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Independence of the Fed - Final Research Paper

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Headers

• Chirag Mehta
• Economics: Money and Banking (304)
• Prof. Paczkowski
• 16 Apr. 2001
• Grade: A

Independence of the Fed - Final Research Paper

Abstract:

• Background: In the last century, central banks all over the world gained varying degrees of independence from their ruling governments, including the Federal Reserve of US, which has been highly autonomous in making its monetary policies since the day of its inception. Whether or not should the central bank enjoy such freedom from government is a question that every country must answer.
• Question: How much independence should the Federal Reserve have?
• Method: To determine the extent to which the Fed should be free from, or under the control of the government, an in-depth analysis of a highly dependent and an equally independent Fed is required. We shall see how an independent Fed checks inflation, encourages employment and stimulates growth and how a puppet-like Fed sends the ruling government on a federal spending spree. We will also see how an all-powerful Fed can in fact misuse its powers and freedom, and bring about a financial turmoil. It is only after weighing both sides of the argument that we can determine the degree of freedom that the Fed should enjoy.
• Conclusion: The Fed, though in its present state is highly autonomous, needs a stricter eligibility criteria, shorter terms for its members, more freedom from the government with respect to biannual reports, and much more power in front of the government in financial matters. That is, the Fed should have the power to recommend, if not require, the government to stay within certain boundaries when it makes decisions related to earning and spending.

Background:

"There have been three great inventions since the beginning of time: fire, the wheel and central banking." - Will Rogers
The monetary policies of most of the countries in the world today are determined by their Central Banks, which more or less, enjoy a certain degree of autonomy from the political front. These central banks control the money supply, influence the interest rates, and regulate the banking system of the respective countries. Simply put, central banks have monetary and regulatory functions; in order to carry out which, they have to remain unbiased and shielded from any external socio-political pressure. The amount of independence that a central bank has in making its monetary and regulatory policies varies from nation to nation but every country has to answer the following question. Should the central bank be given full authority in making its policies or should the government, idealistically composed of democratically elected heads, have a say in the central bank's workings?

This expository paper, within the context of the aforementioned issue, shall attempt to demonstrate why it is necessary for a country to answer this question and what are the consequences over the long-term. It is the immensity of the long-term impact that a central bank has on the country's economy, which begs a discussion as such. In fact this force is so prodigious that Deane and Pringle metaphorically compared central banking to nuclear energy:


"Central banking is an invention, like nuclear energy, with huge potential. Its power can be used either constructively or destructively, either to assure functioning money, or to bring about a total breakdown of society" (p.16).
And surprisingly, like nuclear energy, the concept of central banking is a relatively new one; most central banks did not exist a mere century ago. The oldest central bank in existence, the Sveriges Riksbank, more commonly known as the Bank of Sweden, came into being in 1668 (Holtfrerich, Reis and Toniolo, 111). Then known as the Bank of the Estate of the Realm, it has been the prime innovator in the banking world ever since (Deane and Pringle, 36). Though still a major player in the global banking arena, it is a mere speckle when compared to the Federal Reserve of US.

The Federal Reserve, more affectionately known as the Fed, was founded less than a century ago. On 23rd December 1913, President W. Wilson signed the Federal Reserve Act and a year later on 16th November 1914, twelve branches of the Federal Reserve opened their doors nationwide (Deane and Pringle, 52). Armed with a previously unknown degree of independence, the Fed has ever since attracted strong opposition from the legislators (Mishkin, 381). Time and again they threaten and attempt to curtail its powers, providing a plethora of reasons, many of which shall be discussed herein, along with the opposing views of economists who rally for absolute independence of the central banks from the politicians.

Specific research question:

"Several senators and congressmen are making noises about reducing the Federal Reserve's independence" (Forbes, 25). While a few of them think it is their birthright to question the Fed's freedom, most of the politicians are motivated simply by personal gains or as Blinder said it, "[politicians] would be sorely tempted to reach for short-term gains at the expense of the future" (10). If the Fed would come under their control, then the money supply would too. But personal, political, social, and moral reasons aside, it becomes incumbent upon the economist also, to ask the same question:

How much independence should the Federal Reserve have? Had there been a straightforward answer to this question, then legislators would no longer lobby to sever Fed's independence. However, this does not mean that it is an unanswerable query. The difficulty in answering it lies in the scale of the matter, for the Federal Reserve of US is one of the largest and most powerful central banks of the world. In fact many of the major post-world war II central banks, like Germany's Bundesbank, have been modeled after the Fed and hence any structural changes to it, would send tremors worldwide. (Deane and Pringle, 47).

