McKinsey Executive Roundtable Series in International Economics: What Sort of Fed Do We Want?

JEFFREY E. GARTEN:  We'd like to get started because we have -- we have a lot of territory to cover in a very short period of time.  My name is Jeff Garten, and I'm the presider today.  I have the honor of doing that.

Today we're going to talk about, "What kind of Fed do we want?"  This is part of the McKinsey Roundtable Series on the international economy.

Before we start, I would like to ask everyone to please turn off their cell phones.  And the rule of the council is also turn it -- don't put it on vibrate either because it will interfere with the microphone.  The other thing is that today's meeting is on the record.

I don't think I have to emphasize how important and how timely this subject is.  We all know that the Fed is at the intersection of so many critical issues in our society.  It is essential to the issues of economic growth, jobs, monetary stability and the stability of financial institutions not in the U.S. and abroad.

I would also say that the Fed plays a huge role in shaping really critical relationships, relationships such as those between creditors and debtors.  And while this may sound mundane, it takes on even a bigger role now as the U.S. itself is such a huge debtor and we'll be dealing with that situation in the global economy for many years to come.

I think the Fed also is very critical to shaping the relationship between Wall Street and Main Street, which, of course, puts it at the center of an enormous number of political issues.

The Fed also plays a unique role in our democracy.  Unelected, it is nevertheless incredibly powerful.  And it's no exaggeration, in my view anyway, to say it has become the fourth branch of government.  And this issue raises a huge number of important questions about accountability, transparency and governance.

And finally today, the Fed is really in the spotlight.  Part of that is because of its role in the recent financial crisis, a role of unprecedented activism, a role which made it not only lender of last resort but in many cases lender of first resort.  And the controversy surrounding the Fed's actions also extend to its role in monetary policy.

This is not going to go away, and it's not going to go away for a lot of reasons.  It's the centrality of the Fed but also because we have a change of government in the House.  And the House Financial Services Committee is now headed by someone who recently wrote a book called, "End the Fed."  And he would like to see the Fed abolished, but he's not the only one.  If you look at popular polls, this is not some insignificant minority in the United States that really feels the Fed has gone astray.

So to discuss these issues today, we have a really wonderful panel.  You probably know everyone here.  The bios are in front of you.  But I'll just briefly introduce Alan Blinder, who is a professor of economics and public affairs at Princeton and former vice chairman of the Fed; David Wessel, who's the economics editor of the Wall Street Journal and also the author of a wonderful book on the Fed, "In Fed We Trust"; and John Taylor, professor of economics at Stanford and also former undersecretary of the Treasury for International Affairs.

I think the way we'll do this is that I'm going to pose a few questions to the panel just to get the issues aired, then we'll go to questions from the members here, and I'm just going to reserve a little time at the end to pose a final question to the panel of the three major challenges they think the Fed faces in the decade ahead.

So let me start really by asking -- I'm going to ask you to grade the Fed in three different areas, and grade it from "A" to "F."  Three phases:  the pre-crisis, or the run-up to the crisis; the involvement in the crisis; and then post-crisis, such as it is.  And John, maybe I'll start with you.

JOHN B. TAYLOR:  Thank you.

I think it's important to start before the crisis.  I think the crisis really first flared up, as you know, in August of 2007, went to the panic period in the fall of 2008, and then we have, since the panic, a post-panic period, if you like.  But before this crisis even began in 2007, I think the seeds of it were pretty clear by monetary policy.

After really two decades or more of really, I think, really extraordinary, good economic policy, monetary policy -- the long expansions, low inflation, a lot of stability in most of the '80s and '90s -- we ran into a period where monetary policy, I think, deviated from that policy by keeping interest rates too low for too long, mainly in 2003, '4 and '5.

And there's different ways to look at it.  I like to look at it and compare what -- compare that with what happened in the '80s and '90s.  And there's clearly a too low for too long situation.  So that accentuated the housing boom, led to excessive risk-taking, encouraged a lot of activity which we now look and can't believe it really happened; wasn't the whole story but a big part of the story.  So that's a -- moving from really a strong "A" period to well below "A," not passing.

And I think the crisis, beginning in '07, also sees some different type of activity.  I think early on, the actions were not so good.  I think the -- I would call the on-again, off-again bailout policy, that began with the bailout of the creditors of Bear Stearns. turned off, if you like, for the creditors of Lehman, turned back on for AIG, turned back off again as the TARP was rolled out.  It seems to me that caused a lot of uncertainty and actually added to the panic.

The panic itself, I think the Fed did a very good job.  The commercial paper credit facility; the money market mutual fund facility; extraordinary, if you like, addition to the confidence in the markets that I think had helped arrest the panic, but basically the panic itself was caused, I believe, by the prior activity.

And then finally, post-panic.  Since the fall of 2008, I don't see a lot of good things here, quite frankly.  QE1 was a purchase, roughly, of 1.25 trillion (dollars) of mortgage-backed securities.  I don't think it really did much good.  My studies -- I've done lots of studies of this, careful econometrics.  I don't see it has done much good at all.  There was also 300 billion (dollars) of purchases of medium-term Treasurys during that period, during what we now call QE1, the first quantitative easing bout.  I don't think that did much good, either.

I was hoping that that was going to end when the emergency went away, as it disappeared into the past.  But lo and behold it didn't, and we just got something called now "QE2," which seems to me very disappointing because it really extends this period of really unconventional activity beyond any reasonable justification, in my view.  So, again, we're moving back into low grades, and I'm hopeful we're going to get off of that, and get back to the good kind of policy that worked so well in the '80s and '90s.

GARTEN:  So in sum, the only high grade you give is in the -- in the -- in the middle of the panic.

TAYLOR:  Yes, and in the '80s and '90s.  And don't forget that because we should really -- that was a good period for monetary policy.

GARTEN:  Okay.

Alan, you agree?

ALAN S. BLINDER:  Well, I was on the Fed in the '90s.  So I -- at least I'll agree with that.  (Laughter.)  With the rest, I would take some exception.  I would actually divide in two periods -- you asked for three -- which is -- and dividing it at some X days after Lehman Brothers.  I don't know whether X is three, five, seven, just right after Lehman Brothers.  If you go back to Lehman Brother -- from Lehman Brothers plus X days backward, I think the Fed's grades -- not back to the '80s and '90s, in the bad period, the Fed's grades were poor, especially poor on bank regulatory policy, a supervisory policy, I should say.

I think I'll probably go to my grave not knowing what I really think about the Bear Stearns episode.  I could argue either side of that for myself and convince myself of either -- of either side of that.  I think Lehman was a catastrophic, absolutely catastrophic error.  But -- so what am I grading that whole period?  Pretty low.  I remember years ago Yale abolished the grade of D.  Have you put it back?

GARTEN:  No.

BLINDER:  No.  At Princeton, we proudly use the grade of D.  So maybe that's what I would -- maybe that's what I would give.  But from Lehman plus X days forward, I give the Fed A-plus.  I think it's been extraordinary.  I think it's been necessary.  I shudder to think how things might have been had the Fed not put their heads on the chopping block, as you were sort of suggesting earlier, time and time and time again.

Now, by the time we got to QE2, I'm -- I guess I'm modestly favorable toward what's now being called QE2.  I don't expect any great effects from it, and neither does the Fed, by the way.  I think they engaged it on the belief that turned out to be a slightly false belief that there was nothing if not worse coming out of fiscal policy.  Just in terms of aggregate demand stimulation, let's leave aside what you do to the future deficit.  So -- but just in terms of aggregate demand stimulus, I think the working assumption was there was nothing coming out of the political world, and the Fed had to do what little it could.  And so it did that.  But overall I think the grade has to be extraordinarily high from Lehman plus X days forward.

GARTEN:  David.

DAVID WESSEL:  So this is a kind of an uncomfortable position to be in, with two eminent professors from whom I've learned a lot who disagree on much of everything.  And I'm the one supposed to cast the deciding vote.  (Laughter.)  And I just want to -- there was no lack of respect for the Council on Foreign Relations that my suit jacket is hanging in my mother's closet in New Haven.  And she called me about five minutes ago before I turned off my cell phone to assure me that I knew that my suit jacket was there.  (Laughter.)

I think that -- I don't think there's -- it's very difficult to make the case that the Fed did a good job before this episode because we had an episode that reflects very poorly on the Fed.  I think the difference between Alan and John is interesting.  John sees them as failing on monetary policy.  I think that's a debatable point.  But I do know that a number of people inside the Fed who were involved in those decisions are much more sympathetic to the "we-held-rates-too-long" view now than they were at the time.

Now, hindsight is an important check on one's judgment.  But it's always a lot -- very convenient to say, if I had it to do all over again, I would have done something differently.  And so I think one has to be careful how one judges these things.  Was it obvious at the time that it was too low too long?  Or is that only an after-the-fact judgment?  I think a lot of the judgment is after the fact.

On the regulatory front, which Alan referred to, I don't think there's any question that the Greenspan Fed basically thought the market could take care of itself.  Greenspan has testified that this was his biggest mistake, that it turns out that even if you have a lot of money on the table, it doesn't mean you're going to police the table.  And that was a catastrophic failure.

I don't judge them harshly for Bear Stearns.  Where I judge them harshly is the period between Bear Stearns and Lehman, where as John has pointed out, they gave us very little guidance as to what their thinking was.

You know, you don't want to have a committee meeting to decide whether to send out the fire engines.  Bear Stearns was collapsing.  They had to make a decision in a hurry.  They were not prepared to make that decision.  They made their best judgment.  You can argue that had they not bailed out Bear Stearns, Lehman wouldn't have happened.  You can argue if they had not bailed out Bear Stearns, we would have had Lehman Brothers on Bear Stearns' weekend instead.  I don't know what the right counterfactual is.

But that period between Bear Stearns and Lehman, I think, is the biggest failure of the whole thing.  They weren't prepared for Lehman.  It's very hard to argue that Lehman was a great success.  So I think you have to, of course, judge them harshly on that.

I'm sympathetic to the views that both Alan and John share, the one thing on -- they agree on, is that once the panic started, I think the Fed deserves very high marks.

And there we do -- we do have counterfactuals.  You know, we saw what happened during the Depression when the Fed decided to stick to some prevailing orthodoxy and didn't cooperate with other authorities in the interest of the global economy, and we had a catastrophic capitalism in the -- in the economy that we didn't have this time.  And although most Americans don't believe that, although most Americans are not comforted by the assertion that it could have been worse, the fact is it could have been.  And I think you have to give them very high grades for that period.

I'm closer to Alan than John on the question of whether QE1 and QE2 were indicated, but I judge them very harshly on their inability to explain to us -- and by us, I mean the American people, not the Ph.D. economist, but the American people -- exactly what they were doing and why they were doing it.  And I think it's an extraordinary failure on the part of an institution which has begun to see just how important communications is and a chairman who actually believes in transparency and communication, how difficult it's been for them to explain to us what they're doing.  And that will pay -- that is a serious failure, because it undermines the credibility of an institution that relies on credibility to do its job.

GARTEN:  So let's drop back now from the -- from the actual operations and talk about a mandate of the Fed.  I think most people feel that the Fed has two -- has a mandate to do two things; one is monetary stability and the other is full employment.  Recently there's also been --

WESSEL:  You mean price stability.

GARTEN:  Price stability.  Price stability and full employment.

There are also a lot of issues now relating to financial stability.  I'd like to ask Alan whether -- do you think the mandate of the Fed is right?  Is it too broad?  How would you evaluate it as we look ahead over the next several years?

BLINDER:  I think it's pretty much right, with a couple of footnote exceptions.  So the answer is right and then you put a footnote about how you could do it better.

The right part -- the act gives the Fed -- the Federal Reserve Act gives the Fed responsibility for keeping inflation low, keeping unemployment low.  And I'm glad we have that compared to, say, the ECB, which -- I -- mandates matter.  People take an oath of office and they do what they're supposed to do -- at least most people do what the law directs them to do.

The Dodd-Frank act has now given explicitly the -- a third mandate that was tacit and you might even say implied by the first two, which is for price stability -- excuse me, for financial stability, that is, overseeing and doing something to delimit systemic risk.  That's always a tacit part of the central bank's job, but it's not really in the Federal Reserve Act.

I didn't comb through the 2,400 pages before coming here.  I don't think it's -- the Federal Reserve Act was amended.  I think it would be a good thing to actually amend the Federal Reserve Act, put that in the legal mandate, which is Section 2a or something of the Federal Reserve Act.  That's the footnote.  But the authority is clearly given to it and the responsibility is clearly given to it by the Dodd-Frank act, and I think that's appropriate.

GARTEN:  John.

TAYLOR:  I long thought that the best strategy for the Fed or any central bank is to focus on price stability, because that brings about employment stability and economic stability.  And I think, for many years, since 1977 when the dual mandate was inserted, the Fed worked through that by arguing the best way to have strong economic growth and strong employment growth was to deliver on price stability.  Volcker, Greenspan spoke about that all the time.  And so even though I would object to the confusion that a dual mandate causes, I think they handled it quite well.

Now I think we've seen it working not so well, the dual mandate.  And I think the point, David's point about communication, illustrates this.  For many years, the statement by the FOMC, which they give after their meetings, did not mention the maximum employment aspect of this.  They mentioned the strategy is to make the economy stable by having the price stability.  But for the first time in their FOMC statement -- the first time, October 2010 -- the maximum employment term appeared.  And it was there to really, I think, justify quantitative easing 2.  And it's been repeated in the meetings since then.

So what I see is happening is that dual mandate is being -- is coming back in in a different way, by different people, and confusing the whole situation.  So I'd very much at this point like to argue that the Fed's mandate should be adjusted, if you like, to emphasize price stability -- I call it price stability within a context of economic stability.  When you focus on price stability, that doesn't mean you don't cut interest rates in a recession, it doesn't mean you don't provide liquidity in a crisis, it doesn't mean you don't have lender of last resort.  Those are essential to price stability and economic stability.  But by confusing this and allowing some people to go out and give different motivations for things, I think we're just confusing the situation.

BLINDER:  If I can just --

GARTEN:  I'll get to you in a sec.  I just want to ask --

BLINDER:  Just a very short interjection.  There really wasn't such a big change last October or whatever.  When I was on the Fed in the '90s, whether we were increasing interest rates or decreasing interest rates, we always justified it by sustaining maximum -- "maximum sustainable economic growth," that was the euphemism.  And it went whether -- (inaudible) -- went up or down, which was -- I used to argue about that.  But it's not a new thing.  It started with the '77 act, as John said.

WESSEL:  I think mandates do matter, and our reporting suggests that when the FOMC talked about QE2, they talked quite a bit about what their mandate was.  I'm not sure that I agree with John.  By the Fed's definition, we are below price stability.  This was easy to justify on the grounds that they were missing on both the employment and the inflation target.  The much more intellectually interesting case would have come if inflation were closer to their target of about 2 percent and unemployment were still high.

I think it's naive to think that a central bank of the United States or any democracy is going to be oblivious to 9.8 percent unemployment; and nor should it be.  But I think Jeff raised an interesting question -- which neither Alan or John wants to touch because they're macro-economists -- is so what about this financial stability goal, and what does that actually mean?

And I think that it's quite unclear what it means.  And I think the Fed is being set up in a way to take the blame for the next crisis, which will obviously come.  And this time, the chairman won't be able to go before the Congress and say, "Well, I didn't have authority to worry about the nonbank financial institutions of the shadow banking system."  The members of Congress will say, "Look, after the last crisis, you told us we needed a systemic regulator, and we set up this committee, and you're on it.  And you blew it."

And so I think it's going to be an evolving discussion inside the Fed about what financial stability means.  And I'll just give you two examples of how difficult this is.  One is:  Does it mean that the Fed has a responsibility of acting when it thinks there's an asset price bubble -- stock market bubble or housing price bubble?  And if so, how exactly is it supposed to do that?  Is it supposed to tighten regulation so there's not a lot of lending in those institutions?  Is it supposed to give speeches and say, "Don't buy a house"?  Can you imagine that?  Is it supposed to raise interest rates, even if the conventional measures of price inflation and unemployment are not worrisome, because it sees an asset bubble?  I mean, these are questions that academics have debated and the Fed has never had to cope with before.

And the second is:  Are they supposed to be the ueber-regulator?  It might have been an interesting model to say no, that there was -- someone else was the regulator.  But the Congress chose not to do that; learning from the British model that apparently that's not perfect either.  On the other hand, they didn't say the Fed is the sole regulator.  So you can imagine we will have endless stories in The Wall Street Journal about tension between the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve about banking supervision and financial supervision, all justified in the name of pursuing financial stability.

So I think that in my mind is the biggest question mark:  What exactly has changed now that the Fed has more responsibility for financial stability, and what exactly is that going to mean in practice when we get beyond this current period?

GARTEN:  So let me just follow up that, because the next question I was going to ask is:  Just how significant is the new legislation, is the Dodd-Frank legislation, when it comes to the Fed?  And you -- you're actually on that ground.  Well, just venture an opinion in -- because we don't have a lot of time, but in this light -- is it very?

WESSEL:  Yes, it's very significant, not only because of the letter of the law but because the law embodies a view in Congress and the public that somehow the cops on the beat fell down on the job.  And we wanted to give the cops more power, more ammunition, so we don't go through this again.  So there is an expectation the Fed is going to prevent the next crisis.

The Fed will fail to do that.  It will be blamed.

GARTEN:  Okay.  So final question before we open it up.  This has to do with the global role of the Fed.  Obviously, the Fed has always had a huge international influence.  And in the crisis, it was extremely active in terms of making dollars available to central banks in many countries.  Psychologically, what the Fed does or doesn't do always has a large impact.

But my question is this.  If -- given the way the global economy, the global financial markets have evolved, given all the interconnections, given the growing size of that and the rise of other central banks -- ECB, Bank of China -- Public Bank of China, as you look ahead, what can you say about the changing role of the Fed in the global economy?

What -- Alan, I'll ask you to start with -- you know, if -- the -- Bernanke and his successor -- what's going to be different about the way they run the Fed than previous chairmen, given the way the world economy is going?

BLINDER:  I guess I'd start with the three words "not too much."  But let me elaborate on that a little.  First we have sort of the obvious arithmetic of what is moving toward and eventually will be a more tri-polar world, where the Fed is probably still the first among equals among the Fed, the ECB and the People's Bank of China.  We're a long way from the latter; we're not so far from the second, from the ECB.  So the Fed, as you look over the distant horizon, will not be quite as omnipotent as at least some people like to portray the Fed now and in recent years.

Second factor, which is very important -- and I think you don't really appreciate this until you -- this is already the second time I've mentioned the oath of office.  But Alan Greenspan appreciated this very much, and I'm sure Ben Bernanke does also, which is -- this goes back to the legal mandate.  The Fed has delegated authority from Congress.  Congress gives it its mandate.  And there is nothing in that mandate that says, for example, now and then you should pull punches in order to take the rest of the world into account -- that is to say, if we needed easier monetary policy.

But maybe for the rest of the world that's not so good.  Or the other way around, that the Fed should shade its decision in favor of the rest of the world relative to what it would do if it cared only about one country.  The mandate tells it to care only about one country.

Now, I think it's quite arguable in principle -- a bunch of us academics could argue, you know, in this kind of globalized world, we ought to revive the Fed's mandate, because after all, we're central to the whole world economy, and what happens in the rest of the world reverberates on us and conversely.  But then I'd just ask people in the audience to think how many of the 535 members of Congress do you think would vote for that amendment.  And your estimate is probably the same as mine:  zero.

GARTEN:  David.

WESSEL:  I don't think the Fed's role has changed.  I think America's role has changed, and for the -- all the reasons Alan said.  We've never -- the Fed has never been strictly focused on the United States, and -- nor can it afford to be.  It's the protector of the U.S. dollar.  And we've had periods in the past when the dollar needed some help and they stepped in.

But I think that we live in a very different time.  And I imagine that Paul Volcker would have a hard time understanding why it is that Ben Bernanke has to spend so much time assuring his counterparts in the People's Republic of China that, no, he's not going to get inflation -- let inflation get out of control, and therefore please don't sell all your dollars.

So the Fed's role has changed because our role in the world economy has changed.  We no longer are a master of our own fate given how much we depend on the kindness of strangers to lend us all their savings.

GARTEN:  John.

TAYLOR:  I think the idea of the central bank -- our central bank maintaining the purchasing power of the currency is very important for our world economy.  And to the extent we get away from that, to the extent we, if you like, think about doing too many things, I think that really is in some sense abnegating an important aspect of leadership, for the United States and for the Federal Reserve.

In the period I mentioned earlier, where interest rates were too low for too long, that actually spread around the world.  It made it harder for other central banks to do the right thing.  In fact, if you look at certain areas of the world where they also had housing booms, it was really related to their interest rates being too low at that point.  So in a sense that affected the world economy.

So I think the -- I'm somewhat disappointed that we may be losing that important leadership role, which has been very important for the world economy for so long.  The QE2, in a way, is an example.  I'm not surprised about the complaining from other countries for this.  I was surprised that it was so -- they were so outspoken about it and it interfered with our foreign policy.  I was surprised at that, but not surprised with their logic, because it does make it harder for them to control inflation.  It does have the potential to cause, if you like, a growing inflationary boom globally.  And that's going to feed back on this economy and hurt us.

So I think there's so much here that is, if you like, beneficial for the world economy if we have a central bank that does the kind of things it did for most of the '80s and '90s, which was not only a stable period for the U.S., it was stable elsewhere, too.

So I'd just like to get back to that way of thinking about policy.  It worked.  It was a framework that worked, and it showed a great deal of leadership by this country, which I think's important for the world.

GARTEN:  I think that's good point of departure for questions from the members.  I'd ask you to -- where are the microphones?  Okay.  There are microphones all over.  If you would just stand up, please, just identify yourself and your affiliation, and speak into the microphone.  Do we have -- yes, please.

And let me ask you this.  You could address the question to me and I will farm it out, or to one of the panel members, but we don't really have time for each of the panel members to answer every question.  So I'd like to, in a sense, ask one to do it.

QUESTIONER:  Thank you.  I'm Richard Weinert, Concert Artists Guild.  It's been an article of faith for some decades that the best arrangement is the central banks to be politically independent.  This is obviously under some question and attack now.  And I'd like to ask whomever on the panel would like to comment on what you think would be the ideal arrangement.

GARTEN:  Alan, I'll ask you to --

BLINDER:  Well, I'm not sure I can define the ideal arrangement, but certainly independence -- now independence is not like a point, it's a sort of a range, and I'm not sure I can answer with that kind of precision.  But I think the events of recent years, including the speed that they required, the freedom to take unpopular actions, and the performance of the Fed and other central banks under duress, never minding the poor performance of the regulatory regime, after all points to the -- how vital it is to have quite a lot of central bank independence.  A small piece of evidence, as you probably know, over the '80s and the '90s almost every country in the world -- there are some exceptions -- moved toward central bank independence, and not one single one moved in the other direction.

GARTEN:  David, I'm just going to ask you to comment on this from this standpoint.  How much of a threat to the independence of the Fed do you see boiling up in the American political system?  Not just the rhetoric, but the reality here.

WESSEL:  I think I would say some, by which I mean that it is not surprising the Fed is taking a lot of heat.  The Fed displayed an extraordinary amount of power and became a lightning rod for a sense in America that Wall Street got bailed out and Main Street didn't.  I think when push comes to shove, the Congress will flinch.  So proud of the excellent job they've done managing fiscal policy, I suspect they'll be a little reluctant to take on monetary policy.

And so far the Fed has been extraordinarily successful in beating back every attempt to clip its wings.  But -- and as the economy gets better, I suspect the pressure on the Fed will abate.

But a door has been opened, and it won't be easily closed.  And so if there takes hold in the Congress a kind of people -- (inaudible) -- give voice to the idea that somehow Ben Bernanke is printing money that's all going into the pockets of Goldman Sachs, that will eventually pay dividends in legislation.  But I'd say the chances now are remote, but they're substantially greater than zero.

GARTEN:  John.

TAYLOR:  I think independence is essential as well, but I worry that a lot of these actions already taken are raising questions about its -- the Fed's independence.

When the Fed gets involved in fiscal policy; when it gets involved in credit-allocation policy, helping one market, say, the housing market versus others or one firm versus others, that's not monetary policy.  That's really fiscal policy, and it raises governance questions.  I -- it raises constitutional questions about who -- it's -- Congress has authority to appropriate funds.  And when the Fed moves into that area, it's really losing some of its independence.

It -- during World War II and afterwards, it really was in there helping the Treasury bond market all the time.  We had this accord in 1951 where the Fed regained its independence because it stopped doing those things.  When it starts doing them again -- and it has -- it's -- I think rightfully its independence gets questioned, and I think we should try to find a way to have them stop doing that and then they require a different type of appropriation mechanism.

