The Region

Interview with Frederic Mishkin

Federal Reserve governor and prominent macroeconomist, Frederic Mishkin, on bank supervision, moral hazard, financial globalization and other topics.

Gary H. Stern - President, 1985-2009

Published September 1, 2007  |  September 2007 issue

Interview conducted May 8, 2007.

Photo of Frederic Mishkin "Now I have a seat at the table," said Frederic Mishkin in conversation with Minneapolis Fed President Gary Stern. "Now I'm able to bring my academic experience to actual policymaking, and that is a very exciting enterprise for me."

Mishkin has studied monetary theory and policy for over 30 years—first as a doctoral student at the Massachusetts Institute of Technology, then as a professor at the universities of Chicago, Northwestern, Princeton and Columbia, and a research associate at the National Bureau of Economic Research. During this time, he's been at the forefront of research on bank supervision, financial globalization, inflation targets and other areas relating monetary policy to financial markets and the overall economy.

In September 2006, Mishkin was appointed to the Fed's Board of Governors, thereby gaining his "seat at the table": the opportunity—and responsibility—to shape monetary policy for the nation. Given his academic background, it's difficult to imagine anyone better prepared for the job, but as Region readers are well aware (2006 Annual Report) the transformation of economic theory into effective policy is not a simple task.

Fortunately, Mishkin has extensive experience at the edge of the table, so to speak, as the New York Fed's executive vice president and director of research, as an associate economist of the Fed's Federal Open Market Committee and as an academic consultant to the Board of Governors. He's had substantial international experience as well, serving as adviser or visiting scholar to central banks and ministries of finance from Europe to Asia and the Pacific.

Mishkin brings an almost tangible enthusiasm to the task of translating theory into policy. A conversation with him is a fast-paced journey through macro theory and international history, filled with anecdote, humor and a passion for the field. His zeal is contagious, fueled by the conviction that the work of economists can improve our well-being. "I believe that ideas really do matter," he says in the interview that follows. "I really believe that economics can make the world a better place."

BANK SUPERVISION

Stern: Let's begin with a fairly general question. One of the rationales offered in the past for why banks are special and thus have an important role to play in the financial system is the opaqueness of their assets, their complexities and so forth. But, today, with improvements in technology, reduction in cost of information and a growing variety of financial market innovations, banks may be less special and so play a less important role in the financial system. Does this mean that banking is less important?

Mishkin: Changes in the ability to process information more effectively have allowed a lot of lending to be moved out of the opaque into the more transparent. That has meant that the importance of banks in the overall financial system in terms of lending has decreased.

One of the huge impediments to the effective functioning of securities markets is that if there's not a lot of transparency in assets, then there cannot be a widespread set of holders. They're not going to buy an asset unless it's transparent because they can't do the individual monitoring themselves. In that context, if something has to be monitored very carefully internally, you have to have institutions making private opaque loans like banks.

With better information you now can make some assets much more transparent. For example, credit scoring enables loans that used to be very opaque to be far more transparent. Now you can actually provide the credit scores as part of the information about loans, and you can securitize those assets. What that means is that we actually have a more efficient financial system with a lot of assets moving out of bank balance sheets and out of private lending into public securities markets. That's a big positive for the economy. It means, however, that banks are not going to have the same dominance they used to have.

Nonetheless, banks are still very important in the system. If you look at bank lending as a percentage of total lending, it has declined, but it's still a very significant percentage of the total. So the importance of banks in terms of this private information that they collect with opaque assets is still there, but it's not as dominant as it used to be.

It should be mentioned that countries with lower quality of information, such as developing countries, are much more bank-dominated than the United States is. Although banks are not as dominant as they used to be in the United States, we still have to worry about the possibility that banks may get into trouble if they're no longer able to make these private loans and no longer able to collect the information that nobody else can collect. That is, if they can no longer perform their special role, the result would be a severe hit to the economy and to the efficiency of the capital markets. So the fact that we have an improvement in the overall financial system with banks playing a less dominant role doesn't mean that they and bank supervision are still not important.

TOO BIG TO FAIL

Stern: If banks are, overall, less important, does that mean that the too-big-to-fail [TBTF] issue has diminished in importance as well?

Mishkin: Well, there's one sense in which the overall financial system is a little bit more secure. This is the spare tire that Alan Greenspan used to talk about because securitization makes for a more extensive financial system so that—all else equal—if problems were to arise in the banking sector, they would not be quite as serious overall. But it nonetheless is true that if you have systemic problems in the banking system, it's still going to create serious damage to the economy.

Stern: So if we're concerned about too big to fail, what would you recommend we do about it?

