The Past Speaks

Peter Klein has chapter in a new book edited by David Howden and Joseph Salerno, The Fed at One Hundred: A Critical View on the Federal Reserve System (New York: Springer, 2014). The title is “Information, Incentives, and Organization: The Microeconomics of Central Banking.” You can read a version of the paper here.

Here is the abstract:

Both the Fed’s defenders and critics focus on macroeconomic questions. What is the correct monetary policy? Does the economy need an “activist” Fed? Should the central bank intervene to reduce unemployment, or focus on keeping prices stable? Should the Fed target interest rates or nominal GDP? Has the Fed done a good job? These are critically important questions. Ultimately, however, the Fed’s behavior derives from the way it is organized, managed, and governed. In other words, the macroeconomic problem is built upon a more fundamental, underlying microeconomic problem: How is the Fed’s behavior enabled, shaped, and constrained by its mandate, its legal authority, and its organizational design? For a fuller understanding of the Fed, and central banking more generally, we should turn not only to macroeconomics, but also to microeconomics, specifically at the economic theory of organizations — their nature, emergence, boundaries, internal structure, and governance. This chapter evaluates the Federal Reserve System, and the institution of central banking more generally, from the perspective of organizational economics, and concludes that independent, unaccountable central banks are inefficient, inherently politicized, and incapable of performing the functions assigned to them.

Klein is saying that we need to take a hard look at the incentives of the individuals who run monetary policy. That’s very plausible indeed. In the post-mortem that followed the Financial Crisis, a great of attention was paid to how the employees of banks are compensated (see here). The thinking was that the compensation mix used (a blend of salary plus big bonuses) encouraged bankers to take risks that ultimately took down their employers—and much of the economy. More recently, there have been proposals to legislate deferred payments to traders in financial institutions—part of their bonuses would be put into escrow for a few years and they would only get the money if it turned out that the investments they made on behalf of the bank were good ones. This makes sense. Consider an employee of Lehman Brothers who bet his employer’s money on MBS in say, 2005. The investment performed well in 2006, so he got a big bonus in that year. In 2008, when this investment went sour, neither Lehman Brothers nor its creditors were able to reclaim to bonus.  The prevailing thinking today is that a new compensation system would encourage bank employees to be long-term greedy and avoid the sort of risky, short-term greedy behaviour that contributed to the crisis.  In the UK, Mark Carney Bank of England Governor Mark Carney has called for this system to be part of all new employment contracts in banking.

The thing is, while a great deal has been said about way bankers’ compensation is structured, there is very little popular or scholarly discussion of how central bankers (e.g., Mr Carney) are compensated and how that compensation structure might influence their decisions about monetary policy!

I’ve read Klein’s paper with interest. (I read it because I’m doing some research right now on a British banker who simultaneously managed a large international bank and sat on the board of the Bank of England). Klein makes a very strong a priori case. However, I think that he has run up against a brick wall related to the availability of primary sources. The Fed and other central banks are reluctant to release information about the employment contracts, compensation packages, and so forth of their current and past employees. All they publish are the headline salaries. If we want to examine how the incentive structure for central bankers has evolved over the last 100 years, we would need access to the appropriate archival materials, which would involve looking at both the personal papers of the central bankers, the papers of their family firms, as well as the archives of the central banks.For a start, we would need to compare the terms of the employment contracts given to successive central bankers.  Speaking as a business historian, I think it may be difficult to get access to all of these materials.

Here is a question that can start this research: when were the salaries of central bankers first indexed to inflation? When were automatic COLA adjustments inserted into their employment contracts? It seems to me that a central banker would have less of an incentive to fight inflation if they knew that their real income was going to be unaffected by rising price levels. Which country was the first to inflation-index the pay of the people who set monetary policy? How did its subsequent inflation rate compare to those of the countries that didn’t index their pay?