WESSEL:  (Off mic) -- I think that there -- progress has been made in filling a -- in closing a vacuum that the Fed was forced to fill.  The ability the government now has to close a Bear Stearns or Lehman Brothers under Dodd-Frank removes from the Fed one burden it had.

And it's interesting, and in my judgment appropriate, that in the future if the Fed uses its extraordinary authority to lend under section 13(3) of the Federal Reserve Act, it will require the explicit consent in writing of the Treasury secretary, which I think is a totally appropriate use of the democratic check on the Federal Reserve without making it impotent at a time when we might need its strength.

BLINDER:  I agree with that.  I just want to add, 13(3), as it existed at the time, fully justified what the Fed did.  It was perfectly within the law.

GARTEN:  Okay.  Jacob and then Bill.  Right here.

WESSEL:  Jacob's question's for these guys.

QUESTIONER:  Thank you.  Jacob Frankel, JPMorgan Chase.

In the old days, it was very clear that there were very sharp distinctions between issues that the fiscal authorities deal with and issues that the monetary authorities deal with.  And as a result, there were also very clear distinction between the instruments of the two.  And the question of independence and political pressure, therefore, did not come to the fore to such an extent, because the more you enter fiscal territory, the more political you become and therefore subject to political pressure.

So this comes with the territory.  As we look at it today, we see, for example, that in -- that new assets make themselves to the balance sheet of the central bank, probably much lower-quality assets than used to be with the rationale that is being given, but the picture is very, very different.

Likewise, when we speak about the European Central Bank and it buys Greek government bonds, it's fiscal policy; it's transferring resources from one country to another.

So obviously the political debate is coming up.  The rational for it has been that somehow the leaders of the monetary authority are enlightened, they see that the fiscal authorities are not operational; and therefore, they have national responsibility to step in.

It sounds good, but it's a trap also.  And the question that I have is -- question number one -- are we seeing now a detour from the traditional demarcation that will be returning in normal time, or is it really a new paradigm, a new paradigm in which the end-of-the-Fed syndrome is a legitimate question, because if you consolidate the two, then what's the point of having two departments?

The second --

GARTEN:  Can I -- can I ask you --

QUESTIONER:  Yes.

GARTEN:  Can I ask you to stop at that question?

QUESTIONER:  Yes.

GARTEN:  Because it's such a big question, I'd like to -- I'm afraid we -- John, why don't you --

TAYLOR:  Well, I think I share Jacob's concern that we may even have begun to pass the Rubicon on this.  The -- in a way, to me, QE2 for the Fed was a bit of a watershed here.  And I hope it's not, but the QE1 and the other activities were associated with an emergency, I think a specific thing.  And you could -- we justify it on that basis.

And I remember saying at the time, "Well, you say it's an emergency now.  But what's going to happen if there's like a slowdown in the recovery?  Are you going to start doing this again?"

"No, no, it was an emergency."

But here we have a slowdown in the recovery, and the same time -- type of thing has happened.  So it seems -- I worry if this is like a new type of monetary policy, in which I case I think your questions are quite legitimate.  And I hope we, for that reason, go back to -- to a better demarcation.

GARTEN:  Al.

BLINDER:  I think there are two answers.  You had the emergency situation, and that is the situation under which the Fed acquired most of these dodgy assets.  It still has Maiden Lane and things like on its balance sheets.  They're pretty small.  And then the MBS is something in between.

The QE2 is the acquisition of Treasury debt.  That's what the Fed has done since its founding.  And I just fail to understand why people think it's such a big deal than instead of buying three-month Treasury debt, they're buying three-year Treasury debt.  I mean, it's a small difference, but it's certainly not a difference in kind.

To your question, Jacob, I think these emergency acquisitions of -- what shall we say -- strange assets come with the emergency and they go with -- when the emergency abates.  And I don't think we're going to have anything like this for a very long time, but I certainly don't rule it out sometime way in the future, and the Fed do something like that.

Again, the responsibility for financial stability is permanent, and you could argue a permanent change in the Fed.  And when you have that responsibility and chaotic things happen, you have an implied, very explicit responsibility to try to obviate the consequences of those.  And the Fed will -- the Fed will do that as need be.

The last point I want to make is that -- you didn't quite get this, but this is probably your second question is -- a central bank is in a somewhat different world in terms of the weaponry it has when you're at zero interest rates.  So the things that the Fed would have in an earlier day counteracted by lowering interest rates, it now has to do -- either do nothing or do something else.

GARTEN:  Bill.

QUESTIONER:  Thank you.  Bill Donaldson.  I have a two-phase question that centers around politics.  Part -- question number one is, I wonder if you could comment on the politics inherent in the rank order of what happened to Bear Stearns, Lehman and what followed?  Clearly, there were political -- in my view, political implications.

And number two is, with Dodd-Frank and the whole approach to systemic risk, have we opened up Pandora's box in terms of the continuation of politics in the solution to the thing?  Or does Dodd-Frank solve that now?

GARTEN:  David, I'm going to ask you to take that.  I think -- I think we can package this basically as the degree to which politics has influenced the big Fed's decision, and whether that is going to continue -- that will be intensified or relaxed by the legislation.

WESSEL:  In answer to your second question, I don't think Dodd-Frank opens a Pandora's box.  I think the crisis opened a Pandora's box, and Dodd-Frank makes it more complicated.  But it isn't the -- it isn't the original sin here.

On the -- on -- look, there's politics in Washington.  I mean, are we supposed to be horrified that the Treasury secretary and the chairman of the Fed and the president of the Federal Reserve -- the president of the Federal Reserve Bank of New York actually talked about whether to save Bear Stearns, Lehman and AIG, and somehow some great precept of monetary economics has been violated?  I mean, that seems a bit absurd.

I don't -- I think that where -- I have a great deal of sympathy with -- what John says is I believe that this central bank thinks that when the political authorities are paralyzed, it has a responsibility to act for the good of the country.  Other central banks, sometimes the European central banks, sometimes not say, "Our function is to say no so the fiscal authorities do the right thing."  And there, I think, is a very interesting political thing.

If the question is somehow, did the big moneyed interests of Wall Street force the Fed to bail out Bear Stearns and to screw Lehman Brothers or something like that, I just don't think that's true.

But I think you can see in Hank Paulson's book that people on Wall Street who have access to the Treasury secretary have a way of making their case known.  And because the very act of bailing out big financial institutions involves the fiscal and monetary authorities, it becomes political right away.  And there is -- it's going to be hard for the Fed to extricate itself from that.

I'm not sure that's completely responsive to your question.  It was -- yeah.

GARTEN:  John.

TAYLOR:  Yeah.  I think the very nature of the way these bailouts occurred is, they raised questions about:  Why this, and why not that?  I think it's just (inherent ?).

And so I think that's why it's so important to try to move towards a more rules-based approach to these things, the rule of law, if you like, having more of a role.  And I don't think Dodd-Frank did that.  I think it basically left even more discretion in the hands of -- more power, if you like, in the hands of the authorities.  So that worries me for exactly the reasons you're saying.  It raises questions about what's this power and discretion going to be used for, and who's going to benefit, and what are the intricacies of that?

So I've been working hard on trying to find a way to -- for financial firms to be handled more by rules-based approaches, through some kind of a modification of the bankruptcy code, or as David said, a way that makes it more systematic about how these institutions will be handled so that they can be reorganized or if -- wound down, if necessary, in a way that's not so chaotic; if you like, there can be a Plan B so we don't have to rush in and do these -- I think quite damaging -- bailout operations.

GARTEN:  Okay.

Other questions?

MR.:  One there.

QUESTIONER:  Is this the microphone?  Great.

Hi.  Emil Henry.  And I had the pleasure to serve in the Paulson Treasury, so just a follow-up on Bill's question on politics.  And so you'll see my bias here.  Maybe this is for -- this is best for John, who I agree with on almost everything.

The -- just the political reality going back to Lehman Brothers, why is this not the case, the -- just placing yourselves back in the summer of that year, the system virtually about to grind to a halt in almost every major financial institution?  The political reality -- back to Bill's question -- the political reality is that the -- is that the Congress never acts unless there is a crisis, right?  It's kind of fixing the -- fixing the airplane after the crash.  It never acts until there's a crisis.  So the political reality was that Congress never would have acted and never would have signed up for 700 -- $800 billion, whatever the final number was of that initial TARP, in the absence of a crisis.

So why wasn't it the right thing to let Lehman Brothers go, which was a -- which was a strong signal to the system, perhaps the right signal to the system in terms of moral hazard and all the other elements?  And that was -- the political reality was, that was the impetus for Congress to act and to sign up for TARP, which many might regard as a superb -- ultimately, a superb investment for the people of this country, where they actually might even see a return on their money and an instituted stability to boot because of it.  Anyway, just curious for your reaction.

GARTEN:  Well, I'm going to -- you know what?

QUESTIONER:  Yeah?

GARTEN:  Because we're running out of time, and I want to ask one more question, I'm going to leave that as a -- as a statement.

QUESTIONER:  Okay.  (Chuckles.)

GARTEN:  Okay?  Because you were there, and I think it's a very interesting observation.

But I would like to go back to the panel now and ask the three -- if we do -- we can do the short -- in a short way -- the three biggest challenges that the Fed faces over the next several years.

John, I'll start with you.

TAYLOR:  So I think number one would be to find a way to get back to what was working in the '80s and '90s.  Quite frankly, it -- don't -- let's not forget that this was a period of very long expansions, very short recessions and basic stability.  I think monetary policy deserves credit for that.  So that's really number one.

Number two.  Find a way to preserve its independence in the context of many people are just concerned with what has happened with, if you like, taking on too many things, too many -- too many jobs, fiscal policy, credit-allocation policy, if you like; it needs to have a new accord, somehow, like in 1951.

I think number three is to really reassert the important global role it has had for many years by doing the right thing, quite frankly (by obviously ?) maintaining the purchasing power of the dollar, and making that clear that that's what it's going to do.

Globally, it doesn't have to sacrifice its goals for the United States.  Its global role is quite consistent with that.  But I think, working with other central banks, coordinating more as central banks, quite -- (inaudible) -- if you like, think about a global goal for price stability so that they could work together and cooperate.  I think that would be a third important goal.

GARTEN:  Alan.

BLINDER:  I guess I'd start with adapting to Dodd-Frank.  I mean, I think it's insufficiently appreciated outside the Fed -- it's certainly appreciated inside the Fed -- that the new responsibilities and somewhat altered responsibilities, but mainly the new responsibilities for financial stability and serving kind of as the CEO to the financial stability council's board of directors requires institutional adaptation at the Fed, which is, like most bureaucracies, not that great at institutional adaptation.

My understanding is that the Fed as a system is going to be adding -- I'm not sure I'm right about this, but ballpark, a thousand or 2,000 new employees to do this -- to acquit itself of these new responsibilities, which, as David said, are not entirely well defined.

Let me say, however, that the price stability and maximum employment goals are not entirely well defined.  They're modestly well defined now, but it took decades to get that definition.  And I think it'll take decades to get that kind of definition of financial stability.

But in principle, the financial-stability division of the Federal Reserve, or whatever they call it, is going to be a very powerful piece of the Federal Reserve; and exactly how it's going to exist within that institution, not to mention how it's going to coexist with its tenant -- the Fed has been made the landlord of the Consumer Financial Protection Bureau, one of the sillier things that's in Dodd-Frank.  It makes the Fed a landlord.  That could be on the list of John's functions that you don't really need a central bank to be, to have:  a landlord.

So I think there's a lot of work that's going to occupy a lot of man- and woman-hours at the Fed to adapt to Dodd-Frank.

Secondly, we're not out of the woods yet.  And we are at a zero interest rate right now.  The economy's looking a little bit better in the last month or two, but not -- hardly gangbusters.  It could stagger, again, for any number of reasons, including infection from Europe and things that happen here.  And if that is the case, given the -- given the limited weaponry it has now at a zero interest rate, and given the beating it's taken over QE2, I think the Fed will be severely challenged if the economy stumbles again and/or we move towards deflation -- which is a word that hasn't been mentioned here, but we're a lot closer to deflation than inflation.  The phrase "price stability" is symmetric in principle.

Thirdly, once we get over that -- and we're not over that yet, but you wanted us to look out ahead -- the Fed does have to get back to its exit strategy that John was alluding to.  It really doesn't want to be in this business.  It does not want to own MBS.  It does not want to own assets left over from Bear Stearns and AIG.  It does not want to be doing QE n.  It wants to go back to regular old monetary policy.

And of course, as the critics have pointed out, the deeper we get into QEs -- QE1, QE2, QE3, et cetera -- the bigger the exit problem facing it, just quantitatively, not conceptually; it's the same.  But quantitatively it becomes bigger, and at some point down the road the Fed's going to have to start doing that.

WESSEL:  To avoid repeating what's been said before, let me just say briefly, one is to learn the right lessons from the last several years.  We could learn the wrong lessons and do it again, so we ought to minimize the risk by learning the right lessons.  And as you can see, there's not exactly unanimity in the profession about what the right lessons are.

Two, I think preserving --

GARTEN:  Let me ask you -- what do you think the right lessons are?

WESSEL:  I think the right lessons are that, A, the regulatory function is extremely important, and when everybody says you have nothing to worry about in the financial system, it's the time for the Fed to worry about it, and the same in the William McChesney Martin -- you know, time for the Fed to take away the punch bowl when things get good.

Second -- and this would be my second point -- is to think hard about what the Fed's responsibility is about asset prices and financial stability.

And third -- and this is related -- is to explain effectively on what things the Fed should be independent and what things it's not part of the deal.

Nobody thinks that we need to have a central bank that is unaccountable to the democratic institutions of our society and able to do anything it wants; although, people would be excused if they concluded from the recent crisis that that is the way they interpret their role.

But there are some things where monetary-policy independence is essential for the functioning of our economy.  And I think because the Fed has done so much, as John said, it's hard for people to understand.  So you need to be independent in this and not independent on that.

So laying an effective case for why an independent central bank on monetary policy is important, because -- this is a little bit like running a life insurance company.  You know, the trick to running a life insurance company is to succeed a guy who made good decisions, because when you're the CEO of a life insurance company, nothing you can do now will affect your current results.

Well, when it comes to the independence, the political independence and the credibility of the Fed, what Ben Bernanke does today will determine whether his successor can do a good job or not.  And I think that both Volcker and Greenspan really understood that and did things that they knew were essential investments for the Fed in its future independence.

Well, you know, the Fed can be excused by neglecting that role while it was trying to put out the world's biggest financial fire in our lifetime, but now it's time to get back to that.  So learn the right lessons to establish credibility about what independence is and explain it to people -- they need the consent of the people to be independent -- and thirdly to figure out what does it mean to maintain financial stability, particularly with regard to asset prices.  If they do all that, the next meeting of this group in 10 years will be very boring.

GARTEN:  I won't even try to sum up what was said, but I want to thank the panel and ask you to join me in thanking them for a great discussion.  (Applause.)

 

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THIS IS A RUSH TRANSCRIPT.

 

 

JEFFREY E. GARTEN:  We'd like to get started because we have -- we have a lot of territory to cover in a very short period of time.  My name is Jeff Garten, and I'm the presider today.  I have the honor of doing that.

Today we're going to talk about, "What kind of Fed do we want?"  This is part of the McKinsey Roundtable Series on the international economy.

Before we start, I would like to ask everyone to please turn off their cell phones.  And the rule of the council is also turn it -- don't put it on vibrate either because it will interfere with the microphone.  The other thing is that today's meeting is on the record.

I don't think I have to emphasize how important and how timely this subject is.  We all know that the Fed is at the intersection of so many critical issues in our society.  It is essential to the issues of economic growth, jobs, monetary stability and the stability of financial institutions not in the U.S. and abroad.

I would also say that the Fed plays a huge role in shaping really critical relationships, relationships such as those between creditors and debtors.  And while this may sound mundane, it takes on even a bigger role now as the U.S. itself is such a huge debtor and we'll be dealing with that situation in the global economy for many years to come.

I think the Fed also is very critical to shaping the relationship between Wall Street and Main Street, which, of course, puts it at the center of an enormous number of political issues.

The Fed also plays a unique role in our democracy.  Unelected, it is nevertheless incredibly powerful.  And it's no exaggeration, in my view anyway, to say it has become the fourth branch of government.  And this issue raises a huge number of important questions about accountability, transparency and governance.

And finally today, the Fed is really in the spotlight.  Part of that is because of its role in the recent financial crisis, a role of unprecedented activism, a role which made it not only lender of last resort but in many cases lender of first resort.  And the controversy surrounding the Fed's actions also extend to its role in monetary policy.

This is not going to go away, and it's not going to go away for a lot of reasons.  It's the centrality of the Fed but also because we have a change of government in the House.  And the House Financial Services Committee is now headed by someone who recently wrote a book called, "End the Fed."  And he would like to see the Fed abolished, but he's not the only one.  If you look at popular polls, this is not some insignificant minority in the United States that really feels the Fed has gone astray.

So to discuss these issues today, we have a really wonderful panel.  You probably know everyone here.  The bios are in front of you.  But I'll just briefly introduce Alan Blinder, who is a professor of economics and public affairs at Princeton and former vice chairman of the Fed; David Wessel, who's the economics editor of the Wall Street Journal and also the author of a wonderful book on the Fed, "In Fed We Trust"; and John Taylor, professor of economics at Stanford and also former undersecretary of the Treasury for International Affairs.

I think the way we'll do this is that I'm going to pose a few questions to the panel just to get the issues aired, then we'll go to questions from the members here, and I'm just going to reserve a little time at the end to pose a final question to the panel of the three major challenges they think the Fed faces in the decade ahead.

So let me start really by asking -- I'm going to ask you to grade the Fed in three different areas, and grade it from "A" to "F."  Three phases:  the pre-crisis, or the run-up to the crisis; the involvement in the crisis; and then post-crisis, such as it is.  And John, maybe I'll start with you.

JOHN B. TAYLOR:  Thank you.

I think it's important to start before the crisis.  I think the crisis really first flared up, as you know, in August of 2007, went to the panic period in the fall of 2008, and then we have, since the panic, a post-panic period, if you like.  But before this crisis even began in 2007, I think the seeds of it were pretty clear by monetary policy.

After really two decades or more of really, I think, really extraordinary, good economic policy, monetary policy -- the long expansions, low inflation, a lot of stability in most of the '80s and '90s -- we ran into a period where monetary policy, I think, deviated from that policy by keeping interest rates too low for too long, mainly in 2003, '4 and '5.

And there's different ways to look at it.  I like to look at it and compare what -- compare that with what happened in the '80s and '90s.  And there's clearly a too low for too long situation.  So that accentuated the housing boom, led to excessive risk-taking, encouraged a lot of activity which we now look and can't believe it really happened; wasn't the whole story but a big part of the story.  So that's a -- moving from really a strong "A" period to well below "A," not passing.

And I think the crisis, beginning in '07, also sees some different type of activity.  I think early on, the actions were not so good.  I think the -- I would call the on-again, off-again bailout policy, that began with the bailout of the creditors of Bear Stearns. turned off, if you like, for the creditors of Lehman, turned back on for AIG, turned back off again as the TARP was rolled out.  It seems to me that caused a lot of uncertainty and actually added to the panic.

The panic itself, I think the Fed did a very good job.  The commercial paper credit facility; the money market mutual fund facility; extraordinary, if you like, addition to the confidence in the markets that I think had helped arrest the panic, but basically the panic itself was caused, I believe, by the prior activity.

And then finally, post-panic.  Since the fall of 2008, I don't see a lot of good things here, quite frankly.  QE1 was a purchase, roughly, of 1.25 trillion (dollars) of mortgage-backed securities.  I don't think it really did much good.  My studies -- I've done lots of studies of this, careful econometrics.  I don't see it has done much good at all.  There was also 300 billion (dollars) of purchases of medium-term Treasurys during that period, during what we now call QE1, the first quantitative easing bout.  I don't think that did much good, either.

I was hoping that that was going to end when the emergency went away, as it disappeared into the past.  But lo and behold it didn't, and we just got something called now "QE2," which seems to me very disappointing because it really extends this period of really unconventional activity beyond any reasonable justification, in my view.  So, again, we're moving back into low grades, and I'm hopeful we're going to get off of that, and get back to the good kind of policy that worked so well in the '80s and '90s.

GARTEN:  So in sum, the only high grade you give is in the -- in the -- in the middle of the panic.

TAYLOR:  Yes, and in the '80s and '90s.  And don't forget that because we should really -- that was a good period for monetary policy.

GARTEN:  Okay.

Alan, you agree?

ALAN S. BLINDER:  Well, I was on the Fed in the '90s.  So I -- at least I'll agree with that.  (Laughter.)  With the rest, I would take some exception.  I would actually divide in two periods -- you asked for three -- which is -- and dividing it at some X days after Lehman Brothers.  I don't know whether X is three, five, seven, just right after Lehman Brothers.  If you go back to Lehman Brother -- from Lehman Brothers plus X days backward, I think the Fed's grades -- not back to the '80s and '90s, in the bad period, the Fed's grades were poor, especially poor on bank regulatory policy, a supervisory policy, I should say.

I think I'll probably go to my grave not knowing what I really think about the Bear Stearns episode.  I could argue either side of that for myself and convince myself of either -- of either side of that.  I think Lehman was a catastrophic, absolutely catastrophic error.  But -- so what am I grading that whole period?  Pretty low.  I remember years ago Yale abolished the grade of D.  Have you put it back?

GARTEN:  No.

BLINDER:  No.  At Princeton, we proudly use the grade of D.  So maybe that's what I would -- maybe that's what I would give.  But from Lehman plus X days forward, I give the Fed A-plus.  I think it's been extraordinary.  I think it's been necessary.  I shudder to think how things might have been had the Fed not put their heads on the chopping block, as you were sort of suggesting earlier, time and time and time again.

Now, by the time we got to QE2, I'm -- I guess I'm modestly favorable toward what's now being called QE2.  I don't expect any great effects from it, and neither does the Fed, by the way.  I think they engaged it on the belief that turned out to be a slightly false belief that there was nothing if not worse coming out of fiscal policy.  Just in terms of aggregate demand stimulation, let's leave aside what you do to the future deficit.  So -- but just in terms of aggregate demand stimulus, I think the working assumption was there was nothing coming out of the political world, and the Fed had to do what little it could.  And so it did that.  But overall I think the grade has to be extraordinarily high from Lehman plus X days forward.

GARTEN:  David.

DAVID WESSEL:  So this is a kind of an uncomfortable position to be in, with two eminent professors from whom I've learned a lot who disagree on much of everything.  And I'm the one supposed to cast the deciding vote.  (Laughter.)  And I just want to -- there was no lack of respect for the Council on Foreign Relations that my suit jacket is hanging in my mother's closet in New Haven.  And she called me about five minutes ago before I turned off my cell phone to assure me that I knew that my suit jacket was there.  (Laughter.)

I think that -- I don't think there's -- it's very difficult to make the case that the Fed did a good job before this episode because we had an episode that reflects very poorly on the Fed.  I think the difference between Alan and John is interesting.  John sees them as failing on monetary policy.  I think that's a debatable point.  But I do know that a number of people inside the Fed who were involved in those decisions are much more sympathetic to the "we-held-rates-too-long" view now than they were at the time.

Now, hindsight is an important check on one's judgment.  But it's always a lot -- very convenient to say, if I had it to do all over again, I would have done something differently.  And so I think one has to be careful how one judges these things.  Was it obvious at the time that it was too low too long?  Or is that only an after-the-fact judgment?  I think a lot of the judgment is after the fact.

On the regulatory front, which Alan referred to, I don't think there's any question that the Greenspan Fed basically thought the market could take care of itself.  Greenspan has testified that this was his biggest mistake, that it turns out that even if you have a lot of money on the table, it doesn't mean you're going to police the table.  And that was a catastrophic failure.

I don't judge them harshly for Bear Stearns.  Where I judge them harshly is the period between Bear Stearns and Lehman, where as John has pointed out, they gave us very little guidance as to what their thinking was.

You know, you don't want to have a committee meeting to decide whether to send out the fire engines.  Bear Stearns was collapsing.  They had to make a decision in a hurry.  They were not prepared to make that decision.  They made their best judgment.  You can argue that had they not bailed out Bear Stearns, Lehman wouldn't have happened.  You can argue if they had not bailed out Bear Stearns, we would have had Lehman Brothers on Bear Stearns' weekend instead.  I don't know what the right counterfactual is.

But that period between Bear Stearns and Lehman, I think, is the biggest failure of the whole thing.  They weren't prepared for Lehman.  It's very hard to argue that Lehman was a great success.  So I think you have to, of course, judge them harshly on that.

I'm sympathetic to the views that both Alan and John share, the one thing on -- they agree on, is that once the panic started, I think the Fed deserves very high marks.

