The Fed appears to be on its way to get some long-overdue payback. In response to the extraordinary, extra-legislative measures taken to rescue financial institutions in the wake of the financial crisis, which former IMF chief economist Simon Johnson called a “quiet coup,” Senator Ron Paul and Representative Alan Grayson sponsored an “Audit the Fed” bill, which was pared back to a Dodd-Frank amendment that provided for a one-time audit of the central bank’s emergency lending programs.
The Hill reported today that Republicans in the Senate and House intend yet again to push for the passage of an “Audit the Fed” bill. With their control of both houses, past support by some Democrats, and Trump no fan of the central bank, the measure is likely to become law.
One of the tired rejoinders of Fed defenders is that the central bank is already audited. And in fairness, the choice of the “Audit the Fed” monicker may not have been the best. However, the Fed is currently exempt from GAO audit for its monetary policy decision-making, transactions with foreign entities, and transactions directed by the Federal Open Market Committee. The idea that monetary policy sausage-making could be examined and second-guessed is what has the Fed and its allied up in arms.
The sorry fact is that the Fed has for far too long been able to shield its operations from democratic oversight and accountability by claiming it need to be independent. That is code for “democracies like to spend too freely and create too much inflation.” And the tacit assumption is that economic mandarins, in the form of central bankers, therefore need to be shielded from public pressure.
But this tidy story neglects the fact that central bankers are already subject to political influence, that from the banks for whom they act as a bankers’ bank. Ironically, it was a member of the central banking club, Willem Buiter, who had the bad taste to call out the Fed for being a victim of “cognitive regulatory capture,” meaning intellectually hostage to the banks it nominally supervised.
And the Fed’s claim to be independent has been a joke for decades. As we wrote in a 2008 post, citing the work of former Fed economist Richard Alford, the days of a combative relationship between the Fed and Congress are ancient history. Greenspan compromised the Fed’s vaunted independence and Bernanke continued in that vein, for instance, by weighing in on budget fights. From our archives:
Few have any memory of America’s central bank having a openly contentious relationship with the Treasury and Congress. Even though Paul Volcker had to withstand considerable pressure, some of his predecessors fought open turf wars. Yet from the end of World War II to the (sadly) supine Arthur Burns era, there were not infrequent pitched battles with the Fed with incidents that would seem unthinkable now. For example, Truman summoned the FOMC to pressure them into a more accommodative policy during the Korean War, then issued a White House press release claiming the Fed had made a commitment that it had not agreed to. The Fed played hardball, leaking its version of the meeting, which contradicted the press release. That led Congress to join the fray, trying to bring the Fed to heel via sharply critical hearings….
Since the first Latin American debt crisis, we have had a Fed that has been eager to lean against financial headwinds, but completely unwilling to take in sail when dealing with strong financial tail winds. The Fed did not the lean against either the NASDAQ or housing bubbles. Greenspan acknowledged that the NASDAQ might be a bubble, but decided it was appropriate to wait until the bubble popped and then mop up. Post 2000, the Fed denied the existence of a housing bubble. It ignored the declining credit standards, increased leverage, declining quality spreads and a Fed funds target below that implied by the Taylor Rule. The Fed then chose to characterize the bubble as localized froth even after it started to deflate. It then asserted that it was a contained sub-prime problem.
We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted.
Assuming for the moment that the Fed either made an error of commission (spiking the punch bowl) or omission (failure to exercise its regulatory and supervisory powers), is there any reason to believe it was the result of an erosion of the independence of the Fed? Unfortunately, the public record suggests that Fed independence has been compromised. There is reason to believe that Greenspan entered into deals with two of the three administrations during his tenure as Chairman. Some commentators believe that he entered into deals with all three. However, the number is unimportant. What is important is that the Fed’s independence was compromised and a very public precedent was set. Never again will an FOMC Chairman be able to say “The Fed does not make deals” to a President or a Secretary of the Treasury or a member of Congress.
Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.
Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.
Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.
Back to the current post. If you need further proof of the politicization of the Fed, look at how the central bank decided right on the heels of the Trump win that it would shoot for three interest rate increases in 2017. Do they really believe that Trump will start making America great again right out of the box? His infrastructure plan is designed not to rely on fiscal expenditures. Experts expect any stimulus it provides to come after 2017 and the total infrastructure investment to come in short of its targets. Tax cuts focused on the rich don’t provide much of a boost, and that’s before you get to the fact that tax policy watchers expect the deficit hawks to prevail, which means the level of tax reduction will be trimmed considerably (with Federal spending at 18% of GDP, there’s not much trimming to be had on the expenditure side). And if Trump gets his way on tariffs, that could conceivably produce greater employment and growth down the road. However, there would almost certainly be transition costs, most importantly immediate higher import costs.
So the Fed is finally going to reap what it has sown. Couldn’t happen to a nicer bunch.