Mishkin: I think actually that a lot of things we have done are moving us in the right direction. One thing the Federal Reserve System has done is to create an LCBO [large complex banking organization] program where we do special monitoring of the largest financial institutions, because there is a recognition that if one of these [institutions] fails, it can have much more systemic implications for the economy. We've also put into place elements to reduce secondary, knock-on effects when a large institution fails, making the failure less costly to the financial system. We clearly want to keep on moving in exactly that kind of direction.

Very important, too, is that prudential supervision now focuses on risk management in a forward-looking manner, which is extremely important in terms of these large institutions. So the way that I would view this is that the Federal Reserve is in fact aware of the TBTF problem, and it's trying to make steps in the right direction. Clearly one of the reasons you wrote your book was to help keep pushing this process forward.

We also want to make clear that there are cases where we think the systemic problems are not severe and therefore that institutions can fail. Again, that has a benefit in terms of making market discipline more powerful.

A second issue that is extremely important is the question of punishment. Even if there is some kind of support for an institution, the fact that managers, stockholders, bondholders in fact take a big "haircut" is actually very important in terms of creating the right incentives for people not to take on excessive risk. We've made progress in this regard.

In emerging-market countries, however, the TBTF problem is greatly amplified because it's not just depositors who are protected but bondholders and equity holders. That means the incentives for markets to punish people for taking on excessive risk are decreased very substantially.

We can get one reading of the market's view on TBTF from the rating agencies. The rating agencies have long considered the likelihood of bailouts when they rate banks. Ratings for certain banks benefit significantly from the expectation that the home-country government will step in and provide support to prevent failure. The rating agencies rank the United States as a low-support country overall. That doesn't mean that there isn't an issue of potential support for the largest banks, and in fact the rating agencies indicate that there is. But we have made progress, particularly since the FDICIA [Federal Deposit Insurance Corporation Improvement Act] made it clear that we are going to make sure that people actually take haircuts. Even if institutions are so large that there is a perception that the government will not stand by completely and let them fail, there's still an issue about what kind of punishment is going to be meted out on the people who actually caused the problems in the first place. So there is a gradation here, and on that basis the United States has made progress. And, in fact, it's made progress relative to many other countries in the world.

HEALTH OF THE BANKING SYSTEM

Stern: You touched earlier on the fact that banks are less important overall in the financial system than they were, and that reminded me that one of the explanations, or at least a partial explanation, for the Great Depression was that bank credit dried up and, in particular, small and middle-size firms couldn’t get financed. I take it you would assess that risk as somewhat lower today because the range of alternatives has increased.

Mishkin: I would, but it would still be a problem. If we were to end up killing a lot of banks, we would still have a huge hit to the economy. So, for example, we’ve seen financial crises in emerging market countries, and because they’re so bank-dominated, it freezes up the whole financial system. Well, in our case, if we have a banking crisis, it would not freeze up the whole financial system, but it would close up a good part of the system. And that would mean very severe costs for many, many people. That’s one of the reasons why, as bank regulators and supervisors, we want to make sure that the financial system is safe and sound.

We’ve seen cases where this makes a difference. Let me give you an example. Leading up to the last recession that we had in 2001, we had a lot of very nasty shocks to the economy. We had the collapse of the stock market; we had September 11th; we had the Enron affair, which basically indicated that information in financial markets was not as good as people thought. All of those were very contractionary, yet we had a very mild recession. I was teaching at the time, and while I’m not an economic forecaster, this was one of the times I felt really good about my prognostications on the economy. Students were asking about the recession, and I said to them, “This is going to be a mild recession because the banks are in such good shape.” And I got it right. So having the banking system work well is an extremely important part of keeping the economy stable. This is one of the reasons we do have to worry about too big to fail. I don’t think it’s quite as serious a problem as you make out in your book, but nonetheless I feel that it is a problem we do have to worry about.

FINANCIAL GLOBALIZATION

Stern: Let's shift gears, because you talked a little bit earlier about foreign economies and some of the hindrances to their success. I've been struck for a while that although almost all professional economists and many economic policymakers agree about the benefits of trading goods and services for all countries that participate voluntarily, that same consensus doesn't seem to hold for financial globalization or integration. Why is that, in your view?

Mishkin: This is an area where I've done a lot of research in recent years and is of great interest to me. And it started really because I went to the Federal Reserve Bank of New York in 1994. Previously, I'd done all my work on the domestic U.S. economy; I hadn't really thought very much about emerging-market countries. And then, of course, the Mexican crisis occurred, and the president of the Bank kept asking me questions. I didn't have answers, so I figured I'd better think about it.

