By L. Randall Wray, Professor of Economics at the University of Missouri-Kansas City, Research Director with the Center for Full Employment and Price Stability and Senior Research Scholar at The Levy Economics Institute. Originally posted at New Economic Perspectives
Coda: Is the Fed Independent of Influence?
In my two part series (here and here), I examined conventional views of (mostly) economists on the Fed’s supposed independence. What they focus on is the Fed’s independence from our elected representatives and as well on operational independence of the Treasury. The reason why they believe this is important is because the Fed is supposed to protect us—we can identify us as “money users”—from the danger that the “government” (Congress and Treasury), our “money issuers”, might conspire to degrade our currency by having the Fed “print money” to finance a profligate government. These “Weimar Worriers” are just certain that if a cabal of central bank, treasury and congress had their way, we’d be off and running to hyperinflation. Hence, thank god that our central bank is independent! Any meddling by Congress (or the Treasury) in the affairs of monetary policy making would be the final death knell for our Dollar.
I have argued in the series that the Fed is a “creature of the Congress”. In that sense, we should not see it as “independent” of Congress, which can use its law-making power (as well as other powers) to tell the Fed what to do. As Bernanke (and many others at the Fed have said) the Fed will do what Congress tells it to do. The Congress can, and has, changed the laws that the Fed operates under—as I pointed out in the previous posts. There never has been the kind of independence supposed by economists.
However, the Fed was set up to be free of the usual day-to-day political pressures, with lots of safe-guards put in place. For example, the lengthy terms that do not coincide with those of our President and other elected representatives ensure that appointed Fed officials are not “campaigning” at the same time that we are holding elections. (Indeed, commentary focused on the apparent “running” of Janet Yellen for Chair of the Fed—unusual behavior that looked more “political” than usual.) And with rare exceptions (Hello Ron Paul! Hi Bernie Sanders!) we do not see our politicians running on a platform promising to take over monetary policy-making.
The Congress and the Administration—in normal times—keep a “hands-off” approach with respect to telling the Fed what its “monetary policy” ought to be. Here we are defining “monetary policy” the way the Fed and most economists do: nowadays, that is the setting of the discount rate and the fed funds rate; during the Monetarist period, it was the setting of aggregate “money” targets (reserves or M1 and M2 growth targets). However, as I argued in Parts 1 and 2, in emergencies the Fed cooperates with the Administration to formulate policy. It is not a coincidence that the Fed kept rates low in WWI, WWII, and after the GFC.
If we were to define “monetary policy” much more broadly then it is clear that both the Congress and the Administration “interfere” frequently—in areas of regulation and supervision of banks, financial institutions, and financial instruments. Dodd-Frank continues in that tradition.
With regard to “operational independence” from the fiscal authorities, we have legislated constraints as well as adopted informal rules. However, upon inspection these turn out to have very little practical importance. While the Fed cannot buy Treasury debt directly, the Fed can lend reserves to banks, which then buy the Treasuries and can sell them on to the Fed without constraint. Importantly, the Fed targets the overnight interest rate, which reduces its degrees of freedom (it buys or sells Treasuries as necessary to hit the target). It is also the Treasury’s bank, and those in the Treasury as well as the Fed who are familiar with the operations deny that the Fed actually does—or would—refuse to clear the Treasury’s checks. Operational independence is a formality that doesn’t much matter.
And in the past when it was very important to ensure that fiscal policy could be smoothly run—as in WWI and WWII—the Fed acquiesced, keeping rates low on Treasury debt. There’s every reason to believe the Fed will do so again in the future should it be necessary. We also have the Fed’s unprecedented behavior since 2008, as it sought to keep rates extremely low “in the national interest”. That helped to keep interest service on the debt low in the aftermath of “Obama’s deficits”.
Some commentators have interpreted all of the above as a “whitewash” of the Fed’s relationship with private banking. Some have also tried to argue that the Fed is not really a creature of Congress—rather—the Fed is a “hybrid” with one foot in the private banking business and another in government. Both of these views are fundamentally wrong.