And there we do -- we do have counterfactuals.  You know, we saw what happened during the Depression when the Fed decided to stick to some prevailing orthodoxy and didn't cooperate with other authorities in the interest of the global economy, and we had a catastrophic capitalism in the -- in the economy that we didn't have this time.  And although most Americans don't believe that, although most Americans are not comforted by the assertion that it could have been worse, the fact is it could have been.  And I think you have to give them very high grades for that period.

I'm closer to Alan than John on the question of whether QE1 and QE2 were indicated, but I judge them very harshly on their inability to explain to us -- and by us, I mean the American people, not the Ph.D. economist, but the American people -- exactly what they were doing and why they were doing it.  And I think it's an extraordinary failure on the part of an institution which has begun to see just how important communications is and a chairman who actually believes in transparency and communication, how difficult it's been for them to explain to us what they're doing.  And that will pay -- that is a serious failure, because it undermines the credibility of an institution that relies on credibility to do its job.

GARTEN:  So let's drop back now from the -- from the actual operations and talk about a mandate of the Fed.  I think most people feel that the Fed has two -- has a mandate to do two things; one is monetary stability and the other is full employment.  Recently there's also been --

WESSEL:  You mean price stability.

GARTEN:  Price stability.  Price stability and full employment.

There are also a lot of issues now relating to financial stability.  I'd like to ask Alan whether -- do you think the mandate of the Fed is right?  Is it too broad?  How would you evaluate it as we look ahead over the next several years?

BLINDER:  I think it's pretty much right, with a couple of footnote exceptions.  So the answer is right and then you put a footnote about how you could do it better.

The right part -- the act gives the Fed -- the Federal Reserve Act gives the Fed responsibility for keeping inflation low, keeping unemployment low.  And I'm glad we have that compared to, say, the ECB, which -- I -- mandates matter.  People take an oath of office and they do what they're supposed to do -- at least most people do what the law directs them to do.

The Dodd-Frank act has now given explicitly the -- a third mandate that was tacit and you might even say implied by the first two, which is for price stability -- excuse me, for financial stability, that is, overseeing and doing something to delimit systemic risk.  That's always a tacit part of the central bank's job, but it's not really in the Federal Reserve Act.

I didn't comb through the 2,400 pages before coming here.  I don't think it's -- the Federal Reserve Act was amended.  I think it would be a good thing to actually amend the Federal Reserve Act, put that in the legal mandate, which is Section 2a or something of the Federal Reserve Act.  That's the footnote.  But the authority is clearly given to it and the responsibility is clearly given to it by the Dodd-Frank act, and I think that's appropriate.

GARTEN:  John.

TAYLOR:  I long thought that the best strategy for the Fed or any central bank is to focus on price stability, because that brings about employment stability and economic stability.  And I think, for many years, since 1977 when the dual mandate was inserted, the Fed worked through that by arguing the best way to have strong economic growth and strong employment growth was to deliver on price stability.  Volcker, Greenspan spoke about that all the time.  And so even though I would object to the confusion that a dual mandate causes, I think they handled it quite well.

Now I think we've seen it working not so well, the dual mandate.  And I think the point, David's point about communication, illustrates this.  For many years, the statement by the FOMC, which they give after their meetings, did not mention the maximum employment aspect of this.  They mentioned the strategy is to make the economy stable by having the price stability.  But for the first time in their FOMC statement -- the first time, October 2010 -- the maximum employment term appeared.  And it was there to really, I think, justify quantitative easing 2.  And it's been repeated in the meetings since then.

So what I see is happening is that dual mandate is being -- is coming back in in a different way, by different people, and confusing the whole situation.  So I'd very much at this point like to argue that the Fed's mandate should be adjusted, if you like, to emphasize price stability -- I call it price stability within a context of economic stability.  When you focus on price stability, that doesn't mean you don't cut interest rates in a recession, it doesn't mean you don't provide liquidity in a crisis, it doesn't mean you don't have lender of last resort.  Those are essential to price stability and economic stability.  But by confusing this and allowing some people to go out and give different motivations for things, I think we're just confusing the situation.

BLINDER:  If I can just --

GARTEN:  I'll get to you in a sec.  I just want to ask --

BLINDER:  Just a very short interjection.  There really wasn't such a big change last October or whatever.  When I was on the Fed in the '90s, whether we were increasing interest rates or decreasing interest rates, we always justified it by sustaining maximum -- "maximum sustainable economic growth," that was the euphemism.  And it went whether -- (inaudible) -- went up or down, which was -- I used to argue about that.  But it's not a new thing.  It started with the '77 act, as John said.

WESSEL:  I think mandates do matter, and our reporting suggests that when the FOMC talked about QE2, they talked quite a bit about what their mandate was.  I'm not sure that I agree with John.  By the Fed's definition, we are below price stability.  This was easy to justify on the grounds that they were missing on both the employment and the inflation target.  The much more intellectually interesting case would have come if inflation were closer to their target of about 2 percent and unemployment were still high.

I think it's naive to think that a central bank of the United States or any democracy is going to be oblivious to 9.8 percent unemployment; and nor should it be.  But I think Jeff raised an interesting question -- which neither Alan or John wants to touch because they're macro-economists -- is so what about this financial stability goal, and what does that actually mean?

And I think that it's quite unclear what it means.  And I think the Fed is being set up in a way to take the blame for the next crisis, which will obviously come.  And this time, the chairman won't be able to go before the Congress and say, "Well, I didn't have authority to worry about the nonbank financial institutions of the shadow banking system."  The members of Congress will say, "Look, after the last crisis, you told us we needed a systemic regulator, and we set up this committee, and you're on it.  And you blew it."

And so I think it's going to be an evolving discussion inside the Fed about what financial stability means.  And I'll just give you two examples of how difficult this is.  One is:  Does it mean that the Fed has a responsibility of acting when it thinks there's an asset price bubble -- stock market bubble or housing price bubble?  And if so, how exactly is it supposed to do that?  Is it supposed to tighten regulation so there's not a lot of lending in those institutions?  Is it supposed to give speeches and say, "Don't buy a house"?  Can you imagine that?  Is it supposed to raise interest rates, even if the conventional measures of price inflation and unemployment are not worrisome, because it sees an asset bubble?  I mean, these are questions that academics have debated and the Fed has never had to cope with before.

And the second is:  Are they supposed to be the ueber-regulator?  It might have been an interesting model to say no, that there was -- someone else was the regulator.  But the Congress chose not to do that; learning from the British model that apparently that's not perfect either.  On the other hand, they didn't say the Fed is the sole regulator.  So you can imagine we will have endless stories in The Wall Street Journal about tension between the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve about banking supervision and financial supervision, all justified in the name of pursuing financial stability.

So I think that in my mind is the biggest question mark:  What exactly has changed now that the Fed has more responsibility for financial stability, and what exactly is that going to mean in practice when we get beyond this current period?

GARTEN:  So let me just follow up that, because the next question I was going to ask is:  Just how significant is the new legislation, is the Dodd-Frank legislation, when it comes to the Fed?  And you -- you're actually on that ground.  Well, just venture an opinion in -- because we don't have a lot of time, but in this light -- is it very?

WESSEL:  Yes, it's very significant, not only because of the letter of the law but because the law embodies a view in Congress and the public that somehow the cops on the beat fell down on the job.  And we wanted to give the cops more power, more ammunition, so we don't go through this again.  So there is an expectation the Fed is going to prevent the next crisis.

The Fed will fail to do that.  It will be blamed.

GARTEN:  Okay.  So final question before we open it up.  This has to do with the global role of the Fed.  Obviously, the Fed has always had a huge international influence.  And in the crisis, it was extremely active in terms of making dollars available to central banks in many countries.  Psychologically, what the Fed does or doesn't do always has a large impact.

But my question is this.  If -- given the way the global economy, the global financial markets have evolved, given all the interconnections, given the growing size of that and the rise of other central banks -- ECB, Bank of China -- Public Bank of China, as you look ahead, what can you say about the changing role of the Fed in the global economy?

What -- Alan, I'll ask you to start with -- you know, if -- the -- Bernanke and his successor -- what's going to be different about the way they run the Fed than previous chairmen, given the way the world economy is going?

BLINDER:  I guess I'd start with the three words "not too much."  But let me elaborate on that a little.  First we have sort of the obvious arithmetic of what is moving toward and eventually will be a more tri-polar world, where the Fed is probably still the first among equals among the Fed, the ECB and the People's Bank of China.  We're a long way from the latter; we're not so far from the second, from the ECB.  So the Fed, as you look over the distant horizon, will not be quite as omnipotent as at least some people like to portray the Fed now and in recent years.

Second factor, which is very important -- and I think you don't really appreciate this until you -- this is already the second time I've mentioned the oath of office.  But Alan Greenspan appreciated this very much, and I'm sure Ben Bernanke does also, which is -- this goes back to the legal mandate.  The Fed has delegated authority from Congress.  Congress gives it its mandate.  And there is nothing in that mandate that says, for example, now and then you should pull punches in order to take the rest of the world into account -- that is to say, if we needed easier monetary policy.

But maybe for the rest of the world that's not so good.  Or the other way around, that the Fed should shade its decision in favor of the rest of the world relative to what it would do if it cared only about one country.  The mandate tells it to care only about one country.

Now, I think it's quite arguable in principle -- a bunch of us academics could argue, you know, in this kind of globalized world, we ought to revive the Fed's mandate, because after all, we're central to the whole world economy, and what happens in the rest of the world reverberates on us and conversely.  But then I'd just ask people in the audience to think how many of the 535 members of Congress do you think would vote for that amendment.  And your estimate is probably the same as mine:  zero.

GARTEN:  David.

WESSEL:  I don't think the Fed's role has changed.  I think America's role has changed, and for the -- all the reasons Alan said.  We've never -- the Fed has never been strictly focused on the United States, and -- nor can it afford to be.  It's the protector of the U.S. dollar.  And we've had periods in the past when the dollar needed some help and they stepped in.

But I think that we live in a very different time.  And I imagine that Paul Volcker would have a hard time understanding why it is that Ben Bernanke has to spend so much time assuring his counterparts in the People's Republic of China that, no, he's not going to get inflation -- let inflation get out of control, and therefore please don't sell all your dollars.

So the Fed's role has changed because our role in the world economy has changed.  We no longer are a master of our own fate given how much we depend on the kindness of strangers to lend us all their savings.

GARTEN:  John.

TAYLOR:  I think the idea of the central bank -- our central bank maintaining the purchasing power of the currency is very important for our world economy.  And to the extent we get away from that, to the extent we, if you like, think about doing too many things, I think that really is in some sense abnegating an important aspect of leadership, for the United States and for the Federal Reserve.

In the period I mentioned earlier, where interest rates were too low for too long, that actually spread around the world.  It made it harder for other central banks to do the right thing.  In fact, if you look at certain areas of the world where they also had housing booms, it was really related to their interest rates being too low at that point.  So in a sense that affected the world economy.

So I think the -- I'm somewhat disappointed that we may be losing that important leadership role, which has been very important for the world economy for so long.  The QE2, in a way, is an example.  I'm not surprised about the complaining from other countries for this.  I was surprised that it was so -- they were so outspoken about it and it interfered with our foreign policy.  I was surprised at that, but not surprised with their logic, because it does make it harder for them to control inflation.  It does have the potential to cause, if you like, a growing inflationary boom globally.  And that's going to feed back on this economy and hurt us.

So I think there's so much here that is, if you like, beneficial for the world economy if we have a central bank that does the kind of things it did for most of the '80s and '90s, which was not only a stable period for the U.S., it was stable elsewhere, too.

So I'd just like to get back to that way of thinking about policy.  It worked.  It was a framework that worked, and it showed a great deal of leadership by this country, which I think's important for the world.

GARTEN:  I think that's good point of departure for questions from the members.  I'd ask you to -- where are the microphones?  Okay.  There are microphones all over.  If you would just stand up, please, just identify yourself and your affiliation, and speak into the microphone.  Do we have -- yes, please.

And let me ask you this.  You could address the question to me and I will farm it out, or to one of the panel members, but we don't really have time for each of the panel members to answer every question.  So I'd like to, in a sense, ask one to do it.

QUESTIONER:  Thank you.  I'm Richard Weinert, Concert Artists Guild.  It's been an article of faith for some decades that the best arrangement is the central banks to be politically independent.  This is obviously under some question and attack now.  And I'd like to ask whomever on the panel would like to comment on what you think would be the ideal arrangement.

GARTEN:  Alan, I'll ask you to --

BLINDER:  Well, I'm not sure I can define the ideal arrangement, but certainly independence -- now independence is not like a point, it's a sort of a range, and I'm not sure I can answer with that kind of precision.  But I think the events of recent years, including the speed that they required, the freedom to take unpopular actions, and the performance of the Fed and other central banks under duress, never minding the poor performance of the regulatory regime, after all points to the -- how vital it is to have quite a lot of central bank independence.  A small piece of evidence, as you probably know, over the '80s and the '90s almost every country in the world -- there are some exceptions -- moved toward central bank independence, and not one single one moved in the other direction.

GARTEN:  David, I'm just going to ask you to comment on this from this standpoint.  How much of a threat to the independence of the Fed do you see boiling up in the American political system?  Not just the rhetoric, but the reality here.

WESSEL:  I think I would say some, by which I mean that it is not surprising the Fed is taking a lot of heat.  The Fed displayed an extraordinary amount of power and became a lightning rod for a sense in America that Wall Street got bailed out and Main Street didn't.  I think when push comes to shove, the Congress will flinch.  So proud of the excellent job they've done managing fiscal policy, I suspect they'll be a little reluctant to take on monetary policy.

And so far the Fed has been extraordinarily successful in beating back every attempt to clip its wings.  But -- and as the economy gets better, I suspect the pressure on the Fed will abate.

But a door has been opened, and it won't be easily closed.  And so if there takes hold in the Congress a kind of people -- (inaudible) -- give voice to the idea that somehow Ben Bernanke is printing money that's all going into the pockets of Goldman Sachs, that will eventually pay dividends in legislation.  But I'd say the chances now are remote, but they're substantially greater than zero.

GARTEN:  John.

TAYLOR:  I think independence is essential as well, but I worry that a lot of these actions already taken are raising questions about its -- the Fed's independence.

When the Fed gets involved in fiscal policy; when it gets involved in credit-allocation policy, helping one market, say, the housing market versus others or one firm versus others, that's not monetary policy.  That's really fiscal policy, and it raises governance questions.  I -- it raises constitutional questions about who -- it's -- Congress has authority to appropriate funds.  And when the Fed moves into that area, it's really losing some of its independence.

It -- during World War II and afterwards, it really was in there helping the Treasury bond market all the time.  We had this accord in 1951 where the Fed regained its independence because it stopped doing those things.  When it starts doing them again -- and it has -- it's -- I think rightfully its independence gets questioned, and I think we should try to find a way to have them stop doing that and then they require a different type of appropriation mechanism.

WESSEL:  (Off mic) -- I think that there -- progress has been made in filling a -- in closing a vacuum that the Fed was forced to fill.  The ability the government now has to close a Bear Stearns or Lehman Brothers under Dodd-Frank removes from the Fed one burden it had.

And it's interesting, and in my judgment appropriate, that in the future if the Fed uses its extraordinary authority to lend under section 13(3) of the Federal Reserve Act, it will require the explicit consent in writing of the Treasury secretary, which I think is a totally appropriate use of the democratic check on the Federal Reserve without making it impotent at a time when we might need its strength.

BLINDER:  I agree with that.  I just want to add, 13(3), as it existed at the time, fully justified what the Fed did.  It was perfectly within the law.

GARTEN:  Okay.  Jacob and then Bill.  Right here.

WESSEL:  Jacob's question's for these guys.

QUESTIONER:  Thank you.  Jacob Frankel, JPMorgan Chase.

In the old days, it was very clear that there were very sharp distinctions between issues that the fiscal authorities deal with and issues that the monetary authorities deal with.  And as a result, there were also very clear distinction between the instruments of the two.  And the question of independence and political pressure, therefore, did not come to the fore to such an extent, because the more you enter fiscal territory, the more political you become and therefore subject to political pressure.

So this comes with the territory.  As we look at it today, we see, for example, that in -- that new assets make themselves to the balance sheet of the central bank, probably much lower-quality assets than used to be with the rationale that is being given, but the picture is very, very different.

Likewise, when we speak about the European Central Bank and it buys Greek government bonds, it's fiscal policy; it's transferring resources from one country to another.

So obviously the political debate is coming up.  The rational for it has been that somehow the leaders of the monetary authority are enlightened, they see that the fiscal authorities are not operational; and therefore, they have national responsibility to step in.

It sounds good, but it's a trap also.  And the question that I have is -- question number one -- are we seeing now a detour from the traditional demarcation that will be returning in normal time, or is it really a new paradigm, a new paradigm in which the end-of-the-Fed syndrome is a legitimate question, because if you consolidate the two, then what's the point of having two departments?

The second --

GARTEN:  Can I -- can I ask you --

QUESTIONER:  Yes.

GARTEN:  Can I ask you to stop at that question?

QUESTIONER:  Yes.

GARTEN:  Because it's such a big question, I'd like to -- I'm afraid we -- John, why don't you --

TAYLOR:  Well, I think I share Jacob's concern that we may even have begun to pass the Rubicon on this.  The -- in a way, to me, QE2 for the Fed was a bit of a watershed here.  And I hope it's not, but the QE1 and the other activities were associated with an emergency, I think a specific thing.  And you could -- we justify it on that basis.

And I remember saying at the time, "Well, you say it's an emergency now.  But what's going to happen if there's like a slowdown in the recovery?  Are you going to start doing this again?"

"No, no, it was an emergency."

But here we have a slowdown in the recovery, and the same time -- type of thing has happened.  So it seems -- I worry if this is like a new type of monetary policy, in which I case I think your questions are quite legitimate.  And I hope we, for that reason, go back to -- to a better demarcation.

GARTEN:  Al.

BLINDER:  I think there are two answers.  You had the emergency situation, and that is the situation under which the Fed acquired most of these dodgy assets.  It still has Maiden Lane and things like on its balance sheets.  They're pretty small.  And then the MBS is something in between.

The QE2 is the acquisition of Treasury debt.  That's what the Fed has done since its founding.  And I just fail to understand why people think it's such a big deal than instead of buying three-month Treasury debt, they're buying three-year Treasury debt.  I mean, it's a small difference, but it's certainly not a difference in kind.

To your question, Jacob, I think these emergency acquisitions of -- what shall we say -- strange assets come with the emergency and they go with -- when the emergency abates.  And I don't think we're going to have anything like this for a very long time, but I certainly don't rule it out sometime way in the future, and the Fed do something like that.

Again, the responsibility for financial stability is permanent, and you could argue a permanent change in the Fed.  And when you have that responsibility and chaotic things happen, you have an implied, very explicit responsibility to try to obviate the consequences of those.  And the Fed will -- the Fed will do that as need be.

The last point I want to make is that -- you didn't quite get this, but this is probably your second question is -- a central bank is in a somewhat different world in terms of the weaponry it has when you're at zero interest rates.  So the things that the Fed would have in an earlier day counteracted by lowering interest rates, it now has to do -- either do nothing or do something else.

GARTEN:  Bill.

QUESTIONER:  Thank you.  Bill Donaldson.  I have a two-phase question that centers around politics.  Part -- question number one is, I wonder if you could comment on the politics inherent in the rank order of what happened to Bear Stearns, Lehman and what followed?  Clearly, there were political -- in my view, political implications.

And number two is, with Dodd-Frank and the whole approach to systemic risk, have we opened up Pandora's box in terms of the continuation of politics in the solution to the thing?  Or does Dodd-Frank solve that now?

GARTEN:  David, I'm going to ask you to take that.  I think -- I think we can package this basically as the degree to which politics has influenced the big Fed's decision, and whether that is going to continue -- that will be intensified or relaxed by the legislation.

WESSEL:  In answer to your second question, I don't think Dodd-Frank opens a Pandora's box.  I think the crisis opened a Pandora's box, and Dodd-Frank makes it more complicated.  But it isn't the -- it isn't the original sin here.

On the -- on -- look, there's politics in Washington.  I mean, are we supposed to be horrified that the Treasury secretary and the chairman of the Fed and the president of the Federal Reserve -- the president of the Federal Reserve Bank of New York actually talked about whether to save Bear Stearns, Lehman and AIG, and somehow some great precept of monetary economics has been violated?  I mean, that seems a bit absurd.

I don't -- I think that where -- I have a great deal of sympathy with -- what John says is I believe that this central bank thinks that when the political authorities are paralyzed, it has a responsibility to act for the good of the country.  Other central banks, sometimes the European central banks, sometimes not say, "Our function is to say no so the fiscal authorities do the right thing."  And there, I think, is a very interesting political thing.

If the question is somehow, did the big moneyed interests of Wall Street force the Fed to bail out Bear Stearns and to screw Lehman Brothers or something like that, I just don't think that's true.

But I think you can see in Hank Paulson's book that people on Wall Street who have access to the Treasury secretary have a way of making their case known.  And because the very act of bailing out big financial institutions involves the fiscal and monetary authorities, it becomes political right away.  And there is -- it's going to be hard for the Fed to extricate itself from that.

I'm not sure that's completely responsive to your question.  It was -- yeah.

GARTEN:  John.

TAYLOR:  Yeah.  I think the very nature of the way these bailouts occurred is, they raised questions about:  Why this, and why not that?  I think it's just (inherent ?).

And so I think that's why it's so important to try to move towards a more rules-based approach to these things, the rule of law, if you like, having more of a role.  And I don't think Dodd-Frank did that.  I think it basically left even more discretion in the hands of -- more power, if you like, in the hands of the authorities.  So that worries me for exactly the reasons you're saying.  It raises questions about what's this power and discretion going to be used for, and who's going to benefit, and what are the intricacies of that?

So I've been working hard on trying to find a way to -- for financial firms to be handled more by rules-based approaches, through some kind of a modification of the bankruptcy code, or as David said, a way that makes it more systematic about how these institutions will be handled so that they can be reorganized or if -- wound down, if necessary, in a way that's not so chaotic; if you like, there can be a Plan B so we don't have to rush in and do these -- I think quite damaging -- bailout operations.

GARTEN:  Okay.

Other questions?

MR.:  One there.

QUESTIONER:  Is this the microphone?  Great.

Hi.  Emil Henry.  And I had the pleasure to serve in the Paulson Treasury, so just a follow-up on Bill's question on politics.  And so you'll see my bias here.  Maybe this is for -- this is best for John, who I agree with on almost everything.

The -- just the political reality going back to Lehman Brothers, why is this not the case, the -- just placing yourselves back in the summer of that year, the system virtually about to grind to a halt in almost every major financial institution?  The political reality -- back to Bill's question -- the political reality is that the -- is that the Congress never acts unless there is a crisis, right?  It's kind of fixing the -- fixing the airplane after the crash.  It never acts until there's a crisis.  So the political reality was that Congress never would have acted and never would have signed up for 700 -- $800 billion, whatever the final number was of that initial TARP, in the absence of a crisis.

So why wasn't it the right thing to let Lehman Brothers go, which was a -- which was a strong signal to the system, perhaps the right signal to the system in terms of moral hazard and all the other elements?  And that was -- the political reality was, that was the impetus for Congress to act and to sign up for TARP, which many might regard as a superb -- ultimately, a superb investment for the people of this country, where they actually might even see a return on their money and an instituted stability to boot because of it.  Anyway, just curious for your reaction.

GARTEN:  Well, I'm going to -- you know what?

QUESTIONER:  Yeah?

GARTEN:  Because we're running out of time, and I want to ask one more question, I'm going to leave that as a -- as a statement.

QUESTIONER:  Okay.  (Chuckles.)

GARTEN:  Okay?  Because you were there, and I think it's a very interesting observation.

But I would like to go back to the panel now and ask the three -- if we do -- we can do the short -- in a short way -- the three biggest challenges that the Fed faces over the next several years.

John, I'll start with you.

TAYLOR:  So I think number one would be to find a way to get back to what was working in the '80s and '90s.  Quite frankly, it -- don't -- let's not forget that this was a period of very long expansions, very short recessions and basic stability.  I think monetary policy deserves credit for that.  So that's really number one.

Number two.  Find a way to preserve its independence in the context of many people are just concerned with what has happened with, if you like, taking on too many things, too many -- too many jobs, fiscal policy, credit-allocation policy, if you like; it needs to have a new accord, somehow, like in 1951.

I think number three is to really reassert the important global role it has had for many years by doing the right thing, quite frankly (by obviously ?) maintaining the purchasing power of the dollar, and making that clear that that's what it's going to do.

