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Independence of the Fed - Research Proposal

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

Independence of the Fed - Research Proposal

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. It is only after weighing both sides of the argument that we can determine the degree of freedom that the Fed should enjoy.

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, it has 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 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, p.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, p.36). Though still a major player in the global banking arena, it is a mere speckle when compared to the Federal Reserve of US.

Incidentally, 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, p.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.

Brief 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, as well as every 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). All the prevalent monetary systems failed the test of time and there was an urgent need for a strong 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, avert and rescue the economy from sudden crises and panics, and encourage employment and 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.

But of all these, the most important function is to maintain low inflation, or "price stability" as it more popularly called in a misuse of language (Deane and Pringle, p.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. In an extensive literature review, we shall discuss what the benefits of an independent Fed are, how independence might be misused, and what conclusion can be derived from these benefits and harms. This would enable us to answer our question regarding the degree of independence that should be granted to the Fed.

Firstly, we shall discuss how freedom from the government allows the Fed to have a smooth monetary policy, how it can make immediate decisions to avert and address economic crises, and how it can make sound long term decisions, without fretting over short term situations. Moreover, we will have an insight into how a free Fed can stop the government from using it as a piggy bank to finance their unnecessary projects and how despite political turmoil, the nation's currency can remain stable, if the monetary policy is sound and Fed acts promptly.

The second part shall highlight the possible detriments of a totalitarian Fed. How an incorrect decision by the Fed might result in an economic turbulence and how the segregation between the fiscal and monetary policies is unhealthy for the economy. We shall also provide an answer to why should not other agencies like Internal Revenue System and Chief of Staff enjoy the same privileges as the Fed when all of them are involved in important long term decision making. While commenting on the side effects of an all-powerful Fed, we shall review how these might actually be far-fetched and highly improbable, though not entirely impossible.

Once we have outlined both the sides of the argument, we shall attempt to arrive at the conclusion, while making sure that it is practically possible that is, not entirely theoretical. Based on the evidence available till date, the conclusion shall most probably be in favor of higher independence for the Fed, though not absolute freedom.

Some possible sources that might lead us to our conclusion are as follows:
1. Articles published in the regional, financial, and economic reviews and quarterlies of the Federal Reserve Banks.
2. Wall Street Journal, The Economist, and Barron's.
3. Clifford, Albert Jerome, The Independence of the Federal Reserve System.
4. Further reading of the sources already referenced in the text above and attached along with.

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. Forbes Jan. 1994: 25.
• Holtfrerich, Carl, Jaime Reis, and Gianni Toniolo. The Emergence of Modern Central Banking from 1918 to the Present. Vermont: 1999.
• Lippi, Francesco. Central Bank Independence, Targets and Credibility. Massachusetts: 1999.
• Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 6th ed. 2000.

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