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Should Ben Bernanke Roll the Dice?

PH2009051702189.jpgReuters writer Felix Salmon writes up an idea I've never heard before, or even thought I'd hear:

[Nick Denton] has a theory about how we ended up in the midst of this huge economic crisis: he blames the hubris of central bankers in general and Alan Greenspan in particular — people who thought they had abolished the business cycle, and whose belief was shared by the business and finance worlds. It’s the theory of the Greenspan put, basically — we all reckoned that if things got really bad then the Fed would bail us all out, as they did in 1991-2 and then again in 2000-1. As a result people weren’t nearly as cautious as they might otherwise have been inclined to be, and dangers built up until they exploded.
How to fix this? Is it not the job of the Fed to try to minimize the severity of recessions? One alternative approach would be to consider it to be the job of the Fed to minimize the severity of the worst possible recession. What would happen if, for instance, rates were set using a random-number generator? Every FOMC meeting, some kind of virtual die would be rolled, moving rates up or down even if that was the opposite of “correct” monetary policy. The resulting uncertainty would force people to take a more defensive stance at all times, just in case rates went sharply upwards — even if the probability of such a rate hike was quite low.
Maybe monetary policy is a bit like optimal poker strategy: a certain percentage likelihood that you’ll do this, a certain percentage likelihood that you’ll do that. The Fed governors can then release a decision saying, essentially, “we plugged in a 10% chance of a 50bp cut, a 50% chance of a 25bp cut, a 25% chance of keeping rates steady, and a 15% chance of a 25bp raise, and rolled the electronic dice; guess what, we we ended up with the 25bp raise.”

"OK, so that’s probably a silly idea," Salmon says. "But some element of uncertainty is I think useful in monetary policy." He's right about the uncertainty bit. And I'd add another rationale for this idea that admittedly we shouldn't try: It further reduces the capacity for human error. Looking back, I think you have to conclude that Alan Greenspan wasn't as insulated from traditional incentives as some have argued. He liked being reappointed. He liked a happy Congress. He liked being a hero on Wall Street. And how insulated from intellectual trends can you be if your wife is Andrea Mitchell?

Salmon's idea takes the traditional independence of the Fed to another level. It admits that insulation from short-term electoral concerns is not the same as insulation from politics and popularity altogether. You may not be an elected official. But you're still human. And the fact that you're human -- that you demonstrate patterns and tendencies -- makes you somewhat predictable, and thus lowers an investor's perception of uncertainty, and thus his caution. Introducing computerized randomness that even you, the human, couldn't control would help counteract that.

Anyway, probably not a good policy proposal. But interesting to think about!

(Photo credit: AP photo.)

By Ezra Klein  |  May 22, 2009; 8:00 AM ET
Categories:  Federal Reserve , Financial Crisis , Solutions  
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Comments

Holy smokes! It is my understanding that predictability is generally good. Milton Friedman argued for conducting monetary policy by strict formula, one known to everybody.

It is true that uncertainty about what the Fed may do does give the Fed more control in the short term. But the control is useless if the action is random. When everybody knows rates will go down (or up) it is because pushing them in the opposite direction is known to be a bad idea. Thus, the Fed's control is over how much, but not which direction.

What Salmon may be worried about is moral hazard. With entities that are too big to fail, moral hazard is unavoidable.

The solution is to break up the "too big" things, to the extent possible. But the US economy itself cannot be broken up. Shocking it with random rate changes sounds like a dumb way to solve the unsolvable.

Posted by: TheIncidentalEconomist | May 22, 2009 8:45 AM | Report abuse

Why not just go back to the way it was in the old days when the Fed did not tell the public much of anything.

In particular, they did not release the target funds rate and the markets had to guess what the rate was.

Posted by: seerrees | May 22, 2009 8:53 AM | Report abuse

There is a difference between smoothing the business cycle for the society and holding the players harmless. This conflation - that somehow the bank executives have to be protected from any consequence to protect the banking system - is not useful. If the MotU folks were at risk they would be more careful...

Posted by: loki251 | May 22, 2009 9:49 AM | Report abuse

Just what we need - less thought and more gambling in the regulatory process that oversees the financial sector...

http://wardonwords.blogspot.com

Posted by: anne3 | May 22, 2009 10:23 AM | Report abuse

clearly, it was the feds that helped get us where we are. But i think the culprits are more fannie and freddie than the fed. Aren't they the ones that basically said they'd buy up any mortgages any company put out there?

Posted by: atlmom1234 | May 22, 2009 10:47 AM | Report abuse

I just got done reading an awesome book, "Do They Walk On Water," about the five most recent Fed chairmen, by Dr. Leonard Santow, a former Fed economist who then built a 30-year career as a Fed-watcher on a consultative basis for banks, including central banks in other countries.

Santow advocated something quite similar with regard to rates. Rather than setting a specific target for rates, he said the Fed should set a range of expectation. Instead of targeting a rate of 2.75, the fed could recommend a range of 2.5 to 3; or if it wanted to tighten, it could say 2.75 to 3.25, and if it wanted to free things up, it could recommend 2.25 to 2.75. The spread of the range could be wider if conditions warranted as well. He recommended this course for exactly the reasons cited in the post -- a modest amount of uncertainty is necessary to keep bankers focused.

He also criticized the Fed for using the overnight rate as the primary, and often only, tool to combat inflation and determine monetary policy. Further, he said that the Fed's research is lacking, leading to bad predictions. That has meant the Fed has responded too late, and often swung to hard with its corrective measures (usually rate changes only) when problems have developed.

If anyone's interested, "Do They Walk On Water" is available at Amazon.com. I wouldn't go so far as to call it a quick read, but it's highly accessible to the non-specialist with a very helpful glossary of terms that this non-economist appreciated.

Posted by: Rick00 | May 22, 2009 10:50 AM | Report abuse

Thanks Rick00 for the tip on the book. People may also want to check the writings of William Greider, whom I first read in his book on the Fed called Secrets of the Temple.

It studies the inner deliberations and actions of the Fed during the transition from Carter into the Reagan years, including the fight to kill inflation, and the Savings and Loan collapse. It tells a story of massive hardships forced year after year upon working people and businesses by the Fed's primary concern for its true constituency, the banks (and secondarily, bondholders).

And it's true as a commenter said above, that the Fed's judgment is pretty poor when it comes to its adjustments. A study of financial history shows that the Fed has actually been screwing up pretty consistently since its creation.

So there's one thing consistent about the Fed for you. I'd say on that basis the randomness is already built in.

Posted by: wapomadness | May 22, 2009 12:04 PM | Report abuse

atlmom1234: if the culprits are more Fannie and Freddie than the Fed, then the REAL culprit must be the banking sector. After all, Fannie and Freddie only made 15% of the bad loans, and with few exceptions they were *all* looking to buy mortgages with no questions asked.

Posted by: BigTunaTim | May 22, 2009 1:17 PM | Report abuse

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