Globally, it doesn't have to sacrifice its goals for the United States.  Its global role is quite consistent with that.  But I think, working with other central banks, coordinating more as central banks, quite -- (inaudible) -- if you like, think about a global goal for price stability so that they could work together and cooperate.  I think that would be a third important goal.

GARTEN:  Alan.

BLINDER:  I guess I'd start with adapting to Dodd-Frank.  I mean, I think it's insufficiently appreciated outside the Fed -- it's certainly appreciated inside the Fed -- that the new responsibilities and somewhat altered responsibilities, but mainly the new responsibilities for financial stability and serving kind of as the CEO to the financial stability council's board of directors requires institutional adaptation at the Fed, which is, like most bureaucracies, not that great at institutional adaptation.

My understanding is that the Fed as a system is going to be adding -- I'm not sure I'm right about this, but ballpark, a thousand or 2,000 new employees to do this -- to acquit itself of these new responsibilities, which, as David said, are not entirely well defined.

Let me say, however, that the price stability and maximum employment goals are not entirely well defined.  They're modestly well defined now, but it took decades to get that definition.  And I think it'll take decades to get that kind of definition of financial stability.

But in principle, the financial-stability division of the Federal Reserve, or whatever they call it, is going to be a very powerful piece of the Federal Reserve; and exactly how it's going to exist within that institution, not to mention how it's going to coexist with its tenant -- the Fed has been made the landlord of the Consumer Financial Protection Bureau, one of the sillier things that's in Dodd-Frank.  It makes the Fed a landlord.  That could be on the list of John's functions that you don't really need a central bank to be, to have:  a landlord.

So I think there's a lot of work that's going to occupy a lot of man- and woman-hours at the Fed to adapt to Dodd-Frank.

Secondly, we're not out of the woods yet.  And we are at a zero interest rate right now.  The economy's looking a little bit better in the last month or two, but not -- hardly gangbusters.  It could stagger, again, for any number of reasons, including infection from Europe and things that happen here.  And if that is the case, given the -- given the limited weaponry it has now at a zero interest rate, and given the beating it's taken over QE2, I think the Fed will be severely challenged if the economy stumbles again and/or we move towards deflation -- which is a word that hasn't been mentioned here, but we're a lot closer to deflation than inflation.  The phrase "price stability" is symmetric in principle.

Thirdly, once we get over that -- and we're not over that yet, but you wanted us to look out ahead -- the Fed does have to get back to its exit strategy that John was alluding to.  It really doesn't want to be in this business.  It does not want to own MBS.  It does not want to own assets left over from Bear Stearns and AIG.  It does not want to be doing QE n.  It wants to go back to regular old monetary policy.

And of course, as the critics have pointed out, the deeper we get into QEs -- QE1, QE2, QE3, et cetera -- the bigger the exit problem facing it, just quantitatively, not conceptually; it's the same.  But quantitatively it becomes bigger, and at some point down the road the Fed's going to have to start doing that.

WESSEL:  To avoid repeating what's been said before, let me just say briefly, one is to learn the right lessons from the last several years.  We could learn the wrong lessons and do it again, so we ought to minimize the risk by learning the right lessons.  And as you can see, there's not exactly unanimity in the profession about what the right lessons are.

Two, I think preserving --

GARTEN:  Let me ask you -- what do you think the right lessons are?

WESSEL:  I think the right lessons are that, A, the regulatory function is extremely important, and when everybody says you have nothing to worry about in the financial system, it's the time for the Fed to worry about it, and the same in the William McChesney Martin -- you know, time for the Fed to take away the punch bowl when things get good.

Second -- and this would be my second point -- is to think hard about what the Fed's responsibility is about asset prices and financial stability.

And third -- and this is related -- is to explain effectively on what things the Fed should be independent and what things it's not part of the deal.

Nobody thinks that we need to have a central bank that is unaccountable to the democratic institutions of our society and able to do anything it wants; although, people would be excused if they concluded from the recent crisis that that is the way they interpret their role.

But there are some things where monetary-policy independence is essential for the functioning of our economy.  And I think because the Fed has done so much, as John said, it's hard for people to understand.  So you need to be independent in this and not independent on that.

So laying an effective case for why an independent central bank on monetary policy is important, because -- this is a little bit like running a life insurance company.  You know, the trick to running a life insurance company is to succeed a guy who made good decisions, because when you're the CEO of a life insurance company, nothing you can do now will affect your current results.

Well, when it comes to the independence, the political independence and the credibility of the Fed, what Ben Bernanke does today will determine whether his successor can do a good job or not.  And I think that both Volcker and Greenspan really understood that and did things that they knew were essential investments for the Fed in its future independence.

Well, you know, the Fed can be excused by neglecting that role while it was trying to put out the world's biggest financial fire in our lifetime, but now it's time to get back to that.  So learn the right lessons to establish credibility about what independence is and explain it to people -- they need the consent of the people to be independent -- and thirdly to figure out what does it mean to maintain financial stability, particularly with regard to asset prices.  If they do all that, the next meeting of this group in 10 years will be very boring.

GARTEN:  I won't even try to sum up what was said, but I want to thank the panel and ask you to join me in thanking them for a great discussion.  (Applause.)

 

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THIS IS A RUSH TRANSCRIPT.

 

 

JEFFREY E. GARTEN:  We'd like to get started because we have -- we have a lot of territory to cover in a very short period of time.  My name is Jeff Garten, and I'm the presider today.  I have the honor of doing that.

Today we're going to talk about, "What kind of Fed do we want?"  This is part of the McKinsey Roundtable Series on the international economy.

Before we start, I would like to ask everyone to please turn off their cell phones.  And the rule of the council is also turn it -- don't put it on vibrate either because it will interfere with the microphone.  The other thing is that today's meeting is on the record.

I don't think I have to emphasize how important and how timely this subject is.  We all know that the Fed is at the intersection of so many critical issues in our society.  It is essential to the issues of economic growth, jobs, monetary stability and the stability of financial institutions not in the U.S. and abroad.

I would also say that the Fed plays a huge role in shaping really critical relationships, relationships such as those between creditors and debtors.  And while this may sound mundane, it takes on even a bigger role now as the U.S. itself is such a huge debtor and we'll be dealing with that situation in the global economy for many years to come.

I think the Fed also is very critical to shaping the relationship between Wall Street and Main Street, which, of course, puts it at the center of an enormous number of political issues.

The Fed also plays a unique role in our democracy.  Unelected, it is nevertheless incredibly powerful.  And it's no exaggeration, in my view anyway, to say it has become the fourth branch of government.  And this issue raises a huge number of important questions about accountability, transparency and governance.

And finally today, the Fed is really in the spotlight.  Part of that is because of its role in the recent financial crisis, a role of unprecedented activism, a role which made it not only lender of last resort but in many cases lender of first resort.  And the controversy surrounding the Fed's actions also extend to its role in monetary policy.

This is not going to go away, and it's not going to go away for a lot of reasons.  It's the centrality of the Fed but also because we have a change of government in the House.  And the House Financial Services Committee is now headed by someone who recently wrote a book called, "End the Fed."  And he would like to see the Fed abolished, but he's not the only one.  If you look at popular polls, this is not some insignificant minority in the United States that really feels the Fed has gone astray.

So to discuss these issues today, we have a really wonderful panel.  You probably know everyone here.  The bios are in front of you.  But I'll just briefly introduce Alan Blinder, who is a professor of economics and public affairs at Princeton and former vice chairman of the Fed; David Wessel, who's the economics editor of the Wall Street Journal and also the author of a wonderful book on the Fed, "In Fed We Trust"; and John Taylor, professor of economics at Stanford and also former undersecretary of the Treasury for International Affairs.

I think the way we'll do this is that I'm going to pose a few questions to the panel just to get the issues aired, then we'll go to questions from the members here, and I'm just going to reserve a little time at the end to pose a final question to the panel of the three major challenges they think the Fed faces in the decade ahead.

So let me start really by asking -- I'm going to ask you to grade the Fed in three different areas, and grade it from "A" to "F."  Three phases:  the pre-crisis, or the run-up to the crisis; the involvement in the crisis; and then post-crisis, such as it is.  And John, maybe I'll start with you.

JOHN B. TAYLOR:  Thank you.

I think it's important to start before the crisis.  I think the crisis really first flared up, as you know, in August of 2007, went to the panic period in the fall of 2008, and then we have, since the panic, a post-panic period, if you like.  But before this crisis even began in 2007, I think the seeds of it were pretty clear by monetary policy.

After really two decades or more of really, I think, really extraordinary, good economic policy, monetary policy -- the long expansions, low inflation, a lot of stability in most of the '80s and '90s -- we ran into a period where monetary policy, I think, deviated from that policy by keeping interest rates too low for too long, mainly in 2003, '4 and '5.

And there's different ways to look at it.  I like to look at it and compare what -- compare that with what happened in the '80s and '90s.  And there's clearly a too low for too long situation.  So that accentuated the housing boom, led to excessive risk-taking, encouraged a lot of activity which we now look and can't believe it really happened; wasn't the whole story but a big part of the story.  So that's a -- moving from really a strong "A" period to well below "A," not passing.

And I think the crisis, beginning in '07, also sees some different type of activity.  I think early on, the actions were not so good.  I think the -- I would call the on-again, off-again bailout policy, that began with the bailout of the creditors of Bear Stearns. turned off, if you like, for the creditors of Lehman, turned back on for AIG, turned back off again as the TARP was rolled out.  It seems to me that caused a lot of uncertainty and actually added to the panic.

The panic itself, I think the Fed did a very good job.  The commercial paper credit facility; the money market mutual fund facility; extraordinary, if you like, addition to the confidence in the markets that I think had helped arrest the panic, but basically the panic itself was caused, I believe, by the prior activity.

And then finally, post-panic.  Since the fall of 2008, I don't see a lot of good things here, quite frankly.  QE1 was a purchase, roughly, of 1.25 trillion (dollars) of mortgage-backed securities.  I don't think it really did much good.  My studies -- I've done lots of studies of this, careful econometrics.  I don't see it has done much good at all.  There was also 300 billion (dollars) of purchases of medium-term Treasurys during that period, during what we now call QE1, the first quantitative easing bout.  I don't think that did much good, either.

I was hoping that that was going to end when the emergency went away, as it disappeared into the past.  But lo and behold it didn't, and we just got something called now "QE2," which seems to me very disappointing because it really extends this period of really unconventional activity beyond any reasonable justification, in my view.  So, again, we're moving back into low grades, and I'm hopeful we're going to get off of that, and get back to the good kind of policy that worked so well in the '80s and '90s.

GARTEN:  So in sum, the only high grade you give is in the -- in the -- in the middle of the panic.

TAYLOR:  Yes, and in the '80s and '90s.  And don't forget that because we should really -- that was a good period for monetary policy.

GARTEN:  Okay.

Alan, you agree?

ALAN S. BLINDER:  Well, I was on the Fed in the '90s.  So I -- at least I'll agree with that.  (Laughter.)  With the rest, I would take some exception.  I would actually divide in two periods -- you asked for three -- which is -- and dividing it at some X days after Lehman Brothers.  I don't know whether X is three, five, seven, just right after Lehman Brothers.  If you go back to Lehman Brother -- from Lehman Brothers plus X days backward, I think the Fed's grades -- not back to the '80s and '90s, in the bad period, the Fed's grades were poor, especially poor on bank regulatory policy, a supervisory policy, I should say.

I think I'll probably go to my grave not knowing what I really think about the Bear Stearns episode.  I could argue either side of that for myself and convince myself of either -- of either side of that.  I think Lehman was a catastrophic, absolutely catastrophic error.  But -- so what am I grading that whole period?  Pretty low.  I remember years ago Yale abolished the grade of D.  Have you put it back?

GARTEN:  No.

BLINDER:  No.  At Princeton, we proudly use the grade of D.  So maybe that's what I would -- maybe that's what I would give.  But from Lehman plus X days forward, I give the Fed A-plus.  I think it's been extraordinary.  I think it's been necessary.  I shudder to think how things might have been had the Fed not put their heads on the chopping block, as you were sort of suggesting earlier, time and time and time again.

Now, by the time we got to QE2, I'm -- I guess I'm modestly favorable toward what's now being called QE2.  I don't expect any great effects from it, and neither does the Fed, by the way.  I think they engaged it on the belief that turned out to be a slightly false belief that there was nothing if not worse coming out of fiscal policy.  Just in terms of aggregate demand stimulation, let's leave aside what you do to the future deficit.  So -- but just in terms of aggregate demand stimulus, I think the working assumption was there was nothing coming out of the political world, and the Fed had to do what little it could.  And so it did that.  But overall I think the grade has to be extraordinarily high from Lehman plus X days forward.

GARTEN:  David.

DAVID WESSEL:  So this is a kind of an uncomfortable position to be in, with two eminent professors from whom I've learned a lot who disagree on much of everything.  And I'm the one supposed to cast the deciding vote.  (Laughter.)  And I just want to -- there was no lack of respect for the Council on Foreign Relations that my suit jacket is hanging in my mother's closet in New Haven.  And she called me about five minutes ago before I turned off my cell phone to assure me that I knew that my suit jacket was there.  (Laughter.)

I think that -- I don't think there's -- it's very difficult to make the case that the Fed did a good job before this episode because we had an episode that reflects very poorly on the Fed.  I think the difference between Alan and John is interesting.  John sees them as failing on monetary policy.  I think that's a debatable point.  But I do know that a number of people inside the Fed who were involved in those decisions are much more sympathetic to the "we-held-rates-too-long" view now than they were at the time.

Now, hindsight is an important check on one's judgment.  But it's always a lot -- very convenient to say, if I had it to do all over again, I would have done something differently.  And so I think one has to be careful how one judges these things.  Was it obvious at the time that it was too low too long?  Or is that only an after-the-fact judgment?  I think a lot of the judgment is after the fact.

On the regulatory front, which Alan referred to, I don't think there's any question that the Greenspan Fed basically thought the market could take care of itself.  Greenspan has testified that this was his biggest mistake, that it turns out that even if you have a lot of money on the table, it doesn't mean you're going to police the table.  And that was a catastrophic failure.

I don't judge them harshly for Bear Stearns.  Where I judge them harshly is the period between Bear Stearns and Lehman, where as John has pointed out, they gave us very little guidance as to what their thinking was.

You know, you don't want to have a committee meeting to decide whether to send out the fire engines.  Bear Stearns was collapsing.  They had to make a decision in a hurry.  They were not prepared to make that decision.  They made their best judgment.  You can argue that had they not bailed out Bear Stearns, Lehman wouldn't have happened.  You can argue if they had not bailed out Bear Stearns, we would have had Lehman Brothers on Bear Stearns' weekend instead.  I don't know what the right counterfactual is.

But that period between Bear Stearns and Lehman, I think, is the biggest failure of the whole thing.  They weren't prepared for Lehman.  It's very hard to argue that Lehman was a great success.  So I think you have to, of course, judge them harshly on that.

I'm sympathetic to the views that both Alan and John share, the one thing on -- they agree on, is that once the panic started, I think the Fed deserves very high marks.

And there we do -- we do have counterfactuals.  You know, we saw what happened during the Depression when the Fed decided to stick to some prevailing orthodoxy and didn't cooperate with other authorities in the interest of the global economy, and we had a catastrophic capitalism in the -- in the economy that we didn't have this time.  And although most Americans don't believe that, although most Americans are not comforted by the assertion that it could have been worse, the fact is it could have been.  And I think you have to give them very high grades for that period.

I'm closer to Alan than John on the question of whether QE1 and QE2 were indicated, but I judge them very harshly on their inability to explain to us -- and by us, I mean the American people, not the Ph.D. economist, but the American people -- exactly what they were doing and why they were doing it.  And I think it's an extraordinary failure on the part of an institution which has begun to see just how important communications is and a chairman who actually believes in transparency and communication, how difficult it's been for them to explain to us what they're doing.  And that will pay -- that is a serious failure, because it undermines the credibility of an institution that relies on credibility to do its job.

GARTEN:  So let's drop back now from the -- from the actual operations and talk about a mandate of the Fed.  I think most people feel that the Fed has two -- has a mandate to do two things; one is monetary stability and the other is full employment.  Recently there's also been --

WESSEL:  You mean price stability.

GARTEN:  Price stability.  Price stability and full employment.

There are also a lot of issues now relating to financial stability.  I'd like to ask Alan whether -- do you think the mandate of the Fed is right?  Is it too broad?  How would you evaluate it as we look ahead over the next several years?

BLINDER:  I think it's pretty much right, with a couple of footnote exceptions.  So the answer is right and then you put a footnote about how you could do it better.

The right part -- the act gives the Fed -- the Federal Reserve Act gives the Fed responsibility for keeping inflation low, keeping unemployment low.  And I'm glad we have that compared to, say, the ECB, which -- I -- mandates matter.  People take an oath of office and they do what they're supposed to do -- at least most people do what the law directs them to do.

The Dodd-Frank act has now given explicitly the -- a third mandate that was tacit and you might even say implied by the first two, which is for price stability -- excuse me, for financial stability, that is, overseeing and doing something to delimit systemic risk.  That's always a tacit part of the central bank's job, but it's not really in the Federal Reserve Act.

I didn't comb through the 2,400 pages before coming here.  I don't think it's -- the Federal Reserve Act was amended.  I think it would be a good thing to actually amend the Federal Reserve Act, put that in the legal mandate, which is Section 2a or something of the Federal Reserve Act.  That's the footnote.  But the authority is clearly given to it and the responsibility is clearly given to it by the Dodd-Frank act, and I think that's appropriate.

GARTEN:  John.

TAYLOR:  I long thought that the best strategy for the Fed or any central bank is to focus on price stability, because that brings about employment stability and economic stability.  And I think, for many years, since 1977 when the dual mandate was inserted, the Fed worked through that by arguing the best way to have strong economic growth and strong employment growth was to deliver on price stability.  Volcker, Greenspan spoke about that all the time.  And so even though I would object to the confusion that a dual mandate causes, I think they handled it quite well.

Now I think we've seen it working not so well, the dual mandate.  And I think the point, David's point about communication, illustrates this.  For many years, the statement by the FOMC, which they give after their meetings, did not mention the maximum employment aspect of this.  They mentioned the strategy is to make the economy stable by having the price stability.  But for the first time in their FOMC statement -- the first time, October 2010 -- the maximum employment term appeared.  And it was there to really, I think, justify quantitative easing 2.  And it's been repeated in the meetings since then.

So what I see is happening is that dual mandate is being -- is coming back in in a different way, by different people, and confusing the whole situation.  So I'd very much at this point like to argue that the Fed's mandate should be adjusted, if you like, to emphasize price stability -- I call it price stability within a context of economic stability.  When you focus on price stability, that doesn't mean you don't cut interest rates in a recession, it doesn't mean you don't provide liquidity in a crisis, it doesn't mean you don't have lender of last resort.  Those are essential to price stability and economic stability.  But by confusing this and allowing some people to go out and give different motivations for things, I think we're just confusing the situation.

BLINDER:  If I can just --

GARTEN:  I'll get to you in a sec.  I just want to ask --

BLINDER:  Just a very short interjection.  There really wasn't such a big change last October or whatever.  When I was on the Fed in the '90s, whether we were increasing interest rates or decreasing interest rates, we always justified it by sustaining maximum -- "maximum sustainable economic growth," that was the euphemism.  And it went whether -- (inaudible) -- went up or down, which was -- I used to argue about that.  But it's not a new thing.  It started with the '77 act, as John said.

WESSEL:  I think mandates do matter, and our reporting suggests that when the FOMC talked about QE2, they talked quite a bit about what their mandate was.  I'm not sure that I agree with John.  By the Fed's definition, we are below price stability.  This was easy to justify on the grounds that they were missing on both the employment and the inflation target.  The much more intellectually interesting case would have come if inflation were closer to their target of about 2 percent and unemployment were still high.

I think it's naive to think that a central bank of the United States or any democracy is going to be oblivious to 9.8 percent unemployment; and nor should it be.  But I think Jeff raised an interesting question -- which neither Alan or John wants to touch because they're macro-economists -- is so what about this financial stability goal, and what does that actually mean?

And I think that it's quite unclear what it means.  And I think the Fed is being set up in a way to take the blame for the next crisis, which will obviously come.  And this time, the chairman won't be able to go before the Congress and say, "Well, I didn't have authority to worry about the nonbank financial institutions of the shadow banking system."  The members of Congress will say, "Look, after the last crisis, you told us we needed a systemic regulator, and we set up this committee, and you're on it.  And you blew it."

And so I think it's going to be an evolving discussion inside the Fed about what financial stability means.  And I'll just give you two examples of how difficult this is.  One is:  Does it mean that the Fed has a responsibility of acting when it thinks there's an asset price bubble -- stock market bubble or housing price bubble?  And if so, how exactly is it supposed to do that?  Is it supposed to tighten regulation so there's not a lot of lending in those institutions?  Is it supposed to give speeches and say, "Don't buy a house"?  Can you imagine that?  Is it supposed to raise interest rates, even if the conventional measures of price inflation and unemployment are not worrisome, because it sees an asset bubble?  I mean, these are questions that academics have debated and the Fed has never had to cope with before.

And the second is:  Are they supposed to be the ueber-regulator?  It might have been an interesting model to say no, that there was -- someone else was the regulator.  But the Congress chose not to do that; learning from the British model that apparently that's not perfect either.  On the other hand, they didn't say the Fed is the sole regulator.  So you can imagine we will have endless stories in The Wall Street Journal about tension between the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve about banking supervision and financial supervision, all justified in the name of pursuing financial stability.

So I think that in my mind is the biggest question mark:  What exactly has changed now that the Fed has more responsibility for financial stability, and what exactly is that going to mean in practice when we get beyond this current period?

GARTEN:  So let me just follow up that, because the next question I was going to ask is:  Just how significant is the new legislation, is the Dodd-Frank legislation, when it comes to the Fed?  And you -- you're actually on that ground.  Well, just venture an opinion in -- because we don't have a lot of time, but in this light -- is it very?

WESSEL:  Yes, it's very significant, not only because of the letter of the law but because the law embodies a view in Congress and the public that somehow the cops on the beat fell down on the job.  And we wanted to give the cops more power, more ammunition, so we don't go through this again.  So there is an expectation the Fed is going to prevent the next crisis.

The Fed will fail to do that.  It will be blamed.

GARTEN:  Okay.  So final question before we open it up.  This has to do with the global role of the Fed.  Obviously, the Fed has always had a huge international influence.  And in the crisis, it was extremely active in terms of making dollars available to central banks in many countries.  Psychologically, what the Fed does or doesn't do always has a large impact.

But my question is this.  If -- given the way the global economy, the global financial markets have evolved, given all the interconnections, given the growing size of that and the rise of other central banks -- ECB, Bank of China -- Public Bank of China, as you look ahead, what can you say about the changing role of the Fed in the global economy?

What -- Alan, I'll ask you to start with -- you know, if -- the -- Bernanke and his successor -- what's going to be different about the way they run the Fed than previous chairmen, given the way the world economy is going?

BLINDER:  I guess I'd start with the three words "not too much."  But let me elaborate on that a little.  First we have sort of the obvious arithmetic of what is moving toward and eventually will be a more tri-polar world, where the Fed is probably still the first among equals among the Fed, the ECB and the People's Bank of China.  We're a long way from the latter; we're not so far from the second, from the ECB.  So the Fed, as you look over the distant horizon, will not be quite as omnipotent as at least some people like to portray the Fed now and in recent years.

Second factor, which is very important -- and I think you don't really appreciate this until you -- this is already the second time I've mentioned the oath of office.  But Alan Greenspan appreciated this very much, and I'm sure Ben Bernanke does also, which is -- this goes back to the legal mandate.  The Fed has delegated authority from Congress.  Congress gives it its mandate.  And there is nothing in that mandate that says, for example, now and then you should pull punches in order to take the rest of the world into account -- that is to say, if we needed easier monetary policy.

But maybe for the rest of the world that's not so good.  Or the other way around, that the Fed should shade its decision in favor of the rest of the world relative to what it would do if it cared only about one country.  The mandate tells it to care only about one country.

Now, I think it's quite arguable in principle -- a bunch of us academics could argue, you know, in this kind of globalized world, we ought to revive the Fed's mandate, because after all, we're central to the whole world economy, and what happens in the rest of the world reverberates on us and conversely.  But then I'd just ask people in the audience to think how many of the 535 members of Congress do you think would vote for that amendment.  And your estimate is probably the same as mine:  zero.

GARTEN:  David.

WESSEL:  I don't think the Fed's role has changed.  I think America's role has changed, and for the -- all the reasons Alan said.  We've never -- the Fed has never been strictly focused on the United States, and -- nor can it afford to be.  It's the protector of the U.S. dollar.  And we've had periods in the past when the dollar needed some help and they stepped in.