The reason financial globalization is much more controversial, I think, is severalfold. One is that economists have always been trained in terms of thinking about comparative advantage and the benefits of trade. It's one of the first things you learn in your Economics 101 course and is an idea that has been around for over a hundred years. On the other hand, the new literature on the importance of finance to economic growth has been around only 15 years or so. It's remarkable that so many people, including economists, don't understand how important finance is to economic growth. For example, the best selling undergraduate textbook in economic growth, which I actually think is a terrific book, doesn't discuss the link between financial and economic development. That to me is remarkable.

We have even had high-level government officials who've said, "Why is finance important? All these finance people get paid huge amounts of money and what do they do? They don't make anything real." Many people just don't understand the importance of finance. And yet when you start looking at why some countries are rich and others aren't, one of the things you realize is that finance is crucial. A good financial system allocates capital to its most productive uses, and this turns out to be absolutely essential to economic development.

When we look at developing countries, one thing we have learned is that throwing money at a country doesn't work. The most extreme example, of course, is that many countries that have oil wealth actually have not developed well. In fact, frequently countries with fewer resources are the ones that have done much better. Why is that the case? Because if you have money just pouring in, the government may not feel that it needs to actually develop institutions to make the capital markets work well. The government doesn't have trouble getting tax revenue, and it doesn't need to set up institutions that make it easy for people to do business. So we find that just throwing a lot of money at a country doesn't actually help.

What really is important to a country's growing rich is TFP [total factor productivity] growth. The countries that have done well are the ones that are able to allocate capital to productive uses. That increases productivity, and that's the source of growth in these countries. And so the question is, How do you get them to make that happen? Well, one view is that we can just open our capital markets to the world. In textbook versions that has the advantage of lowering the cost of capital by having it coming from outside. And it will be beneficial if you have the right institutional framework in place. But if the right framework isn't in place, opening up your capital markets can lead to a financial crisis and blow up your economy.

The benefits of financial globalization are clear cut. It lowers the cost of capital and therefore makes it easier to finance. It also increases competition in the banking system, which encourages domestic financial institutions to support institutional reform, because now that they have foreigners competing with them, they will lose business unless their country has the institutional framework that allows them to make good loans. So there are those benefits. But there's also the potential cost of opening up in the wrong way. So, does globalizing financially help a country? The evidence is mixed.

We take for granted the ease with which our institutions work. For example, at one point, because of my textbook, I decided to open a corporation called Mishkin Economics, Inc. It turned out it wasn't a great idea, so I eventually got rid of it. But it only took me an hour and $300 to set it up initially. But if you want to open up a small business in many developing countries, it's an extremely costly and difficult enterprise that only rich people can do.

If you ask yourself, Why does this happen? Why are legal businesses so hard to set up? Why is there corruption in these countries? Why aren't there enough judges and a good legal system to enforce contracts? The answer is that the elites in these countries do better if there's no competition. How do you keep competition from occurring? Make sure that you don't have an institutional framework that allows financial systems to allocate capital to your competitors. So financial repression—the fact that the financial system is not developing—is something that elites have frequently promoted. But then at some point they may have to open up the economy. The same elites may try to do that in a way that's very attractive to themselves, but which hugely increases risk-taking that can lead to a financial crisis and government bailouts that cost the public dearly. In my research, I have described how financial crises evolved in places such as Mexico in 1994 and in East Asia, especially South Korea in 1997.

The issue here is not, Is financial globalization inherently a good or a bad thing? If it's done right, it's extremely important to success in these countries. But if you do it wrong, it's going to create huge problems. So the issue is, How do you get it right? And one of the big problems in many of these countries is the too-big-to-fail problem. TBTF is much more pernicious than it is in advanced countries like the United States.

INTERNATIONAL CAPITAL FLOWS

Stern: If you look at capital flows around the world in the last decade or more, despite what you might predict, capital seems to flow more toward the developed economies. And what flows into the developing economies seems to be small, at least compared to what some people predicted and hoped for. Are these infrastructure flaws a factor in that?

Mishkin: Absolutely. We're actually in an extraordinary period where money is flowing uphill. If you think about it, you should be able to make a lot of money by taking a factory that you could build in Europe or the United States and, instead of putting it in a country with high-cost labor, you could put it in a developing country where labor costs 10 cents on the dollar. So the standard view is that the returns should be very high in developing countries and much lower in rich countries. We should then expect to see large amounts of capital flow from rich to poor countries. We don't. This phenomenon is called the Lucas paradox because Bob Lucas first brought attention to it. But when Lucas raised this paradox in 1990, he was just commenting on how little capital flows from rich to poor countries.

