“Summer” Rerun: Should the Fed Be Independent?

This post first appeared on June 6, 2008

An article in today’s Wall Street Journal, “Insider Joins Critics of the Fed, Faulting Credit-Crisis Programs,” discusses at some length a recent speech by Richmond Fed president Jeffrey Lacker in which he took issue with some of the Fed’s recent financial services industry rescue efforts. The article itself failed to do justice to his speech, which was more nuanced than the usual “bailing out banks creates moral hazard” argument.

In fact, as we’ll discuss, the expanded charter of the Fed calls into question the appropriateness of its independence. It is increasingly making resource allocation decisions which are political in nature and should arguably be debated and determined in that realm.

In his London speech, Lacker defined two types of bank runs: non-fundamental, when the institution is sound but hit by a liquidity crisis, versus a fundamental run, where depositors and creditors wanted out because they know someone would wind up holding the bag. In the latter case, speed of exit is a virtue, since the laggards are the ones who run the risk of not recovering their assets.

The problem with central bank intervention is two-fold. It may not always be possible to parse out whether a crisis is fundamental or non-fundamental in nature. However, when a crisis is fundamental (or as we like to say here, a solvency rather than a liquidity crisis), Fed assistance distorts relative asset prices and delays the relevant markets finding clearing prices. As Lacker stated:

The ideal central bank lending policy would require making clear distinctions between different possible sources of bank or financial distress. If an episode of financial disruption is a true liquidity crisis, like a non-fundamental run on the banking system, then aggressive central bank lending can, in theory, stem the crisis and prevent unnecessary insolvencies that impose real losses on the economy. Lending when in fact the financial sector is just coping with deteriorating fundamentals, however, distorts economic allocations by artificially supporting the prices of some assets and the liabilities of some market participants. Moreover, it is likely to affect the perceptions of market participants regarding future intervention, and thus alter their incentives and future choices.

But Lacker made a second set of observations, which the Journal breezed by: the existence of a central bank safety net leads banks to neglect cheap risk reduction measures they could take on their own.

For instance, the big reason that bank runs happen is that depositors go to yank all their funds out at once, when those institutions are set up to handle only a comparatively small proportion of those holdings being withdrawn on any day. But most customers don’t need that much liquidity on a daily basis and can be given incentives to sacrifice such quick trigger access. As Lacker points out:

The intuition behind the classic bank run story is that banks are susceptible to runs because depositors are free, at any time, to claim all of their money on demand. This is a contractual choice, and one that makes some sense given depositors’ demand for short duration, liquid savings instruments. But if a bank can restrict its depositors’ ability to demand their funds on the spot in certain circumstances – in the event of heavy demands for withdrawals, for example – then the bank will be less susceptible to a run. And there is ample precedent for deposit contracts with such characteristics. In 19th century U.S. banking panics, banks preserved their liquidity, individually, by suspending the convertibility of their deposits into currency. They also had recourse to collective actions through the issuance of loan certificates by clearinghouses in the major cities, which allowed the clearinghouse members to meet their interbank obligations and customers to make interbank transfers without drawing on banks’ scarce supplies of currency.

While Lacker’s candor is refreshing, he has not teased out the full implications of his observations. Supporting the prices of some assets has the effect of enriching certain interests at the expense of others. Similarly, shifting risk from individual banks onto the central bank is believed to be worthwhile because any collective costs are assumed to be lower than that of a financial crisis. But the degree of risk transfer we’ve seen in the last year, which seems close to a “heads I win, tails you lose” game for the financiers, again raises question of fairness and resource allocation.

Axel Leijonhufvud, in a Centre for Economic Policy Research paper “Keynes and the Crisis,” (hat tip Richard Alford) does a first-rate job of analyzing what the credit market upheaval has revealed about the limitations of various economic models and institutional arrangement. In particular, he found that it called into question the central premise of modern central banking, including central bank independence (emphasis his):

There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned that doctrine.

