importance of communication in monetary policy. Bernanke’s statement was fairly unexceptional. But it led to a change in market psychology, perceiving that the Fed had altered their view of the appropriate policy. This heightened uncertainty created what economist Brad DeLong has called the largest and most rapid contractionary shift for U.S. monetary policy in two decades. A new Fed chair must recognize the value of public statements, and take care not to damage his or her own policies by unintentionally generating new expectations.

Jens Weidmann. The head of the German central bank (the Bundesbank) is, like most Germans, obsessed with fighting inflation. Still scarred 80 years later by the policy of the Weimar era, Weidmann last week argued for the European Central Bank to raise interest rates if it needed to curb inflation. This comes at a time when European unemployment reaches new highs every month and is expected to soar even higher.

The ECB doesn’t have a dual mandate, but the Fed does. It’s supposed to be concerned with employment and price stability. But too often Fed policymakers seem more consumed with the latter than the former. The latest monthly numbers show inflation still below the 2 percent target commonly mentioned by the Fed as a goal, and well below the 2.5 percent target they said they would be willing to tolerate until unemployment falls (inflation has in fact been decelerating for the last two years). If unemployment is above the Fed target and inflation below it, that means they’re failing at both their mandates, and they should be talking about looser monetary policy to reach those targets. That means continued quantitative easing, as the economy remains too sick to get by without help.

Pope Urban VIII. The 17th-century pope banned the sale of Galileo’s Dialogues, leading to the astronomer’s conviction on heresy charges for “for holding as true the false doctrine taught by some that the sun is the center of the world.” In short, Pope Urban VIII detested experimentation, which is exactly what the Fed needs right now. The current program of quantitative easing has been good for asset holders on Wall Street, but has had trouble filtering down to ordinary Americans. There are other creative options that the Fed could explore.

Instead of purchasing mortgage-backed securities, for example, the Fed could purchase mortgages, and sell them back to their previous owners at a market rate. They could enter municipal bond markets to lower financing costs for local infrastructure projects, which would likely lead to more construction projects and increased hiring. In 1976, the Fed purchased bonds that helped build the DC Metro rail system. They have a far more varied ability than they’re currently engaged in. Monetary policy’s limits, in other words, have not yet been fully explored. Directly injecting more government purchasing into the economy would be preferable at a time of reduced aggregate demand, but with Congress hopelessly gridlocked, the Fed must be willing to try anything.

John Boehner’s wife. I assume the Speaker’s spouse is among the roughly 15 to 17 percent of Americans who approve of Congress’ job performance, a number that Senate Majority Leader Harry Reid said ranks “lower than North Korea.” There’s no question that Congress has harmed the economic recovery with a focus on deficit reduction rather than job creation. Though insiders sniff that sequestration didn’t destroy the economy as advertised, it has depressed overall activity from where it could have been. Public investment has reduced dramatically since the Great Recession, in completely counter-productive ways.

Ben Bernanke has been willing to criticize Congress for premature fiscal tightening, and this week he really took a broadside to them, basically saying that they represent the biggest roadblock to recovery. A public campaign explaining that Congress is hurting the economy probably won’t move Congress to act. But it could at least further clarify the source of the problem for the public.

Jamie Dimon (I would also accept Larry Summers). A core function of the Federal Reserve, along with its agency partners, is financial regulation. Before the financial crisis, the Fed was guilty of failing in its consumer protection responsibilities, allowing mortgage fraud to proliferate and pumping up a housing bubble that was sure to crash. More recently, they have nonchalantly let big banks off for demonstrated fraud in their foreclosure operations. The Fed needs to play a stronger role in reducing risk in the financial system and preventing taxpayer bailouts. They have nudged in this direction with their new rules on leverage requirements, doubling the ratio at the nation’s largest banks between their equity and their assets. Daniel Tarullo, an Obama nominee, led this effort amid lots of bank-friendly resistance among his counterparts. Tarullo needs some help to actually go further, and ensure that banks have more capital to absorb their own losses, rather than throwing losses on the taxpayer and threatening the overall economy.

Finally, some counsel for Barack Obama, the man making the Fed chair selection. Don’t follow the lead of this guy:

Barack Obama. Janet Yellen would probably make a fine choice; she has indicated more interest in full employment than keeping inflation below target. But the problem is that she would just move one seat over, from vice-chair to chair. That wouldn’t change the overall composition of the Federal Reserve Board of Governors. President Obama has a real opportunity here. Not only is Bernanke due for a replacement, but Elizabeth Duke, brought onto the board at the tail end of George W. Bush’s Administration, announced her retirement last week, effective at the end of August. This gives Obama two open spots to fill on the board, and once he does, every member of the board will have been an Obama appointee. This allows a Democratic President to put his stamp on monetary policy well into the future, as Governors can serve a full term of 14 years. In the past, Obama has dragged his feet on Fed appointments; he should not delay now. And moving over Yellen while letting her spot lie fallow for years wouldn’t exactly help matters. A new Fed chair should suggest that they have a full complement of fellow board members so they can implement their preferred policies.

David Dayen is a writer living in Los Angeles. 

 

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