Willem Buiter on the Fed’s Limited Independence

I hope you don’t think this blog is in danger of becoming the “all Fed, all the time” channel, but this is an otherwise slow news period and central bankers are very much in the spotlight.

Willem Buiter has a long post on his blog which discusses the Fed’s limited independence compared to other central bankers. I’ve excerpted his remarks on that topic. His other thoughts, such as how a central banker acting as a market marker of the last resort (a policy suggestion of his) would discover prices for illiquid paper, are wonky but worthwhile as well.

A front page story in today’s Wall Street Journal, “Investors Default On Outsize Share Of Home Loans,” confirms Buiter’s view:

The darkening outlook for the housing sector has prompted economists at Goldman Sachs Group to predict that home prices nationwide will fall an average of about 7% both this year and next. Alarmed by such prospects, a group of top executives from home-building and supply companies are scheduled to meet next Wednesday with Federal Reserve Chairman Ben Bernanke to argue for Fed actions to support the housing industry.

The housing industry is not the Fed’s job. And even if it were, it’s not clear Bernanke could solve the underlying problem: the level of home ownership has risen to an unsustainable high. Some people who now own will become renters again because they never should have bought a home in the first place. That is an ugly reality (or is it? Some analysts have found that home ownership tend to lower rather than increase income by reducing labor mobility).

Importantly (and I’ve put that section in bold for reader convenience) Buiter thinks that that the idea that we need what he calls “techfin” is rubbish. If these complicated new instruments were to go belly up, the only losers would be the parties that had a direct stake in them, not commerce as a whole.

From Buiter:

Flanked by Christopher Dodd, Chairman of the US Senate’s Banking Committee (and also a candidate for the Democratic nomination for the US Presidency) and by Hank Paulson, US Treasury Secretary, Ben Bernanke looked more like a Taliban hostage than an independent central banker at his August 21 meeting in Dodd’s office. The letter from Bernanke to Senator Charles Schumer, circulated around Washington DC on Wednesday August 29, 2007, in which the Governor of the Federal Reserve offered reassurances that the Federal Reserve was “closely monitoring developments” in financial markets, and was “prepared to act” if required, reinforces the sense of a Fed leant upon and even pushed around by the forces of populism and special interest representation.

This is not a new phenomenon. With the explosion of operationally independent central banks since the New Zealand experiment of 1989, the US has become one of the least operationally independent of the central banks in the industrial world. Only the Bank of Japan is, I believe, even more readily influenced by political pressures from the Executive or from Parliament. Also, what operational independence the Fed has, is of relative recent origin. From 1942 until the Treasury-Federal Reserve Accord of 1951 released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and made possible the independent conduct of monetary policy, US monetary policy was made in the Treasury. For those 9 years, the Taylor rule was: i = 2%.

Even after the Accord, the fact that the Fed is a creature of Congress, and can be abolished or effectively amended out of existence with simple majorities in both Houses, has acted as a significant constraint on what the Fed can do and say. The strong populist, anti-banking currents in American politics in general, and in the Congress in particular, mean that the threat that what limited operational independence there is could be taken away is not perceived as an idle one by any Fed governor.

To illustrate the difference between the degree of operational independence of the Fed and the ECB, consider the inflation target. The ECB has price stability as its primary target. Without prejudice to price stability, it can pursue all things bright and beautiful, and is indeed mandated to do so. All this is in the Treaty. There is, however, no quantitative, numerical inflation target in the Treaty. Nor does the Treaty spell out which institution should set such at target, if there were to be one. So the ECB just went ahead and declared that an annual inflation rate of just below but close to 2 percent per annum on the CPI index, would be compatible with price stability. Neither the European Parliament, nor the Council of Ministers were consulted.

The Federal Reserve Act has stable prices as one of the three goals of monetary policy. The other two are maximum employment and moderate long-term interest rates. There is no quantitative or numerical definition of any of the three targets in the Act. Could the Fed do what the ECB did, and specify a numerical inflation target? Most certainly not. Congress would not stand for it.

Politically, the job of Chairman of the Fed is therefore much more difficult than that of the ECB or even the Bank of England. Strong Chairmen, like Paul Volcker and Ben Bernanke, manage to create a larger choice set for the Fed than a weak Chairman like Alan Greenspan, but even the most independent-minded and strong-willed Fed Chairman is much more subject to political influences and constraints than the President of the ECB or the Governor of the Bank of England.

Both populism and special interest representation are key driving forces in the US Congress. Preventing large numbers of foreclosures on madcap home mortgages taken out especially since 2003, unites the forces of populism and special interest representation, although they tend to part company when it comes to who will pay the bill for the bail-out.

Both the Congress and the Executive branch of government lobby mightily for Fed actions aimed at preventing or at least limiting the losses on highly leveraged bets taken by hedge funds, private equity funds and a large number and variety of other financial institutions and special purpose vehicles – ‘conduits’, ‘structured investment vehicles’; the names vary but the economic essence of highly leveraged open positions is the same. Appeals to safeguard systemic financial stability often obscure the obvious truth. The special interests that would benefit most directly from such actions as a cut in the Federal Funds rate – highly leveraged Wall Street firms and tycoons caught on the wrong end of the increase in credit risk spreads and the disappearance of liquid markets for structured products and other contingent claims –claims that had often been touted as the ‘techfin’ solution to the illiquidity of traditional forms of credit such as secured (mortgages) and unsecured (credit card debt) – rarely play a systemically indispensable role in the intermediation of saving into investment or in the efficient management of financial wealth. Were they to go bust and disappear, they would be missed only by their shareholders and other stakeholders, and those who had lent money to them. If these shareholders and creditors are systemically significant, one assumes that the prudential regulatory regimes they are subject to would have ensured sufficient portfolio diversification for them to be able to absorb the losses caused by the insolvency of a number of highly leveraged funds/institutions

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  1. zcs_shoemaker

    I am no chicken little nor a Paul Revere, however I still since danger here. I understand the Mr. Ben is a smart and strong willed man, but I still sense that overwhelming politicians and lobbyist could sway Americans into a quick fix of easy money(cut rates). I am not an economist but I do study up on the times. It looks like we are dooming ourselves one quick cheap dollar at a time.

  2. Anonymous

    Thanks for the post. Buiter’s comments are very interesting. It’s not the main point of his essay…but I like how he is categorizing Bernanke as a “strong” Fed chairman (already!)

    I agree.

    Bernanke’s “helicopter Ben” moniker is undeserved & much of the criticism directed his way so far has been based on the unfounded premise that he is following Greenspan’s playbook.

    Recent events hint against that (if not disprove it). When he relaxed the Discount rate rather than the Fed Funds rate, the market celebrated the sweet relief without realizing that there was some bitter medicine in that spoonful.

    Bernanke also seems to be playing the politcos quite nicely – not making any concrete promises, but not being blunt enough that they realize that he’s not exactly playing along…


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