Nov 21, 2016

Mark Calabria on Housing Policy and the Behavioral Case for Monetary Rules

David Beckworth Senior Research Fellow , Mark Calabria

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Mark Calabria is the director of Financial Regulation Studies at the Cato Institute. Before joining Cato in 2009, he worked as a member of the senior staff of the U.S. Senate Committee on Banking, Housing, and Urban Affairs. He joins the show to discuss working on Capitol Hill amidst the 2008 financial crisis. Mark also discusses his recent Cato paper where he argues insights from behavioral economics suggest monetary policy should be more rules-based.

Read the full episode transcript

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Mark, welcome to the show.

Mark Calabria: Thanks David, it's great to be here.

Beckworth: Okay, like with all my guests, we are curious to find out, how did you get into finance as well as Fed related issues?

Calabria: So, I would say mine was actually quite roundabout, if you will. I, at heart, think of myself as actually an applied micro guy, so I appreciate being included in the macro scope. So, my graduate work, for instance, was mostly in topics around information, around process. You think about a lot of these moral hazard asymmetric information questions, and in fact to give you an example, my dissertation was on food and drug regulation. So, I think about my career having moved from the study of toxic foods to the study of toxic assets.

Beckworth: Very nice.

Calabria: And to some extent there's a lot of the same models actually do apply. So, like many of us, I looked at teaching, honestly didn't like a lot of the offers I got, and ended up working for a couple of trade associations, and then I ended up also being able to do a fellowship at Harvard's Joint Center for Housing Studies, and got me really interested in mortgage markets, which are obviously also vulnerable to asymmetric information questions, and again, that's sort of been a theme of my interest, and working on mortgages is actually what ended up getting me on the banking committee.

Calabria: I actually started my career doing a little bit less than a year for the end of Phil Graham's 10 years chair, and as you recall, Graham was an economist, still an economist as well. So, they brought me on to do mortgage issues, and slowly started working my way into the rest of the issues facing the committee, and then when Graham retired, ended up spending a year at HUD running their mortgage regulation area. Interestingly, for another economist, John Weicher, who's a Chicago PhD from that golden era of the '60s, but he's at the Hudson Institute now, and really kind of got to banking via thinking about the transmission mechanism of monetary policy that is property markets, that is housing, that is mortgage markets. I think it was Ed Lehrman who said something along the lines of housing is the business cycle?

Beckworth: Yep.

Calabria: So, to me, it really ... it's hard to think about these markets for a long time without really thinking about monetary policy. Say as aside before working on the Hill, spent a little bit of time at a couple of trade associations in a real estate industry, and spent a little time there doing regional macro forecasting. So, really, the exciting things of sitting around, thinking about what housing starts in Des Moines were going to be next quarter, and it really did kind of get you thinking about how does the economy work, and how does monetary policy feed into all this, which got me to the committee, and started working on monetary policy there. I was our only PhD on either side, and got the opportunity to work on nominations.

Calabria: So, for instance, worked on Bernanke's not only his CEA nomination, but his first nomination is Fed chairman. I also got to know other members of the Fed board that way and interacted pretty regularly despite what my friends over at the Joint Economic Committees do, which is very important. They're an oversight committee, banking actually does most of the actual economics stuff in terms of legislation. So, it was really a wonderful opportunity to kind of see economic policy making from the inside, and quite frankly, not what I thought I was going to do when I was in grad school, but it ended up being a lot of fun.

Beckworth: Well, let's talk about your experience on the committee in the Senate, and let's go to the Fed hearings that you just alluded to. Maybe, how did you prepare your senator for those hearings, because often when you watch them it seems, and maybe this is more on the House side, that the communication between the Fed chair, and the congressman, or congresswoman, are often ... there are different levels, they're on same things that they don't really speak to each other. So, how did you prepare your senator?

Calabria: I think that's a very fair observation. I may be a little biased and saying that I think the dialogue in the Senate hearings are slightly better-

Beckworth: Better, okay. That's my impression, too.

Calabria: ... than they are in the House hearings. So, in one way I think it's gotten worse, in one way I think it's gotten better, and I'll talk about my preparation in terms of going to that as well. So, rarely do you have anybody, even in the Senate, where a member understands much about monetary policy. So, first getting yourself to the point of being to explain to them the pros and cons, it really depends on the member. Unsurprisingly, the short time I worked for Phil Graham, you didn't prep him at all, you didn't write questions for him, you didn't write statements for him, he knew what he was going to ask, he had his own thoughts on monetary policy, and he asked them.

Calabria: Shelby was a much different animal in that we would walk Shelby through the ... we'd write his opening statement, you'd write questions, you'd talk him through what the points were. He certainly wasn't going to ask anything he wasn't comfortable with, but you tried to educate him on what the basic parameters were. You certainly were never going to be in a situation, where you could get to very detailed questions. Shelby wasn't going to ask how much you can rely on an expectations-augmented Phillips curve. You weren't going to get those sort of questions.

Beckworth: Okay.

Calabria: Unfortunately, one of the things I think has gotten ... Well, one of the things that's been consistent, but it's probably actually gotten better in some ways, particularly in the Greenspan era, this was such a media circus that the hearings were always an opportunity, especially in the House, for members to get their 30 seconds of national TV time. So, you had a lot of discussions of things that weren't monetary. You go back 10 years, and you watch these hearings, and maybe a third of it was actually discussions of monetary. I think that's gotten better. I think the conversations have actually gotten a little deeper from the members. I think you've seen a little bit more engagement.

Calabria: Again, I would be the first to say, I think there's a lot talking past each other. I think there's a lot of positioning. I think there's unfortunately not as much dialogue as you would like, but we would look to a lot of outside sources. So, for instance, the Congressional Research Service has a very fine macroeconomist who's still there who would come over and brief the committee, and we would do hearings for the staff, and we would walk them through the dozen or so basic metrics of the macroeconomy you'd look at, and we'd talk about what the impact were. So, we would get members and their staff up to speed so they weren't completely embarrassed to ask a question, but very, very difficult, and unfortunately I think it's fair to say other than the twice a year Humphrey-Hawkins there really is very little engagement at a really in depth level. I mean, yes, the Fed chair would normally have lunch or breakfast with members of the committees, but those conversations were rarely quite deep.

Improving the Discourse on Monetary Policy

Beckworth: Yes, I had Andy Levin on the show recently, and he proposed something that Scott Summer has also proposed, and that is to have a quarterly report come out from the Fed that assesses what it has done recently, and where it is going. He also talked about having an annual ... each chair annual goal have quarterly reports kind of update what they've done, kind of give an accounting of why they may have gotten close to their target, why they haven't, and I think that would be incredibly useful for these hearings. Something that both sides could speak from. Congressman, the Senator could say, "Hey, what's happening? Your own report says you have deviated for these reasons.", and then the Fed chair could respond to that, as opposed to speaking past each other.

