Replacing Bernanke: who should be next head of the Federal Reserve?

Note: This article was written before the recent changes in candidacy. Nevertheless, it provides a valuable analysis of important factors to consider when evaluating candidates’ credentials.

On September 15 Lawrence Summers unexpectedly withdrew as a candidate for the next Federal Reserve chairman. His letter to Barack Obama stated, ‘I have reluctantly concluded that any possible confirmation process for me would be acrimonious and would not serve the interests of the Federal Reserve, the Administration, or ultimately, the interests of the nation’s ongoing economic recovery.’ Janet Yellen now faces competition from new candidate Donald Kohn or, some have speculated, an as-yet unnamed economist.

Whether you love or loathe him, there is no question that Ben Bernanke in his last eight years as chairman of the United States Federal Reserve has had his work cut out for him.

Compared with today, the United States economy was a very different beast in 2006 when Bernanke took over from Alan Greenspan as head of the U.S. reserve bank. The country had enjoyed almost 15 years of uninterrupted GDP growth and any notion of “financial crisis” existed only as speculation in the minds of a few, largely ignored, business commentators. Unemployment hovered around the 5% level (currently it is around 7.5%, and was as high as 10% in 2000). After 7 years at the helm of the world’s most important central bank, the time has come for Bernanke to be replaced, and the list of potential successors at President Obama’s disposal has been shortened down to two possibilities, Janet Yellen and Lawrence Summers.

Janet Yellen

The Fed’s current vice chairwoman Janet Yellen could be considered a natural choice, given her current role and career experience, but her appointment is facing fierce resistance from a number of key advisors to Obama. Assessment of her professional record reveals that in 2007 Yellen expressed concern over the subprime mortgage issues in the U.S. and directly linked the recent creation of mortgage-backed securities to a potential recession. Prior to this in 2005, she warned that a housing bubble may pose a serious threat to economic stability in the U.S. The field of economics is often criticised by outsiders who see those within it as seeming to rely on a crystal ball to influence their decisions, yet Yellen’s crystal ball appears more accurate than most, a testament to her level of caution mixed with rich experience in the area of monetary policy.

Janet Yellen has also gained the endorsement of Joseph Stiglitz, who has worked with both candidates yet identifies Yellen as the right person for the job in the U.S.’s current, fragile economic climate. Along with controlling interest rates and price levels, the Federal Reserve is tasked with the duty of reducing unemployment. Yellen has shown high regard for this role and has written a number of notable papers on labour economics and the social cost of long-term unemployment. Detractors argue that this is proof that she is “soft on inflation” and views a return to full employment as more important than ensuring price stability. The balance, and the difficulty in achieving it, is a major preoccupation of Yellen’s and she defends her position by stating that this is the “wise and humane” thing to do.

Lawrence Summers

Lawrence Summers’ career focus has primarily been growth of the economy – seemingly at any cost, at times. Summers supported deregulation of the banking industry in the 1990s whilst as treasury secretary and many cite his repeal of certain laws (specifically, the Glass-Steagall Act) limiting activities that banks are allowed to undertake as a fundamental trigger for the financial crisis. The abolition of laws which ensured separation of commercial banking and securities firms allowed for the creation of Citigroup, JP Morgan Chase and other ‘mega banks’ that subsequently needed a financial bail-outs during the crisis of 2008-2009. The emergence of the shadow banking sector was also the result of a belief in deregulation which Summers worked towards realising. Still, in a climate of steady GDP growth this may have seemed an appropriate measure to take. In his defence, he had the vocal support of President Clinton in working to reduce regulation of the financial sector. Summers is unashamedly laissez-faire and working at the U.S. treasury during the economic boom years of the mid to late 1990s gave him unopposed opportunity to implement his ideals through changes to regulatory controls in the banking sector.

Few people saw the global financial crisis approaching. With the power of retrospect this seems absurd, as does the idea that economists who warned of its possibility were ignored and labelled as heterodox. In 2005 Raghuram Rajan, the chief economist on the International Monetary Fund presented at a conference in Wyoming, warning that the current structure of the finance system laid the groundwork for a “full-blown financial crisis”. Summers, who was in the audience, vocally objected by calling Rajan a “luddite” and claiming that a return to stringent banking regulation would stymie productivity. Summers’ inability to heed warning about impending economic instability at that time is cause for concern. Whilst most with a connection to or affinity towards the financial sector support Mr Summers, Janet Yellen is seen as the economist’s choice. She has particular favour with academic economists who admire her ability to accurately predict complex economic trends. To these economists, Summers is perceived as arrogant and unable to consider views which contradict his own. Unfortunately, this character assessment seems to be close to the truth.
It has been stated that Obama’s choice between Lawrence Summers and Janet Yellen will be the most important economic decision he makes during his presidency. He has in front of him two candidates who are extremely experienced and highly qualified, yet display quite disparate ideas about the role of the Federal Reserve and where its priorities should lie. In the past decade, the Fed has been criticised for failing to properly deal with financial bubbles, reacting ineffectively to the financial crisis, and showing more regard for those who are already financially comfortable in America whilst ignoring the glaring issue of inequality within the country. It seems that if Obama wants to show real commitment to helping the increasingly disillusioned middle and lower classes, he would be best to choose Janet Yellen. As a bonus, this decision would make Yellen the first female head of the U.S. Federal Reserve, and serve as important inspiration for women in the currently male-dominated profession of economics.