The Federal Reserve Board

The central role of the Fed has put it top of many people’s agenda’s as either a heroic bastion against the disasters wrought by the big private banks, or as the epicenter of all that is evil in the tangled world of oligopolistic big money.

The truth is somewhere in the middle.

I don’t want to re-hash my views on the Fed too much, but allow me to call attention to an awful article in the Huffington Post by way of demonstrating how difficult it must be to be a central banker – no one likes you.

The central argument of the HuffPo piece is that the Fed, by virtue of its patronage and power has effectively captured and molded the economics profession in its own ‘big money’ image. This is supposed, I think, to be a commentary to elaborate on Paul Krugman’s excellent New York Times article over the weekend. Krugman asks rhetorically: what happened to economics? And this very thin piece by the HuffPo is supposed – presumably – to further the discussion.

Except it fails miserably.

The truth is exactly the other way around. Which is what any sensible reading of Krugman would have led you to conclude.

Still I imagine it is always more easy to roll out yet more populist anti-establishment drivel than it is to think through and come up with a constructive comment.

The fact as I see it is this: economics as a serious academic body of thought has wandered way off track. Most of the major work of the past few decades, including much of that for which Nobel prizes have been awarded, is lamentably irrelevant to the furtherance of our understanding of real world economies. That we have known this for some time, and that a debate has been simmering within the profession for decades was largely and understandably unknown to the public at large.

Who knew? Well economists knew. Or at least some of them.

The point is that we have known for years that the models used to shape economic policy are so abstracted from reality that their usefulness has been eroded practically to zero. Unfortunately they are also what is taught in all the major universities. It is simply not possible to build a solid reputation within economics unless you subscribe to the central dogma. And it is this dogma that the HuffPo article argues flows from the Fed. It does not. It flows from academia into the Fed. The causation is reversed from that described in HuffPo.

That this is so makes for a much different article. In fact it makes for the kind of article Krugman wrote.

The key public policy issues we face in finance and economics are not driven by an attempt by the Fed to dictate economic thinking; but by the fact that our central economic theories are screwed up.

None of this exonerates the Fed. As a center for applying economics it should have been more open to non-traditional ideas. It, like Wall Street, was captured by ‘free market’ theories. This was most evident in Greenspan’s era, but it carried over under Bernanke’s rule too. It took the crisis to highlight to the economics elite that they were off track – they would still be adhering to a deregulatory free market viewpoint were it not for the recession. In many ways they still subscribe to the old theories. Why? Because, as Krugman tells us, there are no fully formed alternatives. We are learning on the fly.

The good news is that the Fed staff is sufficiently intelligent that they were able to kluge together a response to the crisis that has worked so far. We are not done yet – we need a good exit strategy – but the signs so far give me confidence that the Fed can perform that task as well.

Now, I don’t want to go too far in defending the Fed. I think they have been deplorable in the commitment of their regulatory duties. They are so steeped in central banking that the details of regulation sometimes [always?] take a secondary place on the agenda. People like Bernanke understand, roughly, how an economy works at the high level of macroeconomic policy, but they are far less certain about the organization and governance issues that affect the day-to-day execution of banking. This is the only plausible explanation I can give for the mess the banks were allowed to make of the derivatives market. There seems to be little or no public purpose served by much of the fancy finance that goes on in the Wall Street trading rooms: big profits are made, big bonuses are generated, but at enormous risk and in, ultimately, anti-social ways. So why was it permitted?

If we assume, as I think it is safe to do, that the objective of the banking system is to allocate capital across the economy in efficient ways such that growth is encouraged and supported, then the primary purpose of regulation is to ensure that task occurs as flawlessly and at as low a social cost as possible. Financial innovation is meant to help this allocation of capital become even more efficient. And by efficient I think we mean less expensive and at lower risk. If these are the two primary markers of success, then modern finance, economics, and thus the regulatory framework has failed as about as abysmally as it could. We have just plunged the entire world into a near depression, tens of millions of people worldwide have lost their jobs, and we have burdened ourselves with trillions of dollars of debt precisely because Wall Street and its regulators fouled up. Someone should be accountable for that. I think the Fed is right at the heart of the problem.

It is one thing to be applauded for taking the steps needed to right the ship, it is another to avoid owning up to the fact that it was you who nearly sank it to start with.

So as we look forward to financial reform – which is now bubbling to the surface again as a top agenda item – I, for one, would feel a lot safer and better about the future were the Fed to be restricted to banking and left out of a revamped regulatory structure.

The entire banking industry is operating, still, a failed business model. That will change as the clean up proceeds and regulators enforce higher and better quality capital standards. We need a regulatory system untainted by rotten theory and distanced from the banks. Right now the Fed is neither of these things.

Which brings me back to that awful HuffPo article: it argues the Fed has too much clout in economics. My take is that the Fed caved too easily to the fanciful dreamlike theories peddled by the likes of Lucas, Fama, and Prescott. Had it been a bastion of practical banking, the way I envisage it should be, it could have pushed back against those utopian models and injected a sense of reality. In other words it would have been good for the Fed to dictate economic thinking as long as it wasn’t what was being taught out there in Chicago!

If we are to break the stranglehold of mythical free market economics a good place to start would be the Fed. Will we see that? I doubt it. As Krugman indicates, economic theory is now in crisis. We have exposed the ‘flat earthers’ as clinging to a foolish argument, but have yet to discover a good alternative. Meanwhile the Fed needs to act. So what does it use? Whatever ad hoc stuff it can lay its hands on. That doesn’t give me much confidence, but it would have provided a much better story than the nonsense HuffPo posted this morning.

My solution? Get the Fed to focus on central banking and monetary policy. Recent experience tells me it has a lot to learn and an equally large task ahead to steer us clear of any new bubbles that may be forming on the back of our massively re-liquified economy. Leave bashing the banks – and I mean bashing in the harshest sense – to someone better equipped.

And ignore HuffPo.