So on Friday, WSJ reported that Trump and Mnuchin met with ex-Fed governor Kevin Warsh about possibly taking over for Janet Yellen.
As we and others noted when the news first hit the tape, Warsh would likely take the Fed in a hawkish direction. That leads directly to this question: has anyone told Donald Trump that an excessively hawkish Fed would likely imperil his beloved equity rally?
Yields and the dollar moved higher immediately on the Warsh report, and for the remainder of the day there was a notable effort on the part of “White House officials” to make it clear that Trump has met with other candidates as well. Here’s Bloomberg:
President Trump has interviewed at least four people for Fed Chair, according to two people familiar with the talks.
- Janet Yellen, current Fed chair, whose term expires Feb. 3, 2018
- Gary Cohn, top White House economic adviser
- Jerome Powell, Fed governor
- Kevin Warsh, Hoover Institution fellow and former Fed governor
Ok, so here’s the thing: if what Donald Trump is aiming at is a Fed that’s going to be beholden to him in that kind of way where he sits you down like he did James Comey and demands loyalty or, perhaps more importantly, if the President intends to nominate someone who will continue to keep the communication loop open with the market in the interest of ensuring that the “Yellen put” becomes the “[fill in the blank] put”, he might want to go back and read the following speech delivered by Warsh last year at the 15th BIS Annual Conference in Lucerne, Switzerland.
Do read this and try to imagine how things could go “wrong” both for Trump and for equity investors who are expecting the punchbowl to remain in place indefinitely…
“Reform Or Perish” by Kevin Warsh, delivered on Friday 24 June 2016
I observe some smart and earnest economic professionals running with the pack, less willing to undertake a rigorous assessment of ideas that could belie their hypotheses, and more disposed to making ad hominem arguments to relegate alternative views. An immodest disposition from the leading lights in our guild might be understandable amid an economic boom. It is more puzzling given the meagre state of economic output.
The antidote to groupthink involves revisiting and, ultimately, reforming the role of central banks and the conduct of monetary policy. For those like me who believe in the promise and purpose of independent central banks – and believe that central banks find themselves at a particularly vulnerable and vexing policy conjuncture – we must raise our voices to break the conformity of views and consider a new paradigm for policy.
The annual meeting of the BIS is the proper venue to seek support for consideration of a rigorous reform agenda. The BIS deserves great credit for its data, analysis and scholarship. Its leaders merit the highest praise, however, for their courage – the courage to question the fashionable trends in monetary policy theory and to raise doubts about the favoured fads in policy practice.
What is the groupthink of which I speak? It’s a groupthink on monetary policy tactics, tools, governance and strategy, all. Its stated mantra of data dependence causes erratic lurches owed to noisy economic measures. Its statutory medium-term policy objectives are at odds with its myopic compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its preferred output gap models are deeply flawed and troublingly unreliable, obfuscating uncertainty and masking policy bias.
Moreover, the groupthink seeks to fix interest rates and control foreign exchange rates simultaneously. Its forward guidance begets ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. It recasts poor economic results with a high-sounding slogan of secular stagnation. And it expresses grave concern about income inequality while refusing to acknowledge the effect of its policies on more consequential asset inequality.
All the while, the groupthink gathers adherents as its successes become harder to find. Too many in the guild tighten their grip when they should open their minds to new data sources, new data analytics, new economic models, and a new paradigm for policy.
With low and declining global economic growth rates, rising debt levels, weak productivity measures and stagnant incomes, we should be engaging in a more robust debate about the economy, and be willing to rethink the causes of low growth and the appropriate conduct of macroeconomic policy.
With high and rising global asset prices – aided and abetted by aggressive quantitative easing – we should subject the vaunted portfolio balance channel to stricter scrutiny. The guild is unwise to treat financial markets as some beast to be tamed, cub to be coddled, or market to be manipulated. Too many policymakers appear in thrall to financial markets, and financial markets are in thrall to policymakers, but only one of them will get the last word. Reconsidering the transmission mechanism of financial markets and the responsibility of policymakers is of a piece with a reform agenda.
With monetary policy (pre)dominance, we should be clearer about the lines that circumscribe central bank authority and central bank prudence, alike. We should reverse the trend that increasingly turns central banks into the general-purpose agencies of our governments.
A common view of the guild is that central bankers – non-partisan, high-minded experts – are particularly well equipped to make a wide range of governmental decisions. I praise the virtue of most in our profession, but disagree strongly with the prevailing ethos that elevates us to the level of wise central planners. The scale of central bank power is permissible in a democracy only when its scope is limited, and its accountability assured.
