December 7, 2009
Should the Fed Remain Independent?
Should the Fed Remain Independent? Posner
I agree with Becker; no matter how badly the Fed performed in the run-up to the financial collapse of September 2008, stripping it of its political independence could only make things worse.
The Fed indeed performed badly, and Bernanke himself—not just Greenspan—must (though he's refusing to) shoulder a significant share of the blame. Bernanke approved of, and may even have played the key role in advocating, Greenspan's policy of pushing interest rates way down beginning late in 2001, keeping them there, and promising that when the Fed started raising rates it would do so gradually and would use monetary policy to prevent asset prices from diving in consequence of higher rates (that is, it would push down interest rates, which would firm up housing prices because houses are a product bought mainly with credit). These actions by the Fed nourished the housing bubble.
The Fed not only mismanaged monetary policy, but was notably lax in regulating the commercial banks and bank holding companies, ignored warning signs of a coming financial collapse, and prepared no contingency plans to deal with such a crisis even after Bear Stearns' collapse signaled the existence of potential solvency problems in a wide range of banks and "shadow banks" (such as Bear Stearns, a broker-dealer rather than a commercial bank). The Fed was blindsided by the collapse of the other dominoes in September 2008 and blundered gravely in failing to bail out Lehman Brothers, a failure that precipitated a run on the other shadow banks.
These failures have shaken confidence in the Fed, and provide I think a strong argument against giving the Fed additional powers. But the failures do not provide an argument for reducing the Fed's political independence. The critical reason is Becker's: looking back at the behavior of Congress in the years and months (and weeks and days) preceding the financial collapse of September 2008, there is absolutely no reason to think that, had Congress exercised more control over the Fed, the financial collapse would have been averted or its gravity diminished.
The reason is related to the principal argument for the independence of a nation's central bank: that without it there would be much more inflation. Politicians want low interest rates because they stimulate economic activity and thus create at least the illusion of prosperity, for which politicians want to take credit. But if inflation is already high or expected to be high, low interest rates create a serious risk of more inflation. The reason is that the way a central bank reduces interest rates (to simplify) is by buying Treasury securities; the cash it pays for them increases bank balances and therefore reduces interest rates and stimulates lending. The more lending, the more spending, and the more spending the more money there is in circulation relative to output and therefore the more inflation there is, since inflation is determined by the ratio between the amount of money in circulation and the amount of goods and services available for purchase.
Congress would undoubtedly have wanted interest rates to stay low throughout the past decade and thus would have fought the Fed had the latter heeded warnings of a housing bubble and raised interest rates. In fact there was inflation—asset-price inflation, the assets being houses and common stock, and at times oil and other commodities. The Fed should have raised interest rates higher and earlier, and probably would have done so if it had realized that there was asset-price inflation. But had it done so, it would have caused a slowdown in economic activity, and Congress would have intervened had it not been for the Fed's independence. Elected officials have short time horizons.
The Fed isn't really that independent because, unlike the independence of the Supreme Court from the other branches of government, the Fed's independence is not based on the Constitution but merely on statute, and Congress can change a federal statute at any time. Because of this the Fed cannot ignore political pressures entirely. But if the "reformers" get their way, the political pressures will operate directly, and inflation will be an even more serious problem.
The hostility to Fed is in part a hostility to "Wall Street," especially to firms like Goldman Sachs which have made enormous profits this year while most of the country was suffering from the economic downturn. The combination of the government's having bailed out Goldman and the other big banks, thereby signaling that it will not allow such firms to fail, and the Fed's current interest-rate policy, which has pushed short-term interest rates down almost to zero, has enabled Goldman to borrow capital at very low rates and lend or otherwise invest it very profitably because the distress of other banks has reduced aggregate private lending and investing.
Because private banks elect two-thirds of the members of the board of directors of each of the 12 regional federal reserve banks, and five of the presidents of those banks serve on a rotating basis on the Federal Open Market Committee—the body within the Fed that sets monetary policy and thus interest rates—there is suspicion that the Fed is a tool of Wall Street. That impression would be dissipated, to a degree anyway, by cutting the private banks out of any role in determining the governance of the federal reserve banks. Such a change might reduce the political pressure to reduce the Fed's independence.
