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. continue reading…