As financial turmoil in Europe threatened to overwhelm the region’s banks last November, Bank of England Governor Mervyn King arranged conference calls with the world’s top central bankers to decide what steps to take.
The result: Six leading monetary authorities agreed to make it cheaper for financial institutions outside the U.S. to borrow dollars in emergencies. The funding squeeze on European banks eased and stocks worldwide rallied.
The Nov. 30 plan could be created and announced quickly because “we trust each other,” King told reporters the following day in his role as chairman of the bankers’ group.
For some, that trust has a common source: three of the six banks are led by economists who studied or taught at the Massachusetts Institute of Technology in the late 1970s and early 1980s. Then, as now, the emphasis was on what former MIT professor and now Bank of Israel Governor Stanley Fischer describes as “economics about the real world.”
The MIT central bankers represent “an extraordinary level of policy influence for any one economics department,” said James Poterba, president of the National Bureau of Economic Research, which is responsible for dating the beginnings and endings of U.S. recessions. “I’m trying to think about what was in the water.” He was head of the economics department from 2006 to 2008 and is still a faculty member.
At MIT, King, 63, and then-professor Ben S. Bernanke, 58, had adjoining offices in 1983, spending the early days of their academic careers in an environment where economics was viewed as a tool to set policy. Earlier, Bernanke and European Central Bank President Mario Draghi, 64, earned their doctorates from the university in the late 1970s, Draghi with a thesis entitled “Essays on Economic Theory and Applications.”
Fischer, 68, advised Bernanke’s thesis on “Long-Term Commitments, Dynamic Optimization and the Business Cycle,” and taught Draghi. Greek Prime Minister and former ECB vice president Lucas Papademos and Olivier Blanchard, now chief economist for the International Monetary Fund in Washington, earned their doctorates from MIT at about the same time.
Other monetary policy makers who have passed through MIT’s doors include Athanasios Orphanides, head of the Central Bank of Cyprus, Duvvuri Subbarao, governor of the Reserve Bank of India and Charles Bean, King’s deputy in the U.K.
Central banking is filled with former attendees of the Cambridge, Massachusetts, university not just because it was and is one of the world’s top schools for economics.
Its emphasis on solving policy problems instead of perfecting theories, as well as a collegial atmosphere, attracted students and professors alike. That was especially true during the late 1970s and early 1980s, when global oil- price shocks helped trigger both inflation and recession.
“The faculty makes the place but the students also make the place,” Fischer said in a telephone interview. “One of the reasons you go to MIT is because you have the best students in the world.” To him, economics was a tool to “do something useful.”
“The goal was not to find beautiful theories, the goal was to have a grasp of what was actually happening, and we taught it that way,” said Robert Solow, a Nobel-prize winning economist who started as an associate professor at MIT in 1950 and has stayed there for his entire career. “We turned out students who were actually interested in macroeconomic policy and understanding daily events and not in showing off.”
Faced with the worst financial crisis since the Great Depression, Bernanke, Draghi and King have shaken up the standard toolbox of monetary policy.
All three have cut interest rates to record lows and pumped extra liquidity into their economies. The U.S. and the U.K. (UKAPTARG) have gone through at least two rounds of money-printing to buy government debt. Draghi, who took over as ECB president from France’s Jean Claude Trichet on Nov. 1, has so far resisted starting a bond-purchase plan with newly created money.
Jose De Gregorio, who stepped down last month after four years heading Chile’s central bank, took a class on the Great Depression from Bernanke while the Fed chairman was a visiting professor at MIT. De Gregorio said the emphasis at the university was on trying to understand “real phenomena and how the world works” rather than seeking to come up with elaborate theories or better techniques.
The MIT economics department, along with counterparts at other U.S. coastal universities including Harvard, also in Cambridge, is considered a “saltwater” school: The professors see a role for economic policy in providing discretionary aid for the economy.
Samuelson vs Friedman
A standard-bearer for this approach was Paul Samuelson, the first American to win a Nobel prize in economic sciences. He joined MIT in 1940, earning a Ph.D. at Harvard University, and spent his career there until his death in 2009.
At “freshwater” schools such as the University of Chicago and the University of Minnesota — so-called because of their relative proximity to the Great Lakes — the approach favored by the late Nobel laureate Milton Friedman is skeptical about the part governments can and should play in the economy.
Robert Hall, a professor at Stanford University in California who got his doctorate from MIT, coined the terms “freshwater” and “saltwater” in a 1976 note on macroeconomics.
The MIT activists deployed their knowledge in the real world as well. Samuelson was an adviser to President John F. Kennedy while Solow served as a senior economist on Kennedy’s Council of Economic Advisers.
Later, Lawrence Summers, who received a bachelor’s degree in economics at MIT in 1975 and taught there in 1979 after getting a doctorate from Harvard, was Treasury secretary for President Bill Clinton from 1999 to 2001. He also led President Barack Obama’s National Economic Council from 2008 to 2010.
Other alumni who have held policy positions include Christina Romer, who earned her Ph.D. at MIT in 1985 and was head of Obama’s CEA, and Alan Blinder, a former vice chairman of the Fed who received his doctorate from MIT in 1971.
Whether in class at the Alfred P. Sloan building on the east end of campus or in informal study groups, relationships between graduate students and faculty were cooperative because professors “treated students as equals,” said the BOE’s Bean, who was there from 1979 to 1981.
Students would meet on campus or in someone’s apartment over sandwiches they’d bought at a local deli. More expensive evenings took place in bars near Harvard Square. Their discussions on economics took place as the U.S. responded to the oil crisis with “Drive 55” billboards and to the Iranian hostage crisis with pictures of the Ayatollah Ruhollah Khomeini.