Calabria: I think that would be incredibly helpful. One of the ... I should say, the primary reason that I have been relatively sympathetic to proposals, the sort of audit the Fed proposals, and I'm not dismissive of the political concerns, and I may be naively optimistic here, but I see it as at least an attempt to try to educate members of Congress, and we really do this is so many areas where, and we may come to this later, but I said along the path of trying to figure out what the right regulatory framework for Fannie and Freddie was, the first thing we did was ask GAO to do a number of reports, and say, "What can you tell us about what the literature says? What's best practice?"

Calabria: I think having that external voices, and again, GAO any sort of report is going to be relatively bland, and relatively unbiased, and we'll give you here's kind of what the consensus of the literature is. So, trying to get members and staff up to speed, you certainly seen some improvement. Again, office size, I was the only PhD on either side of the committee staff at the time, you didn't even have that on the House then, you do now. So, there's been some improvement there, and that's going to back and forth. I mean, you've certainly seen times where it's worked well and where it hasn't. I don't know if we'll ever get back to the era.

Calabria: I think back, I guess this must've been '50s or '60s when Paul Douglas of, of course, the Cobb-Douglas Production Function, chaired the monetary subcommittee, and just like you rarely get senators, of course, with their own productions functions named after them, but also, ones that can engaged, and you go back and look at those hearings, and you really have really good just conversations about monetary policy. I think it's tough to get there without getting members to that point. So, more exposure, more briefing, more background, I think that would help move the conversation, because I do think you need to have a conversation that doesn't occur today.

Beckworth: Right. I think there needs to be some kind of benchmark against which Fed policy can be evaluated. I know the Form Act has created a lot of controversy, a lot of pushback, in my own view, I don't think it is that onerous. I think, if anything, it's just purely a benchmark. If you look at the Act closely, if you can get past your emotions and look at that closely it says, "Pick a rule, you choose it, and yes, if it's different than a Taylor rule, justify why." But the Fed will pick its own rule, and it would give reports on why it deviated from that, but it's not a binding rule, it's not a rule that's going to punish them. But I think it'd be useful, something like the Form Act, maybe not the Form Act, but something like it, in a sense there'd be a benchmark, because it's kind of hard right now for our congressperson to evaluate the Fed if they don't even know what the Fed's own goals are.

Beckworth: Now, the Fed has an inflation target, it has consistently undershot it, so it kind of creates this uncertainty of what are you trying to do? You trying to maximize employment? Are you trying to ... price stability? It's very murky, very unclear. Something I've pushed for is I wish the Federal Reserve would release their own estimates of the natural or neutral interest rate, because they often talk about it, even now, this last week, Stanley Fisher talked about rates are going to be lowered permanently, maybe there's demographic reasons, and they talk about this natural rate, but they never tell us what they think it actually is. It's going to be low.

Beckworth: Now, the Board of Governors release the projections, which show the long run estimate, but we don't know what their short run real-time estimates are, and Janet Yellen had a speech in the last year where she had a chart that showed a range of estimates based on different models, and I know that the natural rate is uncertain, we don't know it perfectly. But something like that, that would give a ballpark where we think the neutral policy is, why we're there, why we're not there, just as a starting point for conversation.

Calabria: I very much agree with that, and I think the Form Act has been misinterpreted in a lot of ways, and to some extent what it is suggesting, because we know that for the most part the Fed is running together rules internally. So, to some extent, the real substance of it is, why don't you share with us what you're already doing so that we can have a conversation about it to see whether it's effective or not. Of course, it's worth reminding people that, to me, inherent in the Taylor rule is kind of this Keynesian output gap trade off. So, it's not as if you're asking for some sort freedom and style rule. I mean, it's really not all that radical, it's what the Fed does today you're really just asking them to tell you that.

Calabria: I'll note what I think has been not really looked at in terms of what I think could ultimately be a very powerful but minor reform, and the Form Act suggests that like a lot of other agencies, such as the SEC and the CFTC, that individual members of the Fed board get some of their own staff. This is something I think it just seems minor, but the fact that if you were a board member that all the staff work for the chair, and that is the control of information. I think this is particularly important as long as we're going to lead in a world where the Fed does not only monetary policy, but also regulatory policy.

Calabria: I mean, for instance, I don't think I'm disrespecting Dan Tarullo to suggest that his expertise is regulation, not monetary policy. Again, I think we saw this in the Greenspan years where he, quite frankly, for good or bad to very little interest in the regulatory side, and I think that's true with Yellen. So, to me, to have a situation where Dan Tarullo could have an economist that works for him are ... if you're an economist on the board, and you might want a lawyer to work for you to tell you understand how the capital rules work. So, I think that would actually help empower debate, because right now the staff control, or the resources are really controlled by the chair, and it's not the way that other agencies work.

Beckworth: This leads to groupthink-

Calabria: Absolutely.

Beckworth: ... and the possibility for that decision, which we'll get to later, some of the cognitive biases that we learn from behavioral economics. You have a paper in the Cato Journal, and gave another version of that at a conference, and it's really interesting, we'll get to that in a bit. So, we've been talking about the Fed, we've segued into that from your experience in becoming a macroeconomist/finance person. Yes, we will let you wear the hat that says macroeconomist on it, during this interview at least. I'm also curious about your time on the Senate Banking Committee during the crisis. So, can you tell us about that experience, some of the things that had happened? That was a very intense time, and you lived right through it front lines. Tell us what it was like.

Calabria: Oh, absolutely. Let me first say, I started on the committee in the summer of 2001, and again, went to the administration for a year and was back by 2003, and there were a number of things early on that we had very strong concerns about. So, I often hear in the popular press that nobody saw it coming, and of course, nobody saw exactly what happened, but many of us had a lot of strong concerns. I had put together hearings on the housing market starting in 2005, where we were worried even before then about imbalances that were there. We were certainly, most of my time actually on the committee was spent on a form of Fannie and Freddie, which we felt was not going to end well, and of course did not end well. Some other issues, so for instance, I worked on a credit rating agency bill in 2006 where we thought we needed to bring more competition to that market.

Calabria: I'd be the first to say it ended up being too little too late, but again, it was an issue of concern of how the rating of securitized mortgage-backed securities and other ABS were being rated, and trying to fix that market. So, there were a number of things that I think we got right in terms of we saw, it put it on our radar screen, but in many instances ... simply couldn't get 60 votes in the Senate for us, is the short answer of it. So, there was certainly a frustration on my part in that 10 years ago the broad sense in congress was everything's fine. It certainly was very commonly heard that housing prices only go up, and worse case scenario they flatten down. So, you remember, this was the heart of the great moderation, and of course it was not long after during that time when Bernanke's famous speech to Freedman, "We won't do it again."

Calabria: So, there really was this sense of complacency. I feel a lot better at least today, because I don't feel like when I raise issues of financial instability I'm alone in the same way. But that's pre-crisis, so getting to the crisis, there really was ... Let me put it this, the call you would get from Treasury and the Fed were generally either minutes before they were going to do something, or right after, so the decisions were certainly made. There really was not an interactive kind of, "We're going to tell you what we're doing, or we're going to seek input from Congress on this.", up until the TARP, and of course they had to come to Congress for that.

