Trading Places

An especially interesting contretemps in economics has been resolved with a trade of sorts that promises gains in two places.

It was just two years ago that Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, fired two researchers and demoted a third, Kei-Mu Yi, head of his research department. He also cancelled visiting arrangements with two prominent University of Chicago economists, Robert Lucas and Nancy Stokey.

All were associated with an esoteric macroeconomic research tradition known as “real,” or technology-driven, business cycle theory that has been pioneered by economists associated with the University of Minnesota and the bank.  RBC theory, which holds that business cycles are natural and mostly unavoidable responses to new inventions, is widely thought to have offered little guidance to the financial crisis of 2007-09 and its aftermath.

Six months after the firings and demotion, Kocherlakota hired back as consultants Patrick Kehoe and Ellen McGrattan, the two who had left (though they had retreated no farther than to the University of Minnesota a mile or so away, where both are professors of economics).

Six months after that, the regional bank’s board appeared to fire Kocherlakota himself – or at least accepted with equanimity his announcement that he would not seek to renew his contract when it expired at the end of 2015.

Last June, the University of Rochester announced that Kocherlakota, 52, would become the first Lionel McKenzie Professor of Economics, in January 2016.

And last week the Minneapolis Fed announced that it had hired Neel Kashkari, 42, as its new president. A onetime aeronautical engineer, Kashkari retooled as a MBA at the Wharton School of the University of Pennsylvania before joining Goldman Sachs in San Francisco as a banker.

He is best known for his time as an aide to Treasury Secretary Henry Paulson during the financial crisis. Assigned in the wake of the forced merger of Bear Sterns in March 2008 to write a “break the glass” plan for use in the event of the failure of another firm, Kashkari produced a memo that, given his boss’s commitment to private efforts to defuse the subprime mortgage problem, turned out to have little relevance until the actual event.

Kashkari nevertheless helped fashion the Troubled Asset Relief Program into a bank-recapitalization plan, and stayed on for six months to serve as its administrator, disbursing $430 billion in loans and eventually recovering $442 billion from them.  In 2009, Kashkari joined the Pacific Investment Management Company, or PIMCO, and, in 2014, was Republican nominee for governor of California, finishing just under nineteen points behind the incumbent democrat Jerry Brown.

Who exactly does the choosing?  The search committee was led by bank directors MayKao Hang, president of the Amherst Wilder Foundation,  and Randall Hogan, chairman of Pentair, a large conglomerate. They are in turn responsive to the sentiments of the broad banking and business communities within the Fed’s ninth district, which includes Minnesota, Montana, North and South Dakota, northwestern Wisconsin, and the Upper Peninsula of Michigan.  Minneapolis is the hub:  two of the four firms that dominate global trade in agricultural commodities have their roots there:  Cargill and Archer-Daniels-Midland.

Kashkari’s appointment to the Minnesota bank caused wry smiles in New York. ”[I]f the Minneapolis Fed felt the need to maintain conservation of NK, they could have chosen to replace Narayana Kocherlakota with a New Keynesian,” wrote New York Times columnist Paul Krugman, a strong Kocherlakota supporter, on his blog. In fact the effect would seem to be just the other way around.

Since the1970s, the Minnesota Fed, one of twelve regional banks in the Federal Reserve System, has been a potent generator of new policy ideas, thanks to its close association with the  economics department at the University of Minnesota, first the rational expectations movement, then the real business cycles vogue.

Kocherlakota, with his 1987 PhD from the University of Chicago, was expected to lead the bank into a new area, known as dynamic public finance – an attempt by economists to come to grips with the more airy speculations of supply-side economics.

By 2012, Kocherlakota had, as a member of the Fed’s policy-making Open Market Committee, experienced what Binyamin Appelbaum of The New York Times aptly termed a battlefield conversion with respect to monetary policy. Formerly viewed as an inflation hawk, he became an enthusiastic supporter of the doctrine known as quantitative easing and the economy failed to recover as quickly as often in the past.

Receiving what seemed to be little useful advice from his bank’s interest rate forecasters, Kocherlakota decided to go to war with them, in the words of Stephen Williamson, a research associate at the St. Louis Fed, who blogged about the incident.  Nobel laureate Edward Prescott, of Arizona State University, who introduced real business cycle theory while a professor at the University of Minnesota, called the dismissals “crazy.” In short order the affair was hushed up. Kocherlakota’s decision to leave soon followed.

Kocherlakota, one of the most talented economists of his generation, will now be able to test the old adage that only a theory can replace another. Kashkari, no economist but a dynamic executive possessed of strong free market convictions, presumably will seek to restore to Minneapolis the relevance to contemporary policy it has lost.  The careers of both men bear watching.

Leave a Reply

Your email address will not be published. Required fields are marked *