But I think that we live in a very different time.  And I imagine that Paul Volcker would have a hard time understanding why it is that Ben Bernanke has to spend so much time assuring his counterparts in the People's Republic of China that, no, he's not going to get inflation -- let inflation get out of control, and therefore please don't sell all your dollars.

So the Fed's role has changed because our role in the world economy has changed.  We no longer are a master of our own fate given how much we depend on the kindness of strangers to lend us all their savings.

GARTEN:  John.

TAYLOR:  I think the idea of the central bank -- our central bank maintaining the purchasing power of the currency is very important for our world economy.  And to the extent we get away from that, to the extent we, if you like, think about doing too many things, I think that really is in some sense abnegating an important aspect of leadership, for the United States and for the Federal Reserve.

In the period I mentioned earlier, where interest rates were too low for too long, that actually spread around the world.  It made it harder for other central banks to do the right thing.  In fact, if you look at certain areas of the world where they also had housing booms, it was really related to their interest rates being too low at that point.  So in a sense that affected the world economy.

So I think the -- I'm somewhat disappointed that we may be losing that important leadership role, which has been very important for the world economy for so long.  The QE2, in a way, is an example.  I'm not surprised about the complaining from other countries for this.  I was surprised that it was so -- they were so outspoken about it and it interfered with our foreign policy.  I was surprised at that, but not surprised with their logic, because it does make it harder for them to control inflation.  It does have the potential to cause, if you like, a growing inflationary boom globally.  And that's going to feed back on this economy and hurt us.

So I think there's so much here that is, if you like, beneficial for the world economy if we have a central bank that does the kind of things it did for most of the '80s and '90s, which was not only a stable period for the U.S., it was stable elsewhere, too.

So I'd just like to get back to that way of thinking about policy.  It worked.  It was a framework that worked, and it showed a great deal of leadership by this country, which I think's important for the world.

GARTEN:  I think that's good point of departure for questions from the members.  I'd ask you to -- where are the microphones?  Okay.  There are microphones all over.  If you would just stand up, please, just identify yourself and your affiliation, and speak into the microphone.  Do we have -- yes, please.

And let me ask you this.  You could address the question to me and I will farm it out, or to one of the panel members, but we don't really have time for each of the panel members to answer every question.  So I'd like to, in a sense, ask one to do it.

QUESTIONER:  Thank you.  I'm Richard Weinert, Concert Artists Guild.  It's been an article of faith for some decades that the best arrangement is the central banks to be politically independent.  This is obviously under some question and attack now.  And I'd like to ask whomever on the panel would like to comment on what you think would be the ideal arrangement.

GARTEN:  Alan, I'll ask you to --

BLINDER:  Well, I'm not sure I can define the ideal arrangement, but certainly independence -- now independence is not like a point, it's a sort of a range, and I'm not sure I can answer with that kind of precision.  But I think the events of recent years, including the speed that they required, the freedom to take unpopular actions, and the performance of the Fed and other central banks under duress, never minding the poor performance of the regulatory regime, after all points to the -- how vital it is to have quite a lot of central bank independence.  A small piece of evidence, as you probably know, over the '80s and the '90s almost every country in the world -- there are some exceptions -- moved toward central bank independence, and not one single one moved in the other direction.

GARTEN:  David, I'm just going to ask you to comment on this from this standpoint.  How much of a threat to the independence of the Fed do you see boiling up in the American political system?  Not just the rhetoric, but the reality here.

WESSEL:  I think I would say some, by which I mean that it is not surprising the Fed is taking a lot of heat.  The Fed displayed an extraordinary amount of power and became a lightning rod for a sense in America that Wall Street got bailed out and Main Street didn't.  I think when push comes to shove, the Congress will flinch.  So proud of the excellent job they've done managing fiscal policy, I suspect they'll be a little reluctant to take on monetary policy.

And so far the Fed has been extraordinarily successful in beating back every attempt to clip its wings.  But -- and as the economy gets better, I suspect the pressure on the Fed will abate.

But a door has been opened, and it won't be easily closed.  And so if there takes hold in the Congress a kind of people -- (inaudible) -- give voice to the idea that somehow Ben Bernanke is printing money that's all going into the pockets of Goldman Sachs, that will eventually pay dividends in legislation.  But I'd say the chances now are remote, but they're substantially greater than zero.

GARTEN:  John.

TAYLOR:  I think independence is essential as well, but I worry that a lot of these actions already taken are raising questions about its -- the Fed's independence.

When the Fed gets involved in fiscal policy; when it gets involved in credit-allocation policy, helping one market, say, the housing market versus others or one firm versus others, that's not monetary policy.  That's really fiscal policy, and it raises governance questions.  I -- it raises constitutional questions about who -- it's -- Congress has authority to appropriate funds.  And when the Fed moves into that area, it's really losing some of its independence.

It -- during World War II and afterwards, it really was in there helping the Treasury bond market all the time.  We had this accord in 1951 where the Fed regained its independence because it stopped doing those things.  When it starts doing them again -- and it has -- it's -- I think rightfully its independence gets questioned, and I think we should try to find a way to have them stop doing that and then they require a different type of appropriation mechanism.

WESSEL:  (Off mic) -- I think that there -- progress has been made in filling a -- in closing a vacuum that the Fed was forced to fill.  The ability the government now has to close a Bear Stearns or Lehman Brothers under Dodd-Frank removes from the Fed one burden it had.

And it's interesting, and in my judgment appropriate, that in the future if the Fed uses its extraordinary authority to lend under section 13(3) of the Federal Reserve Act, it will require the explicit consent in writing of the Treasury secretary, which I think is a totally appropriate use of the democratic check on the Federal Reserve without making it impotent at a time when we might need its strength.

BLINDER:  I agree with that.  I just want to add, 13(3), as it existed at the time, fully justified what the Fed did.  It was perfectly within the law.

GARTEN:  Okay.  Jacob and then Bill.  Right here.

WESSEL:  Jacob's question's for these guys.

QUESTIONER:  Thank you.  Jacob Frankel, JPMorgan Chase.

In the old days, it was very clear that there were very sharp distinctions between issues that the fiscal authorities deal with and issues that the monetary authorities deal with.  And as a result, there were also very clear distinction between the instruments of the two.  And the question of independence and political pressure, therefore, did not come to the fore to such an extent, because the more you enter fiscal territory, the more political you become and therefore subject to political pressure.

So this comes with the territory.  As we look at it today, we see, for example, that in -- that new assets make themselves to the balance sheet of the central bank, probably much lower-quality assets than used to be with the rationale that is being given, but the picture is very, very different.

Likewise, when we speak about the European Central Bank and it buys Greek government bonds, it's fiscal policy; it's transferring resources from one country to another.

So obviously the political debate is coming up.  The rational for it has been that somehow the leaders of the monetary authority are enlightened, they see that the fiscal authorities are not operational; and therefore, they have national responsibility to step in.

It sounds good, but it's a trap also.  And the question that I have is -- question number one -- are we seeing now a detour from the traditional demarcation that will be returning in normal time, or is it really a new paradigm, a new paradigm in which the end-of-the-Fed syndrome is a legitimate question, because if you consolidate the two, then what's the point of having two departments?

The second --

GARTEN:  Can I -- can I ask you --

QUESTIONER:  Yes.

GARTEN:  Can I ask you to stop at that question?

QUESTIONER:  Yes.

GARTEN:  Because it's such a big question, I'd like to -- I'm afraid we -- John, why don't you --

TAYLOR:  Well, I think I share Jacob's concern that we may even have begun to pass the Rubicon on this.  The -- in a way, to me, QE2 for the Fed was a bit of a watershed here.  And I hope it's not, but the QE1 and the other activities were associated with an emergency, I think a specific thing.  And you could -- we justify it on that basis.

And I remember saying at the time, "Well, you say it's an emergency now.  But what's going to happen if there's like a slowdown in the recovery?  Are you going to start doing this again?"

"No, no, it was an emergency."

But here we have a slowdown in the recovery, and the same time -- type of thing has happened.  So it seems -- I worry if this is like a new type of monetary policy, in which I case I think your questions are quite legitimate.  And I hope we, for that reason, go back to -- to a better demarcation.

GARTEN:  Al.

BLINDER:  I think there are two answers.  You had the emergency situation, and that is the situation under which the Fed acquired most of these dodgy assets.  It still has Maiden Lane and things like on its balance sheets.  They're pretty small.  And then the MBS is something in between.

The QE2 is the acquisition of Treasury debt.  That's what the Fed has done since its founding.  And I just fail to understand why people think it's such a big deal than instead of buying three-month Treasury debt, they're buying three-year Treasury debt.  I mean, it's a small difference, but it's certainly not a difference in kind.

To your question, Jacob, I think these emergency acquisitions of -- what shall we say -- strange assets come with the emergency and they go with -- when the emergency abates.  And I don't think we're going to have anything like this for a very long time, but I certainly don't rule it out sometime way in the future, and the Fed do something like that.

Again, the responsibility for financial stability is permanent, and you could argue a permanent change in the Fed.  And when you have that responsibility and chaotic things happen, you have an implied, very explicit responsibility to try to obviate the consequences of those.  And the Fed will -- the Fed will do that as need be.

The last point I want to make is that -- you didn't quite get this, but this is probably your second question is -- a central bank is in a somewhat different world in terms of the weaponry it has when you're at zero interest rates.  So the things that the Fed would have in an earlier day counteracted by lowering interest rates, it now has to do -- either do nothing or do something else.

GARTEN:  Bill.

QUESTIONER:  Thank you.  Bill Donaldson.  I have a two-phase question that centers around politics.  Part -- question number one is, I wonder if you could comment on the politics inherent in the rank order of what happened to Bear Stearns, Lehman and what followed?  Clearly, there were political -- in my view, political implications.

And number two is, with Dodd-Frank and the whole approach to systemic risk, have we opened up Pandora's box in terms of the continuation of politics in the solution to the thing?  Or does Dodd-Frank solve that now?

GARTEN:  David, I'm going to ask you to take that.  I think -- I think we can package this basically as the degree to which politics has influenced the big Fed's decision, and whether that is going to continue -- that will be intensified or relaxed by the legislation.

WESSEL:  In answer to your second question, I don't think Dodd-Frank opens a Pandora's box.  I think the crisis opened a Pandora's box, and Dodd-Frank makes it more complicated.  But it isn't the -- it isn't the original sin here.

On the -- on -- look, there's politics in Washington.  I mean, are we supposed to be horrified that the Treasury secretary and the chairman of the Fed and the president of the Federal Reserve -- the president of the Federal Reserve Bank of New York actually talked about whether to save Bear Stearns, Lehman and AIG, and somehow some great precept of monetary economics has been violated?  I mean, that seems a bit absurd.

I don't -- I think that where -- I have a great deal of sympathy with -- what John says is I believe that this central bank thinks that when the political authorities are paralyzed, it has a responsibility to act for the good of the country.  Other central banks, sometimes the European central banks, sometimes not say, "Our function is to say no so the fiscal authorities do the right thing."  And there, I think, is a very interesting political thing.

If the question is somehow, did the big moneyed interests of Wall Street force the Fed to bail out Bear Stearns and to screw Lehman Brothers or something like that, I just don't think that's true.

But I think you can see in Hank Paulson's book that people on Wall Street who have access to the Treasury secretary have a way of making their case known.  And because the very act of bailing out big financial institutions involves the fiscal and monetary authorities, it becomes political right away.  And there is -- it's going to be hard for the Fed to extricate itself from that.

I'm not sure that's completely responsive to your question.  It was -- yeah.

GARTEN:  John.

TAYLOR:  Yeah.  I think the very nature of the way these bailouts occurred is, they raised questions about:  Why this, and why not that?  I think it's just (inherent ?).

And so I think that's why it's so important to try to move towards a more rules-based approach to these things, the rule of law, if you like, having more of a role.  And I don't think Dodd-Frank did that.  I think it basically left even more discretion in the hands of -- more power, if you like, in the hands of the authorities.  So that worries me for exactly the reasons you're saying.  It raises questions about what's this power and discretion going to be used for, and who's going to benefit, and what are the intricacies of that?

So I've been working hard on trying to find a way to -- for financial firms to be handled more by rules-based approaches, through some kind of a modification of the bankruptcy code, or as David said, a way that makes it more systematic about how these institutions will be handled so that they can be reorganized or if -- wound down, if necessary, in a way that's not so chaotic; if you like, there can be a Plan B so we don't have to rush in and do these -- I think quite damaging -- bailout operations.

GARTEN:  Okay.

Other questions?

MR.:  One there.

QUESTIONER:  Is this the microphone?  Great.

Hi.  Emil Henry.  And I had the pleasure to serve in the Paulson Treasury, so just a follow-up on Bill's question on politics.  And so you'll see my bias here.  Maybe this is for -- this is best for John, who I agree with on almost everything.

The -- just the political reality going back to Lehman Brothers, why is this not the case, the -- just placing yourselves back in the summer of that year, the system virtually about to grind to a halt in almost every major financial institution?  The political reality -- back to Bill's question -- the political reality is that the -- is that the Congress never acts unless there is a crisis, right?  It's kind of fixing the -- fixing the airplane after the crash.  It never acts until there's a crisis.  So the political reality was that Congress never would have acted and never would have signed up for 700 -- $800 billion, whatever the final number was of that initial TARP, in the absence of a crisis.

So why wasn't it the right thing to let Lehman Brothers go, which was a -- which was a strong signal to the system, perhaps the right signal to the system in terms of moral hazard and all the other elements?  And that was -- the political reality was, that was the impetus for Congress to act and to sign up for TARP, which many might regard as a superb -- ultimately, a superb investment for the people of this country, where they actually might even see a return on their money and an instituted stability to boot because of it.  Anyway, just curious for your reaction.

GARTEN:  Well, I'm going to -- you know what?

QUESTIONER:  Yeah?

GARTEN:  Because we're running out of time, and I want to ask one more question, I'm going to leave that as a -- as a statement.

QUESTIONER:  Okay.  (Chuckles.)

GARTEN:  Okay?  Because you were there, and I think it's a very interesting observation.

But I would like to go back to the panel now and ask the three -- if we do -- we can do the short -- in a short way -- the three biggest challenges that the Fed faces over the next several years.

John, I'll start with you.

TAYLOR:  So I think number one would be to find a way to get back to what was working in the '80s and '90s.  Quite frankly, it -- don't -- let's not forget that this was a period of very long expansions, very short recessions and basic stability.  I think monetary policy deserves credit for that.  So that's really number one.

Number two.  Find a way to preserve its independence in the context of many people are just concerned with what has happened with, if you like, taking on too many things, too many -- too many jobs, fiscal policy, credit-allocation policy, if you like; it needs to have a new accord, somehow, like in 1951.

I think number three is to really reassert the important global role it has had for many years by doing the right thing, quite frankly (by obviously ?) maintaining the purchasing power of the dollar, and making that clear that that's what it's going to do.

Globally, it doesn't have to sacrifice its goals for the United States.  Its global role is quite consistent with that.  But I think, working with other central banks, coordinating more as central banks, quite -- (inaudible) -- if you like, think about a global goal for price stability so that they could work together and cooperate.  I think that would be a third important goal.

GARTEN:  Alan.

BLINDER:  I guess I'd start with adapting to Dodd-Frank.  I mean, I think it's insufficiently appreciated outside the Fed -- it's certainly appreciated inside the Fed -- that the new responsibilities and somewhat altered responsibilities, but mainly the new responsibilities for financial stability and serving kind of as the CEO to the financial stability council's board of directors requires institutional adaptation at the Fed, which is, like most bureaucracies, not that great at institutional adaptation.

My understanding is that the Fed as a system is going to be adding -- I'm not sure I'm right about this, but ballpark, a thousand or 2,000 new employees to do this -- to acquit itself of these new responsibilities, which, as David said, are not entirely well defined.

Let me say, however, that the price stability and maximum employment goals are not entirely well defined.  They're modestly well defined now, but it took decades to get that definition.  And I think it'll take decades to get that kind of definition of financial stability.

But in principle, the financial-stability division of the Federal Reserve, or whatever they call it, is going to be a very powerful piece of the Federal Reserve; and exactly how it's going to exist within that institution, not to mention how it's going to coexist with its tenant -- the Fed has been made the landlord of the Consumer Financial Protection Bureau, one of the sillier things that's in Dodd-Frank.  It makes the Fed a landlord.  That could be on the list of John's functions that you don't really need a central bank to be, to have:  a landlord.

So I think there's a lot of work that's going to occupy a lot of man- and woman-hours at the Fed to adapt to Dodd-Frank.

Secondly, we're not out of the woods yet.  And we are at a zero interest rate right now.  The economy's looking a little bit better in the last month or two, but not -- hardly gangbusters.  It could stagger, again, for any number of reasons, including infection from Europe and things that happen here.  And if that is the case, given the -- given the limited weaponry it has now at a zero interest rate, and given the beating it's taken over QE2, I think the Fed will be severely challenged if the economy stumbles again and/or we move towards deflation -- which is a word that hasn't been mentioned here, but we're a lot closer to deflation than inflation.  The phrase "price stability" is symmetric in principle.

Thirdly, once we get over that -- and we're not over that yet, but you wanted us to look out ahead -- the Fed does have to get back to its exit strategy that John was alluding to.  It really doesn't want to be in this business.  It does not want to own MBS.  It does not want to own assets left over from Bear Stearns and AIG.  It does not want to be doing QE n.  It wants to go back to regular old monetary policy.

And of course, as the critics have pointed out, the deeper we get into QEs -- QE1, QE2, QE3, et cetera -- the bigger the exit problem facing it, just quantitatively, not conceptually; it's the same.  But quantitatively it becomes bigger, and at some point down the road the Fed's going to have to start doing that.

WESSEL:  To avoid repeating what's been said before, let me just say briefly, one is to learn the right lessons from the last several years.  We could learn the wrong lessons and do it again, so we ought to minimize the risk by learning the right lessons.  And as you can see, there's not exactly unanimity in the profession about what the right lessons are.

Two, I think preserving --

GARTEN:  Let me ask you -- what do you think the right lessons are?

WESSEL:  I think the right lessons are that, A, the regulatory function is extremely important, and when everybody says you have nothing to worry about in the financial system, it's the time for the Fed to worry about it, and the same in the William McChesney Martin -- you know, time for the Fed to take away the punch bowl when things get good.

Second -- and this would be my second point -- is to think hard about what the Fed's responsibility is about asset prices and financial stability.

And third -- and this is related -- is to explain effectively on what things the Fed should be independent and what things it's not part of the deal.

Nobody thinks that we need to have a central bank that is unaccountable to the democratic institutions of our society and able to do anything it wants; although, people would be excused if they concluded from the recent crisis that that is the way they interpret their role.

But there are some things where monetary-policy independence is essential for the functioning of our economy.  And I think because the Fed has done so much, as John said, it's hard for people to understand.  So you need to be independent in this and not independent on that.

So laying an effective case for why an independent central bank on monetary policy is important, because -- this is a little bit like running a life insurance company.  You know, the trick to running a life insurance company is to succeed a guy who made good decisions, because when you're the CEO of a life insurance company, nothing you can do now will affect your current results.

Well, when it comes to the independence, the political independence and the credibility of the Fed, what Ben Bernanke does today will determine whether his successor can do a good job or not.  And I think that both Volcker and Greenspan really understood that and did things that they knew were essential investments for the Fed in its future independence.

Well, you know, the Fed can be excused by neglecting that role while it was trying to put out the world's biggest financial fire in our lifetime, but now it's time to get back to that.  So learn the right lessons to establish credibility about what independence is and explain it to people -- they need the consent of the people to be independent -- and thirdly to figure out what does it mean to maintain financial stability, particularly with regard to asset prices.  If they do all that, the next meeting of this group in 10 years will be very boring.

GARTEN:  I won't even try to sum up what was said, but I want to thank the panel and ask you to join me in thanking them for a great discussion.  (Applause.)

 

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THIS IS A RUSH TRANSCRIPT.

 

 

JEFFREY E. GARTEN:  We'd like to get started because we have -- we have a lot of territory to cover in a very short period of time.  My name is Jeff Garten, and I'm the presider today.  I have the honor of doing that.

Today we're going to talk about, "What kind of Fed do we want?"  This is part of the McKinsey Roundtable Series on the international economy.

Before we start, I would like to ask everyone to please turn off their cell phones.  And the rule of the council is also turn it -- don't put it on vibrate either because it will interfere with the microphone.  The other thing is that today's meeting is on the record.

I don't think I have to emphasize how important and how timely this subject is.  We all know that the Fed is at the intersection of so many critical issues in our society.  It is essential to the issues of economic growth, jobs, monetary stability and the stability of financial institutions not in the U.S. and abroad.

I would also say that the Fed plays a huge role in shaping really critical relationships, relationships such as those between creditors and debtors.  And while this may sound mundane, it takes on even a bigger role now as the U.S. itself is such a huge debtor and we'll be dealing with that situation in the global economy for many years to come.

I think the Fed also is very critical to shaping the relationship between Wall Street and Main Street, which, of course, puts it at the center of an enormous number of political issues.

The Fed also plays a unique role in our democracy.  Unelected, it is nevertheless incredibly powerful.  And it's no exaggeration, in my view anyway, to say it has become the fourth branch of government.  And this issue raises a huge number of important questions about accountability, transparency and governance.

And finally today, the Fed is really in the spotlight.  Part of that is because of its role in the recent financial crisis, a role of unprecedented activism, a role which made it not only lender of last resort but in many cases lender of first resort.  And the controversy surrounding the Fed's actions also extend to its role in monetary policy.

This is not going to go away, and it's not going to go away for a lot of reasons.  It's the centrality of the Fed but also because we have a change of government in the House.  And the House Financial Services Committee is now headed by someone who recently wrote a book called, "End the Fed."  And he would like to see the Fed abolished, but he's not the only one.  If you look at popular polls, this is not some insignificant minority in the United States that really feels the Fed has gone astray.

So to discuss these issues today, we have a really wonderful panel.  You probably know everyone here.  The bios are in front of you.  But I'll just briefly introduce Alan Blinder, who is a professor of economics and public affairs at Princeton and former vice chairman of the Fed; David Wessel, who's the economics editor of the Wall Street Journal and also the author of a wonderful book on the Fed, "In Fed We Trust"; and John Taylor, professor of economics at Stanford and also former undersecretary of the Treasury for International Affairs.

I think the way we'll do this is that I'm going to pose a few questions to the panel just to get the issues aired, then we'll go to questions from the members here, and I'm just going to reserve a little time at the end to pose a final question to the panel of the three major challenges they think the Fed faces in the decade ahead.

So let me start really by asking -- I'm going to ask you to grade the Fed in three different areas, and grade it from "A" to "F."  Three phases:  the pre-crisis, or the run-up to the crisis; the involvement in the crisis; and then post-crisis, such as it is.  And John, maybe I'll start with you.

JOHN B. TAYLOR:  Thank you.

I think it's important to start before the crisis.  I think the crisis really first flared up, as you know, in August of 2007, went to the panic period in the fall of 2008, and then we have, since the panic, a post-panic period, if you like.  But before this crisis even began in 2007, I think the seeds of it were pretty clear by monetary policy.

After really two decades or more of really, I think, really extraordinary, good economic policy, monetary policy -- the long expansions, low inflation, a lot of stability in most of the '80s and '90s -- we ran into a period where monetary policy, I think, deviated from that policy by keeping interest rates too low for too long, mainly in 2003, '4 and '5.

And there's different ways to look at it.  I like to look at it and compare what -- compare that with what happened in the '80s and '90s.  And there's clearly a too low for too long situation.  So that accentuated the housing boom, led to excessive risk-taking, encouraged a lot of activity which we now look and can't believe it really happened; wasn't the whole story but a big part of the story.  So that's a -- moving from really a strong "A" period to well below "A," not passing.

And I think the crisis, beginning in '07, also sees some different type of activity.  I think early on, the actions were not so good.  I think the -- I would call the on-again, off-again bailout policy, that began with the bailout of the creditors of Bear Stearns. turned off, if you like, for the creditors of Lehman, turned back on for AIG, turned back off again as the TARP was rolled out.  It seems to me that caused a lot of uncertainty and actually added to the panic.

The panic itself, I think the Fed did a very good job.  The commercial paper credit facility; the money market mutual fund facility; extraordinary, if you like, addition to the confidence in the markets that I think had helped arrest the panic, but basically the panic itself was caused, I believe, by the prior activity.

And then finally, post-panic.  Since the fall of 2008, I don't see a lot of good things here, quite frankly.  QE1 was a purchase, roughly, of 1.25 trillion (dollars) of mortgage-backed securities.  I don't think it really did much good.  My studies -- I've done lots of studies of this, careful econometrics.  I don't see it has done much good at all.  There was also 300 billion (dollars) of purchases of medium-term Treasurys during that period, during what we now call QE1, the first quantitative easing bout.  I don't think that did much good, either.