What's even more extraordinary since Lucas wrote his paper is that the flow has actually gone the other way. Why is this happening? Because some of these countries with very high savings rates—China, for example—know that if they put the money into their economy, it will be misallocated. A much better deal is for them to take the money, send it to a rich country like the United States and get very low interest rates on it. So they're basically sending us cheap goods and helping us finance their purchase with extremely low interest rates. But they're still getting a better deal than putting it into their own financial system, because it's so undeveloped.

Is it a bad situation if this money is flowing to rich countries? It's a plus from the standpoint of where developing countries currently are. But it's a bad situation because they haven't developed the institutional framework to allow them to allocate capital well. For them to be successful and to remove some of these global economic imbalances, the solution is for them to develop their financial systems, making it more advantageous to keep their funds in country. That way they can earn higher returns in their country and develop. Also, it will mean that these huge capital flows that are coming to the rich countries and the coincident current account deficits that we have in countries like the United States will no longer occur.

Stern: Let me take that a step further. This would suggest a fair amount of risk aversion on the part of global investors—that they're willing to give up a fair amount of potential return for the safety of investing in, say, dollar- or euro-denominated assets. On the other hand, if you look at quality spreads in financial markets or even between developing- and developed-country bonds, you would often reach the opposite conclusion, that you're not very well-compensated for taking risks. How do you reconcile that discrepancy?

Mishkin: The reason you're unwilling to invest more in these countries is that they don't have the absorptive capacity to allocate capital well. For example, in many of these countries, if you put money in, it won't be put to good use. Underdevelopment of their property rights and legal systems, high levels of corruption—all these things are impediments to financial development. These are exactly the reasons that returns are not very high.

So in a sense, the answer to the Lucas paradox, the reason money is not flowing from rich to poor countries is that returns are not as high as they should be in these poor countries because of poor institutional development. If the world had good markets in all places, then money would be flowing from rich to poor. But when the markets are very undeveloped in poor countries and developed in rich countries, then the returns are not high in the poor countries. There are actually better returns in the rich countries, and money's going to flow uphill. That, of course, is not a great situation for world welfare because it is one of the reasons that these countries stay poor. It's not in our interest that these countries stay poor.

FINANCIAL CONTAGION

Stern: Let me explore one other aspect of this. You were talking about Korea back in 1997. That brought to mind the contagion of financial problems, especially among developing countries. And 1997, 1998 was illustrative of that. This is another concern people raise about global financial integration: You might be enhancing vulnerability by allowing global financial integration to progress.

Mishkin: There is one sense in which you are enhancing vulnerability. If flows of capital can move very quickly from one place to another—they can move in and they can move out quickly—in that sense you can have some vulnerability. But there are two views of contagions; people typically emphasize just one and not the other. One view is that if something happens at the center of the world financial system, in terms of its views about a particular asset class, then investors will lump a set of emerging-market countries together and might pull out money from many of them at the same time; in this way contagion can actually come from the advanced countries.

However, another very important view that I think is not emphasized enough is that contagion occurs when one country gets into trouble and investors start to look at whether other countries are like it in terms of bad policies. When the Asian crisis started, for example, it started with Thailand. Government policies to liberalize the capital account along with lack of appropriate supervision and regulation resulted in excessive borrowing from abroad and risky lending by Thailand's finance companies. When the crisis erupted after the failure of Thailand's largest finance company, it exposed the underlying weaknesses of financial institutions' balance sheets. Nonperforming loans were so large that attempts by the government to bail them out and defend its currency at the same time failed, leading to a currency and financial crisis in Thailand.

At that point investors started to say, Well, what other countries might be like Thailand? There was new information from the problems in Thailand that suggested that some East Asian countries that we thought couldn't have any problems actually may have had some deep-seated problems. So investors took a look at South Korea. Has South Korea got a problem? Oh, yeah, Korea has a similar problem. Indonesia, oh, my God, even worse problems in Indonesia.

In addition, there were speculative attacks on Taiwan, Hong Kong and Singapore. Those countries had better bank supervision, and investors soon realized that the financial system problems that existed in Korea, Indonesia and Thailand were not a problem in this other set of East Asian countries. The speculative attacks stopped, and they didn't have financial crises. So when you look at this issue of contagion, one of the issues is that contagions can occur because there are bad policies in a set of countries, and once this fact gets revealed, you start looking elsewhere for the same bad policies.

It's no different in the United States. When Enron went belly up, people started to realize that maybe there were other companies that weren't providing reliable information. So the view here is that if there are similar bad policies in a number of countries or companies, there can be contagion when that fact is revealed.

