My intellectual influences, part 3: 1980-1986

From 1980-1986 I was an economist at the Fed.

I started in Financial Research (a section focused on the banking industry), then went to Mortgage and Consumer Finance (the section that dealt with housing), then to National Income (the section that forecast GDP, unemployment, and inflation), then to International (where I worked on solving a puzzle regarding the way that the Fed’s econometric model saw the impact of a dollar depreciation on output–it turned out that there was a mistake in the model), then back to Financial Research.

In Financial Research, my colleague Paul Burik noted what he called the “New York Fed view of the world,” which is that if the big financial institutions in New York are doing ok, then the economy is fine. This observation made it easy to predict the policy response to the 2008 financial crisis: there were enough big NY financial institutions not doing ok that an all-out bailout for them was the Fed’s top priority.

In National Income, Peter K. Clark inclined me to be concerned about the time series properties of macroeconomic data. He passed around Benoit Mandelbroit’s Fractal Geometry of Nature, which is a cool book but did not really help me with the problem. But he also passed around Ed Leamer’s Specification Searches, which was a major influence on my thinking, to the point where I recommend Leamer for the Nobel Prize. The then-standard practice of trying different regression specifications with the same data leads to totally unreliable results.

Also in Financial Research, I wrestled with the problem of reconciling modern finance theory with conventional monetary theory and macro. In conventional monetary economics, changes in the relative supplies of different financial instruments have enormous effects. But in modern finance, all people care about are the underlying risk characteristics of the real projects that households and firms undertake. How those projects are financed does not matter, because of the way that financial instruments can be re-arranged. As Merton Miller put it, “Whether you cut a pizza into 8 slices or 6 slices, it’s still the same pizza.” The pizza is a risky project, like building a piece of commercial real estate. Whether it is financed mostly by equity or mostly by debt, the economic issue is how profitable the building turn out to be.

Eugene Fama and Fischer Black were willing to go all out with the finance view. Fama’s paper “Banking in a Theory of Finance” and Black’s paper “Bank Funds Management in an Efficient Market” were the most influential in my thinking. It leads me to downplay the significance of the Fed as a macroeconomic force, and this opinion of mine is rejected by pretty much everyone else. I do accept that the Fed plays a role in allocating credit to the state and to the state’s preferred clients, as in the aforementioned bailout. Fed regulations, which are often overlooked by macroeconomists, are important for credit allocation purposes.

I also learned a lot about organizational culture. One of my aphorisms is that an organization is like a college. An organization teaches you with its culture. But just as with college, after you have been there a few years, you should have absorbed its lessons and leave.

In sociologist Michele Gelfand’s terminology, the Fed’s culture is very “tight.” Peter K. Clark was driven out for being too rebellious, although in most organizations he would have been considered a perfectly satisfactory team player. In that sense, the Fed was a terrible fit for me, and I should not have stuck with it as long as I did.