Calabria: So, you would hear about these things only a little bit before they'd hit the press. The benefit of course was you'd have them come up, and Scott Alvarez who's a general counsel with the Fed spent a lot of time coming up, and walking us through why they did decision X, why they did decision Y. As much as I like Scott I will say some of the justifications that I think I got at that term were not, to me, from a legally perspective very compelling, but you got a lot of real-time, or at least after that time analysis of why they made the choices they made.

Calabria: I will say, unfortunately, I think a lot of it, which is just a very difficult, and is sort of a falsifiable matter, almost always came back to fears and panic. They were rarely about could we resolve these institutions in a manner where we could allocate losses correctly. They were rarely questions about could we reorganize this? It really was how will markets react? It's very hard to kind of figure out whether that's right or wrong. Of course there were frustrations the other side. I often say, if you don't think you have a panic then putting the President and the Treasury Secretary or NTB and telling people you need bill X by Monday will probably cause a panic.

Calabria: So, there was this really kind of running around. I think if you read some of the things ... I actually think one of the best books during that time is Paulson's, because it was written right after the crisis, he doesn't have any scores to settle, and it conveys what I think I felt at the time, that fog of war. So, there certainly was, "Put out this fire. Put out that fire.", and it really was until they got to the TARP, and even the TARP was not clearly thought out, as you know, it was first supposed to buy assets, and then later it was turned to equity injections. So, there was very little long term thinking, the most anybody was seeing was two weeks in front of themselves, if that.

Beckworth: So, wasn't there a meeting where Paulson and Bernanke came in and said, "Look, if you don't do ..." Was it TARP where they came in-

Calabria: Yes.

Beckworth: ... and said, "If you don't sign this bill by Monday your debit card won't work, your bank account won't work."?

Calabria: There was a lot of what ... I don't think I would ungenerously call fear mongering, there really ... we got that on the committee. We got literally I was told, "If we didn't do this you couldn't go to your ATM and get cash out.", and I don't know whether that's true or not. I was working on Capitol Hill on 9/11 and we know on 9/11 actual physical components of the payment system were destroyed, and despite that, and despite the grounding of planes, the stopping of check transactions, you were able to cash checks in the system largely worked.

Calabria: So, at some extents, I guess I'd put it this way, what we were being told felt like we were being sold a bag of goods without necessarily an explanation, and that was really one of the more frustrating parts is someone trying to play an oversight role on behalf of the public is you don't feel like you were getting the full story, and I understand, I mean, I think the perspective of the Fed was kind of, we're in the middle of this, you don't stop a firefighter in the middle of a fire to tell you what he's going to do, you you let him do it. That was defense perspective, and I understand their logic to it, I disagree with a number of the decisions that were made, but there really was not as much dialogue as I think needed to happen, and there really was a sort of doomsday scenario regularly promised that if we didn't do X really bad things would happen.

Beckworth: Well, that only reinforced the fear though, I mean-

Calabria: Absolutely.

Beckworth: ... and the thing is, I wrote about it, others wrote about it, it wasn't just you, so the fact that the media got ahold of it and spread it, maybe it was used to manipulate certain people on the Hill. But that's just generating and reinforcing the fear that's already out there.

Calabria: I think that's absolutely the case, and if you've ... there was a piece a couple of years ago on the trust crisis where he tries to measure some of this trust impact, and I mean, I guess this is part of my inner Keynesian talking, I think confidence is important, and I think is certainly a contributor to macroeconomics stability and instability, but it cuts both ways. I mean, to me, you simply can't believe that the government can be a strong source of confidence without believing the government can be a strong source of undermining confidence, and I would say, what we got during the crisis was not a sense of strong hand at the wheel, there was a sense of panic.

Beckworth: This reminds me of a talk that Ben Bernanke gave soon after he became Fed chair in, I think, March 2006, where he's discussing the flattening of the yield curve, and in that talk he tries to explain away why the yield curve is flattening. So, for our listeners who don't know, whenever the treasury yield curve which shows the relationship between the maturity of a treasury security, and the interest rates on them, whenever that yield curve flattens, or another way of saying it, whenever short term rates start to go above long terms rates, usually it has led to a recession.

Beckworth: So, this was beginning to happen, and in 2006 it was evident, so Bernanke in a speech said, "Don't worry about it, it's different this time." In theory, you could argue it was due to a change in the term premium. The traditional story is if short term rates are going up, or if long term rates are going down it must mean that the market expects a recession in the future, because short term rates are going down. He argued that wasn't what was happening. What was happening was the term premium, and there were some things that had happened, some accounting law changes and stuff that had occurred, but in retrospect, it was the market was forward looking and concerned.

Calabria: I think the market was certainly forward looking, and you might remember earlier Greenspan talked about it as the bond market conundrum. I actually think going to the small contributing factors of that in the mortgage side, because you do remember when rates started going up in mid 2004, the long term rates in the mortgage market were quite sticky.

Beckworth: Mm-hmm (affirmative).

Calabria: Interestingly during this period, and I don't think we fully recognized this until later that the channel of essentially global savings, and this is one of the things I think Bernanke gets partly right, the global savings glut, setting aside of course that global savings nets zero, but that money coming in from the rest of the world, much of it flowed through Fannie and Freddie, and they were buying long dated assets. So, this is not to disagree with the expectation part of the yield curve, but to also add in that, to me, I am a believer in that there are segmented markets along the yield curve, and that the greater demand for assets at that end of the yield curve in the terms of mortgage-backed securities flowing through Fannie and Freddie I think were one of the things that held down the long end of the curve.

Beckworth: I completely buy that, and that would be the term premium story-

Calabria: Exactly, agreed.

Beckworth: ... that this inversion wasn't entirely the result of-

Calabria: Expectations.

Beckworth: ... weakening of economic forecasts, but it was part of the story. But you can go look at ... people have studied, they do decompositions, what part expectation, what part term premium, and the largest part is expectations, although term premium was going down. However, I guess the point I'm bringing this up, even if Bernanke did believe that it was due to a weakening of expectations, even if he thought the bond market was saying look out ahead, he couldn't really say that. I mean, I guess, just as maybe as the opposite side of what he said to you guys, the world's falling apart, and maybe that was an extreme care, but what if Bernanke had believed that the yield curve would stay in recession, I mean, could somebody in his position acknowledge that?

Calabria: That's a really good question. So, I've actually had this conversation a number of times with friends of mine who worked at the board, and they were there for the meetings, and they often say to me that, yeah, there's more of a recognition of the uncertainty, and there is this concern of the Fed projecting confidence. And again, if you might remember McCain, remember in 2008, got all sorts of abuse in the presidential race saying that the fundamentals of the economy were fine, and of course what he was trying to do was talk ... to me, he was trying to do the public spirited thing of talk up the economy to try to avoid a recession, and I do think you're in this situation where, and again, it's a long term credibility issue, I don't think the Fed chair really ... there's a degree to which your limited in how honest you can be. I think that that's true, and I say that at somebody who's very frustrated with feeling like I don't often get as much honesty from the Fed as I'd like, but it's a gamble, and it is a risky thing.

