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central dilemma

Three big questions for Larry Summers, Janet Yellen, and anyone else who wants to head the Fed

The financial crisis of 2008 and the miserable performance of the US economy since then made the Federal Reserve look bad. And almost everything the Federal Reserve has done since then to try to get the economy back on track—from the role it took in the Wall Street bailouts (detailed in David Wessel’s book In Fed We Trust), to dramatically increasing the money supply, to quantitative easing—has also made the Fed look bad.

Despite how bad the Fed’s performance looks, things could have been worsemuch worse—and I have argued that Ben Bernanke, who led the Fed through this difficult time, should be given a third term as head of the Fed. But as President Obama has made very clear, that is not going to happen.

Now there are rival campaigns for who will follow Bernanke as Fed chief, with former Treasury Secretary Larry Summers and Fed Vice Chairman Janet Yellen as the leading candidates. Ezra Klein has repeatedly written on Wonkblog that Obama’s inner circle favors Summers, and Senate Democrats were galvanized by the prospect to write a letter favoring Yellen, followed a few days later by a New York Times editorial board weighing in strongly for Yellen. Much of the discussion has focused on personality differences that I can verify: Larry Summers was one of my professors in economics graduate school and I had a memorable dinner talking about the economics of happiness with Janet Yellen and her Nobel-laureate-to-be husband George Akerlof when I gave a talk at Berkeley in 2006.

I distilled my own observations into tweets saying on the one hand that “Larry Summers can dominate a room full of very smart economists” while “Janet Yellen, like her husband George Akerlof, is one of the nicest economists I have ever met.” Despite that personal knowledge, and the same publicly available information as everyone else, I had to confess on a HuffPost Live segment on July 25, 2013, that my own views on the relative merits of Summers and Yellen go back and forth on an hourly basis. The source of my trouble is this: there are many questions Larry Summers has studiously avoided addressing about monetary policy (Neil Irwin in Wonkblog thinks this is a deliberate, but flawed strategy) and even Yellen, who has an extensive and laudable record on past and current monetary policy and financial stability policy, hasn’t answered all the questions I have about the future of monetary policy and policy to enhance financial stability. On financial stability, Summers has made mistakes in the past (helpfully listed by Erika Eichelberger at motherjones.com), so I especially want to know where he would go in the future in this important function of the Fed.

The questions I would like to ask Larry Summers and Janet Yellen are many, but let’s focus on three big ones:

  1. Eliminating the “Zero Lower Bound” on Interest Rates. Given all of the problems that a floor of zero on short-term interest rates causes for monetary policy, what do you think of going to negative short-term interest rates, as I have argued for here and here and here? If we repealed the “zero lower bound” that prevents interest rates from going below zero, there would be no need to rely on the large scale purchases of long-term government debt that are a mainstay of “quantitative easing,” the quasi-promises of zero interest rates for years and years that go by the name of “forward guidance,” or inflation to make those zero rates more potent. Repealing the “zero lower bound” would require  dramatic changes in monetary policy (and in particular, a dramatic change in the way we handle paper currency), but wouldn’t that be worth it?
  2. Nominal GDP Targeting. What do you think of clarifying monetary policy by guiding short-term interest rates by the velocity-adjusted-money-supply (nominal GDP) targets recommended by the Market Monetarists, combined with regular, explicit forecasts for how high GDP can go without raising inflation?  (See “This Economic Theory was Born in the Blogosphere and Could Save the Markets from Collapse.”) In hindsight, it is clear that the Fed should have acted more quickly, and done more, to get the US economy out of the slump the financial crisis put it in. During that time, the behavior of the velocity-adjusted money supply clearly indicated that more monetary stimulus was needed. Wouldn’t it make sense to pay more attention to an indicator that does well both in ordinary times and when the economy faces a crisis the likes of which we haven’t seen since the Great Depression—and move away from the faulty reliance some of those who vote in the Fed’s monetary policy committee put on non-velocity-adjusted money supply numbers?
  3. High Equity Requirements for Banks and Other Financial Firms. What do you think of what Anat Admati and Martin Hellwig have to say about financial regulation in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It? Their argument comes down to this: despite all of the efforts of bankers and the rest of the financial industry to obscure the issues, it all comes down to making sure banks are taking risks with their own money—that is, funds provided by stockholders—rather than with taxpayers’ or depositors’ money. For that purpose, there is no good substitute to requiring that a large share of the funds banks and other financial firms work with come from stockholders. (For follow-up questions on financial regulation, Admati and Hellwig have an invaluable cheatsheet.)

Any serious candidate for the Fed who gives positive answers to these three questions will have my enthusiastic support, and I hope, the enthusiastic support of all those who have a deep understanding of monetary policy and financial stability. But any candidate for the Fed who gives negative answers to these three questions will be indicating a monetary policy and financial stability philosophy that would leave the economy in continued danger of slow growth (with little room for error) and high unemployment in the short run, and the virtual certainty of another serious financial crisis a decade or two down the road.

We welcome your comments at ideas@qz.com.

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