Glenn Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Justin Muzinich is president of the international investment firm Muzinich & Co.
Since the financial crisis, there has been debate about the Federal Reserve’s appropriate role in preventing future crises. The emerging consensus is that the Fed’s “tool kit” should be expanded to better respond to financial excess. The opposing view holds that the Fed missed the buildup of risk before 2008 and that giving it more tools to manipulate capital, liquidity or lending margins would be dangerous.
The debate we should be having is how to increase the chances that the Fed will identify excesses, not about the powers it has to address them. Indeed, during a time of unprecedented monetary easing, a Fed focused on identifying excess would be less likely to inadvertently cause another bubble. Rather than narrow, technical reform, we should focus on institutional reform. Here, the Founders are good guides.
There was perhaps no human shortcoming they perceived as more dangerous to the political order than groupthink. They worried that masses of people, though ordinarily even-minded, could be so swept up in political movements that the liberty of minority groups might be threatened. James Madison wrote in Federalist No. 10: “A common passion or interest will be felt by a majority, and there is nothing to check the inducements to sacrifice the weaker party.”
This propensity to follow the herd is at the root of financial instability. In the most recent crisis, homeowners, investors and, notably, the Fed so succumbed to groupthink that we were almost unanimously blind to the risks of rising housing prices and bank leverage. So, how to create a Fed that guides its governors to be skeptical of crowd-induced financial excess?
To protect against passions of the crowd in the political arena, the Founders did two important things.
First, they established an independent Supreme Court. Justices receive lifetime appointments so they can make unpopular decisions without fearing for their jobs.
Second, the Founders explicitly made the court counter-majoritarian. The Bill of Rights protects certain rights even in the face of a passionate crowd that wishes to threaten them.
Like the judiciary, Fed governors benefit from political independence. They are appointed for 14-year terms. Unlike the court, however, the Fed is not charged with stopping a herd. The Fed’s mandate is to pursue price stability and maximum employment. When this mandate runs against the majority, the Fed can be counter-majoritarian, as when Paul Volcker raised interest rates in the face of inflation and widespread dissent.
Yet when financial excesses are building and not accompanied by inflation or unemployment, the Fed is unlikely to act. We need not accept this inaction. Fed governor Jeremy Stein, who has been writing on bubbles, said this summer that deflating a bubble would be consistent with the goal of promoting full employment because a bursting bubble affects employment.
In the abstract, Stein is right. The problem is that he almost surely expects too much of Fed governors. During a buildup of financial imbalances, most people view the excess as a rational function of some new development. In the early 2000s, the efficiency of the Internet justified unsustainable valuations that formed a bubble. Leading up to 2008, Alan Greenspan pointed to new credit derivatives as one reason risk would be controlled at banks. Simply including financial stability within a reconstruction of the Fed’s present mandate relies on Fed governors to discern excesses when other economic participants do not. But our Founders understood that organizations must be built to account for the fallibility of those in power, not assuming policymakers have greater wisdom than the country as a whole.
The simplest way to encourage Fed governors to be vigilant for excesses is to make maintaining financial stability explicitly part of the Fed’s mandate. This would have two effects. First, governors would be required to search, proactively, for imbalances. In essence, Fed officials would have to approach the economy from a different perspective than would most Americans. They would need to look more suspiciously at situations of potential overheating, just as Supreme Court justices have to look more suspiciously than most Americans do at attempts to infringe on minority rights. Changing this frame of reference would increase the likelihood that Fed governors would address financial excesses for the simple reason that people are more likely to be counter-majoritarian when told it is their job to be so. A different job description is a much more dependable solution than relying on those in power to be extraordinary.
An explicit mandate would also give the Fed greater cover to act. Currently, if the Fed believes a dangerous bubble is forming without inflation, action may be difficult. Governors would be challenged by some as exceeding their mandate. An explicit mandate would resolve this.
An explicit mandate would not mean a more powerful Fed. We are not advocating expanding the Fed’s tool kit and do not think the Fed should micromanage the economy. But a Fed focused on identifying excess could more actively use its bully pulpit to alert the public to perceived overheating, much as Stein did to some effect with the corporate bond market several months ago. If the excess becomes a systemic threat, the Fed should then address it through its (existing) powerful interest-rate levers.
No solution will eliminate financial excesses, but the country can reduce the probability of another crisis. The debate leading up to Dodd-Frank is a cautionary tale of what happens when there is an emphasis on individual rules without a discussion of framework and organizations. There may be options even better than changing the Fed’s mandate. But to find the best reforms, we must look beyond technical arguments and, as our Founders appreciated, to a proper understanding of human nature and the fallibility of those in power.