Yellen vs Summers: Bird Fight
Fed chairman Ben Bernanke's second four-year term expires on 31 January 2013 and his successor needs to be vetted by Congress before then. Although a dark horse cannot be ruled out, there are two clear candidates: Lawrence Summers and Janet Yellen. The debate of who is the most suited successor to Big Ben has been surprisingly little about the candidate's economic views and the level of innuendo has been a US presidential campaign worthy. The US economy is on the path to recovery and it is now as important as ever how the new chairman plans to run future US monetary policy. This paper discusses the differences in economic policy of Yellen and Summers and in particular if it is fair to call Yellen the most dovish of the two.
Our conclusions are as follows. We believe that the characterisation by the media of Lawrence Summers as being more hawkish than Janet Yellen is too simplistic. In fact we argue that Summers and Yellen are equally dovish when economic conditions improve, since they both have a very strong aversion to unemployment relative to inflation. It is first when the US is hit by a negative demand shock while interest rates are at the zero lower bound that Summers is likely to be more hawkish than Yellen. This is due to Summers's open scepticism towards alternative monetary stimulus instruments such as QE - a scepticism not shared by Yellen.
We point out the importance of a transparent Fed and we believe that Yellen would support this transparency. On the other hand, Summers's flamboyant personality together with his comments that he will be a fire-fighting Fed chairman indicate that the Fed would become less transparent if he was to be chosen by Obama.
Janet Yellen - The Fed dove with the steady hand
Janet Yellen is an American economist with a Jewish background who was born in Brooklyn, New York. She graduated summa cum laude in economics from Brown University in 1967 and received a PhD in economics from Yale University in 1971. She is married to George Akerlof, who won the 2001 Nobel Prize in economics.
Yellen has a long history of economics teaching and research. She has taught at Harvard University, the London School of Economics and University of California, Berkeley's Haas School of Business - the latter at which she has been a Professor since 1985.
Apart from serving as chairwoman of President Bill Clinton's Council of Economic Advisors (1997-1999), Yellen's career is characterised by a long history in the Federal Reserve System. From 1977-1978 she worked as an economist in the Division of International Finance, from 1994-1997 she was a member of the Board of Governors, from 2004-2010 she was the President of the Federal Reserve Bank of San Francisco, she was a voting member of the FOMC in 2009 and in 2010 she was not only appointed Daniel Kohn's successor as vice-chair of the Federal Reserve System but also became a member of the Federal Reserve Board for a 14-year period (2010-2024).
Her biggest advantages in her Fed chairwoman candidacy are her many years of experience within the Fed system and her huge knowledge of monetary policy theory. Also her policy is unlikely to differ much from Bernanke's and she is considered Obama's safe choice. During her time as vice-chair in the Fed she has been head of a communication subcommittee. She believes agents' expectation formation is key for economic activity and she would likely support Fed transparency as chairwoman - a key feature in relation to FOMC tapering.
Lawrence Summers - The shrewd and unpopular power player
Lawrence Summers is a flamboyant American economist with a Jewish background who grew up in New Haven, Connecticut. He's a nephew of two Nobel laureates in economics (Paul Samuelson and Kenneth Arrow) and is himself often praised for his intellectual and creative thinking. He has a PhD from Harvard University where he also taught as a professor for nine years. After a stop in the World Bank, Summers became a dominant figure in Democratic policy circles, first serving as Bill Clinton's treasury secretary (1999-2001) and later as director of Obama's National Economic Council (2009-2010). He has close connections to the Clinton family and has a good relationship to President Obama, who has praised his work at the National Economic Council. His intellectual capabilities are highly recognised at Wall Street and hedge fund founder David E. Shaw has called him 'a brilliant, brilliant guy'.
