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

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