In her book, Fed Up: An insider’s take on why the Federal Reserve is bad for America, Danielle DiMartino Booth explains why the Fed failed in the run up to and since the financial crisis.
Failure was the direct result of both the 1,000 economists employed by the Fed and their colleagues in academia being blinded by the brilliance of their models. Needless to say, in her well written book, Mrs. Booth provides plenty of war stories to support her central thesis.
Her observations confirm former Fed Chair McChesney Martin’s warning in 1970:
The danger with these econometricians is they don’t know their own limitations, and they have a far greater sense of confidence in their analyses than I have found to be warranted. Such people are not dangerous to me because I understand their limitations. They are, however, dangerous to people like you and the politicians because you don’t know their limitations, and you are impressed and confused by the elaborate models and mathematics. The flaws in these analyses are almost always embedded in the assumptions on which they are based. And that is where broader wisdom is required, a wisdom that these mathematicians generally do not have. You always want these technical experts on tap in positions like this, but never on top.
As I pointed out in Transparency Games, the flaw in their models is they assumed transparency existed across the global financial system. In fact, large segments of the financial system ranging from banks to structured finance securities were and still are hidden behind a veil of opacity. When the financial crisis hit, it hit these opaque corners of the financial system.
Mr. Martin went on to say what type of person he felt should be appointed to the Board of Governors of the Federal Reserve System:
Do not appoint an academic economist and particularly avoid econometricians … [instead appoint someone] who had broad personal reach in the American and global economy, who understood how markets operated, and who was able through a network of personal contacts to anticipate developments before they were finally reported in the official statistics.
In her comments on how to reform the Fed, Mrs. Booth also calls for just these type of individuals to be appointed to the Board of Governors.
The book is well worth reading as it raises several interesting questions:
- Under the Dodd-Frank Act, the Fed’s role was expanded to include financial stability. Is the Fed fit for this purpose?
- Should the Fed be responsible for bank supervision and regulation?
- Should the Fed be reformed so the regional banks better reflect the US economy?