Those who worry whether Janet Yellen, President Obama's nominee as Federal Reserve chair, has the personal heft for the job are singing an old tune. That's what they said when Alan Greenspan replaced Paul Volcker, and Ben Bernanke replaced Greenspan.
Yellen's tenure will nevertheless be challenging. Given her reputation as leader of the Fed's dovish wing, both debt and equity markets will almost certainly test her resolve.
Yellen needs to be particularly careful early on. When Alan Greenspan assumed the chairmanship in 1987, critics complained that the acolyte of former Chairman Arthur Burns was too political. Burns was charged with engineering an excessively easy monetary policy to help facilitate the 1972 reelection of Richard Nixon.
In his first FOMC meeting, Greenspan surprised financial markets with a discount rate hike. Bond traders suspected, perhaps unfairly, that the move was to demonstrate the new chairman's independence.
A number of other developments helped lead to the stock market crash six weeks later. But the unexpected rate hike didn't help matters. Yellen should avoid the temptation to try to immediately prove her credibility.
The new chair already faces Mission Impossible over the $90 billion in bonds the Fed purchases each month to keep interest rates from rising. The Fed is now central banker to the world. It is a world increasingly investment-dependent for growth, financed to a surprising degree by the Fed's quantitative easing.
Keep buying bonds for too long, and the world risks an ever-expanding financial bubble that could someday burst. Taper, or taper too much, and the result could be the same, perhaps sooner.
Yellen's dilemma is that it is impossible to predict when financial bubbles burst. Policymakers also have a poor track record of successfully pricking bubbles.
Yellen must also confront the Bernanke legacy. During the financial crisis, Bernanke deserved enormous credit for injecting liquidity quickly into the financial system, avoiding a depression. Yet in the five years since, there have been difficulties:
Independence. The Fed could be at risk of losing its independence. The undefined goal of "financial stability" appears to have replaced the Fed's traditional dual role of maintaining price stability and full employment.
To achieve this stability, bank credit has migrated away from the private economy and into government debt. As analyst Criton Zoakos points out, pursuing financial stability the last five...