Wednesday, July 22, 2009

Anti-Federal Reserve Sentiment On The Rise

No one is immune from blame for the financial crisis, including the Federal Reserve, which is facing renewed anti-fed sentiment. This has reintroduced the debate on whether the role of the Federal Reserve should be part of the reform of the financial system. Mark Thoma from Economist's View discusses this issue in the following post.

Continuing the recent discussion here and elsewhere on Fed independence, this is not the first time audits and other threats to independence have been seriously considered:
On the mend, The Economist: It has been a long time since comments on the economy by an official of America’s Federal Reserve comments could be described as cheerful. Yet there was no denying the upbeat tone of Ben Bernanke’s testimony to Congress on Tuesday... His fingers may be crossed but it is clear that Mr. Bernanke thinks the recession, if not over now, soon will be.

That is a far cry, though, from seeing a threat from inflation and Mr. Bernanke made it clear that the federal funds target rate, now near zero, will remain there for a long time. On Wall Street, most reckon that means until well into 2010 at least.

Yet the Fed is already under pressure to explain how it intends to tighten monetary policy, even by congressmen who usually want nothing of the sort. ... Whether inflation [occurs] depends on if the Fed raises interest rates in time and thereby curbs the appetite for credit. Mr. Bernanke spent much of his testimony explaining how he can do just that. ...

Politics could ... interfere with the Fed’s willingness to tighten monetary policy in time. Congress’s nonpartisan investigative arm, the Government Accountability Office, can now audit the Fed with the exception of its monetary policy, lending programs or relations with foreign central banks. A bill in Congress would lift those prohibitions. Mr. Bernanke argued that the threat of such audits would lead investors to question the Fed’s willingness to do unpopular things, like tighten monetary policy, unsettling them and driving up long-term interest rates.

This is not idle speculation. Anti-Fed sentiment was also strong in the 1970s, when Congress first sought to have the GAO audit the central bank. Arthur Burns, chairman at the time, fought back, and a compromise was struck to allow audits, but with the current prohibitions. Mr. Burns later reflected that the effort of “warding off legislation that could destroy any hope of ending inflation” involved “political judgments” that may have weakened his anti-inflationary resolve.

For all the discussion, any tightening of policy is a long way off. ...

I think one of the problems that people are trying to get at when they want to take away the Fed's independence is the concentration of power within the Board of Governors (the view by some that the Board represents special rather than public interests, e.g. Wall street, also plays a role), and they see devices such as audits from the GAO as a check on that concentration of power. Here's an edited version of part of an old post:

While the Fed was initially structured to balance competing interests and to share power, the system has evolved into an institution with centralized rather than shared power. The intent to share power and balance competing interests is evident in the structure of the Federal Reserve system. For example, individual district banks are overseen by a board of nine part-time directors. These directors come in three types. Three of the nine are type A and are bankers, and three are type B and represent the business community. Legislation prohibits type B board members from being bankers. In a further attempt to make the process representative, type A and type B directors representing banking and business interests are elected by member banks within each of the twelve Federal Reserve districts. Type C directors are appointed by the Board of governors and are intended to represent the public interest within the district banks.

Thus, the districts themselves provide geographic representation that is population based, while control of the district banks balances public, banking, and business interests. Initially, the district banks functioned as twelve cooperating banks and each district had considerable control of monetary conditions within the district. It was very much a shared power arrangement. As one example of the power district banks had, each bank had full control of the discount rate for its district (the discount rate was the only tool available for controlling the money supply when the Fed was formed, open-market operations were not well understood until later and there was no provision for the Federal Reserve system to control reserve requirements, another way to affect the money supply).

The shared power arrangement within the Federal Reserve system changed after the Great Depression when monetary authorities failed to respond adequately to crisis condition. The problem, or so it seemed, was the shared power nature of the system. The deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances, it was mostly equipped to deal with problems at individual banks (the discount window is well-suited to help individual banks, but not system wide disruptions; on the other hand, open-market operations can inject reserves system-wide and hence is a better tool for systemic problems).

The solution to this was to concentrate power into the hands of the central bank so that should a crisis occur, they can act quickly. There are risks, of course, to concentrating power so narrowly, but in the aftermath of the Depression we were quite willing to take that risk if it helped to avoid another catastrophic outcome (as it may well have done).

Thus, after the Great Depression power was concentrated. For example, banks no longer control the discount rate in their districts. They can propose a change in the discount rate at an FOMC meeting, but the Board of Governors must approve the rate and they will only approve one rate, the rate they decide. So while the rates are still formally set in the districts, they are essentially set by the Board of Governors. When all such changes in the concentration of power over time from the districts to the Central Bank in Washington D.C. are considered, it becomes very clear that the Fed has evolved from a very democratic, shared power arrangement at its inception to one where it functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.


I am not at all in favor of lessening the degree of independence that the Fed currently has, but I do think we need to make changes in the way the President and Boards of the district banks are chosen. As it stands, the Board of Governors in Washington has considerable influence over who is appointed to key positions such as the President of the district banks, and those Presidents represent five of the twelve votes at the meetings where monetary policy is set. More independence of the district bank Presidents and other district bank personnel from the Board of Governors would be a healthy change (there is also a question of whether geographic representation through district banks is the best way to capture the public interest, but I'll leave that aside for now).

This article was republished from Mark Thoma's blog, Economist's View.

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