Summers's biggest disadvantages are his lack of Fed experience and his unpopularity among many groups. Summers in particular got in trouble for many of his actions while he was President of Harvard University (2001-2006), which ultimately led to a faculty vote of no confidence. Many in the black community dislike Summers for his 2001- dispute with a Harvard-employed black professor. Feminists dislike him for saying (in 2005) that the cleverest of men are cleverer than the cleverest of woman. A large group found it wrong that Summers in 2005 let Harvard pay a USD28.5M lawsuit by the US government against a close friend and employee at Harvard who had traded Russian stocks using insider information. During Summers's presidency Harvard also entered very speculative interest rate swaps, which lead to losses of USD1bn. Additionally, although Time Magazine named him a member of 'the committee to save the world' for his role in bailing out Asian companies in the Asian crisis in the 1990s, many Asian business people found Summers unnecessarily brutal and non-diplomatic. Lastly, many people dislike him for his close connections to Wall Street and his role in deregulating financial markets, which contributed to the magnitude of the financial crisis.
Yellen's and Summers's reaction functions
A dove vs an asymmetric hawk - an instrument consideration
There has been a tendency by the media to say that Summers will be a more hawkish Fed chairman than Janet Yellen due to his scepticism of quantitative easing. In our view this is a too simplistic characterisation.
Normally we would define a hawkish central banker as somebody who has bigger aversion to inflation than a dovish central banker who on the other hand has a large aversion to unemployment. If we think of Summers's and Yellen's preferences in terms of inflation versus unemployment we believe that both should be described as doves. Summers's outspoken support for significant fiscal easing indicates his strong aversion to unemployment. Similarly, Yellen has not only been a dove in the past five years - she has always been a dove. Furthermore, it is clear that Summers and Yellen agree that the main problem in the US economy is a lack of demand rather than supply side problems.
Hence, the difference between them is not really about what they want to achieve but rather how they want to achieve it. Both Summers and Yellen want to 'stimulate' demand to bring down unemployment and both would probably be relatively relaxed if a byproduct turned out to be a slight increase in inflation - even in the longer run. The main difference between the two is rather how they want to achieve their targets. It is wellknown that Summers has been sceptical about the usefulness of QE, while Yellen has wholeheartedly supported it in the past five years.
Summers; a fire-fighting arsonist?
Summers has several times indicated that he would be a fire-fighting Fed chairman - that is to consider a solution for each distinct problem. This self-confident approach blurs market transparency and the benefits from self-fulfilling central banking (as we have recently seen with Mark Carney, Governor of the Bank of England) are lost. As Summers would not be a rule-following central banker, it becomes even more important for markets to figure out his reaction function. A paper - Fiscal Policy in a Depressed Economy - that Summers wrote with Brad Delong in 2012 might give us a clue about Summers's reaction function as a Fed chairman. The following quotations are particularly interesting:
- 'There are limits to the efficacy of non-standard measures, so even if they were contracted, the impact is likely to be to only partially offset fiscal expansions.' (p.41)
- 'It seems to us that if fiscal policy is self financing it will be desirable to use as an instrument once it is recognized that (i) with uncertainty about multipliers diversification among policy instruments is appropriate as suggested by Brainard (1967), (ii) expansionary monetary policies carry with them costs not rep-resented in standard models (including distortions in the composition of investment, impacts on the health of the financial sector, and impacts on the distribution of income), and (iii) the historically-clear tendency of low interest rate environments to give rise to asset market bubbles.' (p.41)
This clearly shows Summers's view that effects of unconventional monetary policy are limited and that fiscal policy is a superior instrument in a zero lower bound environment. In addition, as the second quotation highlights, he is also worried about other negative byproducts of unconventional monetary policy, especially about creating asset price bubbles.
This we believe tells us something about Summers's reaction function. He might be a dove when it comes to unemployment aversion, but his aversion to certain monetary policy instruments - particularly to quantitative easing - gives him a hawkish edge. Yellen does not have this kind of reservation. Put differently, on the one hand, if we had fiscal stimulus with Summers as Fed chairman he would clearly be against offsetting the impact on aggregate demand with monetary policy. In that case he would be at least as dovish as Yellen - maybe even more so. If, on the other hand, fiscal policy was tightened he would not necessarily support an expansion of QE to offset the impact on aggregate demand. Hence, when the fiscal authorities are fiscally conservative, Summers will be hawkish (at the zero lower bound) and when the fiscal authorities are 'Keynesian' he will be dovish. In that sense we expect Summers to have an asymmetric reaction function.