While it is true that time and again politicians have attempted to take away Fed's autonomy for personal gains, it is also possible for the Fed to become an arbitrary institution controlled by a handful of individuals, answerable to none. If the Fed makes an economically fatal decision, for whatsoever reason or under whomever's pressures, it would most definitely result in an immediate economic catastrophe, the shocks of which would be felt around the globe; the most devastating form of moral hazard.

Therefore an in-depth analysis of the matter is imperative and both the sides of the story have to be heard. In the consequent section, we shall review the arguments and allegations made by both parties, how they might affect the national economy in the short and long term, and what lies ahead for the Fed.

Extensive literature review:

Before jumping into the crux of the matter, let us first understand why the Fed is so important, what its functions are and why it must fulfil them. It is crucial to address these issues at this stage because it is only after understanding them, that we would be able comprehend how independence from the government affects the way Fed functions, what its advantages and disadvantages are and therefore how much independence should there be.

The Fed, just like every other central bank around the world, has gained considerable importance over the last century. Previously it was the ruling government or the State's duty to issue currency notes or coins, fix market prices, and manage foreign exchange (De Kock, 1). But as communism fell on its knees, as people challenged monarchies, and as democracy gained acceptance, free markets became the key determinants of prices and thus dictated the value of money (Deane and Pringle, 15, 30). As the prevalent monetary systems failed the test of time, there emerged a need for a stronger system that would discipline the rampageous money markets, regardless of the political turmoil. The only solution was to give central banks the independence they needed to control the monetary policy effectively (Lippi, 10).

And once the central banks achieved this independence, they began to concentrate on performing their primary functions. Today it rests upon the Fed's shoulders to check inflation, maintain acceptable levels of unemployment, rescue the economy from sudden crises and panics, and encourage growth (Blinder, 5). They also have to supervise the financial intermediaries, mostly commercial banks, set appropriate interest rates for overnight bank loans and determine the amount of reserves the banks need to maintain.

One of the most important functions is maintaining low inflation, or "price stability," as it more popularly called in a misuse of language (Deane and Pringle, 4). Inflation refers to the increase in cost prices of goods and services, due to the devaluation of money. Empirical evidence proves that inflation is disastrous for international trade, mainly imports, for people with fixed incomes, like pensioners, and for maintaining public's confidence in the nation currency (Deane and Pringle, 24). While it may seem far-fetched, extremely high rate of inflation can, and in the past has, resulted in the reemergence of the barter system, when people would rather exchange goods and services than accept a failed currency (Caprio and Levine).

Although at this stage of research, we have talked more about the concepts that are relevant not only to the Fed, but to every central bank, in the next phase we shall narrow down the topic and concentrate solely on the Federal Reserve. And now equipped with some knowledge regarding the functions of a central bank and why it aims to fulfil them, we can begin our main discussion: Independence of the Fed.
• Political Viewpoint:
  
