Monday, June 6, 2011

Peter Diamond and the Fed

I have a lot of respect for Peter Diamond's academic work. At one time I routinely taught two of his classic papers, "National Debt in a Neoclassical Growth Model" and "Aggregate Demand in Search Equilibrium," to first-year graduate students.

When Diamond was nominated to be a Fed Governor, my first reaction was that this was an odd choice, as Diamond's policy expertise is related mainly to social security and taxation. I was told that one of the objections from Republicans in Congress had to do with this interview in Macroeconomic Dynamics, where Diamond says:
I think there are things you can learn from macro models that have the underlying market-clearing, competitive, structure, but you shouldn’t weight them too heavily when thinking about policy because they are missing some key ingredients. I don’t know if I have anything more to say, because it’s not the case that I stay abreast with macro developments.
Now, you might be a little troubled at the thought that a nominee for a post as Fed Governor does not think much about macroeconomics, but if you read the rest of the interview, he comes across as a fairly open-minded and thoughtful individual. Knowing Diamond's work, and reading that interview might lead me to conclude that Diamond probably dominates most of the people who have actually served as Fed Governors. Surely, given his knowledge of economics, he could fill in for any particular shortcomings in terms of monetary economics, banking, and institutions.

Now, after reading Diamond's piece in the New York Times and reviewing his Nobel address (with slides here) I'm not so sure.

First, as Diamond points out in his Nobel address, in policy analysis you are allowed to be somewhat loose:
Understanding of the economy, and policy recommendations and decisions, should reflect analysis through multiple models. And they should incorporate insights that seem right even though they have not yet been modeled.
What does that last sentence mean? What makes things "seem right?" Does this mean you vote in the FOMC based on a thought that popped into your head in the shower that morning? You get an idea about what seems right in Diamond's mind from his New York Times piece and the rest of his Nobel lecture. We understand that it is fine to jump from talk about labor search and observations on labor market flows to statements about inflation; we understand that inflation cannot rise when unemployment is high; we understand that we are in a state of aggregate demand deficiency.

Diamond seems like a breed of economist we have seen before: the smart theorist who, when faced with a macroeconomic problem, for some reason reverts to the Keynesian crosses and IS-LM models he or she learned as an undergraduate, rather than putting to good use the solid economics that he/she knows well. Richard Shelby and the other Republicans on the Senate Banking Committee may be goofy. They also appear inconsistent, as Peter Diamond would surely not behave much differently from Janet Yellen at an FOMC meeting, and he knows far more economics than does Sarah Bloom Raskin. However, maybe Shelby did society a favor, and we're much better off if Peter Diamond works at MIT than at the Fed. Diamond may not realize it, but he may be much better off as well. A Fed Governor does not have the same access to and control over staff economists that a regional Fed President does, and there are constraints on how a Governor can interact with other Governors. Seems like a lonely life.


  1. Steve:

    No, we don't want policy to be made by way of random thoughts from one's daily shower. Yes, we want the analytical and empirical foundations for policy to be sound, rigorous, and consistent.

    That said, Shelby's boorish blocking of Peter Diamond was simply a tit-for-tat response to similar earlier action by Senate Democrats with respect to Randy Kroszner. It guarantees that when a future Republican president nominates someone like Marvin Goodfriend to the Board, the Democrats will deliver payback, clearing the way for intellectually stellar appointees like Sarah Bloom Raskin and Elizabeth Duke.

  2. Yes, I agree. You can argue the fine points of Obama's choice in this case, but the government cannot function properly if this is the way the Senate confirmation process works. Putting yourself in Peter Diamond's shoes, why would you want to be nominated for a position requiring Senate confirmation?

  3. If a Nobel Prize were enough, Paul Krugman would be a valid nomination for the Board.


  4. RV,

    Yes, I did not like the statement in the first paragraph of Diamond's NYT op-ed that it should be obvious that a Nobel prize qualifies you for something. The Nobel is recognition for creating something important. The person who creates something important may be very bad at doing policy. Similarly, someone like Krugman who writes economic nonsense for public consumption might actually be a good Fed Governor, but I doubt it. Krugman would not take the job anyway, as that would entail a huge salary cut.