The opposite is true too. For example, the crisis in Argentina in late 2001 and early 2002 did not spread elsewhere—with the exception of Uruguay, which was closely tied to the Argentine economy—because it was clear Argentina had been on a path of bad policies that were not being reproduced in other countries in Latin America. As a result, what happened to Argentina pretty much stayed in Argentina.

So, to sum up, although there is an element of truth in the view that these financial crises occur because of what happens in advanced countries, I think the ultimate responsibility when things go really wrong resides in the countries that have blown up. That is very important because it tells you that they have to improve their own policies with regard to how to get to a financial system that is well-supervised and well-regulated, just as we have in advanced countries. And how do you deal with the too-big-to-fail issue? As I said, TBTF is even a more severe problem in these countries because their banks are more dominant in the economy and the information flows are not as good. But it's not just too big to fail, it's also that many financial institutions are too politically connected to fail. The issues that we worry about here in the United States are actually a whole order of magnitude worse in these countries and emerging-market countries, and this is why it's very important to focus on encouraging them to get their fundamentals right.

DUAL MANDATES AND THE GREAT MODERATION

Stern: Unlike a number of other central banks around the world, the Federal Reserve has a very explicit dual mandate, and frequently it's portrayed as if there's a conflict between the objectives of price stability and maximum employment. What's your view of that?

Mishkin: When any monetary economist writes down how a central bank should operate, we write down that it should have a dual mandate. I've done it in my papers, as have almost all monetary economists, because we always write down that a central bank should try to minimize not just fluctuations in the inflation gap [actual minus the optimal level of inflation] but also fluctuations in the output gap [actual minus potential output]. But then you have to ask yourself, What's the best way to minimize this loss function that includes both output gaps and inflation gaps?

Well, one thing that we've learned over the years is how important it is to have a strong nominal anchor in terms of not only producing less fluctuation in inflation but also less fluctuation in output gaps. By strong nominal anchor, I don't necessarily mean a nominal inflation target or objective, more broadly I mean a concerted effort by the central bank to control—and also make it clear that it will control—inflation. By doing so, the bank anchors both inflation and inflation expectations. That's important because it gets you a much more efficient monetary policy.

It is possible to think about the dual mandate as a trade-off between inflation gap fluctuations and output gap fluctuations. In fact this is described by the Taylor curve, a standard indifference curve that shows the trade-off between these two things. And we've found that if inflation expectations and inflation are not anchored, which was the situation we had in most advanced countries, including the United States, in the 1970s and early 1980s, then you're in the interior of the curve—you're in an inefficient position in terms of monetary
policy.

It's remarkable that central banks throughout the world, including the U.S., have now focused much more on promoting a strong nominal anchor. If you're focused on price stability as a major concern, there is the worry that maybe you're going to focus less on the output fluctuation part of the dual mandate, and the result will be that you might get lower volatility of inflation, but you'll get more volatility in terms of output fluctuation.

But that's not what's happened. Throughout the world we're seeing much lower inflation fluctuations: In fact, nobody, myself included, would have predicted 15 or 20 years ago that so many countries in the world would have such low and very stable inflation. But what's even more remarkable is that we actually have more stable output fluctuations.

Stern: Is that your explanation for the Great Moderation [the widespread decline of macroeconomic volatility in recent decades]?

Mishkin: It's one of the explanations. I think there are a lot of other things that may be going on. I take the view that monetary policy becoming more efficient is one of the important sources of the Great Moderation. But I also think that, as my mother always said, "It's better to be lucky than good." Although I always like to modify her dictum to, "It's better to be lucky and good." And I think that's also part of the explanation. Monetary policy in the United States especially, but also elsewhere in the world, has been much better than it was before. That's part of the Great Moderation. But we've also been lucky. There seem to be fewer shocks to the economy than we've had in previous periods.

Monetary policy is not a unicausal explanation for the Great Moderation, but I think it's actually a very important part of the picture. And this is one of the great monetary policy successes. As I said, it's an extraordinary period in terms of where we are relative to 15 to 20 years ago. In most cases central banks did not have somebody like "the maestro," Alan Greenspan, yet they also id very well.

Indeed, as an economist I believe that ideas really do matter. I am proud as an economist that our better understanding of monetary theory has improved monetary policy and has actually contributed to economic world welfare. Indeed, I didn't become an economist because I just wanted to get tenure at a good university. I really believe that economics can make the world a better place.

PERFORMANCE OF THE U.S. ECONOMY

Stern: Let me ask you a question about the U.S. economy. Since the early 1990s, the United States has done, I would say, appreciably better economically than most of the other advanced industrial countries. What's your explanation for that?

