A Limited Central Bank

The President of the Philadelphia Federal Reserve Bank from 2006–2015 discusses the Fed's essential role as preserver of the currency's purchasing power and how the institution might be improved to better fulfill that role. To that end, the author proposes the imposition of four limits on the central bank that, by restricting its discretion, can be expected to improve outcomes and accountability.

• First, limit the Fed's monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed's discretion in monetary policymaking by requiring a systematic, rule‐like approach; and
• Fourth, limit the boundaries of its lender‐of‐last‐resort credit extension.

These changes, by creating a more limited central bank, would help preserve the central bank's independence, thereby improving the effectiveness of monetary policy. They would also make it easier for the public to hold the Fed accountable for its policy decisions.     

Convertible Securities and Bankruptcy Reforms: Addressing Too Big to Fail and Reducing the Fragility of the Financial System*

Eliminating too big to fail should be the first priority of any regulatory reform. But this is easier said than done. As the crisis has taught us, when the systemic risks are perceived to be large, regulators will be very reluctant to close down insolvent firms or impose losses on creditors. So how do we reduce these risks so that regulators can credibly commit to a policy of allowing financial companies to fail and not resort to rescues or bailouts? The author proposes two complementary approaches to this problem: The first is to design capital structures with corrective mechanisms that kick in when a financial firm displays signs of trouble, but still has positive economic capital. To this end, the author endorses the Squam Lake Report's proposal that encourages financial firms to issue convertible debt with an “automatic” provision for converting to equity. In contrast to the Squam Lake proposal, however, the author argues that the conversion to equity should not depend on regulators' decisions and should take place before individual banks and the financial system are in full crisis mode. The second approach is to design a resolution mechanism that will close failing financial firms when early intervention has not led to the firm's recovery. The author argues that the best model for this mechanism is bankruptcy, because of its resolution of claims according to predetermined rules rather than regulatory discretion. However, certain forms of early intervention can also help to lower the costs of permitting firms to fail. For example, the Squam Lake idea that financial institutions be required to develop living wills should make it easier to unwind these firms in an orderly fashion and provide regulators with insight into the degree of systemic risk that these firms impose. The author notes that the challenges associated with getting the executives of healthy banks to plan for their own bankruptcy may indicate that a better use of regulatory resources might be to view the living will as one of the tools of prompt corrective action for firms that become undercapitalized but are still solvent. Once a firm has been declared undercapitalized, regulators would have greater bargaining power to insist on a serious plan for bankruptcy.     

Estimation of a non-invertible moving average process: The case of overdifferencing

The effect of differencing all of the variables in a properly specified regression equation is examined. Excessive use of the difference transformation induces a non-invertible moving average (MA) process in the disturbances of the transformed regression. Monte Carlo techniques are used to examine the effects of overdifferencing on the efficiency of regression parameter estimates, inferences based on these estimates, and tests for overdifferenccing based on the estimator of the MA parameter for the disturbances of the differences regression. Overall, the problem of overdifferencing is not serious if careful attention is paid to the properties of the disturbances of regression equations.     

Money,income, and sunspots: Measuring economic relationships and the effects of differencing

This paper discusses the question of whether economic time series regression models should be estimated between the levels or the changes of the variables of interest. We argue that many economic models should be estimated between the changes of the variables, rather than the levels of the variables. In addition, comparisons of the levels and changes regressions can be used as a crude test of model specification. These issues are illustrated with examples from Friedman and Meiselman's (1963) study of annual income and consumption and with data on sunspot activity from 1897–1958.     

Government financing decisions and asset returns

This paper presents an empirical investigation of the relation between government financing decisions and asset returns. In particular, the focus is on whether a substitution of debt financing for tax financing of a given level of expenditures is associated with an increase in interest rates. The paper brings a different perspective to empirical investigations of government fiscal policies by examining the response of asset prices in an efficient capital market to such policies rather than focusing on aggregate consumption behavior. The results are consistent with the idea that asset prices are unrelated to how the government finances its expenditures. The results, however, also indicate that the capital market is not indifferent with respect to the level of government expenditures as higher interest rates are associated with increases in government purchases.     