  5. There is an element of tit-for-tat in the rejection.

    Diamond’s statement that if much of the unemployment is caused by a lack of adequate demand, the Fed can act to reduce it without touching off inflation suggests that he has not accepted the ideas that founded the great moderation. Back to the 70s is Peter diamond in theory and policy.

    Richard Posner’s public intellectuals: a study in decline. Makes many interesting points abut how academics make poor politicians and political advocates:

    • Academics lack the ability to build coalitions and to compromise, flatter and lie, and make package deals;
    • Academics cannot forgo the prideful self-satisfaction of purity and devotion to principle;
    • Tenured academics have little incentive and/or residual ability to get along with their colleagues or with anyone else.

    These drawbacks as a bureaucrat-politician apply before Peter Diamond’s views on information as a monetary phenomenon and what monetary policy can and can not do are considered.

    Would the Democratic Party looked favourably on a hypothetical nomination of Milton Friedman or other members of the shadow open market operations committee to the Fed?

    I think that Friedman would have used an op-ed opportunity after a hypothetical rejection to talk about what he wanted to do rather than what a noble nominee he would have been.

    Most of all, Friedman would have defended his policy ideas by pointed to where they and worked and where rival policies had failed.

    Diamond did not mention any prior empirical success of his proposed policies nor how he would overcome the leads and lags on monetary policy or the mounting unpleasant monetary arithmetic.

  6. "• Academics lack the ability to build coalitions and to compromise, flatter and lie, and make package deals;
    • Academics cannot forgo the prideful self-satisfaction of purity and devotion to principle;
    • Tenured academics have little incentive and/or residual ability to get along with their colleagues or with anyone else."

    There is certainly some truth here. Some academics self-select into a profession where their idiosyncrasies tend to be forgiven. I have known plenty of academics who would probably starve in the for-profit sector. That said, I have also seen plenty of coalition-building, compromise, flattery, and outright lies. The urge to get along is pretty fundamental, and I'm not sure that we are that much worse at it than anyone else.

  7. I think you dismiss his point about "what seems right" a little too quickly. What he meant, I think, is that policy questions come up all the time for which fully-fledged models have not been developed and optimal policies not derived. Even when the latter do exist somewhere in the literature, it's typically the case that the results may not be as general as necessary to be practical from a policymaker's point of view. So in these cases, which I would guess occur more often than not, policymakers have to strike a balance between the lessons of very stylized models (when those are available) and the policymakers' intuition about the nature and potential solutions to the problem. Given this real-time issue, it seems we want people with broad analytical skills and open minds to make decisions, and Peter Diamond would seem to fit the bill quite well. So I view this outcome as a disappointing one.

    The one caveat in my mind is that it's not clear to me that having a Nobel-prize caliber mind as opposed to a more typical really smart mind makes much difference to the quality of policymaking. It will, however, deprive us of potential contributions to literature made by the Nobel prize mind. So the opportunity cost to society of Nobel-ers going to policy may, in general, outweigh the benefits from having them make policy. But this was not the reason for his being snubbed for the job.
    - C

  8. The opportunity cost in terms of lost research of having Diamond on the Fed is negligible. He is well past his productive peak and society would benefit from his wisdom on the Fed board.

  9. Second to last anonymous,

    "What seems right" is certainly open to interpretation, and I like yours. Diamond's Nobel address is very Krugmanesque, so the talk about "seems right" gave me pause.

    Last anonymous,

    I'm not sure. The optimal Fed Governor might be a 45-50 year-old with a reasonable track record as an economist, and no Nobel in sight. There is a new set of skills to learn in that job. There's a thing they say about that. Something about dogs and tricks.

  10. "The optimal Fed Governor might be a 45-50 year-old with a reasonable track record as an economist, and no Nobel in sight."

    I appreciate your support, Steve.