Mishkin: I think it gets back to this issue of finance. The United States has been blessed with a financial system that has in many ways worked better than other countries' financial systems. The common law legal system that we inherited from the British is very good at dealing with financial contracts. Countries that have a common law system have bigger, better-functioning securities markets because the quality of enforcement and the improvement of information have actually made the securities market more important.

That helped us in terms of the so-called new economy. We have a better venture capital system than most other countries have. That has allowed nerdy guys with great ideas to get access to capital. Our legal system has meant that venture capitalists are willing to give money to these nerdy guys because of two things: First, venture capitalists can put in governance to make sure that if a guy has a good idea but doesn't know how to manage, venture capitalists can put in a CEO or put people on the board of directors to make sure their money is used properly.

Second, we have a very deep securities market, so when the company does well, venture capitalists can issue an IPO [initial public offering] and basically cash out. So our financial system is a tremendous advantage for the U.S. economy; it has allowed us to be more dynamic than other countries. We have an extremely competitive economy, and as an economist, I think competition is key to having an economy that does well.

You can see this in our university system, which I have seen firsthand as a professor over the past 30 years. The American university system is the most dominant in the world. Why? Because it's not this ivory tower that everybody pictures; it's actually very dog-eat-dog. Competition in the U.S. university system is what drives the system, and it has made it one of the dominant export sectors that we have in the United States.

And, in general, we are a very, very dynamic economy. The financial system has helped in that regard. Monetary policy has also helped in the following sense: Monetary policy did not create the new economy, but if monetary policy keeps the economy on an even keel and keeps inflation low, that also contributes to an environment that enables the new economy to blossom.

IS THE BUSINESS CYCLE DEAD?

Stern: You brought up the term new economy. That term became popular sometime in the second half of the 1990s, and I always took it to mean that productivity was on a new and more-favorable path. I think some people took it to mean that the business cycle was now dead, and we would see sustained economic growth forever. I'd like to get your take on that.

Mishkin: My view is that there are a few things we're always going to have:  There's death, there's taxes and there's the business cycle. Good policy can certainly minimize the propagation of shocks. But there are always going to be surprises to the economy. And, as I said, if you look at the most recent recession, there were several surprises. Who could have anticipated September 11? A terrible thing. The Enron episode. Who could have anticipated it? You could have energy shocks. You could have a terrorist incident. You can have a war. So there are always shocks to the economy. You can't always anticipate those shocks, and those shocks frequently produce business cycle movements.

Good policy, however, makes it less likely that shocks will be propagated. One of the reasons I think monetary policy has contributed to the Great Moderation is that monetary policy has propagated adverse shocks much less than it did in the past. Think about oil price shocks in the '70s. There we had monetary policy that did not have a strong nominal anchor. Inflation and inflation expectations were not anchored. In that context, when we had an oil price shock, people thought, "Gee, inflation's going to spin out of control. This means that interest rates are going to rise for two reasons. One, higher expected inflation drives interest rates up; and two, the central bank, in order to restore credibility, has to raise interest rates." What was the result of that? Not only high and variable inflation, but also much larger business cycle swings. We had a very severe recession in 1974-75, and we also had very severe recessions in 1980 and 1981-82.

It's a huge benefit to have credible monetary policy with a strong nominal anchor. Think of the recent very strong energy price shock. It led to a temporary rise in inflation, but only temporary, because the central bank had convinced people with its past, present and continuing actions that it was not going to let inflation get out of control. The Fed would do what it had to do.

This is a very important part of central banking. It's not just what you do now but also people's expectations of what you're going to do in the future. It's extremely important that people understand that the Federal Reserve is monitoring inflation very carefully and that we will make sure that if inflation starts to rise, we will do something about it. If inflation doesn't moderate to levels that we think are appropriate, or if inflation falls too low so that we have the potential for deflation-we will do the right things about it. That creates exactly this kind of stabilization of not only inflation but also of output fluctuations.

CENTRAL BANK MANDATES

Stern: The European Central Bank arguably doesn't have a dual mandate. At the end of the day, do you think that's going to matter to economic performance in Europe?

Mishkin: The Congress has given us a dual mandate; that is, the Federal Reserve seeks to promote the two equal objectives of maximum employment and price stability, so that's what we have to execute. Even if the Congress hadn't given us such a mandate, the basic structure of the dual mandate is what I would feel is appropriate, and so we should be aiming to pursue such an objective anyway.

A hierarchical mandate says that first we focus on price stability and if we're successful then we'll focus on other concerns, particularly output fluctuations. If you interpret a hierarchical mandate as focusing on price stability in the long run, making sure that long-run inflation expectations are grounded—and we've seen tremendous success not just in the United States but in Europe in terms of grounding inflation expectations—then the dual mandate and the hierarchical mandate are identical.

