July 22, 2009
Federal Reserve Independence

An “Open Letter” regarding Federal Reserve Independence went to Congress on Monday, signed by 386 economists, many of them faculty in top doctoral-granting economics departments. My name was not among the signatories.

The opening sentence warns that “the independence of U.S. monetary policy is at risk.” At risk from what? Not specified. Possibly the authors had Ron Paul’s bill to audit the Fed in mind. The letter continues:

We urge Congress and the Executive Branch to reaffirm their support for and defend the independence of the Federal Reserve System as a foundation of U.S. economic stability.

If “independence” means discretion, then independent Fed policy in 2001-07 did not deliver stability, but fueled an unsustainable path in mortgage volumes and housing prices. The key to stability is not the independence but the restraint of the Fed, self-adopted or externally imposed. Failing self-adoption, external imposition is surely reasonable.

First, central bank independence has been shown to be essential for controlling inflation.

Actually, the correlation between measured independence and low inflation has been shown to disappear with a widening of the sample of countries.

Sooner or later, the Fed will have to scale back its current unprecedented monetary accommodation. When the Federal Reserve judges it time to begin tightening monetary conditions, it must be allowed to do so without interference.

No argument.

Second, lender of last resort decisions should not be politicized.

Consider cases where the Fed has intervened to stave off the resolution of an insolvent firm or to sweeten the deal for its acquisition, e.g. the cases of AIG and Bear Stearns. The Fed or its defenders may call those “lender of last resort” operations, but they weren’t. They had nothing to do with the standard historical (Bagehot) understanding of the LOLR role, which is to lend liquid reserves to solvent commercial banks facing temporary liquidity problems. The LOLR role does NOT include lending to insolvent firms, or lending to non-banks. The Fed’s actions in those cases had even less to do with the modern understanding of the LOLR, which is to prevent the money stock from shrinking. Likewise the Fed’s decisions to create new “loan facilities” for broker-dealers and money-market mutual funds had nothing to do with acting as a LOLR.

The Fed’s decisions in those cases were actually the sort of decisions that were traditionally left to Congressional appropriations (as in the Chrysler bailout of the 1970s). Congress should not be blocked from questioning (“politicizing”) the Fed’s fiscal-policy decisions simply because the Fed mislabels them or self-finances them.

Finally, calls to alter the structure or personnel selection of the Federal Reserve System easily could backfire by raising inflation expectations and borrowing costs and dimming prospects for recovery. The democratic legitimacy of the Federal Reserve System is well established by its legal mandate and by the existing appointments process. Frequent communication with the public and testimony before Congress ensure Fed accountability.

If the Fed’s legitimacy is established by mandates that the Congress gave it, how is it improper for Congress to revisit that mandate, for example to improve Fed accountability? We don’t want changes that raise inflation expectations, agreed. For that very reason we should welcome a new mandate that better restrains the Fed from inflating.

If the Federal Reserve is given new responsibilities every effort must be made to avoid compromising its ability to manage monetary policy as it sees fit.

Congressional backseat-driving of discretionary monetary policy is not an attractive prospect, granted. But this sentence reads like a blanket rejection of any and all rules that would usefully constrain the Fed’s conduct of monetary policy. Have 386 economists forgotten the lesson of Kydland and Prescott, that discretion means an inability to precommit to not inflating, which raises inflation expectations and thereby makes it more painful to achieve low inflation?

Posted by Lawrence H. White at 01:35 PM in Economics

The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. -Adam Smith

Our Bloggers
Joshua Hall
Robert Lawson
E. Frank Stephenson
Michael C. Munger
Lawrence H. White
Craig Depken
Tim Shaughnessy
Edward J. Lopez
Brad Smith
Mike DeBow
Wilson Mixon
Art Carden
Noel Campbell

Search

Archives
By Author:
Joshua Hall
Robert Lawson
E. Frank Stephenson
Michael C. Munger
Lawrence H. White
Edward Bierhanzl
Craig Depken
Ralph R. Frasca
Tim Shaughnessy
Edward J. Lopez
Brad Smith
Mike DeBow
Wilson Mixon
Art Carden
Noel Campbell

By Month:
February 2014
November 2013
October 2013
September 2013
August 2013
July 2013
June 2013
May 2013
April 2013
March 2013
February 2013
January 2013
December 2012
November 2012
October 2012
September 2012
August 2012
July 2012
June 2012
May 2012
April 2012
March 2012
February 2012
January 2012
December 2011
November 2011
October 2011
September 2011
August 2011
July 2011
June 2011
May 2011
April 2011
March 2011
February 2011
January 2011
December 2010
November 2010
October 2010
September 2010
August 2010
July 2010
June 2010
May 2010
April 2010
March 2010
February 2010
January 2010
December 2009
November 2009
October 2009
September 2009
August 2009
July 2009
June 2009
May 2009
April 2009
March 2009
February 2009
January 2009
December 2008
November 2008
October 2008
September 2008
August 2008
July 2008
June 2008
May 2008
April 2008
March 2008
February 2008
January 2008
December 2007
November 2007
October 2007
September 2007
August 2007
July 2007
June 2007
May 2007
April 2007
March 2007
February 2007
January 2007
December 2006
November 2006
October 2006
September 2006
August 2006
July 2006
June 2006
May 2006
April 2006
March 2006
February 2006
January 2006
December 2005
November 2005
October 2005
September 2005
August 2005
July 2005
June 2005
May 2005
April 2005
March 2005
February 2005
January 2005
December 2004
November 2004
October 2004
September 2004
August 2004
July 2004

Powered by
Movable Type 2.661

Site design by
Sekimori

XML