Who will be the next Fed chair?

On the campaign trail, now President Donald Trump made it pretty clear that he wanted Janet Yellen gone as the Chairperson of the Federal Reserve.  Now in a televised speech on Instagram last week (see here), President Trump offered the biggest clue to his intentions by dropping in the word "hopefully" in his wish that "they will do a fantastic job".  That "hopefully" is, in my view, a definite hint that change is on the way, as if he really had another Yellen term in mind he wouldn't have needed that "hopefully" word. As in so many areas with President Trump, he will break precedence if he doesn't reappoint Chairwoman Yellen, as every Fed chair in modern history who has completed a first term has been nominated for a second term.

So now that I believe it is fairly clear that he has signaled that he will replace her, the media has been looking at the candidates that the President has in mind, and focusing on the daily rumors that appear to emanate from the White House about who is in favor.  But the decision is not as easy as you might think, and for two reasons: i) the President has economic growth objectives that many conservative central bankers might see as unlikely and therefore may try and be more hawkish on monetary policy than otherwise would be the case; and ii) the end of the business cycle expansion is approaching, so the President would likely not want a Fed Chair that is inexperienced in the art of central banking.

This is probably the most important appointment that the President will make in his current term of office, as the likelihood of an economic downturn is extremely high, given that we are coming towards the end of the expansionary phase of the business cycle.  Whoever the next Fed chair is will very likely have to cope with a recession, and will have to position the Fed accordingly.

Therefore, in my view, given that Yellen has effectively dropped out of the race, there are really only 3 candidates left in the running. I will deal with each one separately below:

i) Jerome Powell.  Powell is currently on the Fed Board of Governors, so is no stranger to the Fed.  He was appointed to the Board in 2012 and is a card-carrying Republican as well as a multimillionaire having worked at the Carlyle Group.  He is moderate when it comes to monetary policy views but is not an economist, which may be seen by some as a weakness.  Nevertheless he clearly understands monetary policy well, but may not be the right guy for the job if the economy has another severe recession in the next 4 years.

ii) Kevin Warsh.  Warsh was first appointed an economic advisor at the White House in 2002, and then from 2006 to 2011 Warsh served as a Fed governor, but then resigned to join the Hoover Institution where he is currently employed.  He has been a frequent critic of the Fed, and there are already a website that has been established to lobby against his appointment (see here).  He is definitely seen as more of a hawk, and the consensus is that monetary policy would likely be on a tighter trajectory. He was trained as an economist, so that is a plus, but on the other hand many of his predictions when he was previously employed at the Fed (such as higher inflation if the Fed maintained QE) have not transpired, which doesn't give the markets much confidence in his judgment.

iii) Professor John Taylor, is the only distinguished economics professor among the  candidates. He is the author of the so-called "Taylor rule" which was an effort to use a rule-based setting of monetary policy for modelling purposes.  Taylor was at the US Treasury during the George W. Bush administration and served at the White House under Presidents Carter and Ford.  Through his comments on the maintenance of QE, the markets view him as somewhat hawkish, and the media believes that a Taylor appointment would "spook" the markets.

So what is the perception of the odds for each of these candidates?  The website "Predictit" (see here), has odds based on actual bets, and as of Nov 1st at 11.30am, the odds currently are:

So what is my assessment?  For me this comes in 3 parts - i) who will Trump choose and ii) who would be the best choice in my assessment; and iii) who would actually be best for stockmarket gains?  Let's deal with each in turn.

First, who do I think Trump will choose?  It seems that the President has changed his mind almost daily, so although the latest anonymous leak from the White House stating that Powell is the favorite (see here), I doubt this will be sustained until the announcement.  My belief is that Trump will want to go with an economist and someone who will shake things up at the Fed, as he will want to please his base and also impress other Republicans on Capitol Hill.  So my guess is that Trump will go with Taylor as long as he has Taylor's assurances that he will not enact a rules based policy as this would tend to raise rates faster than would be the case with the other candidates and might then derail the so-called "Trump rally" and spook the markets.  Of course if a Taylor appointment is made, then the markets might still be temporarily spooked until they can get reassurance during the Senate confirmation process.

Second, who do I think would be the best choice for the top job at the Fed?  I believe that continuity is important here, and that likely another Yellen term would actually be best for the country as a whole, as Yellen is already acting on "normalizing" Fed policy, but is doing so at a cautious rate that allows for economic growth to be sustained going forward.

Third, who would be the best choice for the markets?  I think the markets, as the polls show, would prefer Powell, as he possesses the element of continuity, but at the same time is a little more "light touch" on financial regulation than Yellen.

What is almost certain though is that whoever takes over at the Fed (unless it is a Yellen reappointment) will change Fed policy going forward, and that will undoubtedly impact the bond markets and perhaps the pace of interest rate hikes and the withdrawal of the QE stimulus, with its attendant effects on economic growth.  

Free Trade on Trial - What are the Lessons for Economists?

This election season in the US there has been an extraordinary and disturbing trend at work: vilifying free trade as a "job killer". The main front runners in both political parties in this Primary season are all apparently questioning free trade as a way to garner more votes.

So although in January 2015 Ted Cruz said "I am a full-throated advocate of free trade. Free trade benefits America, produces jobs,

produces economic growth and it is good for our country", he has gone on record saying that he is not in favor of the Trans Pacific Partnership (TPP).  The front-runner on the Republican side, Donald Trump says that the Trans Pacific Partnership (TPP) is a "terrible, terrible deal", and that he would cancel most of the existing trade deals as well as building a wall between the US and Mexico. And lastly, John Kasich has said that "I think that we have, in some ways, been saps. We can't have people coming in here and dumping stuff and destroying our jobs in this country. That's where I grew up! I grew up with steel workers."