Some people have said to me that the dual mandate versus hierarchical mandate dichotomy is a red herring. I don't agree, because I think it is an important issue in communications strategy. It's important to make it clear that you care about output fluctuations, but you're going to look at this from a long-run context and never take your eye off the inflation ball. That's the right way to do the dual mandate.

Similarly, with the hierarchical mandate, you should not be an "inflation-nutter," as Bank of England Governor Mervyn King has expressed it. That is, you shouldn't be focused solely on inflation control. You must also worry about the fact that if you act too quickly to get inflation down to your long-run objective, you might have excessive, unnecessary fluctuations in output. So I think modern monetary theory, in writing down a hierarchical mandate or a dual mandate, will write exactly the same loss function, exactly the same kind of optimization theory for a central bank.

In some contexts it may be better to discuss monetary policy in terms of the hierarchical mandate. I think the reason it's been done in Europe is because they have had so much worse monetary policy in many countries. To make sure that people understood that they would really control inflation, they had to do it by talking about it as a hierarchical mandate. While in the United States, which has actually never had a hyperinflation and has had much more successful monetary policy, it's more appropriate to talk about it in terms of a dual mandate.

Stern: Maybe we're less prone to the time consistency problem.

Mishkin: Exactly. The time consistency problem is a central issue in thinking about how to do central banking—and also in terms of bank supervision. It's really the same issue. You want to make sure that you're doing the right thing in the long run and not pursuing short-run strategies that end up with very bad long-run outcomes. It's extremely important—in order to deal with the time consistency problem—to say that in the long run, price stability is absolutely going to happen. And that means that you can actually exercise "constrained discretion," the phrase Ben Bernanke and I coined in our earlier work. The idea is that you do need some discretion to deal with the shocks in the economy, but you want to make sure that that discretion is constrained in the sense that you don't ever get into the time consistency problem of allowing the nominal anchor to be weakened. And that's really what the whole concept of constrained discretion is.

This also relates to bank supervision. In my research on this, I felt that the distinction between rules and discretion is too stark. We know with discretion you can get into the time consistency problem. The way I think about this is, suppose it's New Year's Eve and I say I'm going to go on a diet. Then, of course, at the next meal I see a beautiful piece of cake and I can't resist: I've got to eat it. But I say to myself, It's no problem because I won't eat it tomorrow. Well, the next day comes and I can't resist again and keep on eating that cake, and I end up being obese. So we know that one of the ways to solve that problem is to set yourself a rule: Thou shalt not eat cake.

The problem is that there are always going to be unforeseen circumstances where actually you may need to use discretion. It's something you couldn't predict beforehand. If you have a rigid rule, you may find the rule no longer applies, and if you stick to it you will get very bad outcomes.

In terms of bank supervision, in my initial work on this I looked at prompt corrective action strategies. Originally, the idea was that PCA should be a hard and fast rule. No matter what, it has to be done. When you hit particular triggers, you automatically have to do X, Y and Z. What the Congress did in the FDICIA legislation of 1991, which I thought was very smart, was to say, "Look, there is a norm, and that's what should usually be done. But there could be unforeseen circumstances where we need to allow for deviation from that rule." They did this by saying that there would be a presumption that the rule should be followed but did give the supervisory agencies some discretion to deviate from the rule.

Why then aren't we back in a time inconsistency view of the world? Because Congress constrained the discretion. How? Through transparency. FDICIA requires a mandatory review of any bank failure that imposes a cost on the FDIC. The result report on what actions the supervisory agencies took must then be made available to any member of Congress and to the general public upon request, and the Government Accountability Office must do an annual review of these reports. Opening up the actions of the supervisors to public scrutiny will make it far more likely that they will follow PCA unless they have a very good reason for doing otherwise.

So it's exactly this constrained discretion kind of idea. Constrained discretion says that for most cases you want to operate according to a rule. On the other hand, there are going to be circumstances we can't predict where you may have to deviate from the rule. But in that case we don't want to let you do whatever you want. We want to have some check-and-balance on the system. In fact, my view is that this is also what our Constitution is all about. Having an institutional framework to deal with some of these time consistency problems is something that we see in the political sphere as well.

SYSTEMIC RISK EXCEPTIONS

Stern: I would agree that having some discretion to deviate from a rule, such as the systemic risk exception to using least-cost resolution of a banking failure, is probably a good idea. But as you know, my Too Big to Fail coauthor and I are more concerned than you are that that exception will be invoked in circumstances where it’s not really appropriate.