Financial Econometrics, Financial Innovation, and Financial Stability

Innovation in financial markets, spurred to a significant extentby developments in finance theory and financial econometrics,has played a critical role in spurring economic growth. However,the current turmoil in financial markets raises fundamentalquestions about the nature of financial innovation and the roleof policymakers in maintaining financial stability. This paperexplores these questions, focusing on the complexities of modelingfinancial risk and the potential trade-off between policiesaimed at combating short-run financial instability on the onehand and the potential financial market distortions and moralhazard that can result from such policies on the other.     

The analysis of seasonal economic models

Many important insights can be obtained about economic relationships and seasonality when an economic model contains an explicit specification of the mechanism generating seasonality in the endogenous variables. Unfortunately, determining the correct structure is difficult. The purpose of this paper is to outline a methodology for the analysis of seasonal economic models. In particular, several ways of incorporating seasonality into a structural model are considered and the implications for the behavior of the endogenous variables are derived. Finally, a rational expectations version of Cagan's money demand function is analyzed to demonstrate some of the important aspects of the techniques and seasonal economic models in general.     

New Leadership at the Federal Reserve*

As Chairman of the Federal Reserve for the past 18 years, Alan Greenspan deserves praise for his stewardship of monetary policy. He has guided the Fed and monetary policy in a way that has led to low and stable inflation. But if Greenspan's record clearly deserves praise, he could have done more to move monetary policy into the 21st century and prepare the institution for the future. Greenspan has relied heavily on his personal judgment and has argued repeatedly that the Fed must have extensive flexibility to respond to the economic environment. But if Greenspan's judgment, skill, and luck have served him and the country well, it is dangerous to rely so heavily on the judgment of a single individual. When he departed, he took with him his skill and judgment, as well as his credibility and his personal commitment to low inflation. The Fed he leaves behind has no explicit institutional commitment to long‐run price stability. This article argues that by operating with a set of rules and guidelines, or at a minimum clearly stated institutional objectives, the Fed would eliminate much of the second guessing about what it is doing and why, and the associated volatility in markets. More generally, the benefits of more explicit guidelines for monetary policy include:

• ? Increasing public understanding of monetary policy, including what it can and cannot do.
• ? Increasing transparency and accountability. Most organizations have clear goals and we hold their leaders accountable. The Fed is different. The Fed seems to be held accountable for all things economic and thus it is truly accountable for nothing. It never has to explain its actions and what went right or wrong.
• ? Establishing a clear focus for the Fed regarding its goals and objectives.
• ? Creating increased confidence that sound monetary policy will be followed in the future.

     

Trade, Jobs, and the Economic Outlook for 2005

From newspaper accounts, one might think that the U.S. economy is on the verge of collapse. But the economy performed well in 2004, with real GDP growth of 3.9%, inflation at only 2.2%, unemployment down to 5.4%, and over two million jobs added to the payrolls (performance that is the envy of America's trade partners in Europe). And much the same, perhaps with moderate increases in interest rates, is expected in 2005.
Concerns about the trade deficit in particular have given rise to familiar calls to protect U.S. industries and jobs. But job losses due to "offshoring" amount to just 1% of total job losses each year, with little effect on the growth in overall employment. Manufacturing jobs have declined, but the value of manufactured goods as a share of real GDP has remained steady because of productivity growth in the manufacturing sector. Rather than spending vast amounts of money to protect jobs that are destined to go overseas, the correct policy response is to help people retrain and find employment elsewhere.
Trade deficits arise in countries that experience either investment booms or declines in savings. Thus, trade deficits are not necessarily an indication of economic failure. Foreigners invest in America because the U.S. is still the world's largest and most productive economy. And provided that the U.S. continues to offer such investment opportunities, foreign investors' search for low-risk assets will continue to be a major (if not the main) cause of the U.S. trade deficit.