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.5 Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measure by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is ‘right’. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

A second tenet of the doctrine was central bank independence. Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.

Transparency of central banking was a minor lemma of the doctrine. If monetary policy is a purely technical matter, it does not hurt to have the public listen in on what the technicians are talking about doing. On the contrary, it will be a benefit all around since it allows the private sector to form more accurate expectations and to plan ahead more efficiently. But if the decisions to be taken are inherently political in the sense of having inescapable redistributive consequences, having the public listen in on all deliberations may make it all but impossible to make decisions in a timely manner.

When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

Consider as examples two columns that have appeared in the Wall Street Journal in recent weeks. One, by John Makin (April 14), argued that leaving house prices to find their own level in the present situation would lead to a disastrous depression. Policy, therefore, should be to inflate so as to stabilise them somewhere near present levels. If the Fed were to succeed in this, it might not find it easy to regain control of the inflation once it had gotten underway, particularly since some of the support of the dollar by other countries would surely be withdrawn. But in any case, the distributive consequences of Makin’s proposal are obvious to all who (like myself) are on more or less fixed pensions. The other column, by Martin Feldstein (April 15), argues that the Fed had already gone too far in lowering interest rates and is courting inflation. He wasin favour of the Fed’s attempts to unfreeze the blocked markets and restore liquidity by the unorthodox means that Volcker had mentioned.

The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have. To the extent that this can be determined or at least influenced by policy the choices that will have to be made are obviously not of the sort to be left to unelected technicians.

There has been a great deal of hostility towards the Fed, as witness by comments here and on other blogs, and by the existence of sites such as “Bernanke Panky News.” A lot of that is Greenspan backlash. Having become too willing to take credit for general economic prosperity (and having taken too much interest in the performance of the stock market, something no previous Fed chair gave a fig about), he became the focus of anger over the credit crisis. While the Fed bears significant responsibility, messes this big have many parents.

But there has been another thread mixed in with this: resentment at the Fed salvaging the banking industry, with contingent and real costs, in the form of higher inflation, per Alford’s and Leijonhufvud’s analysis. Now that many of those actions may indeed have been the best among a set of bad choices (although I suspect economic historians will conclude the Fed cut rates too far too fast). However, the big issue is that they involved consequences of such magnitude that they should not have been left to the Fed. I was amazed, and was not alone, when Congress did not dress down the Fed in its hearings on the Bear rescue for the central bank’s unauthorized encroachment into fiscal action (ie., if any of the $29 billion in liabilities assumed by the Fed in that rescue comes a cropper, the cost comes from the public purse). So the frustration isn’t merely about outcomes, it’s about process, about the sense of disenfranchisement. And that will only get worse as this crisis grinds along.

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  1. john bougearel

    Silly me, sneaking a peak at Yves blog on Christmas morning when not even a creature is stirring….

    Wonderfully prescient article, and more prescient concluding statement: “So the frustration isn’t merely about outcomes, it’s about process, about the sense of disenfranchisement. And that will only get worse as this crisis grinds along.”

    It’s two years later and still we are in the early innings of this process of disenfranchisement and transfer of both risk and wealth onto the the taxpayer….As old St Nick said:

    “Happy Christmas to all, and to all a good-night!”

  2. John Locke

    One puzzle from the last quarter of 2008:

    Why did LIBOR peak when it did?

    I think it was around mid-October 2008 …

    1. Cedric Regula

      The pat answer is Lehman went down 9/15/08. The Fed screwed up and didn’t bail them out. The Fed said they coudn’t legally bail them out, and that why the Fed needs Resolution Authority. Frankendodd gave it to them so now we have perfected Moral Hazard.

      Next I’ll try it without seeking Richard Bove’s editorial blessings.

      It was what some call “a wholesale run on banks”. Banks began distrusting counterparties (other banks) and this fear was probably intensified by Lehman and the sudden realization that the industry could be doing a lot of crazy stuff they may actally suffer the consequences.