On the democratic side, Hillary Clinton also opposes the Trans Pacific Partnership (TPP), But probably the most vehement anti free trader in the Primaries has been Bernie Sanders. He has gone on record saying that "Let’s be clear: the TPP is much more than a “free trade” agreement. It is part of a global race to the bottom to boost the profits of large corporations and Wall Street by outsourcing jobs; undercutting worker rights; dismantling labor, environmental, health, food safety and financial laws; and allowing corporations to challenge our laws in international tribunals rather than our own court system".

So what is going on here? Why is one of the biggest trends of the last 3 decades now being questioned and vilified by our leading politicians? Well, there is plenty of analysis in the press (see here in the FT and here in the New York Times, for example), but we need to ask 4 basic questions here:

i) why is free (or freer) trade regarded as a good thing by economists?
ii) why is there now so much opposition to free trade among politicians?
iii) what would happen if we implement some of the suggestions coming from both ends of the political spectrum?
iv) what lessons can we as economists learn from this?

So first, why is free trade regarded as a good thing by economists?. As I explain in my Principles classes, the Ricardian theory of trade says if you have a comparative (relative) advantage in doing something, you should specialize and focus on doing exactly that thing. The unfortunate part of free trade is that if you don't have a comparative advantage in a specific good or service, then the theory says you should let someone else do it and import the good or service. The obvious implication is that people will lose their jobs. And that means that as barriers to free trade have come down over the past 60 years that we will lose jobs in certain industries. But that is not the end of the story - trade theory goes on to point out that in any country the gainers from trade could compensate those with losses from free trade, and we would still be better off. It is this second part that doesn't get taught in the textbooks or emphasized enough.

But what does this mean exactly? It means that from a macro perspective, the gains coming from the industries that can take advantage of comparative and expand to dominate international markets will make more income for the country than the loss in income from declining industries which will eventually be eliminated. Of course, that is the idea behind some of the government "adjustment programs" which usually accompany free trade deals: the government provides money to help workers transition out of an industry where the country does not have a comparative advantage into an industry where the country does have a comparative advantage. This extra transition spending should be temporary, as the dynamic adjustment to a new free trade deal causes workers to move from one industry to another. That is the theory at least.

So now we can answer the second question: why is there now so much opposition to free trade among politicians? One of the UK's leading politicians of the 1980s, Norman Tebbit coined an unfortunate phrase relating to the sectorally unemployed: "on yer bike". What he meant was simply if there isn't any work where you currently live, move to where there is work. The problem with this as relates to the economic theory is that workers often do not like to move - and particularly in a country as big as the US. The loss of social networks established over years, the uprooting of children from schools that they like, often the loss of property values as major parts of certain states see everyone trying to sell at once if the town or city is not industrially diversified, and the different cultural norms in different parts of the country, are all good reasons why we observe inertia in labor mobility. And much of this loss of jobs has come because by and large the US does not have a comparative advantage in manufacturing - that sector has been in long term decline, as it has in many developed countries.

If States are not industrially diversified, there is no doubt that there will be pain - hence the so-called "rust belt" in the central US States, the fisheries in the Atlantic provinces in Canada, the dockyards of Glasgow in Scotland, and the garment industries of North Carolina are all good examples. This pain is clearly one of the festering scars of free trade policy in advanced economies around the world. So if you are a politician campaigning in these States where there has been a decline in specific industries, it is natural that you'll get votes if you oppose free trade - so politicians such as Donald Trump, Bernie Sanders and Hillary Clinton all know that if they are to have a chance of winning in these States they need to argue against free trade, and so they do. 

This leads into the third question. Donald Trump has advocated rejecting the Trans-Pacific Partnership (TPP - which I regard as a coalition type free trade deal against the emergent trading might of China), and said he would raise tariffs by 45% against all goods coming in from China and other countries that he deems to be unfair. I am assuming that the Transatlantic Trade and Investment Partnership (T-TIP) with Europe will also be on the ropes too, Bernie Saunders has also said that he would only do "fair trade" deals, where this is defined as trade where wages and environmental standards are roughly equivalent to those in the US. That implies that Saunders would be against TPP, but would actually be in favor of T-TIP. But it implies that a Saunders Presidency would see international trade collapse with the developing world ( - what a lot of economists call "North-South" trade).  Either of these two scenarios are not good for US economic prospects, as it implies that free trade deals which the US stands to benefit from, would possibly not come to pass, and also that we will see other countries erecting trade barriers against our goods and services.  

What lessons can economists (and the general public) draw from this?  

First, I think that from a theoretical standpoint we need to expand our proselytizing about free trade to make politicians and the general public understand better where the economic argument comes from, and how it needs to come as a complete package rather than just a narrow focus on the benefits. What we have failed to do as economists is recognize the costs, and how best to mitigate those costs. 

Second, what can we do in the policy realm?  It should mean that any free trade deal needs to come with a whole raft of moving grants and loans, retraining grants and loans, and pension and Social Security "top-ups" for those laid-off workers who are deemed to be close to retirement age). But I hear my economist friends saying - "but that might make the international rearrangement of production no longer economic, so that comparative advantage cannot fully operate.  Well my argument would be "so be it".  These are people's lives you are talking about, and government and business instigated policy changes should come with transitional arrangements that protect those that are most vulnerable.

Third, we need to be much more aware of the regional industrial specialization that occurs in the US when making trade deals - perhaps States could be given notice that a free trade deal will happen and then some kind of fiscal transfer can be arranged to help it generate new industries within it's borders. In this sense regional policy and trade policy are much more related than economists have recognized in the past.  

And lastly, and probably the most important lesson that can be learned from this, is that economists need to be much more vocal about these public policy issues, and suggest ways in which the well-being of all our citizens can be improved, or at least maintained.