Saturday, September 15, 2012

When the Fed Chair is an Academic

The big economic news of the week was, in fact, big economic news: the Fed's announcement of significant changes from past practice in the the quantity of its next round of large scale asset purchases ("unlimited"), and in the timing of any future reversal of this expansionary policy ("a considerable time after the economic recovery strengthens").

I view this as a pretty fundamental shift in how the Fed hopes to affect the economy.  Rather than trying to push economic activity one way or the other through its management of interest rates (which can alter economic activity through its portfolio-rebalancing and wealth effects, for example), the Fed is now quite explicitly trying to affect economic activity by altering interest rate and inflation expectations.  As Krugman has put it, the crux of the matter here is that this is pretty close to a "credible promise to be irresponsible".

This is ground-breaking stuff for a central bank.  This type of expectations-management hasn't really been done before -- at least not as an expansionary policy in a zero-lower-bound environment.  And that is why I think that this could only have happened with an academic as Fed chair.  There's a vast academic literature on the channels of monetary policy transmission (important bits of it written by Ben Bernanke himself), and a growing body of academic evidence that suggests that monetary policy's biggest impacts may often be through changing expectations.  Woodford's already-famous August 2012 paper summarizes and crystalizes much of the current thinking on this subject, but the evidence and literature on the expectations channel has been steadily building for more than a decade.

But despite this, it's hard for me to imagine Alan Greenspan, or any Greenspan-like Fed Chair who has primarily a Wall Street background, enacting such significant changes in how monetary policy is conducted purely on the basis of a body of academic research, without prior experience or Wall Street conventional wisdom to fall back on for support.  The academic literature is often theoretically and mathematically complex, and employs statistical techniques that are pretty opaque to most people -- sometimes even to other economists. So unless you're immersed in the field yourself, it would take a pretty big leap of faith to set a new course for monetary policy based solely on the arguments and evidence in such papers.

But Bernanke is immersed in the field.  And so he is in a position to fully understand -- and perhaps more importantly, to really believe -- the conclusions of the academic literature, and therefore to allow that literature to guide the Fed's actions, even though its conclusions have not yet had time to become received wisdom in the financial world more broadly.  And in the current situation, that may make all the difference.

Sometimes a deep understanding of markets and institutions -- such as what one might gain from working on Wall Street -- is probably most helpful to running a central bank.(Think 2008, for example.) But at other times, an academic background can give a Fed Chair profound advantages.  I do not think we would have seen this relatively rapid and remarkably direct implementation of the policy recommendations of academic papers if the Fed Chair had been anyone other than an academic himself.  And with just a little bit of luck, we'll soon have more evidence about whether the academic literature was right.