Monday, June 6, 2011

When a Nobel Prize Isn't Enough [update]

The NY Times published a column by Peter Diamond, an Obama appointee to the Federal Reserve Board. In the column, he looks at the confirmation process and his perception of what are the qualities that are needed for the job.
LAST October, I won the Nobel Prize in economics for my work on unemployment and the labor market. But I am unqualified to serve on the board of the Federal Reserve — at least according to the Republican senators who have blocked my nomination. How can this be? 
The easy answer is to point to shortcomings in our confirmation process and to partisan polarization in Washington. The more troubling answer, though, points to a fundamental misunderstanding: a failure to recognize that analysis of unemployment is crucial to conducting monetary policy.
Actually, an equally likely answer is that by appointing another economist to the Federal Reserve Board, even one as talented as Mr. Diamond, the opportunity to appoint someone who is not an economist but has a different highly relevant background is lost.
.... The leading opponent to my appointment, Richard C. Shelby of Alabama, the ranking Republican on the committee, has questioned the relevance of my expertise. “Does Dr. Diamond have any experience in conducting monetary policy? No,” he said in March. “His academic work has been on pensions and labor market theory.” 
... Senator Shelby also questioned my qualifications, asking: “Does Dr. Diamond have any experience in crisis management? No.” In addition to setting monetary policy in light of a proper understanding of unemployment, the Fed is responsible for avoiding banking crises, not just trying to mop up afterward. 
Among the issues being debated now is how much we should increase capital requirements for banks. Selecting the proper size of the increase requires a balance between reducing the risk of a future crisis and ensuring the effective functioning of financial firms in ordinary times. My experience analyzing the properties of capital markets and how economic risks are and should be shared is directly relevant for designing policies to reduce the risk of future banking crises.
Selecting the proper size of capital requirements is a classic example of why the Federal Reserve Board does not need another economist as a governor.  Selecting the proper size of capital requirements seems to be the province of economists disconnected from how capital markets work.

As this blog has repeatedly stated, the first step in determining if a financial institution is solvent is to analyze its current asset and liability-level data to see if the market value of the assets exceeds the book value of the liabilities.  The reason this is the first step is that all market participants know that the book value of assets and equity is subject to manipulation [for example, regulators can manipulate both by granting forbearance on non-performing assets which in turn leads directly to an overstatement of book equity].

It was not lost on the capital markets that Lehman Brothers reported high capital ratios, but was insolvent.

What is sorely lacking from the current composition of the Federal Reserve Board is the presence of someone who understands how the global capital markets function, predicted the credit crisis and proposed a solution that would have mitigated the impact of the current crisis and reduced the probability of a future crisis.
... But we should all worry about how distorted the confirmation process has become, and how little understanding of monetary policy there is among some of those responsible for its Congressional oversight. We need to preserve the independence of the Fed from efforts to politicize monetary policy and to limit the Fed’s ability to regulate financial firms.
Having worked for the Federal Reserve, I agree with the need for preserving the independence of the Fed to set monetary policy.  However, your humble blogger believes that it is critically important to strip the Fed of its information monopoly on financial firms' current asset and liability-level data.

As this blog has discussed, taking away this monopoly ends the Fed's ability to create instability in the financial system and cause capital to be misallocated from its failures to properly assess risk in the banking system as it did leading up to the recent credit crisis.
Concern about the (seemingly low) current risk of future inflation should not erase concern about the large costs of continuing high unemployment. Concern about the distant risk of a genuine inability to handle our national debt should not erase concern about the risk to the economy from too much short-run fiscal tightening. 
To the public, the Washington debate is often about more versus less — in both spending and regulation. There is too little public awareness of the real consequences of some of these decisions. In reality, we need more spending on some programs and less spending on others, and we need more good regulations and fewer bad ones. 
Analytical expertise is needed to accomplish this, to make government more effective and efficient. Skilled analytical thinking should not be drowned out by mistaken, ideologically driven views that more is always better or less is always better. I had hoped to bring some of my own expertise and experience to the Fed. Now I hope someone else can.
[Update:  In an interview with the Boston Globe, Professor Diamond said that he was going to continue with his research into the underlying causes of the financial crisis so that he can weigh in on policy reforms.  In particular,
[Professor Diamond said] his time would be better spent analyzing the underlying causes of the financial crisis, including trying to answer questions about how much capital financial institutions should be required to hold in reserve.  He said he has been reading academic papers, economists' analyses, and a number of books by reporters about the details of the crisis.
Hopefully he will become a reader and contributor to this blog.

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