I was hoping that that was going to end when the emergency went away, as it disappeared into the past.  But lo and behold it didn't, and we just got something called now "QE2," which seems to me very disappointing because it really extends this period of really unconventional activity beyond any reasonable justification, in my view.  So, again, we're moving back into low grades, and I'm hopeful we're going to get off of that, and get back to the good kind of policy that worked so well in the '80s and '90s.

GARTEN:  So in sum, the only high grade you give is in the -- in the -- in the middle of the panic.

TAYLOR:  Yes, and in the '80s and '90s.  And don't forget that because we should really -- that was a good period for monetary policy.

GARTEN:  Okay.

Alan, you agree?

ALAN S. BLINDER:  Well, I was on the Fed in the '90s.  So I -- at least I'll agree with that.  (Laughter.)  With the rest, I would take some exception.  I would actually divide in two periods -- you asked for three -- which is -- and dividing it at some X days after Lehman Brothers.  I don't know whether X is three, five, seven, just right after Lehman Brothers.  If you go back to Lehman Brother -- from Lehman Brothers plus X days backward, I think the Fed's grades -- not back to the '80s and '90s, in the bad period, the Fed's grades were poor, especially poor on bank regulatory policy, a supervisory policy, I should say.

I think I'll probably go to my grave not knowing what I really think about the Bear Stearns episode.  I could argue either side of that for myself and convince myself of either -- of either side of that.  I think Lehman was a catastrophic, absolutely catastrophic error.  But -- so what am I grading that whole period?  Pretty low.  I remember years ago Yale abolished the grade of D.  Have you put it back?

GARTEN:  No.

BLINDER:  No.  At Princeton, we proudly use the grade of D.  So maybe that's what I would -- maybe that's what I would give.  But from Lehman plus X days forward, I give the Fed A-plus.  I think it's been extraordinary.  I think it's been necessary.  I shudder to think how things might have been had the Fed not put their heads on the chopping block, as you were sort of suggesting earlier, time and time and time again.

Now, by the time we got to QE2, I'm -- I guess I'm modestly favorable toward what's now being called QE2.  I don't expect any great effects from it, and neither does the Fed, by the way.  I think they engaged it on the belief that turned out to be a slightly false belief that there was nothing if not worse coming out of fiscal policy.  Just in terms of aggregate demand stimulation, let's leave aside what you do to the future deficit.  So -- but just in terms of aggregate demand stimulus, I think the working assumption was there was nothing coming out of the political world, and the Fed had to do what little it could.  And so it did that.  But overall I think the grade has to be extraordinarily high from Lehman plus X days forward.

GARTEN:  David.

DAVID WESSEL:  So this is a kind of an uncomfortable position to be in, with two eminent professors from whom I've learned a lot who disagree on much of everything.  And I'm the one supposed to cast the deciding vote.  (Laughter.)  And I just want to -- there was no lack of respect for the Council on Foreign Relations that my suit jacket is hanging in my mother's closet in New Haven.  And she called me about five minutes ago before I turned off my cell phone to assure me that I knew that my suit jacket was there.  (Laughter.)

I think that -- I don't think there's -- it's very difficult to make the case that the Fed did a good job before this episode because we had an episode that reflects very poorly on the Fed.  I think the difference between Alan and John is interesting.  John sees them as failing on monetary policy.  I think that's a debatable point.  But I do know that a number of people inside the Fed who were involved in those decisions are much more sympathetic to the "we-held-rates-too-long" view now than they were at the time.

Now, hindsight is an important check on one's judgment.  But it's always a lot -- very convenient to say, if I had it to do all over again, I would have done something differently.  And so I think one has to be careful how one judges these things.  Was it obvious at the time that it was too low too long?  Or is that only an after-the-fact judgment?  I think a lot of the judgment is after the fact.

On the regulatory front, which Alan referred to, I don't think there's any question that the Greenspan Fed basically thought the market could take care of itself.  Greenspan has testified that this was his biggest mistake, that it turns out that even if you have a lot of money on the table, it doesn't mean you're going to police the table.  And that was a catastrophic failure.

I don't judge them harshly for Bear Stearns.  Where I judge them harshly is the period between Bear Stearns and Lehman, where as John has pointed out, they gave us very little guidance as to what their thinking was.

You know, you don't want to have a committee meeting to decide whether to send out the fire engines.  Bear Stearns was collapsing.  They had to make a decision in a hurry.  They were not prepared to make that decision.  They made their best judgment.  You can argue that had they not bailed out Bear Stearns, Lehman wouldn't have happened.  You can argue if they had not bailed out Bear Stearns, we would have had Lehman Brothers on Bear Stearns' weekend instead.  I don't know what the right counterfactual is.

But that period between Bear Stearns and Lehman, I think, is the biggest failure of the whole thing.  They weren't prepared for Lehman.  It's very hard to argue that Lehman was a great success.  So I think you have to, of course, judge them harshly on that.

I'm sympathetic to the views that both Alan and John share, the one thing on -- they agree on, is that once the panic started, I think the Fed deserves very high marks.

And there we do -- we do have counterfactuals.  You know, we saw what happened during the Depression when the Fed decided to stick to some prevailing orthodoxy and didn't cooperate with other authorities in the interest of the global economy, and we had a catastrophic capitalism in the -- in the economy that we didn't have this time.  And although most Americans don't believe that, although most Americans are not comforted by the assertion that it could have been worse, the fact is it could have been.  And I think you have to give them very high grades for that period.

I'm closer to Alan than John on the question of whether QE1 and QE2 were indicated, but I judge them very harshly on their inability to explain to us -- and by us, I mean the American people, not the Ph.D. economist, but the American people -- exactly what they were doing and why they were doing it.  And I think it's an extraordinary failure on the part of an institution which has begun to see just how important communications is and a chairman who actually believes in transparency and communication, how difficult it's been for them to explain to us what they're doing.  And that will pay -- that is a serious failure, because it undermines the credibility of an institution that relies on credibility to do its job.

GARTEN:  So let's drop back now from the -- from the actual operations and talk about a mandate of the Fed.  I think most people feel that the Fed has two -- has a mandate to do two things; one is monetary stability and the other is full employment.  Recently there's also been --

WESSEL:  You mean price stability.

GARTEN:  Price stability.  Price stability and full employment.

There are also a lot of issues now relating to financial stability.  I'd like to ask Alan whether -- do you think the mandate of the Fed is right?  Is it too broad?  How would you evaluate it as we look ahead over the next several years?

BLINDER:  I think it's pretty much right, with a couple of footnote exceptions.  So the answer is right and then you put a footnote about how you could do it better.

The right part -- the act gives the Fed -- the Federal Reserve Act gives the Fed responsibility for keeping inflation low, keeping unemployment low.  And I'm glad we have that compared to, say, the ECB, which -- I -- mandates matter.  People take an oath of office and they do what they're supposed to do -- at least most people do what the law directs them to do.

The Dodd-Frank act has now given explicitly the -- a third mandate that was tacit and you might even say implied by the first two, which is for price stability -- excuse me, for financial stability, that is, overseeing and doing something to delimit systemic risk.  That's always a tacit part of the central bank's job, but it's not really in the Federal Reserve Act.

I didn't comb through the 2,400 pages before coming here.  I don't think it's -- the Federal Reserve Act was amended.  I think it would be a good thing to actually amend the Federal Reserve Act, put that in the legal mandate, which is Section 2a or something of the Federal Reserve Act.  That's the footnote.  But the authority is clearly given to it and the responsibility is clearly given to it by the Dodd-Frank act, and I think that's appropriate.

GARTEN:  John.

TAYLOR:  I long thought that the best strategy for the Fed or any central bank is to focus on price stability, because that brings about employment stability and economic stability.  And I think, for many years, since 1977 when the dual mandate was inserted, the Fed worked through that by arguing the best way to have strong economic growth and strong employment growth was to deliver on price stability.  Volcker, Greenspan spoke about that all the time.  And so even though I would object to the confusion that a dual mandate causes, I think they handled it quite well.

Now I think we've seen it working not so well, the dual mandate.  And I think the point, David's point about communication, illustrates this.  For many years, the statement by the FOMC, which they give after their meetings, did not mention the maximum employment aspect of this.  They mentioned the strategy is to make the economy stable by having the price stability.  But for the first time in their FOMC statement -- the first time, October 2010 -- the maximum employment term appeared.  And it was there to really, I think, justify quantitative easing 2.  And it's been repeated in the meetings since then.

So what I see is happening is that dual mandate is being -- is coming back in in a different way, by different people, and confusing the whole situation.  So I'd very much at this point like to argue that the Fed's mandate should be adjusted, if you like, to emphasize price stability -- I call it price stability within a context of economic stability.  When you focus on price stability, that doesn't mean you don't cut interest rates in a recession, it doesn't mean you don't provide liquidity in a crisis, it doesn't mean you don't have lender of last resort.  Those are essential to price stability and economic stability.  But by confusing this and allowing some people to go out and give different motivations for things, I think we're just confusing the situation.

BLINDER:  If I can just --

GARTEN:  I'll get to you in a sec.  I just want to ask --

BLINDER:  Just a very short interjection.  There really wasn't such a big change last October or whatever.  When I was on the Fed in the '90s, whether we were increasing interest rates or decreasing interest rates, we always justified it by sustaining maximum -- "maximum sustainable economic growth," that was the euphemism.  And it went whether -- (inaudible) -- went up or down, which was -- I used to argue about that.  But it's not a new thing.  It started with the '77 act, as John said.

WESSEL:  I think mandates do matter, and our reporting suggests that when the FOMC talked about QE2, they talked quite a bit about what their mandate was.  I'm not sure that I agree with John.  By the Fed's definition, we are below price stability.  This was easy to justify on the grounds that they were missing on both the employment and the inflation target.  The much more intellectually interesting case would have come if inflation were closer to their target of about 2 percent and unemployment were still high.

I think it's naive to think that a central bank of the United States or any democracy is going to be oblivious to 9.8 percent unemployment; and nor should it be.  But I think Jeff raised an interesting question -- which neither Alan or John wants to touch because they're macro-economists -- is so what about this financial stability goal, and what does that actually mean?

And I think that it's quite unclear what it means.  And I think the Fed is being set up in a way to take the blame for the next crisis, which will obviously come.  And this time, the chairman won't be able to go before the Congress and say, "Well, I didn't have authority to worry about the nonbank financial institutions of the shadow banking system."  The members of Congress will say, "Look, after the last crisis, you told us we needed a systemic regulator, and we set up this committee, and you're on it.  And you blew it."

And so I think it's going to be an evolving discussion inside the Fed about what financial stability means.  And I'll just give you two examples of how difficult this is.  One is:  Does it mean that the Fed has a responsibility of acting when it thinks there's an asset price bubble -- stock market bubble or housing price bubble?  And if so, how exactly is it supposed to do that?  Is it supposed to tighten regulation so there's not a lot of lending in those institutions?  Is it supposed to give speeches and say, "Don't buy a house"?  Can you imagine that?  Is it supposed to raise interest rates, even if the conventional measures of price inflation and unemployment are not worrisome, because it sees an asset bubble?  I mean, these are questions that academics have debated and the Fed has never had to cope with before.

And the second is:  Are they supposed to be the ueber-regulator?  It might have been an interesting model to say no, that there was -- someone else was the regulator.  But the Congress chose not to do that; learning from the British model that apparently that's not perfect either.  On the other hand, they didn't say the Fed is the sole regulator.  So you can imagine we will have endless stories in The Wall Street Journal about tension between the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve about banking supervision and financial supervision, all justified in the name of pursuing financial stability.

So I think that in my mind is the biggest question mark:  What exactly has changed now that the Fed has more responsibility for financial stability, and what exactly is that going to mean in practice when we get beyond this current period?

GARTEN:  So let me just follow up that, because the next question I was going to ask is:  Just how significant is the new legislation, is the Dodd-Frank legislation, when it comes to the Fed?  And you -- you're actually on that ground.  Well, just venture an opinion in -- because we don't have a lot of time, but in this light -- is it very?

WESSEL:  Yes, it's very significant, not only because of the letter of the law but because the law embodies a view in Congress and the public that somehow the cops on the beat fell down on the job.  And we wanted to give the cops more power, more ammunition, so we don't go through this again.  So there is an expectation the Fed is going to prevent the next crisis.

The Fed will fail to do that.  It will be blamed.

GARTEN:  Okay.  So final question before we open it up.  This has to do with the global role of the Fed.  Obviously, the Fed has always had a huge international influence.  And in the crisis, it was extremely active in terms of making dollars available to central banks in many countries.  Psychologically, what the Fed does or doesn't do always has a large impact.

But my question is this.  If -- given the way the global economy, the global financial markets have evolved, given all the interconnections, given the growing size of that and the rise of other central banks -- ECB, Bank of China -- Public Bank of China, as you look ahead, what can you say about the changing role of the Fed in the global economy?

What -- Alan, I'll ask you to start with -- you know, if -- the -- Bernanke and his successor -- what's going to be different about the way they run the Fed than previous chairmen, given the way the world economy is going?

BLINDER:  I guess I'd start with the three words "not too much."  But let me elaborate on that a little.  First we have sort of the obvious arithmetic of what is moving toward and eventually will be a more tri-polar world, where the Fed is probably still the first among equals among the Fed, the ECB and the People's Bank of China.  We're a long way from the latter; we're not so far from the second, from the ECB.  So the Fed, as you look over the distant horizon, will not be quite as omnipotent as at least some people like to portray the Fed now and in recent years.

Second factor, which is very important -- and I think you don't really appreciate this until you -- this is already the second time I've mentioned the oath of office.  But Alan Greenspan appreciated this very much, and I'm sure Ben Bernanke does also, which is -- this goes back to the legal mandate.  The Fed has delegated authority from Congress.  Congress gives it its mandate.  And there is nothing in that mandate that says, for example, now and then you should pull punches in order to take the rest of the world into account -- that is to say, if we needed easier monetary policy.

But maybe for the rest of the world that's not so good.  Or the other way around, that the Fed should shade its decision in favor of the rest of the world relative to what it would do if it cared only about one country.  The mandate tells it to care only about one country.

Now, I think it's quite arguable in principle -- a bunch of us academics could argue, you know, in this kind of globalized world, we ought to revive the Fed's mandate, because after all, we're central to the whole world economy, and what happens in the rest of the world reverberates on us and conversely.  But then I'd just ask people in the audience to think how many of the 535 members of Congress do you think would vote for that amendment.  And your estimate is probably the same as mine:  zero.

GARTEN:  David.

WESSEL:  I don't think the Fed's role has changed.  I think America's role has changed, and for the -- all the reasons Alan said.  We've never -- the Fed has never been strictly focused on the United States, and -- nor can it afford to be.  It's the protector of the U.S. dollar.  And we've had periods in the past when the dollar needed some help and they stepped in.

But I think that we live in a very different time.  And I imagine that Paul Volcker would have a hard time understanding why it is that Ben Bernanke has to spend so much time assuring his counterparts in the People's Republic of China that, no, he's not going to get inflation -- let inflation get out of control, and therefore please don't sell all your dollars.

So the Fed's role has changed because our role in the world economy has changed.  We no longer are a master of our own fate given how much we depend on the kindness of strangers to lend us all their savings.

GARTEN:  John.

TAYLOR:  I think the idea of the central bank -- our central bank maintaining the purchasing power of the currency is very important for our world economy.  And to the extent we get away from that, to the extent we, if you like, think about doing too many things, I think that really is in some sense abnegating an important aspect of leadership, for the United States and for the Federal Reserve.

In the period I mentioned earlier, where interest rates were too low for too long, that actually spread around the world.  It made it harder for other central banks to do the right thing.  In fact, if you look at certain areas of the world where they also had housing booms, it was really related to their interest rates being too low at that point.  So in a sense that affected the world economy.

So I think the -- I'm somewhat disappointed that we may be losing that important leadership role, which has been very important for the world economy for so long.  The QE2, in a way, is an example.  I'm not surprised about the complaining from other countries for this.  I was surprised that it was so -- they were so outspoken about it and it interfered with our foreign policy.  I was surprised at that, but not surprised with their logic, because it does make it harder for them to control inflation.  It does have the potential to cause, if you like, a growing inflationary boom globally.  And that's going to feed back on this economy and hurt us.

So I think there's so much here that is, if you like, beneficial for the world economy if we have a central bank that does the kind of things it did for most of the '80s and '90s, which was not only a stable period for the U.S., it was stable elsewhere, too.

So I'd just like to get back to that way of thinking about policy.  It worked.  It was a framework that worked, and it showed a great deal of leadership by this country, which I think's important for the world.

GARTEN:  I think that's good point of departure for questions from the members.  I'd ask you to -- where are the microphones?  Okay.  There are microphones all over.  If you would just stand up, please, just identify yourself and your affiliation, and speak into the microphone.  Do we have -- yes, please.

And let me ask you this.  You could address the question to me and I will farm it out, or to one of the panel members, but we don't really have time for each of the panel members to answer every question.  So I'd like to, in a sense, ask one to do it.

QUESTIONER:  Thank you.  I'm Richard Weinert, Concert Artists Guild.  It's been an article of faith for some decades that the best arrangement is the central banks to be politically independent.  This is obviously under some question and attack now.  And I'd like to ask whomever on the panel would like to comment on what you think would be the ideal arrangement.

GARTEN:  Alan, I'll ask you to --

BLINDER:  Well, I'm not sure I can define the ideal arrangement, but certainly independence -- now independence is not like a point, it's a sort of a range, and I'm not sure I can answer with that kind of precision.  But I think the events of recent years, including the speed that they required, the freedom to take unpopular actions, and the performance of the Fed and other central banks under duress, never minding the poor performance of the regulatory regime, after all points to the -- how vital it is to have quite a lot of central bank independence.  A small piece of evidence, as you probably know, over the '80s and the '90s almost every country in the world -- there are some exceptions -- moved toward central bank independence, and not one single one moved in the other direction.

GARTEN:  David, I'm just going to ask you to comment on this from this standpoint.  How much of a threat to the independence of the Fed do you see boiling up in the American political system?  Not just the rhetoric, but the reality here.

WESSEL:  I think I would say some, by which I mean that it is not surprising the Fed is taking a lot of heat.  The Fed displayed an extraordinary amount of power and became a lightning rod for a sense in America that Wall Street got bailed out and Main Street didn't.  I think when push comes to shove, the Congress will flinch.  So proud of the excellent job they've done managing fiscal policy, I suspect they'll be a little reluctant to take on monetary policy.

And so far the Fed has been extraordinarily successful in beating back every attempt to clip its wings.  But -- and as the economy gets better, I suspect the pressure on the Fed will abate.

But a door has been opened, and it won't be easily closed.  And so if there takes hold in the Congress a kind of people -- (inaudible) -- give voice to the idea that somehow Ben Bernanke is printing money that's all going into the pockets of Goldman Sachs, that will eventually pay dividends in legislation.  But I'd say the chances now are remote, but they're substantially greater than zero.

GARTEN:  John.

TAYLOR:  I think independence is essential as well, but I worry that a lot of these actions already taken are raising questions about its -- the Fed's independence.

When the Fed gets involved in fiscal policy; when it gets involved in credit-allocation policy, helping one market, say, the housing market versus others or one firm versus others, that's not monetary policy.  That's really fiscal policy, and it raises governance questions.  I -- it raises constitutional questions about who -- it's -- Congress has authority to appropriate funds.  And when the Fed moves into that area, it's really losing some of its independence.

It -- during World War II and afterwards, it really was in there helping the Treasury bond market all the time.  We had this accord in 1951 where the Fed regained its independence because it stopped doing those things.  When it starts doing them again -- and it has -- it's -- I think rightfully its independence gets questioned, and I think we should try to find a way to have them stop doing that and then they require a different type of appropriation mechanism.

WESSEL:  (Off mic) -- I think that there -- progress has been made in filling a -- in closing a vacuum that the Fed was forced to fill.  The ability the government now has to close a Bear Stearns or Lehman Brothers under Dodd-Frank removes from the Fed one burden it had.

And it's interesting, and in my judgment appropriate, that in the future if the Fed uses its extraordinary authority to lend under section 13(3) of the Federal Reserve Act, it will require the explicit consent in writing of the Treasury secretary, which I think is a totally appropriate use of the democratic check on the Federal Reserve without making it impotent at a time when we might need its strength.

BLINDER:  I agree with that.  I just want to add, 13(3), as it existed at the time, fully justified what the Fed did.  It was perfectly within the law.

GARTEN:  Okay.  Jacob and then Bill.  Right here.

WESSEL:  Jacob's question's for these guys.

QUESTIONER:  Thank you.  Jacob Frankel, JPMorgan Chase.

In the old days, it was very clear that there were very sharp distinctions between issues that the fiscal authorities deal with and issues that the monetary authorities deal with.  And as a result, there were also very clear distinction between the instruments of the two.  And the question of independence and political pressure, therefore, did not come to the fore to such an extent, because the more you enter fiscal territory, the more political you become and therefore subject to political pressure.

So this comes with the territory.  As we look at it today, we see, for example, that in -- that new assets make themselves to the balance sheet of the central bank, probably much lower-quality assets than used to be with the rationale that is being given, but the picture is very, very different.

Likewise, when we speak about the European Central Bank and it buys Greek government bonds, it's fiscal policy; it's transferring resources from one country to another.

So obviously the political debate is coming up.  The rational for it has been that somehow the leaders of the monetary authority are enlightened, they see that the fiscal authorities are not operational; and therefore, they have national responsibility to step in.

It sounds good, but it's a trap also.  And the question that I have is -- question number one -- are we seeing now a detour from the traditional demarcation that will be returning in normal time, or is it really a new paradigm, a new paradigm in which the end-of-the-Fed syndrome is a legitimate question, because if you consolidate the two, then what's the point of having two departments?

The second --

GARTEN:  Can I -- can I ask you --

QUESTIONER:  Yes.

GARTEN:  Can I ask you to stop at that question?

QUESTIONER:  Yes.

GARTEN:  Because it's such a big question, I'd like to -- I'm afraid we -- John, why don't you --

TAYLOR:  Well, I think I share Jacob's concern that we may even have begun to pass the Rubicon on this.  The -- in a way, to me, QE2 for the Fed was a bit of a watershed here.  And I hope it's not, but the QE1 and the other activities were associated with an emergency, I think a specific thing.  And you could -- we justify it on that basis.

And I remember saying at the time, "Well, you say it's an emergency now.  But what's going to happen if there's like a slowdown in the recovery?  Are you going to start doing this again?"

"No, no, it was an emergency."

But here we have a slowdown in the recovery, and the same time -- type of thing has happened.  So it seems -- I worry if this is like a new type of monetary policy, in which I case I think your questions are quite legitimate.  And I hope we, for that reason, go back to -- to a better demarcation.

GARTEN:  Al.

BLINDER:  I think there are two answers.  You had the emergency situation, and that is the situation under which the Fed acquired most of these dodgy assets.  It still has Maiden Lane and things like on its balance sheets.  They're pretty small.  And then the MBS is something in between.

The QE2 is the acquisition of Treasury debt.  That's what the Fed has done since its founding.  And I just fail to understand why people think it's such a big deal than instead of buying three-month Treasury debt, they're buying three-year Treasury debt.  I mean, it's a small difference, but it's certainly not a difference in kind.

To your question, Jacob, I think these emergency acquisitions of -- what shall we say -- strange assets come with the emergency and they go with -- when the emergency abates.  And I don't think we're going to have anything like this for a very long time, but I certainly don't rule it out sometime way in the future, and the Fed do something like that.

Again, the responsibility for financial stability is permanent, and you could argue a permanent change in the Fed.  And when you have that responsibility and chaotic things happen, you have an implied, very explicit responsibility to try to obviate the consequences of those.  And the Fed will -- the Fed will do that as need be.

The last point I want to make is that -- you didn't quite get this, but this is probably your second question is -- a central bank is in a somewhat different world in terms of the weaponry it has when you're at zero interest rates.  So the things that the Fed would have in an earlier day counteracted by lowering interest rates, it now has to do -- either do nothing or do something else.

GARTEN:  Bill.

QUESTIONER:  Thank you.  Bill Donaldson.  I have a two-phase question that centers around politics.  Part -- question number one is, I wonder if you could comment on the politics inherent in the rank order of what happened to Bear Stearns, Lehman and what followed?  Clearly, there were political -- in my view, political implications.

And number two is, with Dodd-Frank and the whole approach to systemic risk, have we opened up Pandora's box in terms of the continuation of politics in the solution to the thing?  Or does Dodd-Frank solve that now?

GARTEN:  David, I'm going to ask you to take that.  I think -- I think we can package this basically as the degree to which politics has influenced the big Fed's decision, and whether that is going to continue -- that will be intensified or relaxed by the legislation.

