The Mercury News Interview: Darrell Duffie, Stanford Economist

Jul. 25--As of last week, nearly 400 economists had signed a petition urging Congress and the executive branch to respect the independence of U.S. monetary policy, which is implemented by the Federal Reserve through its power to set interest rates, helping control inflation and promote stable prices and employment.

It takes something extraordinary to get that many economists to agree on anything, so we asked one of the petition's early signers, Stanford economist Darrell Duffie, what the fuss was about.

Duffie, a professor of finance at the Graduate School of Business, is president of the American Finance Association and one of 15 economists in the Squam Lake Working Group, formed last fall to develop ways to deal with the economic crisis.

Duffie explained that the economists were alarmed by proposals for Congress to audit the Fed's most sensitive activities. Legislation to do that has rapidly gathered support in Congress, and the bills' sponsors say the public has a right to know how the Fed operates and to see how the nation's central bank is spending congressionally authorized bailout money.

Q Why are you and your fellow economists worried about the independence of the Federal Reserve?

A A representative in Congress, Ron Paul, proposed that the Government Accountability Office, which is Congress' investigative arm, be given authority to audit the Fed's monetary actions. There is a long-standing

belief, well understood by many, that you want to have a central bank's monetary policies independent of the government.

That is mostly because they have the responsibility to prevent inflation and promote stability. Congress could have shorter-term goals and try to steer the Fed away from an effective monetary policy. It's pretty much agreed among economists that you don't want to interfere with the Fed's monetary policy.

Q Why not?

A Here's an extreme example. You've heard of the German hyperinflation after World War I? People were literally using wheelbarrows filled with money to buy food. How did it happen? The government had large debts, including reparations payments to those who won the war. The government decided to tell its central bank, which didn't have enough independence at the time, to print more money -- lots of it. Because so much money was chasing so few goods, the result was hyperinflation.

I'm not suggesting that's what's going to happen here, but it's an extreme example of what can happen when you don't have an independent central bank.

Q A lot of people think the Fed helped cause this mess we're in by keeping interest rates too low for too long. Why isn't it reasonable to have some congressional oversight so it doesn't happen again?

A Congress has oversight already that it exercises over long periods of time, first of all by confirming the appointments of the leadership of the Fed. For example, Fed Chairman Ben Bernanke has to be reappointed or replaced after the new year, and Congress will have an opportunity to confirm him or his replacement. So it has oversight, putting in place the Fed's management, which will stay in place for several years at a time.

But you wouldn't want it telling the Fed not to raise interest rates because of some congressional representatives' worries about jobs in certain states, for example. The Fed has a mandate to control inflation that you wouldn't want Congress to overrule in the short run.

The Fed itself has agreed it could have done some things better, for example in the oversight of mortgage origination standards. And when the crisis got rolling they revised their approach to that.

Many people agree interest rates were kept too low by the Fed for too long. Some would say that was more on Alan Greenspan's watch than anybody else's.

Q Are there other proposals to change the Fed?

A It is proposed that the Fed take over systemic risk responsibilities. That makes it even more important that it have independence with respect to monetary policy.

Q An independent Fed isn't going to solve all our systemic problems. What else is needed in the way of reform to prevent a similar economic collapse?

A The intense, fearful part of the crisis is over. Improving the financial system is now on the front burner for Congress. Their job is to look for ways to do that.

The economists who signed the petition believe that this form of oversight of the Fed is not one of the good things to do.

We do need to improve the infrastructure of the financial system. For example, clearing and settlement systems need to be more robust, so that important financial institutions do not fail merely because they cannot count on the performance of other financial institutions who are failing.

There needs to be better risk management by both banks and their regulatory supervisors, and that starts with the boards of directors of those financial institutions.

We need better ways to allow large financial institutions to fail without a need to bail them out. For that to work, we need to make their failures less dangerous. The idea we can stop them from failing has not proved to be a very effective approach.

Contact Pete Carey at 408-920-5419.

DARRELL DUFFIE:

Born: Canada, 1954

Education: Bachelor"s degree in engineering, University of New Brunswick; doctorate in engineering economic systems, Stanford

Awards and honors: 2003, distinguished teacher award in the doctoral program at Stanford. Financial engineer of the year, International Association of Financial Engineering. 2007, elected fellow of the American Academy of Arts and Sciences. 2008, elected to the Council of the Econometric Society. 2008, elected president of the American Finance Association.

Personal: Lives in Palo Alto with wife and two children.

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