As we see it, we may therefore never get to encounter the hawkish Summers if he becomes Fed chairman. If the recovery in the US economy continues - and speed of fiscal consolidation is slowed - he will likely be as dovish as Yellen. It is therefore only if we get another negative demand shock that the hawkish chairman Summers will emerge. In that scenario he will certainly also be setting himself up for a conflict with the Republicans as he will be saying 'The Fed cannot stimulate aggregate demand anymore - the congress will have to approve the President's new fiscal stimulus plan'.
As long as data improve both birds will fly in the same direction
The FOMC's reaction function is important since the economic activity depends on the actions of the Fed. The public is less uncertain when the FOMC conducts monetary policy in a predictable manner. Since the Great Inflation in the 70s the FOMC has followed some kind of Taylor rule depending on inflation and output/unemployment due to the Fed's dual mandate. Both Summers and Yellen are both dovish in the sense that they are in favour of the current monetary policy keeping the interest rate low in the years to come and are willing to accept more inflation in order to fight high unemployment. Their views on traditional monetary policy are not likely to affect markets significantly in the years to come as the Fed's fund rate has hit zero lower bound and economic conditions are improving. The most important difference between the two is their differing view on alternative monetary instruments in a zero lower bound environment. Yellen supports using unconventional monetary policy tools like quantitative easing, while Summers is sceptical regarding its effect and is more likely to put pressure on the politicians to use fiscal policy to stimulate aggregate demand. This difference is important if the US is hit by a large negative shock in the coming years - otherwise we believe the difference in conducting monetary policy between the two will be minimal in the next years.
It's the communication, stupid.
It has become clearer that communication is alpha omega in the conduction of monetary policy, especially in a low interest rate environment. While not much is known about Summers's communication strategy, we know much about Yellen's view on communication of monetary policy. Yellen has chaired the FOMC's subcommittee on communication and held a speech titled Communication in Monetary Policy on 4 April in which she stressed the importance of sound communication. Her main argument was that economic activity is tied to the public's expectations about the future and hence must not be neglected. In her view communication is just as important a monetary policy tool as the traditional tool of changing the Fed's fund rate. In particular she stressed that the nominal thresholds in the so-called Evan's rule are huge improvements in the communication of the Fed's forward guidance relative to the earlier time-dependent measure. She argued how the 'low Fed's fund rate in an extended period of time' communication strategy was creating uncertainty regarding under what circumstances the FOMC would change the Fed's fund rate. The FOMC's communication and transparency remain important in the coming years as the Fed starts to scale back its QE programmes. Clear communication is needed in order to prevent uncertainties regarding the Fed's exit strategy to affect the economy.
The end of the consensus era...?
One important task for the next chairman is to tackle a divided FOMC with different views on how to conduct monetary policy, how to use different instruments and in what direction the economy is heading. The current chairman Ben Bernanke is known for his hard work to reach compromises among the FOMC members. The consensus era has meant less uncertainty regarding FOMC policy and less divergence in statements from its members. On one hand, a less consensus-oriented Fed chairman will challenge Fed credibility, which may ultimately lead to greater market uncertainty. The transmission channel through expectations is as important as ever due to the ineffectiveness of the traditional interest rate policy when interest rates are close to the zero lower bound. If market expectations are not handled correctly, it is likely to make monetary policy less potent. In general Yellen is seen more as a consensus maker than Summers and as a result clear communication might take a hit with him in charge. On the other hand, it is important to note that with less focus on unanimous decisions the FOMC is likely to react faster.
Current market reaction or lack thereof
So who will win? The answer is not clear cut. Although Yellen has a commanding lead among economists polled by both Reuters and Bloomberg, the big global bookmaker Paddy Power has recently made Summers the clear favourite after Obama defending Summers at a closed-door meeting with Democratic members of the House of Representatives.
So far markets have not reacted to changes in the perceived likelihood of election. As pointed out this could reflect that both Yellen and Summers are expected to continue the current line in monetary policy. Nevertheless, we expect more uncertainty and volatility in markets in the case that Summers gets the nomination as his view on monetary policy is less clear.