      But then Ben did do all his special lending programs, currency swaps with other central banks, the FDIC guaranteed money market funds (we found out that we are lending money to 30:1 leveraged hedge funds at money market rates), and by November rates were way lower than they ever were.

  3. Railcar of Borrowers

    Banksters “get off” on QE2, and the Bernanke is fucking with investors minds – at least that’s how I am reading redneck Kevin Hall of McCrusty Inc. But then Hall says this “inflation, or a rise of prices across the economy, can happen only in an environment of economic growth. ” If I remember World History from Kollege, Hyperinflation allowed the Nazis to seize the Vaterland, foreclosing on any democratic pretense, and firing up the wermacht to level 11. I guess things aren’t so right wing these days in the Homeland for this type of thing to happen.

  4. Mickey Marzick in Akron, Ohio

    “Political independence” of the Fed never really meant what it implies on the surface but rather independence from the public interests intimated in this article. So long as the Fed has been insulated from such interests it was deemed sufficiently independent – by bankers!

    Hence the most recent round of Fed intervention is precisely the kind of independence that is meant: protection of banking interests which, if coincident with the “public interest”, so much the better. And to the extent that “finance” has become central to the functioning of the global economy, the Fed can plausibly claim that it acted in the public’s interest by preventing the collapse of the financial system notwithstanding the fact that in doing so some interests were favored over others.

    Clearly the public has taken a bath in this one but if the Fed had acted differently would the bath have been worse? Isn’t that really what is at issue and at the core meaning of political independence today?

    Given that most pension funds had been sliced, diced, and tranched several times over, if the financial system had collapsed would pensioners have received any monies while it was determined who actually was legally required to pay these pensions and with what? Suddenly finding out that the monthly check wasn’t forthcoming for millions pending litigation to determine the latter would have immediate consequences – social, economic, and POLITICAL. Meanwhile, hope your savings last…

    If the determination of “ownership” in the current housing/foreclosure mess decribed in great detail on NC is any indication and just the tip of the iceberg encompassing every financial instrument/obligation imaginable, how long would it have taken to sort this out and then restore it to some semblance of functionality if the Fed had taken a honads off approach [political independence?] and allowed the finanical system to collapse? Is this the kind of “political independence” we’re talking about? There clearly would have been winners and losers in this scenario as well.

    In some ways we want it both ways.

    One possiblity to ensure that the “public interest” is taken into account would be to have that interest specifically delineated with VOTING consumer representation on the Board of Governors of the Fed mandated by law. [CODETERMINATION?] Most, if not all, of the Board of Governors are drawn from the ranks of the finance/banking sectors where they have worked professionally most of their adult lives. That this suggests a certain insularity goes without saying despite criticism of Fed policy by members from time to time.

    Representatives of consumer interests would have to possess sufficient expertise both to maintain credibility and be able to challenge other members of the BOG. And to pretend that they would not be subjest to “capture” is naive. Congressional oversight of the Fed isn’t feasible given its track record and the issues involved. Perhaps such reps could come from the NGO watchdog groups subject to Congressional approval after nomination by the President. Would such representation even accomplish what is intended?This needs more thought and I apologize in advance for its shortcomings. It is Christmas… that I’m even doing this suggests I need to get a life – at least more egg nog!

    But one thing is certain it would politicize the Fed in a way contrary to what is currently meant by “political independence”. That’s why it has about as much chance of happening as that proverbial snowball in hell and I’m not holding my breath. Santa has already come and gone this year… Ho! Ho! Ho!

  5. Cedric Regula

    I’m also getting worried Ben didn’t learn some of the things Al knew.

    In Ben’s last 60 Minutes performance he mentioned that the Fed can raise interest rates in 15 seconds and it’s therefor silly to worry over inflation. He was obviously proud of his new policy tool invention..paying interest on reserves.

