NYFed's Bill Dudley Speech at VAE / VMI

Mike Smitka, Washington and Lee

Tonight I had the opportunity – perhaps I should say privilege – of hearing Bill Dudley, President of the Federal Reserve Bank of New York, speak at the Virginia Association of Economists conference at Virginia Military Institute. (Tomorrow they move next door – literally – to my own Washington and Lee, in a venue 45 seconds from my office.) I've been to many such events, and he spoke largely from script: the text of his talk, The Role of the Federal Reserve—Lessons from Financial Crises is already available on the FRB New York web site. He's been here before, and prefaced his talk with details about VMI and W&L and H. Parker Willis, the first Dean of what is now the Williams School. As a friend of Congressman and then Senator Carter Glass [of Lynchburg VA], Willis helped draft the legislation that set up the Federal Reserve System in 1913, and then went on to become the first Secretary of the Federal Reserve Board. (I'm currently sitting underneath what a century ago was Willis' office.)

It was a fine talk, indeed a very good talk for being accessible to undergraduate economics majors. Dudley is also quite deft at Q&A, which at these events inevitably includes the odd (sometimes very odd) Gold Bug. Of the many central bankers I've known, he may be simultaneously the most ordinary and the most extraordinary. That's because in 2008 the global financial system came very, very close to grinding to a halt. To give one example, only a few central bankers knew enough of the nitty-gritty of markets to understand the implications of money market mutual funds "breaking the buck" – and knew enough of the Federal Reserve System and of Wall Street to understand what the Fed could legally and practically do. Dudley couldn't do it alone, and he and those around him needed high-level backing, but at the operational end he was both the expert and the person who, given the role of the New York Fed, had to oversee the actual implementation of policy. (If this is opaque, post comments and I will elaborate.)

Most of the questions were ordinary, in that he had heard them before. There was, as I said, a Gold Bug who in an audience of 200-plus had the temerity to insist on posing not one but two questions. Dudley is a gentleman and so overruled the moderator-cum-timekeeper to take one more question – and made sure it was from a student. He was consistently clear, direct and careful: the US is in its 7th year of expansion, but growth is only slightly above normal [= a lot of people are still out of work], we're approaching but not yet at "normal" [which in an evolving economy can't be pinned down using some rule grounded in the often distant past] and we have headwinds. So he advocated going slow with interest rate increases, the Fed can always boost rates quickly but has limited room to move in the opposite direction. And so on. Yes, he has had a lot of practice, and as I noted he's encountered these questions before. But so have all the other Fed presidents and governors and Japanese and English central bankers I've known.

One question caused him to pause: what did you learn from your first macro "Principles" course? First, he was honest: to paraphrase, "I don't remember much." He did not stop with an answer that produced a chuckle but no real information. Instead, he continued that when he was young, economics textbooks contained very little on financial markets, and that that remains true even today, and not just of textbooks but of state-of-the-art macroeconomic research. (To his credit he did not mention Dynamic Stochastic Equilibrium Models or let any other such jargon intrude.) Now his hope is that theorists will learn how to incorporate financial markets in a way that allows modeling the impact of a financial crisis. However, that was not the state of the art in the fall 2008, and is not the state of the art 8 years later.

Economic downturns hurt many innocent bystanders, millions of Americans lost their jobs in 2008-2010 through no fault of their own. He was honest that it rankled that in such times "too big to fail" institutions could find policy support while ordinary Americans lost their homes. I won't reiterate his discussion of "systemically important financial institutions," except to note that he never resorted to saying "SIFI". But you can read his comments for yourself, in the link above.

Can we realistically expect economic models to provide practical guidance in times of crisis? I think not for two reasons. The first is that the next financial crisis will be unexpected. Dudley in effect made that point, expressing the hope that thanks to "lessons learned" that he would not live long enough to see another such crisis. Unfortunately models, however sophisticated, can only incorporate the features that those who construct them believe salient. While perhaps optimistic, if we know where the cliff is, we can stop short of going over it. However, while the road may appear familiar, we never take the same route twice, and can be surprised by twists or turns. Or deer in the middle of the day. To use (abuse?) another aphorism, it is simply unrealistic to think that we will be able to position the profession to fight the next war against an as yet unknown enemy. At best we can hope that in refighting the last war we will have keep alive a few skills that prove useful, without having an officer corps incapable when faced with the unexpected.

The second is the matter of simplicity. Advances in analytic tools and computer power are already allowing economists to build models that have more "agents" and are otherwise more complicated. We can include not just one type of consumer, but consumers who can choose their level of saving and consumers who live paycheck to paycheck. We can build financial models (if not full macro models) with "noise" traders who follow the herd, and those who look at fundamentals and get in early and bail out ahead of the crowd. So we can model a panic, even if we can't yet incorporate it in a satisfying manner in a complete macro model. ("Complete" is a technical term…) That may come with time.

A similar elaboration took place in macro models in the 1960s at Wharton Econometrics and elsewhere. The end result was models that were too complicated to handle the unexpected – the "supply side" shocks and inflation of the 1970s – which made them easy targets for proponents of new approaches to macro, starting with rational expectations and real business cycles. This time around the new generation could offer the excuse that they had only just finished constructing the core of the new class of DSGE models, but the reality is that adding layer upon layer of additional features will assuredly lead to a field working with unwieldy constructs that not only fail to explain the unexpected – a straw man critique – but include so many parameters that while they produce a good fit and work well in normal times, they offer no help in handling the unexpected. We will be right back to where were were in 1975.

So back to simplicity. For a model to be useful, it needs to be simple. Such models must then however be either quite specific, or be so generic as to be … innocuous is not quite the right word, maybe unhelpful is better. If models are specific, you then need an array of them, and the wisdom to be able to choose the right one for the task at hand. In my mind models serve a pedagogic role. They help you learn to be more sophisticated about treating interactions seriously, to confront the conceptual and technical challenge of seeing that all the pieces add up to 100%. The problem is that the economics profession is now at the point where career incentives mandate that you work on elaborating a particular model. Only in that way can you do something to demonstrate through your technical "chops" that you are professionally trained and yet "advance the frontier" of the field. Developing familiarity with a wide array of models does not lead to publications and tenure, or even a Ph.D..

Thankfully in 2008 we had Bill Dudley at the New York Fed. He had sufficient background in economics to be a careful thinker, to be able to communicate with the profession and (probably more important) have the respect of the staff economists who had to join the fight to contain the Lehman Shock, as it's termed in much of the world. At the same time, it was important that his knowledge was not so specialized that he only had one narrow perspective on the macroeconomy. At the same time, he had a sufficiently distinguished career in the financial sector to let him interact with the players in financial markets, who had their own narrow specializations. I can spin stories of why individuals with that particular background are likely to end up at the New York Fed. But to be honest, I think we were just very lucky. Personally I am grateful, a technical term of a different sort that comes to my mind so soon after Easter.

News coverage: I will add links as I come across more stories.

• Dudley gets political and opposes rash changes to Fed, Reuters. OK, I know it's a headline, but how is it "political" to oppose a "rash" change??? The article itself claims that he "did not comment on interest rates or the state of the economy". Really?
• Reforms will help economy weather future crises, Fed official says, Roanoke Times story, which is well-done.
• Dudley says agrees with Yellen’s cautious approach on rate rises, Euronews. A Reuters byline, but different (and more carefully phrased) content.
• Fed's Dudley repeats Yellen cautionary tone, FX Street.
• "Fed's Dudley gets political, opposes rash changes" Seeking Alpha. While the content appears derivative of the Reuters post, it attributes items in the question-and-answer period to the speech itself.