Calabria: I think there was more, and again, we've seen this from some of the transcripts that have come out, so of course we didn't know these things at the time, so I think we know two things. On one hand, other than say, Susan B. and a few others, there really weren't all that much discussions at the board late into the game about an impending recession or problems in the housing market. So, some of the public statements of Bernanke, such as saying that he thought subprime would be contained, I think he thought that, and I think the evidence suggest that he thought that. There were other things that I think to your point about, I think there were concerns about a slowering economy that were going on internally that were not spoken, I do think there was this concern of if we voice that it might become self-fulfilling. So, it really is an expectations game, and that's certainly a very important part of it.

Beckworth: Right. So, we had on the show Roger Farmer, who talked about his approach to macro and we talked about this earlier, and how animal spirits can definitely play a part. He considers confidence a fundamental input to production, just as much as technology and capital and labor is. So, it's an interesting decision, and again, must have been an interesting time to be involved in the Senate Banking Committee during that period. Well, let's move on to an area where you're an expert, and spend a lot of time, and that's with Fannie and Freddie, and maybe if you give our listeners a quick history of it, what were the problems, and where do we stand now with Fannie and Freddie?

Fannie and Freddie: History and Current State

Calabria: Sure. Fannie Mae was created in the '30s to buy mortgages from, of course, commercial banks at that time to try to add liquidity to the market. It was initially created as a government agency, so basically what Ginnie Mae is now. It was later in the '60s in order to move it off budget privatized. Freddie was later created in 1970, and interestingly enough when Freddie was created it was created to be the Thrift, the savings and loan version of Fannie.

Beckworth: Okay.

Calabria: So, it only bought from the Thrifts, and Fannie only bought from the commercial banks. Different, but fascinating I think, topic for another day is that Freddie was initially part of the Federal Home Loan Bank System, which was initially created to be kind of a Federal Reserve for Thrifts, because of course, then the Federal Reserve created Thrifts are not eligible, and largely with the advancements to the federal home loan bank, is it's kind of like a discounting business to the federal. That has all converged of course, Fannie and Freddie today will buy from Thrifts, insurance companies, commercial banks, and a whole list of potential originators. And of course, I emphasize, they buy loans, they don't originate them. So, you can't go to Fannie or Freddie and get a mortgage.

Calabria: They are currently, or rather have since been of September of 2008 what we call conservatorship, which is not quite a bankruptcy, but it's a bankruptcy light, there's no real organization, it's meant to be a holding tank. Part of what I worked on on the committee was creating the structure for that. I'll say, as aside, it didn't work out the way we had planned. For reference, the longest bank conservatorship was like 18 months, and we've been Fannie and Freddie conservatorship for about eight years, so much longer than was ever expected, or intended for that matter. So, we began the reform efforts in 2003, and this was really ... not because we didn't think there were problems at Freddie beforehand, but 2003 where we're in the recounting scandals at Freddie Mac began-

Beckworth: Oh, yes.

Calabria: ... and you started to have this momentum for reform, and an opportunity that wasn't there before. I mean, prior to that, I'll give him credit, then congressman Richard Baker of Louisiana was essentially the only voice in congress for we need to be concerned this is not going to end well, and of course there are a few others like Congressman Leach from Iowa who were concerned as well. And there were also consensus were saying that Fannie failed in ... 1981, and got essentially regulatory forbearance, they got a tax ... there were laws pass to basically give them some tax right back so to basically fill the whole, but they failed in 1981, so this isn't like the first time.

Calabria: It is partly that Fannie and Freddie grew out of the ashes of the S&L Crisis. So, before the S&L crisis there were activities were rounding errors, literally low single digit market share. S&L's failed, Fannie and Freddie largely gathered that business and became themselves essentially to very large S&L's. So, a number of problems faced them very, very little capital. So, for instance, one of their business lines was to guarantee mortgage-backed securities they sold. By statute their guaranteed business was leveraged 200 to one.

Beckworth: Wow.

Calabria: So, to me, if you want to think about, and I guess four gentlemen at Stern have a book called guaranteed to fail, which is a great read, but it really was the case, and that to me, one of the fundamental debates about the financial crisis are these issues of liquidity versus solvency, and so to me, they're certainly very interrelated, but at Fannie and Freddie I have no doubt in my mind the primary drivers were simply no capital even in good times. So, certainly, for a number of months Fannie and Freddie were insolvent solely because deferred tax losses were being counted as capital, so you had a lot of game planning accounting wise, certainly Peter Wallace and others have talked about their housing goals, I think that's a part of it.

Calabria: I don't put as much emphasis on that as Peter does, because again, I think just the massive amount of leveraged. Fannie and Freddie would've failed from losses under private loans, because they simply had no capital. You had this ambiguous what we call the implied guarantee. I'll say as an aside, I've always puzzled at that terms, it seems like a contradiction in terms in some sense. I should say, even today, there's no statutory guarantee of Fannie and Freddie debt. In fact, what we thought we were doing in the 2008 legislation was creating a framework where losses could be imposed on creditors, and that we were trying to end too big to fail for Fannie and Freddie.

Calabria: Clearly we did not, but part of the intention of the legislation was to be able to essentially turn debt holders into equity holders, and to recapitalize. We went through a lot of ... I mean, essentially what we did was marked up the Federal Deposit Insurance Act and said, "What do you do that would work in a bank situation? What do you do in a non-bank situation?" So, Fannie, we recognized that unlike most bank failures where the FDIC finds someone else to buy the bank, that was never going to work with Fannie and Freddie, we were never going to be able to find someone to buy Fannie Mae. I think that that's the case probably if Citibank were to fail today, the odds of finding someone to buy Citi are probably pretty low. So, you need to find essentially a bridge bank facility where the main operational things stay in place.

Calabria: This was actually one of the debates we had the time at the TARP too of why aren't we looking at potentially doing debt to equity swaps. One of the things that's talked about a lot today is the TLAC, the total loss-absorbent capital, which is supposed to be a fix to too big to fail. One of the things I point out in terms of my skepticism of that approach is at the time of the TARP, Citi had about 400 billion in long term debt. We could've fill the hole with Citi completely by turning debt holders into equity holders. Would that have caused problems? Might have, but I think it's a conversation we needed to had, it was a conversation we did had and made decisions on for Fannie and Freddie.

Calabria: So, certainly the implied guarantees I think caused a lot of distortions. Certainly Fannie and Freddie, because of that implied guarantee, they were the conduit toward which global saving flowed back into the U.S. market. I mean, essentially what they did was they sold debt to China, they got the money back from China, and they bought subprime mortgage-backed securities with it and held it on their balance sheet, and they arbitraged that difference, and they had no capital behind it. So, again, it was in recipe to end up poorly.

Beckworth: So, the implied guarantee is what made it attractive to foreigners overseas.

Calabria: Yeah. Absolutely. The Chinese central bank was not buying countrywide stock, they were buy treasuries and agencies.

Beckworth: So, tell me about this story then, there was a ... I believe it was on a Bloomberg story that I saw back then that the government of China made a phone call to our treasury secretary about the time of this crisis and said, "Hey, we bought this with the understanding this stuff was backed." Is that a true story?