Mishkin: Right. We have a disagreement. Where we disagree on this is that I think transparency actually has a huge benefit in this regard. And so I view FDICIA as having been more effective than you and Ron Feldman do, as I indicated in my review essay on your book. The reason I take this view is that when you actually expose things to the light of day, then you change behavior. And there is a big difference in terms of the way things were done before, where of course there could always be an agreement between the three agencies, but it was not as transparent.

Stern: And there was, in the Continental Illinois National Bank and Trust Company case in 1984, for instance.

Mishkin: Yes, there was a bailout in the Continental case, but there was no transparency about how the bailout would be done. Now everybody’s on notice that a rule has been put in place, that everybody expects you to follow that rule under normal circumstances, and if you deviate from it you’d better explain why. Now, this kind of transparency may not solve the problem 100 percent, and this is always the tension about constrained discretion. What’s the optimal level of constraint? You’re always afraid, when you say there’s discretion, that when push comes to shove, the constraint won’t be there. My view is that one of the things that helps this process tremendously is the kind of transparency that actually would produce a constraint on behavior. And, in fact, what we’ve seen is really a sea change in the way bank supervisors and regulators operate from pre-1991 to post-1991.

The element of transparency also comes up in the implementation of prompt corrective action, where there is a presumption that the rule will be followed, but prudential supervisors can deviate from the rule. But whenever there’s a bank failure, whatever the supervisors have done has to be reported publicly, making it hard for them to deviate from the rule. They don’t have to pursue prompt corrective action exactly, but clearly the presumption is there, and if they don’t, they’d better explain themselves. They have to send a report to the GAO explaining why they didn’t do what the standard rule told them they were supposed to do. The result we’ve seen is prompt corrective action has been working very well.

Stern: Thank you very much.

—May 8, 2007

More About Frederic S. Mishkin

At the Federal Reserve

Sworn in as a member of the Federal Reserve's Board of Governors on Sept. 5, 2006, to fill an unexpired term ending Jan. 31, 2014

Academic Consultant, Federal Reserve Bank of New York, since 1997;
Member, Academic Advisory Panel, 1990-94, 1997-2006

Executive Vice President and Director of Research, Federal Reserve Bank of New York, and Associate Economist, Federal Open Market Committee of the Federal Reserve System, 1994-97

Member, Center for Latin American Economics, Federal Reserve Bank of Dallas, 1996-2006

Visiting Scholar, Division of International Finance, Board of Governors of the Federal Reserve System, May 1993; Academic Consultant, April 1993

In Academe

Alfred Lerner Professor of Banking and Financial Institutions, Graduate School of Business, Columbia University, 1999-2006;
A. Barton Hepburn Professor of Economics, 1991-99; Professor, 1983-91

Visiting Professor, Department of Economics, Princeton University, 1990-91

Visiting Associate Professor, Department of Economics and Department of Finance, Kellogg Graduate School of Management, Northwestern University, 1982-83

Associate Professor, University of Chicago, 1981-83; Assistant Professor, 1976-81

Professional Activities and Honors

Senior Fellow, FDIC Center for Banking Research, 2003-06

Research Associate, National Bureau of Economic Research, 1980-2006

Adviser, Bank of Korea, Institute for Monetary and Economic Research, 2005-06

President, Eastern Economic Association, 2004-05; President-Elect, 2003-04; Vice President, 2002-03

Visiting Scholar, Bank of England, July 2001

Visiting Research Fellow, World Bank, September 2000-May 2001

Member, International Advisory Board, Financial Supervisory Service, South Korea, 2000-01

Chairman, External Evaluation Committee for Research Activities, International Monetary Fund, January-July 1999

Honorary Professor, Renmin (Peoples) University of China, June 1999

Visiting Scholar, Reserve Bank of Australia, May-August 1994

Visiting Scholar, Institute for Fiscal and Monetary Policy, Ministry of Finance, Japan, May 1986

Publications

Author of more than a dozen books and over 100 articles in professional journals and books, with research focusing on monetary policy and its impact on financial markets and the aggregate economy. Has served on editorial boards or as an associate editor for American Economic Review; Journal of Economic Perspectives; Journal of Applied Econometrics; Journal of Money, Credit and Banking; Journal of International Money and Finance; International Finance; Finance India; Economic Policy Review; Central Banking, Analysis and Economic Policy; and Macroeconomics and Monetary Economics Abstracts.

Education

Massachusetts Institute of Technology, Ph.D., Economics, 1976

Massachusetts Institute of Technology, B.S., Economics, 1973; Balliol College, Oxford, Approved Course in Economics, 1971-72


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