    Putting aside the fact that the Fed’s long term portfolio needs to generate enough yield to make cash available for the Fed to pay interest (yes, I know they have a electronic printing press, but Ben just denied that too), raising interest rates fast and furiously is a problem as well.

    Greenspan tried it in 1994. Orange County promptly blew up, and back then we were told that our comptroller was too dumb to do his derivatives correctly. Now many smart people tell us maybe everyone is too dumb, or crooked, to do their derivatives correctly.

    Not so coincidentally, I think, Mexico blew up. Higher interest rates and the beginning of a strong US economy supported a lot of dollar strength, and much government debt and biz debt around the world is dollar denominated. Much biz debt is variable rate, or at least shorter term. I think this also was a contributing factor to the fall of the overleveraged Asian Tigers.

    Course it’s all hedged with interest rate futures, isn’t it?
    We will probably find out later who the losing counter party is there.

    So now we threw a bunch of Residential ARMs into the mix, lots of CMBS coming due for rollover, Zombie Banks suckling themselves back to health on the treasury carry trade and will see capital marked down by 20%-40% as soon as Mighty Ben makes his move, and a derivousphere that grew to 5 or 10 times global GDP. No forcast for a 1990s economy either.

    Methinks it takes Ben longer than 15 seconds to raise interest rates.

  6. Thomas McGovern

    The Fed does not need to be made independent, it needs to be made non-existent. The bubbles of the past twenty five years, e.g., dot-com, commodities, real estate, were caused by credit being mispriced by the Fed. The Federal Reserve banks are owned by the commercial banks in each district. The New York Fed is owned by Citi, JPMorgan, BoNY, Goldman, etc. Who do you think the NY Fed serves?

  7. 60sradical

    Yup, I agree. The Fed “needs to be made non-existent”.
    The problem seems to be,IMO however,that most of the public does not understand the primary workings of this beast created, clandestinely, in 1910-1913. We cannot see the day-to-day inner workings of the Fed, but we can grasp “factional lending” and “fiat money” which both cause hidden inflation NO MATTER WHO IS CHAIRMAN OR WHAT THE POLITICS OF THE DAY ARE.
    Engoy your break YVES! You’ve earned ir!

  8. solo

    Insightful article, sound prognosis (stagflation) and a suitably understated thesis: The vaunted “independence” of the Fed ab initio has been naught but PR for the hoi polloi. The Fed has always been “political”–by, for and of the financial elite; aptly earning the nickname “fourth branch of government.” The only evolution of note, well manifested in the article, is the secular degeneration of the partisan nature of the Fed in tandem with the degeneration of corporate capitalism into oligopolistic swindling and bullying of the most obvious kind. You can bet that the situation will only worsen, even as the budding protofascist movement (Tea Party, etc.) thrives on the rot of a capitalist system that, historically, is characterized in times of acute crisis by both incitement of and collusion with the special discontents of the petite bourgeoisie.

  9. david

    The FED is not the only “Independent Agency of the Fedral Government.” FEMA and the new conservatorship for Fannie and Freddy FHFA are also. There is a whole government that is independent of the people’s government, but he people fund it.

    FHFA is designed to be under the control of the FED, but to be independent from courts and congress. They are collecting up the nations mortgages in fannie and freddy to pass them off to the FED as collateral in the coming sovereign default. Devious.

  10. joebhed

    Should the Fed (part fish – part foul) be independent of or from ……. what?? Accountability? Transparency ?

    Recalling, IF YOU WILL, SecTreas was Chair of Fed BOQRD and CompCur was vice-Chair by virtue of the ENABLING STATUTE.

    The real Fed solution has to do with the opposite of independence, and has been clearly and explicitly laid out in Congressman Dennis Kucinich’s landmark proposal titled the National Employment Emergency Defense(NEED) Act of 2010. It is available here:

    Perhaps more important than the purchase of Fed stock by Treasury and re-establishing the “Bureau” of the Fed within Treasury to carry out monetary policy is the fact that monetary policy becomes a matter of full public accountability rather than secrecy behind the facade of independence.