  The Fed has always been the legislator's favorite dartboard. Wanting to strip the Fed of all its independence, legislators give a plethora of reasons to support the same. Wright Patman of Texas, a liberal Democrat, waged war on the independence of Fed, for nearly fifty years (Deane and Pringle, 228). The main reasons why the Fed should not enjoy such a high degree of freedom, according to these politicians, are as follows:
  1. Too big a responsibility: In 1832, President Andrew Jackson vetoed the bill to recharter the predecessor of the Federal Reserve, the Second Bank of United States, giving the reason that:
     "Great evils to our country and its institutions might flow from such a concentration of power in the hands of a few men irresponsible to the people." - Jackson, 1832
     Today, according to the opponents of an independent Fed, resting the country's whole monetary policy in the hands of an institution run by a handful of people is like playing Russian Roulette. If almost every major national decision is made only after the Congress and Senate approves of it, why do such important economic matters go without peer reviews by the legislators?
  2. Fed is not Democratic: Moreover, according to these politicians, it is undemocratic to "have monetary policy controlled by an elite group responsible to none" (Mishkin, 387). Although the President has the power to appoint the members into Fed's Board of Governors, the bulk of the Fed is elected by members of the Board of Governors, Federal Reserve Bank branches, commercial banks, and such financial institutions (Mishkin, 369). Putting the economy of the "world's leading democracy" in the hands of a non-democratic organization is denying the democracy of the State (Deane and Pringle, 215).
  3. Too many pitfalls: Recently the majority of the opposition has been with respect to the ill effects of incorrect decisions that the Fed makes or has the power to make. That is, if the Fed makes a wrong move in haste, the whole country suffers. Politicians, like Wright Patman, lobby to curtail the Fed's powers, so that is does not end up destroying the economic stability of the country (Deane and Pringle, 228)
  In the following section we shall review the benefits of a highly independent Fed and what havoc a despotic Fed can wreak. Yet there is a marked difference between why a politician fears a totalitarian Fed and why an economist would want to address this issue. That is, the aforementioned bases on which a Congressman or a Senator would want to curb Fed's power, are very different from why Milton Friedman favored a powerless Fed (Shull, 214)
• Independent Fed:
  
  Firstly, let us examine what exactly do we mean by independence. Independence of the Fed means the degree of freedom it possesses in making its decisions; freedom from government intervention. And since the decisions it makes are of national importance, this freedom is also of prime cruciality. The Fed has two main targets: Price Stability and maintaining acceptable levels of unemployment (Deane and Pringle, 215). These, it fulfils by controlling:
  • Reserve Requirements
  • Discount Rates
  • Open Market Operations
  Its independence comes into play when it goes about controlling these instruments. That is, the Fed exercises its independence by determining what the Reserve Requirements should be, what discount rates to aim for, and when and what open market operations to conduct. When politicians want to restrain Fed's independence, it is this freedom they are pointing at- the freedom of the Fed to carry on Federal Open Market operations without consulting the government. An independent Fed can be benevolent or malevolent, with proponents on either side:
  1. Benevolent Independent Fed: The supporters of an independent Fed claim that the economy can greatly benefit by a Fed that is free from political pressure (Blinder, 10). According to them, some of the major benefits of having a free Fed are as follows:
     • Smooth Monetary Policy - Stability: A good monetary policy provides an economy that does not fluctuate like a seismograph during an earthquake. By its control over the country's monetary policy, the Fed can literally design the course that the country will take for a long time to come. When it is in the hands of an independent Fed, the monetary policy is free from any political pressures, and thus hopefully most beneficial to the citizens in the long run (Mishkin, 386). Because it does not have to ask the Senate for every little move it makes, the Fed can instantly make open market operations whenever the economy demands, without wasting time in asking for the government's permission. This brings us on to its second benefit- immediate decision.
     • Immediate decisions to avert crises: There seems no need to explain how slowly the government makes its decisions. If there is an economic doom impending upon the Wall Street, and the Fed has to go to the Senate to ask for permission in order to stabilize the situation, then it would take the legislators months to come to a decision; chaos shall reign. But an independent Fed with full freedom to act on its own when the situation demands, can easily avert crises in the financial markets, and that too on a day to day basis (Deane and Pringle, 216). If the Fed has to be answerable to the government for every little decision it makes or does not make, then the Fed will seldom make such immediate reactionary decisions. Maybe the political arena functions well this way, but if the Fed began working in such a stereotypical bureaucratic way, it would mean economic doomsday. Financial markets are fickle, unstable and highly prone to bursts. It is the job of an independent Fed to ensure that the markets remain stable or regain their equilibrium states as quickly as possible, after any sudden fluctuations.
     • Long Term Benefits: Fed can be a wonderful toy in the hands of a President hoping to be re-elected. Simply increase the money supply a few months before the election and take all the credit for the booming economy (Mishkin, 386) If the Fed does not have the freedom to act on its own, it can easily become prey to the politicians' short-term needs. A government, which comes to power because of the promise to remove unemployment, can easily fulfil its promises by manipulating the monetary policy and increasing the money supply (Mishkin, 386). Sure, unemployment will fall for a short duration, but then the evils of inflation will come into play. It is the Fed's job to make sure this does not happen. Only an independent Fed can make long-term plans that are not affected by the short-term whims of politicians (Lippi, 13). Besides, a dependent Fed might end up as the legislator's personal piggy bank. The ruling government might order the Fed to print more money to provide for the government's lavish expenditures. Though this may seem far-fetched, it is indeed possible, for this is exactly what happens in most third world nations. A strong independent Fed will prevent misuse of the monetary policy by the government and help ensure long-term stability in the economy.
     • Macroeconomic Evidence: The following chart shows the independence that the central banks of some ten countries enjoy, in conjunction with the average annual inflation rate. It is more than evident from the following that the countries where central banks have higher autonomy, fare well in macroeconomic performance; the inflation rates rising only slightly annually. In contrast, in countries where the central banks were entirely dependent upon the ruling governments, inflation is rampant, as much as 12% to 14% annually.
       
