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Saturday, January 20, 2007

Fed Independence II

As an addendum to the post below this one, here's more on Fed independence. This is from Chapter 12, "Central Banking and the Conduct of Monetary Policy," of the textbook of our newest Federal Reserve Governor, Frederic Mishkin, discussing the arguments for and against central bank independence:

Should the Fed Be Independent?

As we have seen, the Federal Reserve is probably the most independent government agency in the United States. Every few years, the question arises in Congress whether the independence of the Fed should be curtailed. Politicians who strongly oppose a Fed policy often want to bring it under their supervision so as to impose a policy more to their liking. Should the Fed be independent, or would we be better off with a central bank under the control of the president or Congress?

The Case for Independence

The strongest argument for an independent Federal Reserve rests on the view that subjecting the Fed to more political pressures would impart an inflationary bias to monetary policy. In the view of many observers, politicians in a democratic society are shortsighted because they are driven by the need to win their next election. With this as the primary goal, they are unlikely to focus on long-run objectives, such as promoting a stable price level. Instead, they will seek short-run solutions to problems, such as high unemployment and high interest rates, even if the short-run solutions have undesirable long-run consequences. For example, we saw in Chapter 5 that high money growth might lead initially to a drop in interest rates but might cause an increase later as inflation heats up. Would a Federal Reserve under the control of Congress or the president be more likely to pursue a policy of excessive money growth when interest rates are high, even though it would eventually lead to inflation and even higher interest rates in the future? The advocates of an independent Federal Reserve say yes. They believe a politically insulated Fed is more likely to be concerned with long-run objectives and thus be a defender of a sound dollar and a stable price level.

A variation on the preceding argument is that the political process in America leads to the political business cycle, in which just before an election, expansionary policies are pursued to lower unemployment and interest rates. After the election, the effects of these policies - high inflation and high interest rates - come home to roost, requiring contractionary policies that politicians hope the public will forget before the next election. There is some evidence that such a political business cycle exists in the United States, and a Federal Reserve under the control of Congress or the president might make the cycle even more pronounced.

Putting the Fed under the control of the president (making it more subject to influence by the Treasury) is also considered dangerous because the Fed can be used to facilitate Treasury financing of large budget deficits by its purchases of Treasury bonds. Treasury pressure on the Fed to "help out" might lead to more inflation in the economy. An independent Fed is better able to resist this pressure from the Treasury.

Another argument for Fed independence is that control of monetary policy is too important to leave to politicians, a group that has repeatedly demonstrated a lack of expertise at making hard decisions on issues of great economic importance, such as reducing the budget deficit or reforming the banking system. Another way to state this argument is in terms of the principal-agent problem discussed in Chapters 8 and 11. Both the Federal Reserve and politicians are agents of the public (the principals), and as we have seen, both politicians and the Fed have incentives to act in their own interest rather than in the interest of the public. The argument supporting Federal Reserve independence is that the principal-agent problem is worse for politicians than for the Fed because politicians have fewer incentives to act in the public interest.

Indeed, some politicians may prefer to have an independent Fed, which can be used as a public "whipping boy" to take some of the heat off their backs. It is possible that a politician who in private opposes an inflationary monetary policy will be forced to support such a policy in public for fear of not being reelected. An independent Fed can pursue policies that are politically unpopular yet in the public interest.

The Case Against Independence

Proponents of a Fed under the control of the president or Congress argue that it is undemocratic to have monetary policy (which affects almost everyone in the economy) controlled by an elite group that is responsible to no one. The current lack of accountability of the Federal Reserve has serious consequences: If the Fed performs badly, there is no provision for replacing members (as there is with politicians). True, the Fed needs to pursue long-run objectives, but elected officials of Congress vote on long-run issues also (foreign policy, for example). If we push the argument further that policy is always performed better by clue groups like the Fed, we end up with such conclusions as the Joint Chiefs of Staff should determine military budgets or the IRS should set tax policies with no oversight from the president or Congress. Would you advocate this degree of independence for the joint Chiefs or the IRS?

The public holds the president and Congress responsible for the economic well-being of the country, yet they lack control over the government agency that may well be the most important factor in determining the health of the economy. In addition, to achieve a cohesive program that will promote economic stability, monetary policy must be coordinated with fiscal policy (management of government spending and taxation). Only by placing monetary policy under the control of the politicians who also control fiscal policy can these two policies be prevented from working at cross-purposes.

Another argument against Federal Reserve independence is that an independent Fed has not always used its freedom successfully. The Fed failed miserably in its stated role as lender of last resort during the Great Depression, and its independence certainly didn't prevent it from pursuing an overly expansionary monetary policy in the 1960s and 1970s that contributed to rapid inflation in this period.

Our earlier discussion also suggests that the Federal Reserve is not immune from political pressures. Its independence may encourage it to pursue a course of narrow self-interest rather than the public interest.

There is yet no consensus on whether Federal Reserve independence is a good thing, although public support for independence of the central bank seems to have been growing in both the United States and abroad. As you might expect, people who like the Fed's policies are more likely to support its independence, while those who dislike its policies advocate a less independent Fed.

Central Bank Independence and Macroeconomic Performance

Throughout the world we have seen that advocates of an independent central bank believe that macroeconomic performance will be improved by making the central bank more independent. Recent research seems to support this conjecture: When central banks are ranked from least independent to most independent, inflation performance is found to be the best for countries with the most independent central banks. Although a more independent central bank appears to lead to a lower inflation rate, this is not achieved at the expense of poorer real economic performance. Countries with independent central banks are no more likely to have high unemployment or greater output fluctuations than countries with less independent central banks.

    Posted by on Saturday, January 20, 2007 at 03:20 PM in Economics, Monetary Policy, Politics | Permalink  TrackBack (0)  Comments (5)


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