Speculation about who will be the next chair of the US Federal Reserve reminds me of the third season of The Apprentice, and not just because Donald Trump features prominently in both.
In an effort to shake up the TV show’s standard formula, the season’s theme was “street smarts versus book smarts,” pitting a team of college graduates against a team of people without a degree. Maybe because it is natural to root for the underdog, or maybe there’s a visceral pleasure watching arrogant know-it-alls get humbled, or maybe it was just deliberate casting and good production, but I, and most people, rooted for the street-smart team. Even though I was in a PhD program at the time—the “book smart” team were my people—the street-smart team was simply more compelling.
What is notable about the rumored frontrunners to take over for Fed chair Janet Yellen when her term expires in February—Kevin Warsh, Jerome Powell, and Gary Cohn—is that none has a graduate degree in economics, the standard credential since Paul Volker. (Volcker didn’t have a PhD but he did have a master’s degree in economics and a long, distinguished career in monetary policy.)
Warsh, Powell, and Cohn are hardly undereducated. Warsh and Powell have law degrees, and Cohn a business degree, but their economics education mostly occurred on Wall Street. None has a record of scholarship in monetary policy or finance. It could be argued that working on Wall Street gives them more real-world market experience, unlike academics who spend most of their time in the ivory tower. That is, they have street smarts over books smarts.
There is something compelling about these credentials. Many experienced Fed watchers have made it to me. The Fed chair is the most powerful person in global financial markets. He or she sets the world’s most important interest rates and are responsible for regulating the most powerful financial industry. Since the financial crisis, the Fed’s control over financial markets has expanded, and so have the number of tools at its disposal.
It can be argued someone who spent years on Wall Street is now better suited for the top Fed job. Or at least better than a professor who has never been near a trading floor. Until the 1950s, Fed chairs normally were lawyers or practitioners, without much in the way of a formal economics education.
But monetary policy back in those days had a spotty track record (see: the Great Depression). And as monetary policy has evolved, so have the technical skills needed to do the job. A PhD involves years of training and instruction on how to produce and parse research on monetary policy and financial markets. These skills have become critical to setting monetary policy.
Theory and practice
You wouldn’t want chiropractors to perform brain surgery because they have a better hands-on feel for the human body. And crafting good monetary policy is a delicate operation. Rate decisions are based on reams of data and complex models produced by Fed staff. Making sense of it all, most notably its shortcomings, takes technical know-how.
The Fed chair can’t think like a day-trader or hard-charging investment banker. The chair shapes both current and long-term monetary policy. Most people judge monetary policy on its short-term impact, the stock market, inflation, and unemployment. But good monetary policy also considers the long term, bolstering the institution’s credibility and its ability to influence economic variables over extended cycles.
Economics PhD training includes studying the long history of monetary policy, namely what has worked and what hasn’t. Traditionally, academics assume there is a trade off between the long and short-term. The Fed can allow inflation to rise in order to lower unemployment, but if it pushes this too hard then inflation gets too high and the Fed’s credibility to bring it back down suffers. Eventually, the Fed’s inability to lower inflation would undermine its ability to reduce unemployment, too.
Inflation isn’t as much of a concern lately, but Columbia professor Mike Woodford argues that long-term credibility still matters because the long-term outlook for monetary policy (generally expressed by a target inflation rate) factors into how people make decisions. Credibly announcing and explaining those plans may be one of the Fed’s most valuable tools, especially when interest rates are zero.
How the Fed’s conventional tools—interest rates—work is still not perfectly understood. There is a large academic literature that tries to explain it, but as the economy evolves new issues arise. One thing that is certain is that monetary policy is asymmetric. Bad, short-term thinking can damage the economy, which is obvious to all. Meanwhile, the effects of good, thoughtful monetary policy are not well understood and may be limited. Humility, extensive knowledge of the history and latest thinking about monetary policy, the ability to weigh the validity of different economic schools of thought, and extensive knowledge of data and its limitations are the most critical skills for a Fed chair. This suggests there is more value to be gained from book rather than street smarts.
Miller’s crossing
Academics have a pretty good track record leading the Fed. Since Volcker, inflation has been low and predictable. Some blame the Fed for keeping rates too low for too long following the most recent financial crisis. That may be a mistake, but the shock was so severe that it went well beyond the limits of monetary policy. Ben Bernanke’s monetary policy is credited with the world avoiding a devastating depression. And Yellen as presided over a period of low inflation, low unemployment, and steady growth. It is not clear how someone with more street smarts, as it were, would have done any better.
The last Fed chair without academic economic training, Jimmy Carter appointee William Miller, was praised as an outsider who would shake up monetary policy. But on his watch, he didn’t take the proper steps to control inflation, the dollar fell, and inflation and unemployment worsened. He was never able to command the intellectual respect of the board and lasted less than 18 months in the job.
The best monetary policy is formulated from many different points of view. Officials with markets experience should have a seat at the table. They already do. Normally the governors on the Fed’s main policymaking board, as well as presidents of the regional Fed banks, boast diverse academic backgrounds. Ideally, the Fed’s key committees will include some combination of book and street smarts among its members. But history suggests the Fed is better run by leaders with academic credentials.
At the end of the third season of The Apprentice, Trump picked a contestant from the “book smart” team as the winner. Hopefully he’ll do the same for the next head of the Fed.