       
  2. Malevolent Independent Fed: We saw how an independent Fed can help improve the country's economic situation, maintain price stability and check unemployment levels, by acting promptly whenever the markets demand, and not when the Senate orders. But it is equally possible for the Fed to misuse these very functions and powers itself, and bring the country's economy down on its knees. Let us take a look at how an independent Fed, despotic or not, can end up destroying the economy of the nation.
     • Incorrect Decision: Not all the decisions made by the Fed are backed up by years or even months of research. Of course, the targets and aims that the Fed attempts to achieve are set after careful considerations and tons of planning, but its day to day actions are generally automatic responses to the tantrums in the financial markets. E.g., although the Fed has been trying to maintain low inflation rates for decades now, by controlling the interest rates, it took only the months of November and December 2000, to prompt the Fed to cut down the interest rates considerably (Fox, 26). Of course, these too were backed by years of experience, but what this shows is that the Fed has the power to make sudden major decisions, with far reaching impacts. This is what prompts economist like Friedman to question whether the Fed really deserves such a high degree of autonomy (Shull, 214). An incorrect hasty decision, can literally being about a recession, if not a depression. Although, its highly unlikely that Greenspan's decision to cut rates by 1.5% in the first quarter of 2001, will bring about a depression, many fear a recession is not far off; Fed's last rate cut, being the straw that broke the camel's back (Fox, 27).
     • One Man Show: Many think that the problem with Fed is that there is too much power in too few hands, and more so in the hands of the Federal Reserve Board chairman. According to 40% of top business leaders polled, the Federal Reserve Board chairman is at least as important as the President, and many consider his job more crucial than the President's (Welsh, 43). With the power to influence every financial market in the world, the chairman definitely has too many and too heavy responsibilities on his shoulders. Sherman Maisel, an ex-Governor, recollects that the chairman holds 45% of the total power relative to the other board members (Deane and Pringle, 228). Moreover, if the Fed chairman and the President collude, the country will definitely go down the tubes. And strangest of all, the Fed chairman, one of the most powerful men in US, is not even elected by the common man! So it maybe possible for a man, to become one of the most influential man in the world, without even a bit of acceptance by the common man. This is not only against democracy, but also a hark back into the days of yore, when most of the countries of the world were ruled by dictators.
     • Over-confident Fed: What happens if the Fed becomes over-confident of its powers and abilities? Taking the case of 1999, when Fed was so confident of its claim that the stock market was floating in a bubble, that it increased the interest rates drastically in a short period of time, in order to check some "invisible" inflation. As the rates kept increasing, the stock market became more and more prone to a crash. And in the fall of 2000, it did; taking down the economy with it (Fox, 26). It is April 2001 now and the stock market has not recovered still, despite numerous rate cuts by the Fed. This is a clear-cut example of a Fed too full of itself.
     • Practicalities: We discussed above, how the Fed can go haywire and destroy the country. And although the three scenarios are not impossible, they are highly improbable.
       
       It is possible for the Fed to make a hasty decision, but this does not happen everyday. And even if the Fed does make an incorrect decision, the situation would be much worse if it did not make a move the all. If there is a fright of stock market crash and Fed steps in, half of the fears are already gone, for now the Fed has come to the rescue (De Kock, 190).
       
