The discussion of who will lead the Federal Reserve after Ben Bernanke has too often focused on politics and personality and too rarely on the challenges ahead. Will President Obama name Janet Yellen, who would be the first woman in the post, or Larry Summers, a member of his inner circle of economic advisors? Will it be the person often characterized as a soft-spoken consensus builder, or the one more often described as abrasive and arrogant, albeit brilliant?
Regardless of style, these are individuals of great substance. Yellen had a stellar academic career before becoming president of the San Francisco Federal Reserve Bank and being appointed to her current position, vice chair of the Federal Reserve System. Summers had a supremely influential academic career before becoming chief economist of the World Bank, U.S. secretary of the Treasury, and a consultant to Wall Street firms. No matter how you cut it, these two candidates are superstars.
Whoever it is, the next chairperson of the Federal Reserve faces two unprecedented challenges: getting monetary policy and financial regulation on track to sustain long-run prosperity. How the Fed resolves them will shape the global economy.
Since 2008, the Fed has purchased an extraordinary amount of assets from banks, about $2.5 trillion worth. If the banks had turned around and lent these funds to firms and households, the money supply would have skyrocketed, sending inflation soaring. Instead, the banks deposited most of it back with the Fed, waiting to lend them out in a more promising economy. Although inflation has stayed low and the Fed wants the banks to lend more to spur the recovery, it does not want to see this happen so quickly and massively that it fans inflation. That is the monetary policy challenge.
Can the Fed avoid inflation in the long run due to its massive purchase of securities without killing the recovery in the short run? To succeed, it must time things just right. If it reduces that buying, and perhaps even begins selling its securities to banks to reduce their enormous stores of liquidity (and thereby prevent inflation), this might turn the credit spigot off to promising firms and thwart the recovery. If it waits too long to reverse its purchases, this could lead to an inflationary spiral that harms growth. Just as it expanded its balance sheet to stem the repercussions of the crisis, the central bank now must address the resultant liquidity buildup. The next chairaEUR(TM)s difficult decisions will reverberate across the globe.
Fixing financial regulation and supervision is the institutionaEUR(TM)s second great challenge. The 2010 Dodd-Frank Act did not fix the problem. It did, however, trigger many studies and improvements in oversight. But it did not address the key issue: Can the Fed credibly establish that big banks are not aEURoetoo big to fail,aEUR? so that the banksaEUR(TM) stock- and bondholders discipline their approach to risk? Or can the Fed impose the necessary controls on big banks to keep them safe?
Credibility is key. The goal is to make debt and equity holders believe that their own investments are at risk, so theyaEUR(TM)ll force banks to behave prudently. Since the Fed effectively bailed out these investors during the crisis, the task is to change these expectations. Otherwise, the full responsibility for curtailing excessive risk taking falls on regulatory and supervisory authoritiesaEUR"a duty that history suggests they are unlikely to carry out successfully.
If the next Fed chair fails to either credibly address the too-big-to-fail policy distorting banksaEUR(TM) incentives or dramatically intensify constraints on bank investments, this will severely jeopardize U.S. financial stability.
Given the unprecedented monetary and regulatory challenges facing the Federal Reserve, the choice of the next chair is about much more than politics and style. Rather, it is about the stability and prosperity of the world economy. Fortunately, the president has at least two outstanding options.