Calabria: There is truth to that, and Paulson went to China near after, and I mean, I'll say, it's a legal issue. It's actually a violation of the law for Paulson to have said that. It's a violation of the Antideficiency Act, but of course, we don't hold public officials accountable in that way, even though it's going to incur penalties. So, there were promises made ... and this is actually pretty interesting, if you go back and look at the legislative record and the hearings we had ... and organized in, say, 2006 and 2007, the committee is debating this very point where we understand that China has a lot of holdings, and you will find statements of Shelby saying, "That's tough, China, you will take losses if this goes poorly.", that's the will of Congress. We can debate whether foreign creditors should be favored creditors. As you know in a bank, the depositors are first in line-

Beckworth: Right.

Calabria: ... and so we make choices over where people stand in line, and of course things like auto bailouts we sometimes unmake those choices. But so, Congress made a choice that foreign creditors, even official foreign creditors, would be treated as unsecured creditors, and treated just like everybody else. Of course, treasury decided that their policy preferences were a little different than that. So, there were foreign policy considerations that came into place. But it's absolutely the case. Another story that I haven't been able to verify, but I believe is true from the sources I've seen, is that at one point Russia apparently reached out to China and suggested that they both dump their agency securities at the same time-

Beckworth: Really?

Calabria: ... in an attempt to royal the U.S. housing market. Yeah, and China said no, but of course it's partly because of course if you were China and you held that much, your holdings are going to take a hit. So, what is the quip about I borrow $100 from you, but you hold me over a barrel, I borrow a million from you, you hold me over a barrel. We really in some sense had China over a barrel given the amount of-

Beckworth: Well, so Larry Summers, I think, called it the financial balance of terror.

Calabria: Yes. But I mean, this is a frustrating question to me in terms of just the balance of powers and economic policy in general in that ... So, congress very clearly made an affirmative decision that foreign official creditors would not be favored. Treasury decided they weren't going to respect that are very good reasons to not respect that, but the question is who's supposed to be the one to make that decision? One of the reasons I wrote the paper was to kind of flesh out some of these questions, not only in the relevancy of Fannie and Freddie, but to also ask because the Title II of Dodd-Frank resolution authority there is mirrored in some ways on what was done for Fannie and Freddie and didn't work.

Calabria: So, some of my skepticism about Title II's, well, we kind of tried this. To put it in perspective, Freddie is smaller than Citi, and a lot less complex. So, for instance, with Fannie and Freddie you don't need to worry about ring fencing assets in London or anything like that. You don't have to worry about ... we've all seen these organizational charts of Citi and other banks where there's all these hundreds of …

Beckworth: Right. That’s interesting.

Calabria: ... and it's not that way with Fannie and Freddie. Very simple corporate forms, and so to me, and not even round-able debt, all of their debt is long term, most of their debt is over five ... about half it's five year duration. So, I go through this in the paper sort of like here are the common reasons we're told that we couldn't have done it this way, and we have to do it this way, and I walk through this and say, "Well, was this relevant in the Fannie and Freddie context, how would this matter in a, say, Citibank context?" So, this is some of my skepticism that we've ended too big to fail, because I don't think we've actually changed the dynamic in terms of the regulatory incentives.

Beckworth: Especially if we still haven't solved the Fannie and Freddie. I mean, they're still on a conservatorship, I mean, how many years later is this? Eight years later? Eight years later.

Calabria: Eight years later.

Beckworth: I guess I haven't been following, I thought by now they sorted this out. I remember them talk about breaking into smaller entities, maybe.

Calabria: There's been a lot of proposals, but very little done very little likely to be happening.

Beckworth: What do you see happening in, I guess, going forward for Fannie and Freddie?

Fannie and Freddie Going Forward

Calabria: Well, my quip sometimes, and I said it a number of years ago that I was fairly certain that this administration would hand them to the next administration and conservator ship, so my joke is that the next Clinton Administration may hand them to the next Bush Administration, which at some point maybe President Chelsea will deal with them, but there really is not a tremendous amount of urgency. Foreign policy makers deal with it, and there's also a tremendous amount of disagreement, I mean, so you still have a number of republicans who don't want to have the backstop, who don't want this sort of guarantee for the mortgage market.

Calabria: I'll say as an aside, very important caveat, the home ownership rate today is about where it was in 1960 before Freddie was created and when Fannie was in single digits, and largely an irrelevant player. So, the argument that you often hear that we would see reversals in home ownership just aren't borne out by the data. Interestingly enough one of the arguments given for Fannie and Freddie is that they would help close the gap between white and minority home ownership rates, but interestingly enough if you chart out the market share of Fannie and Freddie and you chart out the racial home ownership gap, the racial home ownership gap increases with the market share of Fannie and Freddie. In fact, the difference between black and white home ownership rate today is the largest it's been in 100 years. So, at some point ... you know the quip about you've got to break some eggs to make an omelet, well at some point you have to ask, "Where's the omelet?" And in terms of home ownership and housing policy we've broken a lot of eggs, and we still don't see an omelet yet.

Beckworth: And what's to show for it? Well, very sobering message on Fannie and Freddie. Well, let's move on to another area that you deal with in your job at Cato, and that's the Dodd-Frank Act, and this thing is a beast. I'm told there's very few people who've actually have read it from being to end. Do you know how many pages it is?

Understanding Dodd-Frank

Calabria: Don't know, it's 16 titles, and depending on the version you have it may be 800 or the committee print I have is about 800, but there are versions of it.

Beckworth: That's amazing. So, it's hard to imagine that any senator or congressperson's ever gone through it, but with that said, give us an overview what it was meant to do, and what we know about its success, or lack of success so far.

Calabria: Sure, and that's fair, and there were a number of objectives. So, Titles I and II were really the too big to fail titles, and Title I, of course, is what sets up the financial stability oversight council, where we identify institutions we think are systemically important, personally in my mind that's synonymous with too big to fail, and then we subject them to heightened prudential regulation. Of course, this allows that just to be expanded not simply to banks, but also to non banks. So, there's a couple of insurance companies, MetLife recently wanted to get out of this, but there are a couple of others like AIG, Prudential that are still in.

Calabria: Title II is the Orderly Resolution. So, essentially receivership for non-bank financials. So, those are the too big to fail components. There are other components, maybe the one most famous is the Consumer Financial Protection Bureau that's in Title X. You see titles dealing with derivatives. So, one of the things that doesn't get enough discussion is for the first time clearing houses could have access to the Federal Reserve discount window. And of course, we also expand federal deposit insurance permanently 250.

Calabria: So there's a number of expansions of the safety net, some explicit, some implicit within Dodd-Frank. There are some mergers of the agencies, so for instance the Office of Thrift Supervision was moved down to the Office of the Comptroller of the Currency, there are some changes to the Federal Reserve governance. So, there's a hodge podge of stuff, and there's things that people probably heard of like the conflict minerals components that have nothing to do with the crisis. In fact, it's fair to say that probably half of Dodd-Frank has nothing to do with the crisis, and then the other half's relevance is debatable by how effective it would be.

