Glenn Hubbard and Justin Muzinich had an interesting piece in the Post today discussing whether the Fed's mandate should be explicitly broadened to include preserving financial stability. While I am inclined to agree with Fed governor Jeremy Stein, that attacking bubbles is already implicit in the Fed's goal of maintaining full employment, the more interesting issue is Hubbard and Muzinch's shyness in dealing with the problem of groupthink at the Fed and among other economic policymakers.
"This propensity to follow the herd is at the root of financial instability. In the most recent crisis, homeowners, investors and, notably, the Fed so succumbed to groupthink that we were almost unanimously blind to the risks of rising housing prices and bank leverage. So, how to create a Fed that guides its governors to be skeptical of crowd-induced financial excess?"
Their answer of course is a change in the Fed's mandate. The more obvious solution would be to change incentives. Economists usually think it is important that it is possible to fire workers who perform their jobs badly. This gives workers the incentive to do their jobs well.
If Fed officials, along with other economists in policymaking positions, could lose their jobs and see their careers ruined by failing to stem the growth of destructive asset bubbles then they would have some real incentive not to engage in mindless groupthink. As it is, economists suffer almost no consequence for even the most momentous failures.
None of the Fed governors lost their jobs for failing to stem the growth of the housing bubble. In fact, according to administration sources, President Obama was considering two of these governors (Donald Kohn and Roger Ferguson) as possible replacements for Ben Bernanke as Fed chair.
Unless economists know that they can face real career consequences from engaging in groupthink their incentive is to go along with the herd. Resisting the herd will always carry risks, since it is possible that they will be shown wrong or at least will not be proven right before they lose their job. Given such asymmetric incentives basic economics would show that economists in policymaking positions will almost always choose to just follow the herd.
Note: Typos corrected.
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