Thursday, January 17, 2008

Is the Fed ever up to the biggest challenges?

Mankiw links to Anna Schwartz's comments that the current Fed is not equal to its challenges:

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.
The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

Is any Fed ever up to its challenges? How would we determine if a Fed Chairman was more successful than another. Ray Fair has taken on this task in A Comparison of Five Federal Reserve Chairmen: Was Greenspan the Best?. He concludes that Greenspan was just lucky. His measure of success:

The first way is comparing the actual performance of the economy under his term relative to what the performance would have been had he behaved optimally. Comparing chairmen only on the basis of the actual performance of the economy is not appropriate because it does not control for different exogenous-variable values and shocks that the Fed has no control over. This comparison is done for a wide range of loss functions. It does not assume that the chairman necessarily behaved by minimizing a loss function; it just compares his actual behavior to what he could have done had he minimized a particular loss function. The second way, on the other hand, assumes that each chairman minimized a loss function, and it backs out an estimate of what this loss function was.

My only quibble with the paper is that he focuses only on one specific model (called the MC model which is part of his macro model). Surprisingly, Blinder and Reis conclude (without much analysis) that Greenspan was both good and lucky. I say surprising only because of Blinder's treatment by Greenspan as documented in Bob Woodward's Maestro.

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