WESSEL:  In answer to your second question, I don't think Dodd-Frank opens a Pandora's box.  I think the crisis opened a Pandora's box, and Dodd-Frank makes it more complicated.  But it isn't the -- it isn't the original sin here.

On the -- on -- look, there's politics in Washington.  I mean, are we supposed to be horrified that the Treasury secretary and the chairman of the Fed and the president of the Federal Reserve -- the president of the Federal Reserve Bank of New York actually talked about whether to save Bear Stearns, Lehman and AIG, and somehow some great precept of monetary economics has been violated?  I mean, that seems a bit absurd.

I don't -- I think that where -- I have a great deal of sympathy with -- what John says is I believe that this central bank thinks that when the political authorities are paralyzed, it has a responsibility to act for the good of the country.  Other central banks, sometimes the European central banks, sometimes not say, "Our function is to say no so the fiscal authorities do the right thing."  And there, I think, is a very interesting political thing.

If the question is somehow, did the big moneyed interests of Wall Street force the Fed to bail out Bear Stearns and to screw Lehman Brothers or something like that, I just don't think that's true.

But I think you can see in Hank Paulson's book that people on Wall Street who have access to the Treasury secretary have a way of making their case known.  And because the very act of bailing out big financial institutions involves the fiscal and monetary authorities, it becomes political right away.  And there is -- it's going to be hard for the Fed to extricate itself from that.

I'm not sure that's completely responsive to your question.  It was -- yeah.

GARTEN:  John.

TAYLOR:  Yeah.  I think the very nature of the way these bailouts occurred is, they raised questions about:  Why this, and why not that?  I think it's just (inherent ?).

And so I think that's why it's so important to try to move towards a more rules-based approach to these things, the rule of law, if you like, having more of a role.  And I don't think Dodd-Frank did that.  I think it basically left even more discretion in the hands of -- more power, if you like, in the hands of the authorities.  So that worries me for exactly the reasons you're saying.  It raises questions about what's this power and discretion going to be used for, and who's going to benefit, and what are the intricacies of that?

So I've been working hard on trying to find a way to -- for financial firms to be handled more by rules-based approaches, through some kind of a modification of the bankruptcy code, or as David said, a way that makes it more systematic about how these institutions will be handled so that they can be reorganized or if -- wound down, if necessary, in a way that's not so chaotic; if you like, there can be a Plan B so we don't have to rush in and do these -- I think quite damaging -- bailout operations.

GARTEN:  Okay.

Other questions?

MR.:  One there.

QUESTIONER:  Is this the microphone?  Great.

Hi.  Emil Henry.  And I had the pleasure to serve in the Paulson Treasury, so just a follow-up on Bill's question on politics.  And so you'll see my bias here.  Maybe this is for -- this is best for John, who I agree with on almost everything.

The -- just the political reality going back to Lehman Brothers, why is this not the case, the -- just placing yourselves back in the summer of that year, the system virtually about to grind to a halt in almost every major financial institution?  The political reality -- back to Bill's question -- the political reality is that the -- is that the Congress never acts unless there is a crisis, right?  It's kind of fixing the -- fixing the airplane after the crash.  It never acts until there's a crisis.  So the political reality was that Congress never would have acted and never would have signed up for 700 -- $800 billion, whatever the final number was of that initial TARP, in the absence of a crisis.

So why wasn't it the right thing to let Lehman Brothers go, which was a -- which was a strong signal to the system, perhaps the right signal to the system in terms of moral hazard and all the other elements?  And that was -- the political reality was, that was the impetus for Congress to act and to sign up for TARP, which many might regard as a superb -- ultimately, a superb investment for the people of this country, where they actually might even see a return on their money and an instituted stability to boot because of it.  Anyway, just curious for your reaction.

GARTEN:  Well, I'm going to -- you know what?

QUESTIONER:  Yeah?

GARTEN:  Because we're running out of time, and I want to ask one more question, I'm going to leave that as a -- as a statement.

QUESTIONER:  Okay.  (Chuckles.)

GARTEN:  Okay?  Because you were there, and I think it's a very interesting observation.

But I would like to go back to the panel now and ask the three -- if we do -- we can do the short -- in a short way -- the three biggest challenges that the Fed faces over the next several years.

John, I'll start with you.

TAYLOR:  So I think number one would be to find a way to get back to what was working in the '80s and '90s.  Quite frankly, it -- don't -- let's not forget that this was a period of very long expansions, very short recessions and basic stability.  I think monetary policy deserves credit for that.  So that's really number one.

Number two.  Find a way to preserve its independence in the context of many people are just concerned with what has happened with, if you like, taking on too many things, too many -- too many jobs, fiscal policy, credit-allocation policy, if you like; it needs to have a new accord, somehow, like in 1951.

I think number three is to really reassert the important global role it has had for many years by doing the right thing, quite frankly (by obviously ?) maintaining the purchasing power of the dollar, and making that clear that that's what it's going to do.

Globally, it doesn't have to sacrifice its goals for the United States.  Its global role is quite consistent with that.  But I think, working with other central banks, coordinating more as central banks, quite -- (inaudible) -- if you like, think about a global goal for price stability so that they could work together and cooperate.  I think that would be a third important goal.

GARTEN:  Alan.

BLINDER:  I guess I'd start with adapting to Dodd-Frank.  I mean, I think it's insufficiently appreciated outside the Fed -- it's certainly appreciated inside the Fed -- that the new responsibilities and somewhat altered responsibilities, but mainly the new responsibilities for financial stability and serving kind of as the CEO to the financial stability council's board of directors requires institutional adaptation at the Fed, which is, like most bureaucracies, not that great at institutional adaptation.

My understanding is that the Fed as a system is going to be adding -- I'm not sure I'm right about this, but ballpark, a thousand or 2,000 new employees to do this -- to acquit itself of these new responsibilities, which, as David said, are not entirely well defined.

Let me say, however, that the price stability and maximum employment goals are not entirely well defined.  They're modestly well defined now, but it took decades to get that definition.  And I think it'll take decades to get that kind of definition of financial stability.

But in principle, the financial-stability division of the Federal Reserve, or whatever they call it, is going to be a very powerful piece of the Federal Reserve; and exactly how it's going to exist within that institution, not to mention how it's going to coexist with its tenant -- the Fed has been made the landlord of the Consumer Financial Protection Bureau, one of the sillier things that's in Dodd-Frank.  It makes the Fed a landlord.  That could be on the list of John's functions that you don't really need a central bank to be, to have:  a landlord.

So I think there's a lot of work that's going to occupy a lot of man- and woman-hours at the Fed to adapt to Dodd-Frank.

Secondly, we're not out of the woods yet.  And we are at a zero interest rate right now.  The economy's looking a little bit better in the last month or two, but not -- hardly gangbusters.  It could stagger, again, for any number of reasons, including infection from Europe and things that happen here.  And if that is the case, given the -- given the limited weaponry it has now at a zero interest rate, and given the beating it's taken over QE2, I think the Fed will be severely challenged if the economy stumbles again and/or we move towards deflation -- which is a word that hasn't been mentioned here, but we're a lot closer to deflation than inflation.  The phrase "price stability" is symmetric in principle.

Thirdly, once we get over that -- and we're not over that yet, but you wanted us to look out ahead -- the Fed does have to get back to its exit strategy that John was alluding to.  It really doesn't want to be in this business.  It does not want to own MBS.  It does not want to own assets left over from Bear Stearns and AIG.  It does not want to be doing QE n.  It wants to go back to regular old monetary policy.

And of course, as the critics have pointed out, the deeper we get into QEs -- QE1, QE2, QE3, et cetera -- the bigger the exit problem facing it, just quantitatively, not conceptually; it's the same.  But quantitatively it becomes bigger, and at some point down the road the Fed's going to have to start doing that.

WESSEL:  To avoid repeating what's been said before, let me just say briefly, one is to learn the right lessons from the last several years.  We could learn the wrong lessons and do it again, so we ought to minimize the risk by learning the right lessons.  And as you can see, there's not exactly unanimity in the profession about what the right lessons are.

Two, I think preserving --

GARTEN:  Let me ask you -- what do you think the right lessons are?

WESSEL:  I think the right lessons are that, A, the regulatory function is extremely important, and when everybody says you have nothing to worry about in the financial system, it's the time for the Fed to worry about it, and the same in the William McChesney Martin -- you know, time for the Fed to take away the punch bowl when things get good.

Second -- and this would be my second point -- is to think hard about what the Fed's responsibility is about asset prices and financial stability.

And third -- and this is related -- is to explain effectively on what things the Fed should be independent and what things it's not part of the deal.

Nobody thinks that we need to have a central bank that is unaccountable to the democratic institutions of our society and able to do anything it wants; although, people would be excused if they concluded from the recent crisis that that is the way they interpret their role.

But there are some things where monetary-policy independence is essential for the functioning of our economy.  And I think because the Fed has done so much, as John said, it's hard for people to understand.  So you need to be independent in this and not independent on that.

So laying an effective case for why an independent central bank on monetary policy is important, because -- this is a little bit like running a life insurance company.  You know, the trick to running a life insurance company is to succeed a guy who made good decisions, because when you're the CEO of a life insurance company, nothing you can do now will affect your current results.

Well, when it comes to the independence, the political independence and the credibility of the Fed, what Ben Bernanke does today will determine whether his successor can do a good job or not.  And I think that both Volcker and Greenspan really understood that and did things that they knew were essential investments for the Fed in its future independence.

Well, you know, the Fed can be excused by neglecting that role while it was trying to put out the world's biggest financial fire in our lifetime, but now it's time to get back to that.  So learn the right lessons to establish credibility about what independence is and explain it to people -- they need the consent of the people to be independent -- and thirdly to figure out what does it mean to maintain financial stability, particularly with regard to asset prices.  If they do all that, the next meeting of this group in 10 years will be very boring.

GARTEN:  I won't even try to sum up what was said, but I want to thank the panel and ask you to join me in thanking them for a great discussion.  (Applause.)

 

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THIS IS A RUSH TRANSCRIPT.

 

 

JEFFREY E. GARTEN:  We'd like to get started because we have -- we have a lot of territory to cover in a very short period of time.  My name is Jeff Garten, and I'm the presider today.  I have the honor of doing that.

Today we're going to talk about, "What kind of Fed do we want?"  This is part of the McKinsey Roundtable Series on the international economy.

Before we start, I would like to ask everyone to please turn off their cell phones.  And the rule of the council is also turn it -- don't put it on vibrate either because it will interfere with the microphone.  The other thing is that today's meeting is on the record.

I don't think I have to emphasize how important and how timely this subject is.  We all know that the Fed is at the intersection of so many critical issues in our society.  It is essential to the issues of economic growth, jobs, monetary stability and the stability of financial institutions not in the U.S. and abroad.

I would also say that the Fed plays a huge role in shaping really critical relationships, relationships such as those between creditors and debtors.  And while this may sound mundane, it takes on even a bigger role now as the U.S. itself is such a huge debtor and we'll be dealing with that situation in the global economy for many years to come.

I think the Fed also is very critical to shaping the relationship between Wall Street and Main Street, which, of course, puts it at the center of an enormous number of political issues.

The Fed also plays a unique role in our democracy.  Unelected, it is nevertheless incredibly powerful.  And it's no exaggeration, in my view anyway, to say it has become the fourth branch of government.  And this issue raises a huge number of important questions about accountability, transparency and governance.

And finally today, the Fed is really in the spotlight.  Part of that is because of its role in the recent financial crisis, a role of unprecedented activism, a role which made it not only lender of last resort but in many cases lender of first resort.  And the controversy surrounding the Fed's actions also extend to its role in monetary policy.

This is not going to go away, and it's not going to go away for a lot of reasons.  It's the centrality of the Fed but also because we have a change of government in the House.  And the House Financial Services Committee is now headed by someone who recently wrote a book called, "End the Fed."  And he would like to see the Fed abolished, but he's not the only one.  If you look at popular polls, this is not some insignificant minority in the United States that really feels the Fed has gone astray.

So to discuss these issues today, we have a really wonderful panel.  You probably know everyone here.  The bios are in front of you.  But I'll just briefly introduce Alan Blinder, who is a professor of economics and public affairs at Princeton and former vice chairman of the Fed; David Wessel, who's the economics editor of the Wall Street Journal and also the author of a wonderful book on the Fed, "In Fed We Trust"; and John Taylor, professor of economics at Stanford and also former undersecretary of the Treasury for International Affairs.

I think the way we'll do this is that I'm going to pose a few questions to the panel just to get the issues aired, then we'll go to questions from the members here, and I'm just going to reserve a little time at the end to pose a final question to the panel of the three major challenges they think the Fed faces in the decade ahead.

So let me start really by asking -- I'm going to ask you to grade the Fed in three different areas, and grade it from "A" to "F."  Three phases:  the pre-crisis, or the run-up to the crisis; the involvement in the crisis; and then post-crisis, such as it is.  And John, maybe I'll start with you.

JOHN B. TAYLOR:  Thank you.

I think it's important to start before the crisis.  I think the crisis really first flared up, as you know, in August of 2007, went to the panic period in the fall of 2008, and then we have, since the panic, a post-panic period, if you like.  But before this crisis even began in 2007, I think the seeds of it were pretty clear by monetary policy.

After really two decades or more of really, I think, really extraordinary, good economic policy, monetary policy -- the long expansions, low inflation, a lot of stability in most of the '80s and '90s -- we ran into a period where monetary policy, I think, deviated from that policy by keeping interest rates too low for too long, mainly in 2003, '4 and '5.

And there's different ways to look at it.  I like to look at it and compare what -- compare that with what happened in the '80s and '90s.  And there's clearly a too low for too long situation.  So that accentuated the housing boom, led to excessive risk-taking, encouraged a lot of activity which we now look and can't believe it really happened; wasn't the whole story but a big part of the story.  So that's a -- moving from really a strong "A" period to well below "A," not passing.

And I think the crisis, beginning in '07, also sees some different type of activity.  I think early on, the actions were not so good.  I think the -- I would call the on-again, off-again bailout policy, that began with the bailout of the creditors of Bear Stearns. turned off, if you like, for the creditors of Lehman, turned back on for AIG, turned back off again as the TARP was rolled out.  It seems to me that caused a lot of uncertainty and actually added to the panic.

The panic itself, I think the Fed did a very good job.  The commercial paper credit facility; the money market mutual fund facility; extraordinary, if you like, addition to the confidence in the markets that I think had helped arrest the panic, but basically the panic itself was caused, I believe, by the prior activity.

And then finally, post-panic.  Since the fall of 2008, I don't see a lot of good things here, quite frankly.  QE1 was a purchase, roughly, of 1.25 trillion (dollars) of mortgage-backed securities.  I don't think it really did much good.  My studies -- I've done lots of studies of this, careful econometrics.  I don't see it has done much good at all.  There was also 300 billion (dollars) of purchases of medium-term Treasurys during that period, during what we now call QE1, the first quantitative easing bout.  I don't think that did much good, either.

I was hoping that that was going to end when the emergency went away, as it disappeared into the past.  But lo and behold it didn't, and we just got something called now "QE2," which seems to me very disappointing because it really extends this period of really unconventional activity beyond any reasonable justification, in my view.  So, again, we're moving back into low grades, and I'm hopeful we're going to get off of that, and get back to the good kind of policy that worked so well in the '80s and '90s.

GARTEN:  So in sum, the only high grade you give is in the -- in the -- in the middle of the panic.

TAYLOR:  Yes, and in the '80s and '90s.  And don't forget that because we should really -- that was a good period for monetary policy.

GARTEN:  Okay.

Alan, you agree?

ALAN S. BLINDER:  Well, I was on the Fed in the '90s.  So I -- at least I'll agree with that.  (Laughter.)  With the rest, I would take some exception.  I would actually divide in two periods -- you asked for three -- which is -- and dividing it at some X days after Lehman Brothers.  I don't know whether X is three, five, seven, just right after Lehman Brothers.  If you go back to Lehman Brother -- from Lehman Brothers plus X days backward, I think the Fed's grades -- not back to the '80s and '90s, in the bad period, the Fed's grades were poor, especially poor on bank regulatory policy, a supervisory policy, I should say.

I think I'll probably go to my grave not knowing what I really think about the Bear Stearns episode.  I could argue either side of that for myself and convince myself of either -- of either side of that.  I think Lehman was a catastrophic, absolutely catastrophic error.  But -- so what am I grading that whole period?  Pretty low.  I remember years ago Yale abolished the grade of D.  Have you put it back?

GARTEN:  No.

BLINDER:  No.  At Princeton, we proudly use the grade of D.  So maybe that's what I would -- maybe that's what I would give.  But from Lehman plus X days forward, I give the Fed A-plus.  I think it's been extraordinary.  I think it's been necessary.  I shudder to think how things might have been had the Fed not put their heads on the chopping block, as you were sort of suggesting earlier, time and time and time again.

Now, by the time we got to QE2, I'm -- I guess I'm modestly favorable toward what's now being called QE2.  I don't expect any great effects from it, and neither does the Fed, by the way.  I think they engaged it on the belief that turned out to be a slightly false belief that there was nothing if not worse coming out of fiscal policy.  Just in terms of aggregate demand stimulation, let's leave aside what you do to the future deficit.  So -- but just in terms of aggregate demand stimulus, I think the working assumption was there was nothing coming out of the political world, and the Fed had to do what little it could.  And so it did that.  But overall I think the grade has to be extraordinarily high from Lehman plus X days forward.

GARTEN:  David.

DAVID WESSEL:  So this is a kind of an uncomfortable position to be in, with two eminent professors from whom I've learned a lot who disagree on much of everything.  And I'm the one supposed to cast the deciding vote.  (Laughter.)  And I just want to -- there was no lack of respect for the Council on Foreign Relations that my suit jacket is hanging in my mother's closet in New Haven.  And she called me about five minutes ago before I turned off my cell phone to assure me that I knew that my suit jacket was there.  (Laughter.)

I think that -- I don't think there's -- it's very difficult to make the case that the Fed did a good job before this episode because we had an episode that reflects very poorly on the Fed.  I think the difference between Alan and John is interesting.  John sees them as failing on monetary policy.  I think that's a debatable point.  But I do know that a number of people inside the Fed who were involved in those decisions are much more sympathetic to the "we-held-rates-too-long" view now than they were at the time.

Now, hindsight is an important check on one's judgment.  But it's always a lot -- very convenient to say, if I had it to do all over again, I would have done something differently.  And so I think one has to be careful how one judges these things.  Was it obvious at the time that it was too low too long?  Or is that only an after-the-fact judgment?  I think a lot of the judgment is after the fact.

On the regulatory front, which Alan referred to, I don't think there's any question that the Greenspan Fed basically thought the market could take care of itself.  Greenspan has testified that this was his biggest mistake, that it turns out that even if you have a lot of money on the table, it doesn't mean you're going to police the table.  And that was a catastrophic failure.

I don't judge them harshly for Bear Stearns.  Where I judge them harshly is the period between Bear Stearns and Lehman, where as John has pointed out, they gave us very little guidance as to what their thinking was.

You know, you don't want to have a committee meeting to decide whether to send out the fire engines.  Bear Stearns was collapsing.  They had to make a decision in a hurry.  They were not prepared to make that decision.  They made their best judgment.  You can argue that had they not bailed out Bear Stearns, Lehman wouldn't have happened.  You can argue if they had not bailed out Bear Stearns, we would have had Lehman Brothers on Bear Stearns' weekend instead.  I don't know what the right counterfactual is.

But that period between Bear Stearns and Lehman, I think, is the biggest failure of the whole thing.  They weren't prepared for Lehman.  It's very hard to argue that Lehman was a great success.  So I think you have to, of course, judge them harshly on that.

I'm sympathetic to the views that both Alan and John share, the one thing on -- they agree on, is that once the panic started, I think the Fed deserves very high marks.

And there we do -- we do have counterfactuals.  You know, we saw what happened during the Depression when the Fed decided to stick to some prevailing orthodoxy and didn't cooperate with other authorities in the interest of the global economy, and we had a catastrophic capitalism in the -- in the economy that we didn't have this time.  And although most Americans don't believe that, although most Americans are not comforted by the assertion that it could have been worse, the fact is it could have been.  And I think you have to give them very high grades for that period.

I'm closer to Alan than John on the question of whether QE1 and QE2 were indicated, but I judge them very harshly on their inability to explain to us -- and by us, I mean the American people, not the Ph.D. economist, but the American people -- exactly what they were doing and why they were doing it.  And I think it's an extraordinary failure on the part of an institution which has begun to see just how important communications is and a chairman who actually believes in transparency and communication, how difficult it's been for them to explain to us what they're doing.  And that will pay -- that is a serious failure, because it undermines the credibility of an institution that relies on credibility to do its job.

GARTEN:  So let's drop back now from the -- from the actual operations and talk about a mandate of the Fed.  I think most people feel that the Fed has two -- has a mandate to do two things; one is monetary stability and the other is full employment.  Recently there's also been --

WESSEL:  You mean price stability.

GARTEN:  Price stability.  Price stability and full employment.

There are also a lot of issues now relating to financial stability.  I'd like to ask Alan whether -- do you think the mandate of the Fed is right?  Is it too broad?  How would you evaluate it as we look ahead over the next several years?

BLINDER:  I think it's pretty much right, with a couple of footnote exceptions.  So the answer is right and then you put a footnote about how you could do it better.

The right part -- the act gives the Fed -- the Federal Reserve Act gives the Fed responsibility for keeping inflation low, keeping unemployment low.  And I'm glad we have that compared to, say, the ECB, which -- I -- mandates matter.  People take an oath of office and they do what they're supposed to do -- at least most people do what the law directs them to do.

The Dodd-Frank act has now given explicitly the -- a third mandate that was tacit and you might even say implied by the first two, which is for price stability -- excuse me, for financial stability, that is, overseeing and doing something to delimit systemic risk.  That's always a tacit part of the central bank's job, but it's not really in the Federal Reserve Act.

I didn't comb through the 2,400 pages before coming here.  I don't think it's -- the Federal Reserve Act was amended.  I think it would be a good thing to actually amend the Federal Reserve Act, put that in the legal mandate, which is Section 2a or something of the Federal Reserve Act.  That's the footnote.  But the authority is clearly given to it and the responsibility is clearly given to it by the Dodd-Frank act, and I think that's appropriate.

GARTEN:  John.

TAYLOR:  I long thought that the best strategy for the Fed or any central bank is to focus on price stability, because that brings about employment stability and economic stability.  And I think, for many years, since 1977 when the dual mandate was inserted, the Fed worked through that by arguing the best way to have strong economic growth and strong employment growth was to deliver on price stability.  Volcker, Greenspan spoke about that all the time.  And so even though I would object to the confusion that a dual mandate causes, I think they handled it quite well.

Now I think we've seen it working not so well, the dual mandate.  And I think the point, David's point about communication, illustrates this.  For many years, the statement by the FOMC, which they give after their meetings, did not mention the maximum employment aspect of this.  They mentioned the strategy is to make the economy stable by having the price stability.  But for the first time in their FOMC statement -- the first time, October 2010 -- the maximum employment term appeared.  And it was there to really, I think, justify quantitative easing 2.  And it's been repeated in the meetings since then.

So what I see is happening is that dual mandate is being -- is coming back in in a different way, by different people, and confusing the whole situation.  So I'd very much at this point like to argue that the Fed's mandate should be adjusted, if you like, to emphasize price stability -- I call it price stability within a context of economic stability.  When you focus on price stability, that doesn't mean you don't cut interest rates in a recession, it doesn't mean you don't provide liquidity in a crisis, it doesn't mean you don't have lender of last resort.  Those are essential to price stability and economic stability.  But by confusing this and allowing some people to go out and give different motivations for things, I think we're just confusing the situation.

BLINDER:  If I can just --

GARTEN:  I'll get to you in a sec.  I just want to ask --

BLINDER:  Just a very short interjection.  There really wasn't such a big change last October or whatever.  When I was on the Fed in the '90s, whether we were increasing interest rates or decreasing interest rates, we always justified it by sustaining maximum -- "maximum sustainable economic growth," that was the euphemism.  And it went whether -- (inaudible) -- went up or down, which was -- I used to argue about that.  But it's not a new thing.  It started with the '77 act, as John said.

WESSEL:  I think mandates do matter, and our reporting suggests that when the FOMC talked about QE2, they talked quite a bit about what their mandate was.  I'm not sure that I agree with John.  By the Fed's definition, we are below price stability.  This was easy to justify on the grounds that they were missing on both the employment and the inflation target.  The much more intellectually interesting case would have come if inflation were closer to their target of about 2 percent and unemployment were still high.

