Congratulations on your nomination as chairman of the Federal Reserve. You must feel both daunted and delighted. The job is the pinnacle of the profession. But you will be succeeding a man who, in the words of two fellow academics -- Alan Binder and Ricardo Reis, Understanding the Greenspan Standard, Federal Reserve Bank of Kansas City Symposium 2005 -- "has a legitimate claim to being the greatest central banker who ever lived".
Robert Rubin, the former Treasury secretary, has remarked that a new chairman "should not only have great insight in reading economic data, strong macroeconomic understanding and a deep commitment to sound macroeconomic policy, but also a keen understanding of the psychology of markets and of business and a feel for the politics of Washington and of the global financial policy community, Putting all those together is a tall order, but Paul Volcker and Alan Greenspan show it can be done." [Luncheon Address, August 25, 2005]
Will the name of Ben Bernanke be added to this pantheon? I hope so. You remind me of the Bank of England's Mervyn King, another brilliant academic turned policymaker. But you have big hurdles to jump. So what must you now plan to do?
First, establish your independence from the administration and the Republicans. You will not be the chairman of the Fed for some of the people, but for all of them. One of Mr Greenspan's few errors was the support he gave to George W. Bush's tax cuts. As Fed chairman you should not make partisan incursions in areas outside your jurisdiction. You can (and should) argue for sound fiscal policy. You need not argue for spending cuts over tax increases (or the other way round).
Second, make Fed operations more collegial. This is, in any case, a necessity. You lack Mr Greenspan's experience, particularly of financial markets. You are also unlikely to possess his astonishing ability to extract information from the data, shown in his detection of the upsurge in productivity after 1995. You will have to rely more upon the abilities and intuition of others, instead.
Third, formalise the Fed's objectives and enhance its transparency. Already, under Mr Greenspan, the Fed has taken huge strides in this direction. Your writings suggest you will want to go further. The world has come to rely upon Mr Greenspan's judgement. Now it must rely on the Fed's ability to achieve explicit objectives. But such objectives do not mean that the Fed should rely on one model either of the economy or of how it reacts to events. Mr Greenspan has shown once again that good central banking is an art not engineering. That art must be informed by experience and intelligence. But it is still an art.
Fourth, do not believe for a moment that targeting inflation is all there is to being a successful Fed chairman.
In a recent paper you elaborate your view that a strong policy response to expected inflation is all the needed response to asset prices. [Should Central Banks Respond to Movements in Asset prices?] I am inclined to agree. Mr Greenspan does. Yet, since the Fed's dual mandate includes "maximum employment" with "stable prices", you need to respond swiftly to economic slowdowns. Fortunately, the flexibility of the US economy makes it relatively safe for the Fed to act in this way.
You will need to react strongly to low probability, high cost dangers. You have shown your willingness to do just this with your contributions, in 2002, to the analysis of the risks of deflation. As important, you will need to act as lender of last resort in times of financial panic. The Greenspan Fed was outstanding in its response to such crises, from the stock market crash of 1987 to the aftermath of the Russian default of August 1998 and the terrorist attack of September 2001. Similar tests will lie ahead, if not more so.
Why do I write "if not more so"? The answer is one you have identified in your writings on the "global savings glut". We share the view that the US has rightly been acting as spender and borrower of last resort in the world economy. In seeking internal balance -- or the maximum level of employment consistent with stable inflation -- the Fed has had to offset the contractionary impact of the net private and official capital inflows, now running at over 6.0 per cent of US gross domestic product. If the Fed had not taken this action, the world would have been at risk of a deep recession, if not of something even worse.
The willingness of US monetary and fiscal authorities to sustain demand in this way has been highly desirable. But, at some point, probably on your watch, there will be a correction. Most analyses suggest that this will require a very large depreciation of the real exchange rate, to shift output towards -- and domestic demand away from tradeable goods and services. Such a depreciation would require a big fall in the dollar and rise in domestic prices of tradeables. It would also, almost certainly, entail a jump in long-term interest rates.
Managing this adjustment, without either a deep US recession or an inflationary spiral, would test even an Alan Greenspan. The Fed will need to be both flexible and determined. It will probably have to endure unpopularity, as well. Mr Greenspan was lucky enough and clever enough to be popular for much of the time. But good central bankers must expect to be unpopular at least some of the time. This job is as much a test of character as of intelligence.
I do hope you are a success. This is partly because I want first-rate economists to show they can be effective in the real world. But it is mainly because failure would be devastating. For 25 years the world has enjoyed competent central banking. But the Fed bears responsibility for the two macroeconomic catastrophes of the 20th century -- the great Depression of the 1930s and the great inflation of the 1970s. Mismanagement of money threatens both economic and political stability. This is why the Fed is such an important institution. As a student of economic history, you understand this.
Back in 1987, an unnamed former Treasury official described the decision to drop Paul Volcker as a "riverboat gamble". Losing a great chairman is always a gamble. You must make it pay off, once again, I am sure it will.
FT Syndication Service