Mark Gertler says the Fed's independence should not be compromised:
Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve’s intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank’s independence.
Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.
Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.
The Fed’s role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...
Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.
The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.
A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.
The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.
We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.
Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:
Probably the single most damaging failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way). ...
But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...
Only the Fed can fulfill the macro-prudential regulator-supervisor role. That is because it has the short-term deep pockets. It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money. Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support. It would be ... toothless...
He also makes this point:
The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential. The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause. ...
If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution. Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.
Okay. As much as possible, monetary policy should be kept out of the hands of politicians.
This article has been republished from Mark Thoma's blog, Economist's View.