I think it's naive to think that a central bank of the United States or any democracy is going to be oblivious to 9.8 percent unemployment; and nor should it be.  But I think Jeff raised an interesting question -- which neither Alan or John wants to touch because they're macro-economists -- is so what about this financial stability goal, and what does that actually mean?

And I think that it's quite unclear what it means.  And I think the Fed is being set up in a way to take the blame for the next crisis, which will obviously come.  And this time, the chairman won't be able to go before the Congress and say, "Well, I didn't have authority to worry about the nonbank financial institutions of the shadow banking system."  The members of Congress will say, "Look, after the last crisis, you told us we needed a systemic regulator, and we set up this committee, and you're on it.  And you blew it."

And so I think it's going to be an evolving discussion inside the Fed about what financial stability means.  And I'll just give you two examples of how difficult this is.  One is:  Does it mean that the Fed has a responsibility of acting when it thinks there's an asset price bubble -- stock market bubble or housing price bubble?  And if so, how exactly is it supposed to do that?  Is it supposed to tighten regulation so there's not a lot of lending in those institutions?  Is it supposed to give speeches and say, "Don't buy a house"?  Can you imagine that?  Is it supposed to raise interest rates, even if the conventional measures of price inflation and unemployment are not worrisome, because it sees an asset bubble?  I mean, these are questions that academics have debated and the Fed has never had to cope with before.

And the second is:  Are they supposed to be the ueber-regulator?  It might have been an interesting model to say no, that there was -- someone else was the regulator.  But the Congress chose not to do that; learning from the British model that apparently that's not perfect either.  On the other hand, they didn't say the Fed is the sole regulator.  So you can imagine we will have endless stories in The Wall Street Journal about tension between the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve about banking supervision and financial supervision, all justified in the name of pursuing financial stability.

So I think that in my mind is the biggest question mark:  What exactly has changed now that the Fed has more responsibility for financial stability, and what exactly is that going to mean in practice when we get beyond this current period?

GARTEN:  So let me just follow up that, because the next question I was going to ask is:  Just how significant is the new legislation, is the Dodd-Frank legislation, when it comes to the Fed?  And you -- you're actually on that ground.  Well, just venture an opinion in -- because we don't have a lot of time, but in this light -- is it very?

WESSEL:  Yes, it's very significant, not only because of the letter of the law but because the law embodies a view in Congress and the public that somehow the cops on the beat fell down on the job.  And we wanted to give the cops more power, more ammunition, so we don't go through this again.  So there is an expectation the Fed is going to prevent the next crisis.

The Fed will fail to do that.  It will be blamed.

GARTEN:  Okay.  So final question before we open it up.  This has to do with the global role of the Fed.  Obviously, the Fed has always had a huge international influence.  And in the crisis, it was extremely active in terms of making dollars available to central banks in many countries.  Psychologically, what the Fed does or doesn't do always has a large impact.

But my question is this.  If -- given the way the global economy, the global financial markets have evolved, given all the interconnections, given the growing size of that and the rise of other central banks -- ECB, Bank of China -- Public Bank of China, as you look ahead, what can you say about the changing role of the Fed in the global economy?

What -- Alan, I'll ask you to start with -- you know, if -- the -- Bernanke and his successor -- what's going to be different about the way they run the Fed than previous chairmen, given the way the world economy is going?

BLINDER:  I guess I'd start with the three words "not too much."  But let me elaborate on that a little.  First we have sort of the obvious arithmetic of what is moving toward and eventually will be a more tri-polar world, where the Fed is probably still the first among equals among the Fed, the ECB and the People's Bank of China.  We're a long way from the latter; we're not so far from the second, from the ECB.  So the Fed, as you look over the distant horizon, will not be quite as omnipotent as at least some people like to portray the Fed now and in recent years.

Second factor, which is very important -- and I think you don't really appreciate this until you -- this is already the second time I've mentioned the oath of office.  But Alan Greenspan appreciated this very much, and I'm sure Ben Bernanke does also, which is -- this goes back to the legal mandate.  The Fed has delegated authority from Congress.  Congress gives it its mandate.  And there is nothing in that mandate that says, for example, now and then you should pull punches in order to take the rest of the world into account -- that is to say, if we needed easier monetary policy.

But maybe for the rest of the world that's not so good.  Or the other way around, that the Fed should shade its decision in favor of the rest of the world relative to what it would do if it cared only about one country.  The mandate tells it to care only about one country.

Now, I think it's quite arguable in principle -- a bunch of us academics could argue, you know, in this kind of globalized world, we ought to revive the Fed's mandate, because after all, we're central to the whole world economy, and what happens in the rest of the world reverberates on us and conversely.  But then I'd just ask people in the audience to think how many of the 535 members of Congress do you think would vote for that amendment.  And your estimate is probably the same as mine:  zero.

GARTEN:  David.

WESSEL:  I don't think the Fed's role has changed.  I think America's role has changed, and for the -- all the reasons Alan said.  We've never -- the Fed has never been strictly focused on the United States, and -- nor can it afford to be.  It's the protector of the U.S. dollar.  And we've had periods in the past when the dollar needed some help and they stepped in.

But I think that we live in a very different time.  And I imagine that Paul Volcker would have a hard time understanding why it is that Ben Bernanke has to spend so much time assuring his counterparts in the People's Republic of China that, no, he's not going to get inflation -- let inflation get out of control, and therefore please don't sell all your dollars.

So the Fed's role has changed because our role in the world economy has changed.  We no longer are a master of our own fate given how much we depend on the kindness of strangers to lend us all their savings.

GARTEN:  John.

TAYLOR:  I think the idea of the central bank -- our central bank maintaining the purchasing power of the currency is very important for our world economy.  And to the extent we get away from that, to the extent we, if you like, think about doing too many things, I think that really is in some sense abnegating an important aspect of leadership, for the United States and for the Federal Reserve.

In the period I mentioned earlier, where interest rates were too low for too long, that actually spread around the world.  It made it harder for other central banks to do the right thing.  In fact, if you look at certain areas of the world where they also had housing booms, it was really related to their interest rates being too low at that point.  So in a sense that affected the world economy.

So I think the -- I'm somewhat disappointed that we may be losing that important leadership role, which has been very important for the world economy for so long.  The QE2, in a way, is an example.  I'm not surprised about the complaining from other countries for this.  I was surprised that it was so -- they were so outspoken about it and it interfered with our foreign policy.  I was surprised at that, but not surprised with their logic, because it does make it harder for them to control inflation.  It does have the potential to cause, if you like, a growing inflationary boom globally.  And that's going to feed back on this economy and hurt us.

So I think there's so much here that is, if you like, beneficial for the world economy if we have a central bank that does the kind of things it did for most of the '80s and '90s, which was not only a stable period for the U.S., it was stable elsewhere, too.

So I'd just like to get back to that way of thinking about policy.  It worked.  It was a framework that worked, and it showed a great deal of leadership by this country, which I think's important for the world.

GARTEN:  I think that's good point of departure for questions from the members.  I'd ask you to -- where are the microphones?  Okay.  There are microphones all over.  If you would just stand up, please, just identify yourself and your affiliation, and speak into the microphone.  Do we have -- yes, please.

And let me ask you this.  You could address the question to me and I will farm it out, or to one of the panel members, but we don't really have time for each of the panel members to answer every question.  So I'd like to, in a sense, ask one to do it.

QUESTIONER:  Thank you.  I'm Richard Weinert, Concert Artists Guild.  It's been an article of faith for some decades that the best arrangement is the central banks to be politically independent.  This is obviously under some question and attack now.  And I'd like to ask whomever on the panel would like to comment on what you think would be the ideal arrangement.

GARTEN:  Alan, I'll ask you to --

BLINDER:  Well, I'm not sure I can define the ideal arrangement, but certainly independence -- now independence is not like a point, it's a sort of a range, and I'm not sure I can answer with that kind of precision.  But I think the events of recent years, including the speed that they required, the freedom to take unpopular actions, and the performance of the Fed and other central banks under duress, never minding the poor performance of the regulatory regime, after all points to the -- how vital it is to have quite a lot of central bank independence.  A small piece of evidence, as you probably know, over the '80s and the '90s almost every country in the world -- there are some exceptions -- moved toward central bank independence, and not one single one moved in the other direction.

GARTEN:  David, I'm just going to ask you to comment on this from this standpoint.  How much of a threat to the independence of the Fed do you see boiling up in the American political system?  Not just the rhetoric, but the reality here.

WESSEL:  I think I would say some, by which I mean that it is not surprising the Fed is taking a lot of heat.  The Fed displayed an extraordinary amount of power and became a lightning rod for a sense in America that Wall Street got bailed out and Main Street didn't.  I think when push comes to shove, the Congress will flinch.  So proud of the excellent job they've done managing fiscal policy, I suspect they'll be a little reluctant to take on monetary policy.

And so far the Fed has been extraordinarily successful in beating back every attempt to clip its wings.  But -- and as the economy gets better, I suspect the pressure on the Fed will abate.

But a door has been opened, and it won't be easily closed.  And so if there takes hold in the Congress a kind of people -- (inaudible) -- give voice to the idea that somehow Ben Bernanke is printing money that's all going into the pockets of Goldman Sachs, that will eventually pay dividends in legislation.  But I'd say the chances now are remote, but they're substantially greater than zero.

GARTEN:  John.

TAYLOR:  I think independence is essential as well, but I worry that a lot of these actions already taken are raising questions about its -- the Fed's independence.

When the Fed gets involved in fiscal policy; when it gets involved in credit-allocation policy, helping one market, say, the housing market versus others or one firm versus others, that's not monetary policy.  That's really fiscal policy, and it raises governance questions.  I -- it raises constitutional questions about who -- it's -- Congress has authority to appropriate funds.  And when the Fed moves into that area, it's really losing some of its independence.

It -- during World War II and afterwards, it really was in there helping the Treasury bond market all the time.  We had this accord in 1951 where the Fed regained its independence because it stopped doing those things.  When it starts doing them again -- and it has -- it's -- I think rightfully its independence gets questioned, and I think we should try to find a way to have them stop doing that and then they require a different type of appropriation mechanism.

WESSEL:  (Off mic) -- I think that there -- progress has been made in filling a -- in closing a vacuum that the Fed was forced to fill.  The ability the government now has to close a Bear Stearns or Lehman Brothers under Dodd-Frank removes from the Fed one burden it had.

And it's interesting, and in my judgment appropriate, that in the future if the Fed uses its extraordinary authority to lend under section 13(3) of the Federal Reserve Act, it will require the explicit consent in writing of the Treasury secretary, which I think is a totally appropriate use of the democratic check on the Federal Reserve without making it impotent at a time when we might need its strength.

BLINDER:  I agree with that.  I just want to add, 13(3), as it existed at the time, fully justified what the Fed did.  It was perfectly within the law.

GARTEN:  Okay.  Jacob and then Bill.  Right here.

WESSEL:  Jacob's question's for these guys.

QUESTIONER:  Thank you.  Jacob Frankel, JPMorgan Chase.

In the old days, it was very clear that there were very sharp distinctions between issues that the fiscal authorities deal with and issues that the monetary authorities deal with.  And as a result, there were also very clear distinction between the instruments of the two.  And the question of independence and political pressure, therefore, did not come to the fore to such an extent, because the more you enter fiscal territory, the more political you become and therefore subject to political pressure.

So this comes with the territory.  As we look at it today, we see, for example, that in -- that new assets make themselves to the balance sheet of the central bank, probably much lower-quality assets than used to be with the rationale that is being given, but the picture is very, very different.

Likewise, when we speak about the European Central Bank and it buys Greek government bonds, it's fiscal policy; it's transferring resources from one country to another.

So obviously the political debate is coming up.  The rational for it has been that somehow the leaders of the monetary authority are enlightened, they see that the fiscal authorities are not operational; and therefore, they have national responsibility to step in.

It sounds good, but it's a trap also.  And the question that I have is -- question number one -- are we seeing now a detour from the traditional demarcation that will be returning in normal time, or is it really a new paradigm, a new paradigm in which the end-of-the-Fed syndrome is a legitimate question, because if you consolidate the two, then what's the point of having two departments?

The second --

GARTEN:  Can I -- can I ask you --

QUESTIONER:  Yes.

GARTEN:  Can I ask you to stop at that question?

QUESTIONER:  Yes.

GARTEN:  Because it's such a big question, I'd like to -- I'm afraid we -- John, why don't you --

TAYLOR:  Well, I think I share Jacob's concern that we may even have begun to pass the Rubicon on this.  The -- in a way, to me, QE2 for the Fed was a bit of a watershed here.  And I hope it's not, but the QE1 and the other activities were associated with an emergency, I think a specific thing.  And you could -- we justify it on that basis.

And I remember saying at the time, "Well, you say it's an emergency now.  But what's going to happen if there's like a slowdown in the recovery?  Are you going to start doing this again?"

"No, no, it was an emergency."

But here we have a slowdown in the recovery, and the same time -- type of thing has happened.  So it seems -- I worry if this is like a new type of monetary policy, in which I case I think your questions are quite legitimate.  And I hope we, for that reason, go back to -- to a better demarcation.

GARTEN:  Al.

BLINDER:  I think there are two answers.  You had the emergency situation, and that is the situation under which the Fed acquired most of these dodgy assets.  It still has Maiden Lane and things like on its balance sheets.  They're pretty small.  And then the MBS is something in between.

The QE2 is the acquisition of Treasury debt.  That's what the Fed has done since its founding.  And I just fail to understand why people think it's such a big deal than instead of buying three-month Treasury debt, they're buying three-year Treasury debt.  I mean, it's a small difference, but it's certainly not a difference in kind.

To your question, Jacob, I think these emergency acquisitions of -- what shall we say -- strange assets come with the emergency and they go with -- when the emergency abates.  And I don't think we're going to have anything like this for a very long time, but I certainly don't rule it out sometime way in the future, and the Fed do something like that.

Again, the responsibility for financial stability is permanent, and you could argue a permanent change in the Fed.  And when you have that responsibility and chaotic things happen, you have an implied, very explicit responsibility to try to obviate the consequences of those.  And the Fed will -- the Fed will do that as need be.

The last point I want to make is that -- you didn't quite get this, but this is probably your second question is -- a central bank is in a somewhat different world in terms of the weaponry it has when you're at zero interest rates.  So the things that the Fed would have in an earlier day counteracted by lowering interest rates, it now has to do -- either do nothing or do something else.

GARTEN:  Bill.

QUESTIONER:  Thank you.  Bill Donaldson.  I have a two-phase question that centers around politics.  Part -- question number one is, I wonder if you could comment on the politics inherent in the rank order of what happened to Bear Stearns, Lehman and what followed?  Clearly, there were political -- in my view, political implications.

And number two is, with Dodd-Frank and the whole approach to systemic risk, have we opened up Pandora's box in terms of the continuation of politics in the solution to the thing?  Or does Dodd-Frank solve that now?

GARTEN:  David, I'm going to ask you to take that.  I think -- I think we can package this basically as the degree to which politics has influenced the big Fed's decision, and whether that is going to continue -- that will be intensified or relaxed by the legislation.

WESSEL:  In answer to your second question, I don't think Dodd-Frank opens a Pandora's box.  I think the crisis opened a Pandora's box, and Dodd-Frank makes it more complicated.  But it isn't the -- it isn't the original sin here.

On the -- on -- look, there's politics in Washington.  I mean, are we supposed to be horrified that the Treasury secretary and the chairman of the Fed and the president of the Federal Reserve -- the president of the Federal Reserve Bank of New York actually talked about whether to save Bear Stearns, Lehman and AIG, and somehow some great precept of monetary economics has been violated?  I mean, that seems a bit absurd.

I don't -- I think that where -- I have a great deal of sympathy with -- what John says is I believe that this central bank thinks that when the political authorities are paralyzed, it has a responsibility to act for the good of the country.  Other central banks, sometimes the European central banks, sometimes not say, "Our function is to say no so the fiscal authorities do the right thing."  And there, I think, is a very interesting political thing.

If the question is somehow, did the big moneyed interests of Wall Street force the Fed to bail out Bear Stearns and to screw Lehman Brothers or something like that, I just don't think that's true.

But I think you can see in Hank Paulson's book that people on Wall Street who have access to the Treasury secretary have a way of making their case known.  And because the very act of bailing out big financial institutions involves the fiscal and monetary authorities, it becomes political right away.  And there is -- it's going to be hard for the Fed to extricate itself from that.

I'm not sure that's completely responsive to your question.  It was -- yeah.

GARTEN:  John.

TAYLOR:  Yeah.  I think the very nature of the way these bailouts occurred is, they raised questions about:  Why this, and why not that?  I think it's just (inherent ?).

And so I think that's why it's so important to try to move towards a more rules-based approach to these things, the rule of law, if you like, having more of a role.  And I don't think Dodd-Frank did that.  I think it basically left even more discretion in the hands of -- more power, if you like, in the hands of the authorities.  So that worries me for exactly the reasons you're saying.  It raises questions about what's this power and discretion going to be used for, and who's going to benefit, and what are the intricacies of that?

So I've been working hard on trying to find a way to -- for financial firms to be handled more by rules-based approaches, through some kind of a modification of the bankruptcy code, or as David said, a way that makes it more systematic about how these institutions will be handled so that they can be reorganized or if -- wound down, if necessary, in a way that's not so chaotic; if you like, there can be a Plan B so we don't have to rush in and do these -- I think quite damaging -- bailout operations.

GARTEN:  Okay.

Other questions?

MR.:  One there.

QUESTIONER:  Is this the microphone?  Great.

Hi.  Emil Henry.  And I had the pleasure to serve in the Paulson Treasury, so just a follow-up on Bill's question on politics.  And so you'll see my bias here.  Maybe this is for -- this is best for John, who I agree with on almost everything.

The -- just the political reality going back to Lehman Brothers, why is this not the case, the -- just placing yourselves back in the summer of that year, the system virtually about to grind to a halt in almost every major financial institution?  The political reality -- back to Bill's question -- the political reality is that the -- is that the Congress never acts unless there is a crisis, right?  It's kind of fixing the -- fixing the airplane after the crash.  It never acts until there's a crisis.  So the political reality was that Congress never would have acted and never would have signed up for 700 -- $800 billion, whatever the final number was of that initial TARP, in the absence of a crisis.

So why wasn't it the right thing to let Lehman Brothers go, which was a -- which was a strong signal to the system, perhaps the right signal to the system in terms of moral hazard and all the other elements?  And that was -- the political reality was, that was the impetus for Congress to act and to sign up for TARP, which many might regard as a superb -- ultimately, a superb investment for the people of this country, where they actually might even see a return on their money and an instituted stability to boot because of it.  Anyway, just curious for your reaction.

GARTEN:  Well, I'm going to -- you know what?

QUESTIONER:  Yeah?

GARTEN:  Because we're running out of time, and I want to ask one more question, I'm going to leave that as a -- as a statement.

QUESTIONER:  Okay.  (Chuckles.)

GARTEN:  Okay?  Because you were there, and I think it's a very interesting observation.

But I would like to go back to the panel now and ask the three -- if we do -- we can do the short -- in a short way -- the three biggest challenges that the Fed faces over the next several years.

John, I'll start with you.

TAYLOR:  So I think number one would be to find a way to get back to what was working in the '80s and '90s.  Quite frankly, it -- don't -- let's not forget that this was a period of very long expansions, very short recessions and basic stability.  I think monetary policy deserves credit for that.  So that's really number one.

Number two.  Find a way to preserve its independence in the context of many people are just concerned with what has happened with, if you like, taking on too many things, too many -- too many jobs, fiscal policy, credit-allocation policy, if you like; it needs to have a new accord, somehow, like in 1951.

I think number three is to really reassert the important global role it has had for many years by doing the right thing, quite frankly (by obviously ?) maintaining the purchasing power of the dollar, and making that clear that that's what it's going to do.

Globally, it doesn't have to sacrifice its goals for the United States.  Its global role is quite consistent with that.  But I think, working with other central banks, coordinating more as central banks, quite -- (inaudible) -- if you like, think about a global goal for price stability so that they could work together and cooperate.  I think that would be a third important goal.

GARTEN:  Alan.

BLINDER:  I guess I'd start with adapting to Dodd-Frank.  I mean, I think it's insufficiently appreciated outside the Fed -- it's certainly appreciated inside the Fed -- that the new responsibilities and somewhat altered responsibilities, but mainly the new responsibilities for financial stability and serving kind of as the CEO to the financial stability council's board of directors requires institutional adaptation at the Fed, which is, like most bureaucracies, not that great at institutional adaptation.

My understanding is that the Fed as a system is going to be adding -- I'm not sure I'm right about this, but ballpark, a thousand or 2,000 new employees to do this -- to acquit itself of these new responsibilities, which, as David said, are not entirely well defined.

Let me say, however, that the price stability and maximum employment goals are not entirely well defined.  They're modestly well defined now, but it took decades to get that definition.  And I think it'll take decades to get that kind of definition of financial stability.

But in principle, the financial-stability division of the Federal Reserve, or whatever they call it, is going to be a very powerful piece of the Federal Reserve; and exactly how it's going to exist within that institution, not to mention how it's going to coexist with its tenant -- the Fed has been made the landlord of the Consumer Financial Protection Bureau, one of the sillier things that's in Dodd-Frank.  It makes the Fed a landlord.  That could be on the list of John's functions that you don't really need a central bank to be, to have:  a landlord.

So I think there's a lot of work that's going to occupy a lot of man- and woman-hours at the Fed to adapt to Dodd-Frank.

Secondly, we're not out of the woods yet.  And we are at a zero interest rate right now.  The economy's looking a little bit better in the last month or two, but not -- hardly gangbusters.  It could stagger, again, for any number of reasons, including infection from Europe and things that happen here.  And if that is the case, given the -- given the limited weaponry it has now at a zero interest rate, and given the beating it's taken over QE2, I think the Fed will be severely challenged if the economy stumbles again and/or we move towards deflation -- which is a word that hasn't been mentioned here, but we're a lot closer to deflation than inflation.  The phrase "price stability" is symmetric in principle.

Thirdly, once we get over that -- and we're not over that yet, but you wanted us to look out ahead -- the Fed does have to get back to its exit strategy that John was alluding to.  It really doesn't want to be in this business.  It does not want to own MBS.  It does not want to own assets left over from Bear Stearns and AIG.  It does not want to be doing QE n.  It wants to go back to regular old monetary policy.

And of course, as the critics have pointed out, the deeper we get into QEs -- QE1, QE2, QE3, et cetera -- the bigger the exit problem facing it, just quantitatively, not conceptually; it's the same.  But quantitatively it becomes bigger, and at some point down the road the Fed's going to have to start doing that.

WESSEL:  To avoid repeating what's been said before, let me just say briefly, one is to learn the right lessons from the last several years.  We could learn the wrong lessons and do it again, so we ought to minimize the risk by learning the right lessons.  And as you can see, there's not exactly unanimity in the profession about what the right lessons are.

Two, I think preserving --

GARTEN:  Let me ask you -- what do you think the right lessons are?

WESSEL:  I think the right lessons are that, A, the regulatory function is extremely important, and when everybody says you have nothing to worry about in the financial system, it's the time for the Fed to worry about it, and the same in the William McChesney Martin -- you know, time for the Fed to take away the punch bowl when things get good.

Second -- and this would be my second point -- is to think hard about what the Fed's responsibility is about asset prices and financial stability.

And third -- and this is related -- is to explain effectively on what things the Fed should be independent and what things it's not part of the deal.

Nobody thinks that we need to have a central bank that is unaccountable to the democratic institutions of our society and able to do anything it wants; although, people would be excused if they concluded from the recent crisis that that is the way they interpret their role.

But there are some things where monetary-policy independence is essential for the functioning of our economy.  And I think because the Fed has done so much, as John said, it's hard for people to understand.  So you need to be independent in this and not independent on that.

So laying an effective case for why an independent central bank on monetary policy is important, because -- this is a little bit like running a life insurance company.  You know, the trick to running a life insurance company is to succeed a guy who made good decisions, because when you're the CEO of a life insurance company, nothing you can do now will affect your current results.

Well, when it comes to the independence, the political independence and the credibility of the Fed, what Ben Bernanke does today will determine whether his successor can do a good job or not.  And I think that both Volcker and Greenspan really understood that and did things that they knew were essential investments for the Fed in its future independence.

Well, you know, the Fed can be excused by neglecting that role while it was trying to put out the world's biggest financial fire in our lifetime, but now it's time to get back to that.  So learn the right lessons to establish credibility about what independence is and explain it to people -- they need the consent of the people to be independent -- and thirdly to figure out what does it mean to maintain financial stability, particularly with regard to asset prices.  If they do all that, the next meeting of this group in 10 years will be very boring.

GARTEN:  I won't even try to sum up what was said, but I want to thank the panel and ask you to join me in thanking them for a great discussion.  (Applause.)

 

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