The Fed is a lender of last resort to the banking system; it always has been. This is an important aspect of its “public purpose”. The US tried operating a payments system in which private bank liabilities did not clear at par. That didn’t work. We tried operating a system that was subject to runs, relying only on the banks, themselves, to stop runs. When a financial crisis hit, it was all up to the Original JP Morgan to gather bankers into a room and lock the doors until they worked out a solution. That didn’t work well, either. Indeed that was the major impetus to creating the Fed in the first place (unlike the earliest central banks, which were created to provide government finance). And, yes, it was in large part the bankers’ idea to get a central bank. They convinced Congress to finally do something about the US monetary mess. Our history of financial crises stood out like a sore thumb in comparison with early-adopters of central banks. We had a financial system that was not ready for the 20th century.
There were big debates about how to design our system. The bankers wanted something like the Bank of England—private owned then (but later nationalized). Many in Congress wanted the US central bank to be housed in the Treasury—not a bad idea, in my view. In any event, Congress created the Fed and set it up with the “checks and balances” approach to governance that I described in Part 1 (following Bernie Shull’s great paper). That didn’t work, and overtime, Congress has asserted greater control.
Yes, private banks are nominal “owners” of regional banks. Really it is more of a “membership fee” since their “stock” in the Fed is nothing like normal equity shares. They join up and then get a return based on Fed profits. Profits above 6% go to the Treasury. Policy, however, is set by Congress. The power resides with Board of Governors, with narrowly defined monetary policy established at FOMC meetings.
And, yes, the Fed operates clearing for private banks. It lends when they’ve got liquidity problems. It approves mergers. It watches out for the banking system. And sometimes it acts like the Original JP Morgan when it brings bankers into a room, locks the door, and bangs their heads together until they hammer out a solution—as it did during the LTCM crisis.
But that doesn’t make the Fed a “hybrid”: it gets its mandate from Congress. Yes, the Fed “caters to” private banks in the sense that it is supposed to stop runs, and to lend to troubled banks. But Congress passes the laws that tell the Fed what to do, and can change them if it doesn’t like what the Fed did.
Some argue that the Fed is captured by Wall Street. Heck, I’ve argued that for years! So is the Treasury. So is the entire darned Administration of Obama, and that of Bush, Jr, and that of Clinton. We’ve got the best Government that Wall Street’s money could buy. I agree. That was not the issue I was discussing in the two part series. If the critics are trying to argue that is what they mean by the Fed being “independent” then they can also argue the Treasury is independent of government, as is the Obama Administration, as is the Supreme Court of the United States. They all work for Goldman Sachs and JP Morgan and and Citi and Bank of America and AIG, and so on. Or, in Timmy Geithner’s case, for Warburg Pincus. (Literally.) Fine.
They’ve got the Supreme Court claiming that corporations are people, too.
The first order of business when a new President is elected is to choose which Wall Street firm gets to run Treasury (usually it is Goldman Sachs, which also gets to run many of the treasuries in Europe and around the world). Our conspiracy theorists love to talk about the cabal of bankers running the Fed, but they completely ignore the Rubins, Summerians, Paulsons and Geithners at Treasury where there is a completely open and unashamed Wall Street cabal running the entire show.
If you want to call the Fed “hybrid” public and private, so is the Treasury. Indeed, so is Government Sachs, since it not only runs a bank but also holds many of the top positions in the US government. And in the governments of a number of other countries, too.
Fine and dandy, but that wasn’t the topic.
Finally, the question was raised: do I think that we ought to have an independent central bank? I can see an argument for some Fed independence from pork barrel politics. The Fed is a bank, and all banks have a magic porridge pot. One can imagine that pot-bellied politicians with cigars would love to have the Fed lending to their pork barrel projects. It is bad enough that Congress is pitching the pork—which actually requires budgeting and voting and Presidential signatures. What if a handful of “wise men” on the FOMC in Washington could shovel the pork? Hey, Chairman, I need some financing for a series of Trump Towers in my district!
