New Fed boss faces uphill battle on two fronts
WHO are the most powerful women in the world? German leader Angela Merkel is one. Christine Lagarde, head of the International Monetary Fund, is another.
Last week, an American woman joined those two Europeans as a wielder of global clout. Her name is Janet Yellen, and you will be hearing about her a lot for most of the rest of the decade – and very possibly into the 2020s.
That is because last Monday she became the most powerful central banker in the world, taking the reins at America's Federal Reserve Bank for a four-year term.
The 67-year-old, who was promoted from the number two position at the Fed, becomes the first woman ever to run one of the world's big central banks. That is quite an achievement in a very male-dominated world – at the European Central Bank, for instance, there is only one woman on the 25-person governing council and not a single woman leads a national central bank in the bloc.
Yellen, an academic economist by background, takes the reins at a time when the world of central banking is still at sea following the economic and financial earthquake caused by the crash of 2008.
Up to that point, central bankers had become a pretty smug lot. They credited themselves with slaying the inflation beast of the Seventies and Eighties and slapped themselves on the back for how well they had managed economies over the previous two decades.
But they could hardly have been more wrong. The period they and others called the Great Moderation (characterised by steady economic growth with only shallow recessions and low inflation) turned out to be anything but – the western financial system was not at all moderate in how it was allocating capital. While consumer price inflation was low, asset price inflation ran out of control as financial institutions levered up and misallocated credit on a massive scale.
The failure to see the dangers associated with historically unusual credit expansion and the belief that the financial system could do little wrong (exemplified by no one more than Alan Greenspan, who ran the Fed for two decades until 2006) amounted to an enormous intellectual failure – and one on which the economics community stands indicted. Worse still, despite everything, there has been far too little re-evaluation of thinking within the profession, something that is as evident in Ireland as elsewhere. A recent study by two Irish academic economists dismayingly found that the teaching of the subject in universities here has changed little over the past five years.
If most central bankers and economists didn't see the crisis coming and haven't changed their thinking much since, the scale of downturn left monetary policymakers with no option but to take radical action. Among other responses, the Fed launched a massive money-printing programme, buying $85bn worth of government bonds each month. This caused its balance sheet to quadruple in size to $4trn, or about 25 per cent of GDP.
It resorted to such unorthodox action in the hope that doing so would, via a fairly complicated series of knock-on effects of bond-buying, push down the many different rates of interest consumers and businesses pay, thereby stimulating an economy in its worst slump since the Great Depression.
Has "quantitative easing" (QE) worked? Indicative of how far into uncharted territory the Fed has gone is the very wide range of respectable opinion among economists even now on the short and long-run effects of QE. While those who argued that it was sure to trigger runaway consumer price inflation have very clearly been proved wrong, financial asset price inflation around the world has been fuelled by the massive injections of liquidity. That includes the spectacular recovery in the price of Irish government bonds and those of other peripheral countries. Proof that there is at least some connection came last May when yields spiked upwards in response to the Fed announcing that it intended to begin gradually buying fewer bonds (known as "tapering").
Even if these likely bubbles can be deflated without at least some crashes in some asset prices (something that looks increasingly unlikely as the cash that flooded into many developing economies thanks to rampant American money printing is now rapidly draining out again), it is very hard to prove how effective QE has been for the simple reason that it is impossible to know what state the US economy would be in if there had been no money printing.
All that said, everyone agrees that QE must stop once the economy has returned to durable growth. It does not take an economist to see that there is something inherently risky about one branch of government holding so much of another branch of government's debt.
It will be Yellen's most immediate task first to slow the rate of Fed balance sheet expansion by buying fewer bonds, and then reversing the most audacious experiment in modern central banking history by selling off its massive stock of government debt. While this sounds very technical (and it is), the implications of how this is done – particularly if it goes wrong – will affect every person on the planet. We in Ireland will be affected more than most owing to the fragile public debt position and our huge investment and trade ties with the US economy.
And as if the technocratic challenge facing Yellen was not enough, she also faces an uphill battle to stamp her authority on the institution she now runs against the backdrop of how she was appointed and a war of attrition with some of those to whom she is accountable – Republican Party politicians on Capitol Hill.
While nobody seriously doubts Yellen's qualifications for the job, her authority from day one will be impacted by the fact that she was not Barack Obama's first choice for the top job at the Fed. The US president had favoured his first treasury secretary, Larry Summers, despite concerns about his temperament and his role in financial sector liberalisation during the Clinton administration (the lightening of regulation on Wall Street in the Nineties contributed a lot to the mega bubble that inflated in the following decade).
More potentially troublesome is the low level of bipartisan support Yellen has in the US congress. When senators voted on her appointment last month, only 56 (of 100) gave her the thumbs up, the lowest level of support any incoming Fed chairman has ever had.
That reflects the polarisation of politics in Washington DC in general and, more specifically, the intense opposition to the Fed and what it does among some Republicans – there are even those on the libertarian wing of that party who want to shut down the Fed entirely, believing that it is an abomination of big government.
Yellen's initial four-year term will be enormously challenging given the intellectual uncertainties around so many monetary policy issues in the post-Lehman Brothers era and the ever more dysfunctional political scene in the US.
She will have to be a near miracle worker to win a second term in 2018. If she does not, she will become the first Fed chief to fail to secure reappointment since the Great Inflation of the Seventies.