Influence of late Nobel laureate endures

When James Tobin joined President John F. Kennedy’s administration in 1961, the U.S. economy was struggling to recover from its third recession in seven years.

As a member of Kennedy’s Council of Economic Advisers, the Yale University professor put his theoretical research on asset markets to work in fashioning a novel strategy - nicknamed Operation Twist - to reduce long-term interest rates.

Now, more than half a century later, two of Tobin’s Ph.D. students - Janet Yellen, nominated to be the next chairman of the Federal Reserve, and Koichi Hamada, a special adviser to Japanese Prime Minister Shinzo Abe - are applying some of those same concepts in their efforts to boost their respective countries’ economies.

Tobin’s work on asset markets with fellow Yale professor William Brainard “is essentially the backbone of quantitative easing,” said Edwin Truman, a former Fed official who taught at the school in New Haven, Connecticut, from 1967 to 1972.

The portfolio-balance theory found that policy makers had the ability to affect the prices of individual assets by altering their supply and demand in the financial markets. And that in turn would have an impact on the economy.

The research won Tobin the Nobel Prize in economics and formed the justification for the late economist’s strategy to twist the bond market’s yield curve in 1961 by selling shorter-dated securities and buying longer-term ones.

The aim was to support the dollar with higher short-term interest rates while bolstering the economy with lower long-term yields. The effort, which was smaller than the Fed and BOJ’s current quantitative easing, had a “moderate” impact on bonds, according to a 2011 study by Eric Swanson, a senior research adviser at the Federal Reserve Bank of San Francisco.

Fed Vice Chairman Yellen laid out what she called the “Yale macroeconomics paradigm” in a speech to a reunion of the economics department in April 1999.

“Will capitalist economies operate at full employment in the absence of routine intervention? Certainly not,” said Yellen, then chairman of President Bill Clinton’s Council of Economic Advisers. “Do policy makers have the knowledge and ability to improve macroeconomic outcomes rather than make matters worse? Yes,” although there is “uncertainty with which to contend.”

That philosophy has put the 67-year-old Yellen at the forefront of moves by the Federal Open Market Committee to speed up growth, including initiating a third round of quantitative easing late last year and firming up a promise to keep short-term rates near zero.

Under QE3, the Fed is buying $85 billion of bonds a month in an effort to keep long-term interest rates down and encourage investors to hold more riskier assets, such as stocks, in their portfolios.

“Janet was a force - perhaps ‘the’ force - behind the FOMC’s decision to move to an even more accommodative policy last December,” said Laurence Meyer, a former Fed governor who is now a senior managing director at St. Louis-based Macroeconomic Advisers.

Hamada, who retired from Yale this year after 27 years, also has been aggressive in pushing for more monetary stimulus in Japan, going so far as to publicly criticize his former star pupil Masaaki Shirakawa for not doing enough to lift growth when Shirakawa headed the central bank from 2008 to March of this year.

That was “a little bit of stepping out of the Japanese character,” said Richard Cooper, who taught Hamada at Yale and is now professor of international economics at Harvard University. “It shows the American influence.”

The 77-year-old Hamada is one of the architects of the reflationary policies known as Abenomics and played a role in choosing Haruhiko Kuroda to replace Shirakawa as governor of the Bank of Japan. Under Kuroda, the BOJ is buying more than 7 trillion yen ($71 billion) in bonds a month in a bid to spur growth in the world’s third largest economy.

The BOJ program “is an extension of the Yale Tobin-Brainard approach,” said Hamada. The Japanese central bank is “enhancing activity in asset markets” to “activate the real, stagnated economy.”

Bloomberg