       Similarly, although the chairman has seemingly infinite power, it is highly unlikely that he will ever use it for personal gains or to promote favoritism. Usually, the chairman of the Fed comes from a stable background in economics and banking. Only rarely do non-economists like Bill Miller become chairmen (Deane and Pringle, 230). Moreover the chairman, though very powerful, is not all-powerful. There are seven members in the Board of Governors and twelve in the Federal Open Market Committee (FOMC), and there has to be a majority support for any decision to be made. Of course, if the chairman is supporting an issue, most of the other members agree to it, but not because of reverence to his powers, rather because of his record in making correct decisions for years and even decades.
       
       And lastly, although an all-independent Fed is prone to become over-confident, it would not act as such, for it is composed of "professional bankers and prominent leaders from industry, labor, agriculture, or the consumer sector", who know what they are doing and what the results can be (Mishkin, 369). In case of the recent stock market crash with the Fed highly bent on maintaining low inflation rates, it cannot be determined as of today, if the right decision was made or not. Ironically, the Fed can almost never prove that it has made a correct decision, yet when it makes a small mistake, every finger points at it. We cannot say at the moment whether the rate increases and cuts averted the biggest depression known in written history and turned it into a mere short-term recession or turned a booming economy into dust.
  Now that we have painted two pictures, one that shows a benevolent Fed and the other depicting the ills that a malevolent Fed can bring, we move forward to answer the question at hand: How much independence should the Federal Reserve have?

Conclusion:

"There is yet no consensus on whether Federal Reserve independence is a good thing [or not]." - Mishkin, 388.
Evidently, to decide whether Fed should be totally independent or totally dependent would be futile. What we can do is arrive at a point somewhere between the two extremities so as to let the Fed do what it does best, while making sure it does not go haywire. The Fed that I propose is closer to being absolutely independent than being totally dependent. Therefore I shall begin by taking an all-independent Fed, impose some requirements on it and curtail some of its functions, one by one, to end up with a Fed that is independent enough to do its job well, but not enough to mess it up.

Taking an all-independent Fed that is answerable to none and has absolute power in electing its own members for infinite amount of time, let us set the limits on who can be elected into office, for how long, and why would we want to change the current eligibility criteria. The presidents of all the twelve Federal Reserve banks must hail from solid backgrounds in economics and banking. So should every member on the Board of Governors. Above all, the chairman of the Fed must definitely be a well-professed economist with an established career in banking. It is the economy of the country we are talking here and US cannot afford any more Joe-Shmoe chairmen. Fortunately, in the last few decades, the chairmen and the presidents have mainly been respected economists, but this is not required by law yet. We need laws that explicitly draw the minimum eligibility criterion for these positions. As far as the term duration is concerned, fourteen years is a bit too long for any permanent government position. Agreed that such a long term was proposed because there is always a fear of the Fed colluding with the ruling government, but never in the history of US has a president and his party been in place for more than eight straight years (Deane and Pringle, 217). So why allow the members of the Fed to hold onto their position for so long? In fact these long terms can make the members succumb to the temptation of corruption and bureaucracy. I recommend term duration of maximum ten years. Why? Simply because it is long enough for the Fed to be unaffected by a President's two terms in office, but not long enough for the members to resort to corruption.

Now another question is, how frequently should the Fed update the government of its workings and its future plans and goals? Currently the chairman is required by law to present biannual reports to the Senate (Deane and Pringle, 228). Yet the "Games the Fed plays" are no military secrets and often the Fed uses clever tactics to convince the legislators that it is making the correct decisions and plans (Mishkin, 385). These meetings are an utter waste of time and prevent the chairman from concentrating on issues of real importance. Consequently, it should not be required by law for the chairman to report to the Senate twice a year. However, as a sign of consideration, the chairman may pay the Senators a visit once a year or two, if not to prove economic facts, at least to show that the Fed is still a part of the government.