    That basic national monetary policy is spelled out in the act, creating circulating medium in sufficient quantity to achieve potential GDP without inflation nor deflation – promoting the stable buying power of the dollar.
    In other words, the Act proposes a system to actually perform the exact function of money in a national economy, according to the likes of Kitson, Soddy, Fisher, Simons, Graham and even Friedman.
    Dennis Kucinich’s contribution to the evolving discussion of the national money system is beyond measure at this critically important time – the we ignore its significance at our own peril.
    We are a nation, and a global economy, in NEED.

    1. Mickey Marzick in Akron, Ohio


      As I was reading through the provisions of the proposed NEED Act I was struck by its similarity to “A Program for Monetary Reform” [July 1939] reformatted/published by the Kettle Pond Institute. I recall your pointing us to this document more than once. Yes, I printed and read through it – more than once. Many thanks…

      While not outright “nationalization” of the private banking system, it would certainly put an end to fractional reserve banking – creation of “money” out of thin air. I want to reread it… before saying/doing more.

      If there is an “old left” Democrat in Congress Dennis “the Menace” Kucinich is it! I have met him, spoken with him on the campaign trail, and believe he is genuine – the real deal. I have voted for him in the Ohio presidential primaries every time. Perhaps the time for NEED has come… If anyone can publicize/galvanize/mobilize for an issue Dennis Kucinich can. He has always been an outspoken critic of corporate America, even back when he was Mayor of Cleveland he savaged SOHIO [Standard Oil of Ohio]before it was acquired by British Petroleum. He will fight tenaciously!

      Let’s hope NEED gets some traction/attention. Thanks again!

      1. joebhed


        First, yes the Kucinich NEED Act proposal is similar to the 1939 Program for Monetary Reform(Fisher, Graham), the 1934 Chicago Plan for Monetary Reform(Simons, Fisher) and also closer to Friedman’s Framework for Economic Stability than his Proposal for Monetary Reform.

        Actually I am against government involvement in banking once bankers are out of the money-creation business and we have a money system operating on the principle of ‘stable-buying-power’. The entire banking industry will substantially change as depositors(lenders) become the driving force of bank lending policies – because they’ll be working with real peoples’ real money.

        I agree about Kucinich’s record and his outstanding leadership efforts. In this case, he proves that he is one of a very few that actually understand the complexities of the national monetary system.

        NEEDed: National Monetary Commission II

        1. Paul Repstock

          Gentlemen: There is no way to get from “here” (fractional reserve lending and huge public and private debt), to “there” (real money and a healthy economy), without a devastating crash. Worse yet, this ‘crash’ will place the final remaining bits of private ownership into corporate hands.

          I don’t doubt it will happen; that is the ‘plan’! But, as soon as lending ratios begin to tighten, the banks will be forced (so sorry to have to call your note) to deny all credit (except credit cards) and to demand payment in full on all outstanding balances.

          1. joebhed

            You may very well be right.

            My Dad, a monetary reformer born of a solid conservative capitalist-businessman background, always told me there would only be ONE chance to truly reform the money system – that being whilst amidstream their designed transition from the national to the super-national(his word) debt-based money systems.

            But that one chance will come only when debt-saturation reaches the untenable and undeniable state of monetary insolvency. That is what you are calling the crash.

            Congressman Kucinich’s work can best achieve currency in the public debate between the restoration of monetary sovereignty to free nations or a global super-consolidation to financial stability behind a move to IMF-issued SDRs or whatever they choose to call them, just by being out there.
            Which, is THE significant event of the day.

            Again, what is needed to have this discussion is National Monetary Commission II. With BoE’s Governor Mervyn King openly and loudly calling for the elimination of fractional-reserve banking, that is, the private monopoly creation of national circulating media via debt-issuance, we are a decent ways to the comprehensive reforms of Kucinich’s NEED Act.
            Know thy enemy. And, be prepared.