Beckworth: Yeah, so Larry Summers recently come out and said that the big banks are still leveraged as ever, they're still as risky as ever. So, on that account it doesn't seem to be to have done much, or am I mistaken?

Calabria: No, you're correct, there are two elements to Summers' argument, one of which I don't think he pushes as much as I have, which is a lot of the change in capital happened through the Basel Process, which ran parallel to Dodd-Frank. So, we would've seen changes to the capital regardless of whether Dodd-Frank were passed, and more importantly, a lot of the changes in capital that makes it ... on the surface it looks like banks hold a lot more capital, is simply because of the fact that they've shifted into more assets that have lower risk weights. So, if it's sovereign debt, where the risk weight is zero, and you shift a lot of assets into that, then you look like you've got a lot more capital, but you don't really. So, again, I've actually written about this that there's not a lot more capital in the system there was despite the fact of the claims to that.

Calabria: Summers has written an interesting point in that he looks partly like the franchise value. So, this is, I think, a really important case in that up until the savings and loan crisis, I would say, and I know you've had some great economic historians on the podcast in the past, and to me, one of the interesting facets of banking history in the U.S. is we basically created little monopolies off it, and because we created little monopolies with very high franchise value, you incentivize the institutions to be risk averse. Like I've given you a bank charter, in not going to let anybody in this little town you're in compete with you. You have something of value, you have a very strong incentive not to screw that up.

Calabria: So, what we've seen at least since the erosion of branch banking restrictions, which I think that competition's a great thing, but I think one of the things that we forgot that came out of that is it eroded the franchise value of banks going into the crisis, and what Summers has argued about is that part of what Dodd-Frank did was erode the franchise value of banks, changing the incentive of banks away from holding even more capital, because again, you've got these heavy costs, you're not making a lot of money on it, why would you put more money into it?

Calabria: I do worry that we're getting to a point ... I often describe banking in the U.S. as the state largely curates a kind of pseudo-monopoly, and the debates are really about who gets the division of monopoly rents, and partly some of those monopoly rents are redistributed to preferred constituency, but as importantly, we don't know the level of those monopoly rents ahead of time. So, how does the industry ever credibly say to the government, "There's not a lot more for you to extract."? Once you've extracted all of that you end up with really big problems, and I think fundamentally the problem facing our financial system today is we have a combination of very rigorous competition, which is a good thing generally, but however combined with very extensive guarantees. So, you don't get the normal control on risk taking you would get because of that moral hazard.

Calabria: So, it's one thing to have deposit insurance, and implied guarantees when you've got little monopolies, because the incentive to gamble's a lot less. I don't think we've ... I mean, I don't think we want to put the genie back in the bottle of the benefits of competition Ross Sovine and others have written tons of work on how much benefit we've gotten out of the increase in competition, the banking system, and I think that those benefits have been very real. So, to me, I think our approach going forward has to be a rollback of some of the safety net guarantees, because ultimately vigorous competition combined with extensive guarantees implies to me that those guarantees will someday be called upon.

Beckworth: Okay, so one of the proposals to change Dodd-Frank Act is the Financial Choice Act, and there's a number of things that it does here, I have a list of them, but what is your sense of the Financial Choice Act, and what direction does it push the banking sector towards?

Calabria: Well, I would certainly have written a different Act. I think it's a move in the right direction. The core of it is really to do this swap of more capital for less regulation, and you've got a lot of compliance costs that I don't think fundamentally make the system safer, and as Larry Summers has gotten to, they actually erode the franchise value of these institutions. So, there's really strong incentive to not hold any capital. So, how do you change this where you reduce the moral hazard in the system, and you try to better align those is by having more capital on hand.

Calabria: Again, I think this is the reason what we saw with Fannie and Freddie, but we also so this with Citi, and Bank of America, and others where during the crisis they were essentially for all intents and purposes insolvent. Again, you see so little capital, and it's also meant to try to bring more transparency to it. One of, I think, the real problems is, when the layperson picks up The Wall Street Journal and it says Bank X has 8% tier 1 risk weighted capital the layperson thinks that means 8% capital when the reality is it might be 2% or 3% actual capital, which again ... So, our banks are often leveraged 30 to one, and how do you rollback that leverage and try to readjust the incentive of management not to gamble?

Calabria: So, I do understand, and I think Congressman Hensarling did author a choice that gets this, which is if you don't combine some relief with increased capital you're essentially going to make it impossible for banks to function. So, and this is really along the lines of some of what Ahmadi and others have argued about, you could have much higher capital. I'm certainly of the belief that if we didn't have the guarantees we have in place today the market would force banks to hold more capital, because obviously debt holders would charge you higher. So, in some sense it's a Modigliani-Miller argument, but it really is an argument about let's put more capital in the system. Again, there are other things like see it be in changes of the consumer agency, which I think are very laudable, I think they're structure that's very problematic, but probably a conversation for another day.

Beckworth: Well, let me go back to that point you made, because the name implies choice, the financial Choice Act.

Calabria: Exactly.

Beckworth: So, we didn't hear an excerpt from an article that was on it, the Financial Choice Act would allow the countries largest banks to exempt themselves from capital liquidity requirements and other regulatory standards if they hold enough capital to maintain a leverage ration of 10%. So, it's a choice in the sense if you voluntarily opt in to holding more capital, you don't have to have all these regulatory burdens placed on you.

Calabria: Absolutely, and it's referred to as an off-ramp in the bill, and there's also some elements, I mean, many of the elements of the Consumer Financial Protection stuff that are changed are consistent with that choice of you get to choose the products you want rather than the products the government thinks you should be able to have. But a core component of the higher capital is the institutions being able to choose it themselves, I think ultimately that was likely done for political reasons, if it was me, I would say, "Let's get rid of the regulatory relief, and I'll make you hold higher capital." So, I do worry about ... it wouldn't be the way I would draft it, but I think it's a step in the right direction, and is probably the best you're going to get in this political environment.

Beckworth: I don't suspect it's going to be making any progress with the elections going on.

Calabria: Well, my understanding is Hensarling has some sense from leadership that they will give him floor time in December for it. Obviously, there's no time to pass in the Senate. Hensarling assuming the Republicans keep the House will have another two years as chair. So, there is a degree to which they're explicitly trying to lay groundwork for next year. To go back to my earlier comments about Fannie and Freddie, so we finally passed Fannie and Freddie forum in 2008, we started in 2003. So, it took us five years, three congresses. I guess, put it this way-

Beckworth: That's some dedication.

Calabria: ... it makes looking like resubmissions to internal look easy.

Beckworth: Oh, wow. Okay, they have a long horizon then.

Calabria: You have to, and sometimes these things do take a long time.

Beckworth: And that's why, I guess, having congressional staffers that stick around's important, even if someone looses a seat in Congress.

Calabria: Absolutely.