Rudiger Dornbusch, known for his work in defining modern international economics and for his devotion to his students, hosted “legendary” weekly breakfasts where his doctoral candidates gave progress reports on their dissertations, said Richard Schmalensee, professor of economics and management at MIT. Dornbusch died of cancer in 2002.
The late Franco Modigliani, who won the Nobel prize in 1985 for his work on savings and financial markets, advised fellow Italian Draghi’s doctoral thesis in 1976 and co-authored scholarly articles with Greece’s Papademos. Both spoke at his memorial service in 2003.
Solow was an “important part” of the collegial culture of the economics department, according to Schmalensee. Solow himself said he never would have guessed back then that Bernanke would have ended up as chairman of the Fed. Nor did either Bernanke or Draghi stand out as obvious candidates to lead major central banks.
“If you had known Ben Bernanke as a student you would have never picked him as a future central banker,” said Solow, who won the Nobel in 1987. “He had a lot of hair, and when I say a lot of hair, I mean a lot of hair.”
As for Draghi, Solow said he remembers his smile — and his low-key demeanor. “No drama in Draghi,” the MIT professor emeritus said, adding, “That’s a good trait for him to have” as a central banker confronting a financial crisis.
The “MIT style,” according to Nobel laureate Paul Krugman, who received a doctorate from the university in 1977 and who is now a New York Times newspaper columnist, is the “use of small models applied to real problems, blending real-world observation and a little mathematics to cut through to the core of the issue.” He was writing in an essay published on the MIT website.
The “saltwater” approach to economics instilled in students a sense of “pragmatism and the willingness to be ad hoc” about economic issues, said the BOE’s Bean, 58.
Mindset for Bankers
“It’s being willing to use economics flexibly to cope with whatever the issue is at hand,” he said. “That’s the sort of mindset that informs the Bernankes, the Draghis, the Stan Fischers and Olivier Blanchards of the world.”
Bernanke, Draghi, Blanchard and King declined to comment for this article or weren’t able to comment.
Their time at MIT was marked by a public debate between Friedman and Samuelson over economic policy. In alternating columns in Newsweek magazine, the two men set out their competing visions: Friedman for a laissez-faire approach and Samuelson advocating an active government role.
Their public spat obscured cross-pollination between the two schools. After earning his doctorate at MIT in 1969, Fischer spent three years as an assistant professor at the University of Chicago before returning to Massachusetts in 1973.
The common approach from policy makers’ educational backgrounds means that cooperation in times of crisis is more likely since “they all talk the same language, the language of economics,” said Forrest Capie, professor emeritus of economic history at Cass Business School in London and author of “The Bank of England: 1950s to 1979.”
The institutional history at each central bank may overshadow any influence from MIT on each leader’s approach to the crisis, said Grant Lewis, head of research at Daiwa Capital Markets Europe Ltd. in London.
The hyperinflation that Germany endured in the last century has informed the ECB’s reluctance to plunge into so-called quantitative easing, while the Fed and the BOE are more disposed to pursue that unconventional policy, he said.
The Fed announced its $400 billion “Operation Twist” in September to lower yields on longer-term treasuries by rearranging the composition of its almost $3 trillion balance sheet.
The BOE held its target for bond purchases at 275 billion pounds ($421 billion) yesterday. The ECB, for its part, kept its key rate at 1 percent as Draghi said the euro-area economy was showing “signs of stabilization.”
At a Frankfurt press conference yesterday, Draghi called on the region’s indebted nations to “do their utmost” to control deficits. The bank’s unprecedented 489 billion euros ($627 billion) of three-year loans last month have prevented a “serious” credit contraction, he said, adding that such measures are “temporary in nature.”
Supporters of the freshwater school would say Draghi and his global counterparts should do even less. Central banks’ decisions to intervene in government bond markets and pump liquidity into the financial system have proven to be a policy mistake, said Brendan Brown, chief economist at Mitsubishi UFJ Securities in London. He attended Chicago in the 1970s and last year published “The Global Curse of The Federal Reserve,” which criticized the Fed.
“Blanket intervention to depress market prices is the wrong way to go about it,” he said. “The cost is what we’re seeing: a slow sluggish recovery.”
“You’ve got a problem, you have to do something about it. That is a message which they learned at MIT,” said Allan Meltzer, a professor at Carnegie Mellon University in Pittsburgh, Pennsylvania, and author of a history of the Fed, in an interview. “The danger is that you don’t think about the longer-term consequences of what you’re doing.”
Draghi, for one, has long been aware of such risks. His doctoral thesis discussed, among other subjects, “the tradeoff between short-run stabilization policies and long-run plans” and found that an excessive focus on near-term fixes could prove counterproductive.
Jean-Pierre Roth, who stepped down as chairman of the Swiss National Bank in December 2009, said the international nature of economic issues supports the case for top central banking officials to have doctorates in macroeconomics. Roth was a visiting scholar at MIT from 1976-1977, attending in order to study with Dornbusch.
“What is so important for central bankers is to be able to think globally, in a macro framework, and to understand the interconnections between markets in a global and open economy,” he said in an interview. “This is the kind of education you get when you work a bit more than having a bachelor degree or MA in economics. You need to work more than that.”
Bernanke’s academic work on the Great Depression may have better prepared him for the challenges now facing the U.S. economy and the Fed than if he had first spent a long stretch working at a bank, Daiwa’s Lewis said.
“The fact that Bernanke’s such a student of the Great Depression and Japan’s battles with deflation and low growth arguably makes him the best qualified person to hold that job at the moment,” he said. “It’s clear he saw deflation and depression as a big threat and he understood that from his studies. If he’d been a career banker, he’d never have studied it in such depth.”
By Rich Miller and Jennifer Ryan
Courtesy of Bloomberg News
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