Now, that is not really what the political independence debate is all about. There is the belief that what I described as the normal monetary policy (setting interest rates) is extremely important and needs to be free from political posturing. The fear is that politicos want low interest rates to prod economic growth so that they can go back to their districts and claim the credit, meanwhile inflation soars and we’ve got to buy wheelbarrows to truck worthless dollars to the grocery store. In my view that is all nonsense. Politicos do not have a pro-hyperinflationary constituency.
The true danger is always, has always been, will always be, in the opposite direction. Politicos hate inflation and do not mind unemployment. The unemployed do not contribute to campaigns and don’t vote much (except in Chicago where Mayor Daley pays them to do so and tells them who to vote for).
When Wall Street decides it wants hyperinflation, I’ll worry because it will hire all the politicians needed to get it. Until then, this is all a red herring. We do not need this kind of political independence because there’s zero chance the Fed and the Treasury and the Congress will team up to hyperinflate.
Me? I’d eliminate that kind of independence. Congress should mandate that the overnight rate ought to be set at 0 or 25 or maybe 50 basis points and left there forever. (Oooh, I know that will drive our hyperinflationary Weimar Worriers crazy.)
I think there is some argument for making some kinds of monetary policy—more broadly defined—behind closed doors and with independence. Deciding whether a troubled bank is troubled because it is insolvent or because it is illiquid is the kind of “monetary policy” decision that needs to be free of Congressional pressure. (If it is illiquid, lend; if it is insolvent, turn it over to the FDIC for resolution.) We saw what happened when the Keating Five Senators tried to protect Lincoln Savings and Loan from being resolved (luckily on the other end of that stick was my colleague Bill Black, who is like a bulldog when it comes to fighting corrupt senators, bankers, and regulators). Politicians always need money and banks and thrifts have the magic porridge pot, so elected representatives will always try to interfere with regulators and supervisors that go after a bank in “their” district. We have to insulate the Fed and the FDIC from that kind of interference.
But what the Fed did during the GFC bail-out of Wall Street stunk. It was disgusting. Congress should not, cannot, let that happen again. That is what my project is all about. We do not want the Fed to have that kind of political independence. My project team broke the story of the Fed’s $29 TRILLION in loan originations to save the blood-sucking vampire squids of Wall Street. This wasn’t a liquidity problem. It was an insolvency problem, with the major banks massively insolvent because their top management had turned them into what Bill Black calls “control frauds”. The Fed should not have the political independence to try to save fraudulent and insolvent financial institutions. Maybe we should have bailed them out (I think not)—like we bailed out the auto industry. But that should be done by Congress, not by unelected officials at the Fed.
(To be clear, we have 4500 honest banks. We have a half dozen huge banks that are run as control frauds. Our financial system’s main problems can be found among those SDIs—systemically dangerous institutions. We will not get back our economy or our government until we close them.)
We need a central bank. It needs to serve the public purpose. It needs to be held accountable. We need to improve governance of the Fed. And we need to increase transparency. The Fed is a creature of Congress. It is up to Congress to improve democratic accountability, governance, and transparency of the Fed.
 See two annual reports of research conducted with the support of Ford Foundation Grant no. 1110-‐0184, administered by the University of Missouri–Kansas City. See: L. Randall Wray, 2012. “Improving Governance of the Government Safety Net in Financial Crises,” Research Project Report, April 9. http://www.levyinstitute.org/pubs/rpr_04_12_wray.pdf; and L. Randall Wray, 2013. “The Lender of Last Resort: A Critical Analysis of the Federal Reserve’s Unprecedented Intervention after 2007”, Research Project Report, April http://www.levyinstitute.org/publications/?docid=1739.