          2. Ralph Musgrave

            Paul, I don’t see the problem in “getting from here to there.” First, there’d be no need to abolish fractional reserve overnight. Bank reserve ratios could GRADUALLY be altered. Second, the effect of full reserve is obviously deflationary OTHER THINGS BEING EQUAL. And if other things were left equal, the result would be the “crash” to which you refer.

            However, the above deflation is easily avoided by making up for the reduced amount of bank finance with equity finance. That is, the government / central bank just needs to create and feed extra monetary base into household and corporate pockets, as the freedom that private banks to lend is reduced. Put another way, Wall Street needs to cut down to size and Main Street given a boost.

  11. Gregg Schaaf

    Paul Repstock says: “as soon as lending ratios begin to tighten, the banks will be forced (so sorry to have to call your note) to deny all credit (except credit cards) and to demand payment in full on all outstanding balances.” There is the possibility that something which parallels this is what may happen with the “swap lines of credit” between central banks. The Federal Reserve which looks as if it has given away the keys to the U.S. Treasury to foreign entities may have set up the foreign entitites for a monstrous margin call. This may be part of the possibly unavoidable collapse. The “end game” would be interesting to watch if we weren’t all scrambling to stay warm when it unfolds.

    1. joebhed

      There are many ways for the insolvency to manifest itself.
      Perhaps another couple of Trillion to the international bankers will be all they need, a quick short-sell signal, and viola, a fell-swoop to global insolvency.

      I like to ask my friends at the Fed – who is working on the exit strategy?

      They usually smile and say ‘you are’.

  12. Paul Repstock

    Thanks for your repies. As a “Human person”, I can only pray that there remains enough integrity and common sense to permit us to avoid this Orwellian NWO. Nationalism, for all it’s warts has atleast afforded the competition to prevent the total collapse of humanity.

    The “supra national” state is undoubtably corporatist. Sadly we have, and continue to, abdicate authority in the pursuit of stability and security. If we wish the furtherance of Mankind as a dynamic species, we must conciously risk the tawdry security we enjoy in favor of a brighter future. Nothing ventured, nothing gained has never been truer.

    1. Paul Repstock

      A very personal definition of Humanity

      Humanity resides in a complex mix of individual franchise/choice and benevolent concern for other people. Any system which denies our rights to pursue and reconcile these freedoms is repressive. No system can ever be “all things to all people”, but those systems which are static and do not attempt resolution are by this definition also not Human systems.

  13. Ralph Musgrave

    I agree with joebhed that Kucinich’s proposals (which include abolishing fractional reserve) would go a long way towards a “real Fed solution” as joebhed puts it. But Joebhed didn’t spell out the reason. The reason is that the big fault in fractional reserve is the INSTABILITY it brings (as pointed out for example by Huerta de Soto). I.e. no fractional reserve means (at best) no credit crunches, so we wouldn’t even need to think about what the Fed does in a credit crunch!

    Unlike Joebhed and Kucinich, I’m not keen on having Fed functions performed by a “Monetary Authority” within the Treasury. First, democratically accountable Monetary Authority sounds wonderful, but as the Summer Rerun article above points out, “Congressional oversight of the Fed isn’t feasible given its track record and the issues involved.” I.e. Congress is not up to the job.

    Second, bank funded lobbyists will “get at” Monetary Authority members (and Congress in general) just as they “get at” the Fed. The Monetary Authority won’t solve any problems. What WILL help, is having clearly set out rules as to what the Fed / Monetary Authority does come a recession. Dealing with a recession is a TECHNICAL problem, not a political one. A set of rules set out in advance helps de-politicise the whole process. I like Walter Bagehot’s rule about the central bank lending to problem banks at stiff rates of interest, and only on the basis of decent collateral. But there are other possible rules.

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