Beckworth: Well, let's go back to the Federal Reserve in the time we have left, and I want to turn to an article you've written that came out in the Cato Journal, and you have another article that's similar coming out in Journal of Macro at some point, but you draw upon behavioral economics, and look at cognitive biases, and how this can influence monetary policy making, and I really liked your presentation when I heard it at the conference, because you made this point ... in fact, the other two panelists, they were kind skeptical of monetary policy rules, even though this was a conference about monetary policy rules they went up there and said, "Eh, principals are important, but we don't want to be too, too rigid with the rules.", and you argued that because of all these biases we need rules. So, can you restate that argument, and tell us why it's important.

Behavioral Economics: Insights for Monetary Policy

Calabria: Sure, I thought in a way the other panelist made the argument that we don't know enough to have rules, and I tried to make the argument that we don't know enough not to have rules.

Beckworth: Yes, that's right.

Calabria: So, the way I think about it is, let's say we all start with some model of the economy, and you all start ... whether you're going to follow it or not, and the question is really if you think it's the right model, or you really want to be able to test the model, what are the likelihood that you'll deviate from your own model? Of course, we know that individuals are the ones making monetary policy, we know there's actually group decision making, so the potential for groupthink, and so I really wanted to think through, and a lot of this, I think, happens to any of us who are economists and we look at something in economic policy and say, "Well, seems to me the answer should be X, why aren't we doing that?" So, a lot of my work over my career has been to think about process, and to think about why we end up making decisions that don't seem optimal, both in government and private market to begin with.

Calabria: So, I really wanted to think through, what are some of the biases that we might see for Federal Reserve policy makers? I'll note, it's not original with me, I think I've probably written more extensive papers on it. Bob Shiller, for instance, wrote a fascinating op-ed 2008/2009, arguing that the Fed missed the crisis because of groupthink. Orphanides has written some things on why he thinks they've delayed liftoff in his opinion because of status quo bias. There've been a few other pieces here and there, I tried to pull a lot of this together, and really try to get us thinking systematically about if you wanted to essentially think of yourself as Ulysses, and you wanted to sail through and not get yourself in trouble you would bound yourself with rules, because you wouldn't want to get distracted by other things. That really is kind of the underlying question.

Calabria: In the forthcoming paper, built it little bit out of a mathematical model based on some of the work that Ron Heiner here at George Mason has done over the years in terms of the lower your capacity for making good decisions or the higher likelihood that you'll make mistakes, the more likely you should follow rules. So, one way to think about this in a very simple way is most of us stop at red lights when we drive. There's a lot of times, particularly in the middle of the night, when there's probably nobody else coming in the other direction, and you would argue it'd be more efficient for you to simply drive through. There may be instances where your wife is going into labor, or you've, I don't know, shot yourself in the foot or something, and you need to hurry to the hospital where you may actually break that rule. But by and large, stopping at the red light whether somebody else is there or not is a good rule, and generally efficient overall.

Calabria: The question really is, is your own cognitive ability a risk that you will break from that rule and get yourself into more trouble. Again, it's a recognition that the errors in decision making are on both sides. So, often the argument for discretion is it will stop you from making good choices, and I agree, discretion ... if we have rules, an all-knowing agent will do better under discretion, but the question is we don't have those kind of agents. So, some of the discussion in the paper is trying to look at, at least kind of the circumstantial, the record of conversations you see at the Fed, and putting it in the context of biases we think that might be out there.

Calabria: So, one of the ones I think is interesting for, say, the crisis, is that you think about yourself as a lender of last resort, and you have a couple of institutions that come up to you and say, "We're experiencing liquidity problems." Well, how do you know whether those institutions are representative or not? Is it simply the institutions that are in trouble who are poorly managed that tell you they're having liquidity problems, or are the liquidity problems they're talking about broadly representative of the entire system, and you need broader liquidity provision or not. That's a really hard question to know, but I think trying to frame it that way, and getting central bankers to think about, "How do I make sure the observations I see are far more representative?"

Calabria: So, in fact, I would say one of the arguments for having a regional system is the economy in Cleveland is not the same as the economy in D.C. or the economy in California, and being able to gather those different sources of information so that you reduce that representativeness bias, and get a little bit less groupthink, a little bit more observations that enter the picture. Of course, there's to me, really big in macroeconomics is availability bias, which is we tend to overestimate the probability of things that come quickly to mind. I would go as far to say probably the biggest availability bias in macroeconomics is the Great Depression.

Calabria: It's interesting, if you go back and look at the press and conversations around probably almost every recession we've had since the Great Depression, somebody invokes the Great Depression. Even in 1987 the stock market someone invoked the Great Depression in the press, so every time. It's hard for me to believe that there was a high probability of the Great Depression in happening any of those times. So, how do we kind of de-bias ourselves in that way so that we don't fall into this trap?

Calabria: Of course, it cuts the other way, too. Many of us will talk about the Great Inflation of the '70s, so this isn't simply the other guy's wrong. So, I do think that behavioral economics is still at an early point, I do worry that some of it comes across as just so stories, but there's some good working being done. So, for instance, there's work being done looking across corporate boards, because of course there's a lot of data there across corporate boards, and we can come up with proxies for groupthink such as cohesiveness of the group, and overlap of members. So, some of the empirical studies suggest that these are very real impacts. So, what I'm trying to do in this paper is really to try to set up a framework for thinking about decision making at the Fed, and potentials for cognitive biases, and potentials to offset those. Again, one of those that I suggest is having a sort of rule based policy so that we can try to figure out the impact of those biases, and reduce the temptation.

Calabria: I actually think, when you hear opposition, informed opposition to the Form Act, which we talked about earlier, which again, requires the Fed to put out a rule, but allows the Fed to deviate from the rule. Now, the bill is pretty clear that there's very little penalty to deviate. You got to come up and explain it, which at the end of the day is not all that much of an onus, or a burden. What I think the proponents of that are actually reading into this are very strong status quo bias. I think what they're saying implicitly is that to put this rule out there that the Fed can deviate from will be very difficult psychologically for the Fed, because there'll be a strong status quo bias to go by the rule, and that's the criticism, of course, to me, that's the benefit of it as well. We can have an argument about how much debate you want to be able to have and how much flexibility.

Calabria: I also think just even if you have a rule that we know is going to be imperfect, it allows market participants to make predictable decisions around those rules. So, again, a lot of what I've tried to do, which interestingly has been, I think, a consistent approach of mine over the years is just to ask, why are we making the decisions we're making, and given that we probably don't know what we think we need to know given the ignorance that is there, given the cognitive biases that are there ... I should lastly say, despite all of that, I do think there's a very useful role for rational expectation type models.

Calabria: I'm one of these people that are quite eclectic in terms of let's look at the methodology at hand and figure out what we can learn from this situation. So, I'm not as dismissive of ... we should certainly be ... our starting point should be not to assume a lot of biases unless we can't explain what we're seeing, but then to start looking at biases to start to think about why what we're seeing doesn't match what we would hope to see, or think we should see.

Beckworth: Well, I think it's very interesting-

Calabria: Thank you.

Beckworth: ... and it's another way for me to make sense of the world as I see it-

Calabria: And that's the intention.

Beckworth: ... I mean, maybe it's a bias of my own, I'll invoke the biases to justify my bias. But two examples, there's been this fear since 2009, late 2000 ... when the Fed did QE the massive inflation.