Should the Fed Remain Independent? Becker
Neither former Fed Chairman Alan Greenspan nor the present Chairman Ben Bernanke anticipated the financial crisis that erupted in 2008. In addition, Greenspan helped keep interest rates low for several years after the 9/11 attacks on the United States that contributed to the boom in housing prices, the stock market, and other asset prices. For these and other reasons there is considerable anger and disappointment toward the Fed in Congress and among some economists.
This hostility explains the grilling that Bernanke received this past Thursday in the hearings before the Senate Banking Committee on his nomination for a second term as Chairman. It also explains the drive by many members of Congress to have Congress exercise greater control over the Fed's behavior, and to take away from the Fed its power to supervise banks. As part of this Congressional pressure, Republican Congressman Ron Paul of Texas has introduced a bill to have the policies of the Fed audited by the Government Accountability Office (GAO).
The problem with these attacks and proposals is not that the Fed behaved perfectly either during or before the crisis-far from it- but rather that closer Congressional supervision and oversight is likely to make matters much worse rather than better. For example, although the Fed is criticized for not foreseeing the financial crisis and for its low interest rate policies, at the time there was no outcry in Congress against these policies. In addition, few, if any, Congressmen warned that a financial crisis would develop unless the Fed tightened up its supervision of banks, and also raised interest rates.
Members of Congress also directly contributed to the unsustainable housing boom. Barney Frank, one of the most knowledgeable Congressmen about financial matters, urged banks to increase their mortgages to subprime borrowers. The Community Reinvestment Act of 1977, extended further in 1995, also basically forced banks to increase their mortgage lending to consumers in poorer areas who were not likely to be in a financial position to meet their mortgage payments.
The Fed clearly made some serious mistakes as it struggled to cope with a financial crisis that was far more serious than Bernanke and other members of its governing Board had anticipated. By not letting Bear Sterns collapse, the Fed probably raised expectations that it would do the same for Lehman Brothers and other major investment banks if they got into serious trouble. All hell broke loose in financial markets when the Fed then let Lehman go under.
Perhaps too the Fed should not have put so many resources into saving AIG, the major commercial insurance company that also became a major insurer in the credit default swaps market. Other decisions by the Fed can be legitimately questioned, but there is little support for the view that the Fed would have behaved better if Congress had been more closely supervising Fed policies. In any case, Congress already has considerable supervisory powers over the Fed. This central bank has to produce an annual report on its activities, and the Chairman must testify at least twice a year before Congress. During this testimony, he has to explain what actions the Fed has taken, and to justify them when questioned by members of Congress. The minutes of the Board's eight meetings each year are made publicly available-with a lag- so that everyone can see what the members are discussing, and any disagreements.
Central Banks in many countries have fought over decades and even centuries for the type of independence in their decision-making that the Fed enjoys. The problem usually with dependent central banks is that they engage in considerable inflationary printing of money under the urging of the executive or legislative bodies that control them. The increased money supply is an inflation tax, with the revenues used to finance greater government spending that would not have been feasible with the income tax and other tax revenue raised from companies and households.
The potential for inflation in a few years in the United States is considerable because of the Fed's extensive and unprecedented open market operations as it tried to shore up the financial system. These operations created over a trillion dollars of banks excess reserves. When the upswing in the economy gains momentum, banks will use these reserves to lend much more to companies and households, a process that will increase currency and demand deposits, and thereby inflate prices. In order to subdue this inflation, the Fed will have to sell many of the securities that it purchased in open market operations, and find other ways to withdraw reserves and some of the inflationary potential from the American banking system.
Such Fed actions will raise interest rates, and put downward pressure on the economy's growth, and contribute to increased unemployment. History shows that such inflation-fighting actions are far less likely when central banks are not independent, and legislative or executive branches control their policies. Even the oversight that Congress already has over the Fed is likely to induce the Fed to rein in its inflationary fighting policies. It would be an unpleasant and ironic prospect if increased Congressional control of Fed policies led the Fed to engage in more of the "easy" money policies that many members of Congress are rightly criticizing this central bank for promoting during earlier years of the decade.