Two new picks for the Fed?
By Scott Sumner
The NYT reports that President Trump is about to nominate two people for the Board of Governors:
The Trump administration has selected candidates for at least two of the three open positions on the Federal Reserve’s Board of Governors, according to people with direct knowledge of the decision.
The expected nominees include Randal K. Quarles, a Treasury Department official in the George W. Bush administration, and Marvin Goodfriend, a former Fed official who is now a professor of economics at Carnegie Mellon University.
Here is a WSJ piece written by Randal K. Quarles and Lawrence Goodman:
Focusing on bank size is politically appealing but diverts attention from the major source of systemic risk in the financial sector: a shortage of stable deposits. Banks are but one part of an interconnected financial sector providing over $40 trillion of credit to the economy, but that credit is supported by only about $11 trillion of bank deposits.
The gap must be closed largely with professionally managed, “wholesale” funding, such as short-term repurchase agreements. Wholesale funders are quick to pull their support by not rolling over short-term credit if they perceive those funds are at risk. This leads to periodic runs on financial institutions and the resulting demand for government intervention to prevent the failure of those institutions. . . .
Mr. Kashkari’s alternative proposal, promoted by academics including most vocally Stanford economist Anat Admati, is to ramp up bank capital to such a degree that the possibility of failure would be remote to nonexistent. But the consequence of a dramatic increase in bank capital is an increase in the cost of bank credit, meaning higher interest rates across the board. Those who favor much higher bank capital argue this would not happen, because investors would accept lower returns if the banks they put their money in were safer.
In the real world of capital markets, however, there are not enough natural investors in bank equity seeking utility-like returns. Institutions capitalized largely with debt would encounter similar constraints.
Given these structural facts, the job of the regulatory system is clear. First, facilitate the reallocation of capital during the inevitable periodic crises through orderly liquidation of failing or failed banks. Second, adopt a monetary policy rule, such as the Taylor rule, that would normalize interest rates and reduce the incentive for big banks and even smaller institutions to take dangerous risks.
This completely misses the point. The problem with our banking system is not that wholesale funding that is susceptible to bank runs—the Fed can provide almost unlimited liquidity in an emergency—the problem is excessive risk taking with FDIC-insured deposits. Quarles doesn’t seem to recognize the role of moral hazard in making the banking system less stable.
Even worse, he suggests that monetary policymakers should worry about excessive risk-taking when deciding where to set interest rates. If interest rates had been set according to the Taylor Rule during the recovery from the Great Recession, we’d still be in recession. Indeed the ECB made a similar mistake in 2011, raising rates during a weak recovery, and thus precipitating a double dip recession.
This part of the NYT story also raises some concerns:
At the Fed, Mr. Quarles would take the place of Daniel Tarullo, who led the Fed’s push to tighten financial regulation after the 2008 crisis, though he was never formally nominated to serve as the vice chairman for supervision.
Mr. Quarles is regarded as significantly more sympathetic than Mr. Tarullo to the industry’s concerns that regulation is overly restrictive, limiting economic growth.
Deregulation of banking would be a great idea, once we’ve solve the moral hazard problem. Unfortunately the American banking system doesn’t want to solve the moral hazard problem, because that would be “costly”. Yes, but wasn’t the 2008 financial crisis also sort of costly?
The good news is the pick of Marvin Goodfriend, who is a superb monetary economist and well qualified to serve on the board. Don’t pay attention to discussion of “doves” and “hawks”, which are pretty meaningless terms in a world of 2% inflation targets. Rather there are economists who take seriously the Fed’s responsibility to provide nominal stability, and those who do not. Goodfriend is most certainly in the former group.
PS. I’d expect Miles Kimball to be pleased about Goodfriend, who is (AFAIK) the first economist to propose negative IOR.
PPS. The NYT also has this interesting tidbit:
Mr. Quarles, 59, is a managing director at the Cynosure Group, a private equity firm based in Salt Lake City. His wife’s great-uncle is Marriner Eccles, the Fed’s chairman from 1934 to 1948 and the namesake of the Fed’s marble headquarters on the National Mall in Washington, where Mr. Quarles would have an office.
HT: Tyler Cowen