Calabria: Oh, yeah.

Beckworth: I mean, massive, and that speaks to, to me, the availability bias, because-

Calabria: Absolutely.

Beckworth: ... a lot of these people are older, they're looking back to the 1970s, and that's the first thing comes to mind ... So, I think as a result, it's one of the key reasons that the Fed has undershot its inflation target. I think there's this political economy pressure to be careful, and I think it-

Calabria: It leads you almost to the interesting argument that you want to make sure you have a board that has people from different cohorts and generations, because I mean, we're all influenced by the time in which we went to grad school.

Beckworth: Absolutely.

Calabria: I'll go back and mention that ... So, about half of the time I was on banking committee the senior Democrat there was former Senator Paul Sarbanes of Maryland. He was a lawyer, but he was also very at the beginning of his career a staff assistant to Walter Heller on the CEA, and you could tell it in conversations with him, and listening to him, he learned a lot of economics in about a two year window in the '60s, and that's all he ever learned, and it stuck with him. The fact is, some of it was right, some of it was wrong, and it's interesting. And I think if we could find a way to kind of have staggered cohorts of people on the federal-

Beckworth: Yeah.

Calabria: ... to bring those different things to bear.

Beckworth: Well, that's when I say we will do in our conversation due to time, and that is to a piece you've written called The Fed's Diversity Problems. Right there, their whole generational issue might be one manifestation of this problem, but you talk about this, and you talk about how there's a lack of diversity on the boards. Speak to some of these issues. I mean, let me start you off, some striking things in that paper of yous, one was geography, 80% of the Fed governors, come from the East Coast. That was very surprising me to me-

Calabria: Yeah, wow.

Beckworth: Yes, very, very surprising. Now, is that just chance, or maybe it's a revolving door issue, or ... I mean, later you point to there is a certain number of schools that produce them. So, what is your story for that?

Calabria: So, we'll come back to the schools in a bit, because I think that's more impactful for the economist. So, we should remember that up until the Kennedy Administration it was unusual to have PhDs actually on the board itself-

Beckworth: Oh, okay.

Calabria: ... and this is a modern phenomenon, so it wouldn't have been captures in that. So, of course, I'll also mention Section 10 of the Federal Reserve Act says you can't have any one governor from the same district, and of course there have been problems with that over the years, and I'm trying to remember, there was Nathan Sheets, I forget, the co-author had a fascinating paper several years ago where they found that even board governors their votes were influence by their macroeconomic conditions of the districts that they came from. So, this is not something about the presidents, but also the board members.

Calabria: So, you are getting this narrowing of where ... And again, this is partly representative bias, but it's also partly where your networks are, but I also think because it's gotten to be more political in terms of who we choose people from the board, it's highly unlikely that you're going to end up on the Federal Reserve board today if you haven't spent some time in Washington. You haven't been appointed to something, even if at least you would've traveled through CEA, Council of Executive Advisors, at some point. So, I do think we're limiting it to a narrower range of people within political networks which predominantly ends up being Washington, New York, Boston.

Calabria: I don't think it's been ... it's not some grand conspiracy, it's not how do we make sure that Wall Street takes over, it just happens to be that these are the circle of people you travel through, and the networks that they built, which I think is quite different than how it used to be at the Fed. So, that's a concern of mine, I do think it ends up reflecting the economic conditions more of the East Coast. The fact is, I mean, the only member of the board today that is from west of the Mississippi is Janet Yellen, and Berkeley probably has more in common with Boston and New York than it does with much of the rest of the country.

Beckworth: Well, I remember when Ben Bernanke was appointed it was claimed that he came from Georgia? Or South Carolina?

Calabria: So, he was appointed from the Richmond District and South Carolina is in the Richmond District. Over-

Beckworth: Because he grew up there.

Calabria: Yeah. So, and this is a good ... So, the only thing the Act says is you can't have two people from the same district, it doesn't actually define what any of that means. So, one of the proposals I've put out is let's put a 10 year, doesn't even need to be consecutive, you have to have lived in that district for some point. Even to Bernanke's credit, he did go back regularly to South Carolina, he talked to people there, he had relations there, so you knew that some of the conversations he would have in his life were reflective of that.

Beckworth: Okay.

Calabria: To me, and again, I'm not trying to pick on anybody, to me, it finally reached the ultimate absurdity with Peter Diamond's nomination where the White House claimed that despite living his entire life in Greater Boston he was actually from Chicago, because he'd once given a lecture at North Western. It wasn't even ... Yeah-

Beckworth: Wow, I didn't realize that. That is absurd, yes.

Calabria: Yeah. So, at some point, they've just read that out of the Act, but I think that's an important part of the Act. There's another thing I'll mention, that's in the Federal Reserve Act, which is this might come as a shock to some of our listeners, there's no explicit mention of academia, whereas Section 10 of the Federal Reserve Act says the president must give due consideration to agriculture and commerce. So, the Federal Reserve is very explicitly set up not to be a board of academic economists, it was set up to be a board mostly of people in various lines of industry.

Calabria: So, while I am sympathetic to some of the concerns of capture from the financial services industry, one of my proposals has been that no more than two board members should be from a certain category. One of those categories would be academia, but another would be industry commerce, so that we really get people with different life experiences. So, I understand the calls for diversity from Senator Warren and others, and I don't think those are unimportant, because I think they're trying to get at what I'm trying to get at, which is that we have a different set of perspectives and experiences on the board. Some of those have to be geographic because we are not one economy, some of this have to be ... and I'm sure you run into this on a daily basis, and I often say that I learned more economics in the classes I taught than the classes I took.

Calabria: I learn as much economics trying to explain it somebody else, because it forces you to think about this, and why all this is important for the Fed board is that if you're an economist in the Fed, and you're trying to explain it to other board members who aren't economists, and you're trying to essentially get them to your point of view, you really have to sharpen it, you really have to get to the essence of it in a way that a lot of economics just start from a set of assumptions. So, I think having more of that dialogue, and I actually think it helps the Fed explain their decision making to the broader public. If you are the Fed chair, and you're used to spending your time talking to the board economists, talking to other economists, and going to economic meetings and talking to economists, you lose your ability somewhat to clearly talk to the public.

Beckworth: You're in a bubble.

Calabria: Yeah, and so this is ultimately a lot of my suggestions are how do we eliminate the groupthink that's there? How do we break the bubble open a little bit? I talk about some of the literature that's been done, and there really are this set of characteristics and conditions of groups that have historically been found to lead to groupthink in bad situations, and some of the paper's asking, do those situations and characteristics look applicable to the Fed, and of course my argument is yes for many of them. So, I think there are very legitimate reasons that if we think groupthink is real, we should think that the Fed is susceptible to it, and we should think hard about ways to try to offset that diversity and rules being two such ways.

Beckworth: Very interesting. We will have these papers put up on the page where the podcast is listed. Well, we are out of time. Our guest today has been Mark Calabria. Mark, thank you so much for joining us.

Calabria: Really been my pleasure.

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