Moreover, currently only the President has the power to nominate persons to the Board of Governors (Mishkin, 373). This power should be extended to all the members of the Board of Governors, the FOMC, and the presidents of the Federal Reserve Banks. Although it may seem at first that because of this, the Fed might end up as a closed entity, with its own little government within itself, but that will not be the case. By giving everyone the power to nominate members of the Board of Governors, the Senate has a wider selection to choose from, thus ensuring that the most efficient and responsible persons will be elected to the Board, and not just the few whom the President happens to know.

And yet, these are but small legislative amendments that will not affect the economy as a whole in the long term. What will affect the economy is more participation of the Fed in other financial decisions in the country. I propose the Fed to have supervisory, if not active, involvement in the workings of financial branches of the government like IRS and the Treasury. Rather than the government giving the Fed the recommendations that it has to abide by, the Fed should recommend the Treasury and IRS on the maximum and minimum limits that they should work within, in order to maintain a stable money supply.

I agree that this seems a very ambitious proposal, the benefits of which are not evident at the first. So let us take the example of a recent topic, "The Bush Tax cut," to make this clear. Bush came to power with the promise to reduce taxes. The public would most definitely welcome a $1.6 trillion tax cut spread over the next decade. But how would the markets react? Presumably, Greenspan would know better about this than Bush, yet in his testimony before the Senate on 25 Jan. 2001, Greenspan merely remarked that "the surpluses be lowered by tax reductions than by spending increases," and stayed away from discussing the matter in length (Greenspan, "Testimony").

Whether the tax cut is beneficial or detrimental is not important. But what is important is that the Fed chairman, despite knowing the ins-and-outs of the financial world, did not get a chance to tell the government if they were right or not. It is not supposed to be the Fed's job to put in its two cents in any financial matters other than money.

The Fed must be given importance and powers in this regard, for the economy will only prosper or at least maintain stability, when the decisions made by one branch of the government do not end up negatively affecting the other. If the government gives tax cuts, it means less income for the government, and more incentives to pressure the Fed into printing more money, which would result in inflation. Evidently the tax cuts don't seem to matter much in the long run. I propose that the Fed must have the power to at least recommend, if not require, the government to stay within certain boundaries, when it comes to earning and spending.

Of course, the Fed has no job determining the income or sales tax rates, but twenty-five thousand economists working for the Fed will definitely be able to predict and judge the overall impact of a $1.6 trillion tax cut better than a handful of pseudo-economists in Bush's presidential campaign. Thus we can say that the Fed, though in its present state is highly autonomous, needs a stricter eligibility criteria, shorter terms, a little more freedom from the government with respect to biannual reports, and most importantly, more power in front of the government in financial matters.

Works cited

• Blinder, Alan S. "Central banking in a democracy." Economic Quarterly - Federal Reserve Bank of Richmond Fall 1996: 1-14.
• Caprio, Gerard Jr. and Ross Levine. "Payment Systems in 'Reforming Finance in Transitional Socialist Economies.'" The World Bank Research Observer. Washington: Jan. 1994.
• De Kock, M. H. Central Banking. 4th ed. New York: St. Martin's Press, 1973.
• Deane, Marjorie and Robert Pringle. The Central Banks. New York: Viking Penguin 1994.
• Forbes, Malcolm S. Jr. "Greenspan's quandary." Forbes Jan. 1994: 25.
• Fox, Justin. "Did he blow it?" Fortune. New York: Apr 2001: 26.
• Greenspan, Alan. "Testimony: Outlook for the federal budget and implications for fiscal policy." The Federal Reserve Board. 25 Jan. 2001. http://www.federalreserve.gov/boarddocs/testimony/2001/20010125/
• Holtfrerich, Carl, Jaime Reis, and Gianni Toniolo. The Emergence of Modern Central Banking from 1918 to the Present. Vermont: 1999.
• Jackson, Andrew. "Veto Message." July 10, 1832.
• Lippi, Francesco. Central Bank Independence, Targets and Credibility. Massachusetts: 1999.
• Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 6th ed. Boston: Addison-Wesley, 2000.
• Shull, Bernard. "Federal Reserve independence: What kind and how much?" Journal of Post Keynesian Economics. Armonk: Win 1995-1996.
• Welsh, Tricia. "CEOs: Greenspan by a landslide." Fortune. New York: Mar 1996: 43.

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