Let me test this proposition against the backdrop, however parochial, of the Federal Reserve and the American experience. In the United States, the central bank is suffering from a marked downturn in public support. The Fed’s unpopularity is not merely a function of the economic malaise, or some nuanced misunderstanding of quantitative easing by our citizenry. Allow me to posit another explanation: American citizens are rightly and instinctively concerned about the concentration of power. More so than in Europe, the aggregation of power in government is considered the gravest of threats. For that reason, America’s founders sought to limit the power of government and to disaggregate any necessary power among government authorities. An amateur’s perusal of the Federalist Papers is scarcely required to reach such a conclusion.
The Fed’s post-crisis activities, however wise or ill-considered, involve a large expansion of government power. The Fed exercised new control of the activities of the largest banks and effectively established a permissible rate of return on capital. The Fed expanded its authority over non-bank firms. The Fed directly purchased trillions of dollars of assets that would otherwise be held in private hands. And it took action with the ostensible purpose of managing financial asset prices, including bolstering the share prices of publicly held corporations.
We should take note of a simple, troubling fact: from the beginning of 2008 to the present, more than half of the increase in the value of S&P 500 occurred on the day of Federal Open Market Committee (FOMC) decisions.
Concentration of power in private hands also raises deep suspicions. The culture of American capitalism only survives in the public square and prevails over global competitors when market power is relatively diffuse, decentralised and, equally important, fleeting. An ethos of economic liberty and open competition are essential bulwarks against undue, quasi-permanent concentrations of private power.
The culture of capitalism in the United States is sometimes confused with a birthright. At other times, it’s trivialised in its importance to the success of the country. I take it as a defining, distinguishing element of the micro foundations of US macroeconomics – and one that can easily be lost.
The post-crisis era, including the adoption of the Dodd-Frank Act, purports to have reformed the system of banking and finance. But, the largest financial firms now fit a public utility model. They have grown in size and status alongside that of their principal regulator, the Federal Reserve. The biggest banks and biggest government agencies have achieved a mutual, albeit uneasy, understanding. This big-government, big-business collaboration is antithetical to the history of American style capitalism. Smaller, more dynamic financial firms are not just unable to compete; they are unable to get noticed.
When the embers of the financial crisis were still warm, Zingales (2009) forewarned of the coming challenge: ”The system that allocates finance allocates power and rents; if that system is not fair, there is little hope that the rest of the economy can be. And the potential for unfairness or abuse in the financial system is always great.” Our citizenry fears the concentrations of power at the Fed, and they fear an unholy alliance with big banks. If those reasonable fears are not addressed, the economic system will not just produce poorer economic outcomes.
As the dispenser of faults and favours, the Fed will be perceived as contributing to an unfair, inequitable economic system. Hence, the urgent need for a robust reform agenda. Most leaders in our guild judge that the Fed’s actions were necessary, wise and advantageous. Even if that were all true, the Fed finds itself in a precarious position. Congress will tag the Fed for its failures. And the public will assail the Fed for favouritism for its ostensible successes.
In the best of circumstances, the US economy accelerates to escape velocity. Higher growth would generate higher incomes and higher interest rates. And high asset prices might be explained by markedly improving fundamentals. If this upside scenario were to happen, the Fed might get the benefit of the doubt from our citizenry, and survive the cycle.
Neither the Fed’s latest projections nor the growing mass of experts proclaiming the inevitability of secular stagnation, however, anticipate such a benign outcome. And for reasons of policy error and opportunities squandered, my own judgment is that the economy is showing signs of late-cycle weakness.
Come the next recession, the Fed is, at present, poorly positioned to respond with force, efficacy and, most important, credibility. The Fed’s status will be called into serious question when it’s needed most. That America’s two prior experiments in central banking failed to sustain public support should serve as supporting evidence. The more recent and successful incarnation of an American central bank is the more remarkable development. The Fed’s recent centennial, however, should not be confused with its permanent acceptance in the American political system.
David Brooks describes an optimal position in any organisation. He applauds those who are “at the edge of the inside”. They are sufficiently respected members of the group, but they can resist its central seductions: “A person at the edge of the insider can see what’s good about the group and what’s good about rival groups… A person at the edge of the inside can be the strongest reformer. This person has the loyalty of a faithful insider, but the judgment of a critical outsider…[such] a person knows the standards and practices of an organization but [is] not imprisoned by them…the person on the edge of the inside is involved in constant change.” (Brooks (2016))
We are proud to be members of the economic policymaking community. We believe that our hard work and good judgment can help foster an environment that allows for flourishing of human welfare. However, in our guild as in any other, there is a dangerous tendency to advance by running with the herd. That temptation must be resisted. And a robust reform agenda adopted.
The BIS sits at the edge of the inside, and I hope it proves successful in helping to lead a reform agenda. Time is short, and the need is real.