"Checks and Balances at the Fed"

Jon Faust is worried that the Dodd proposal to change the selection process for members of the FOMC (the committee that sets monetary policy) will lead to too much political control of the Fed and all the problems that come with it:

Checks and Balances at the Fed, by Jon Faust, RTE: The financial crisis has provided, among other things, a civics lesson about the Federal Reserve. Some people have been surprised to learn that 5 of 12 votes on the Fed’s main policy committee–the Federal Open Market Committee (FOMC)–are cast people who are not politically appointed. The 7 politically appointed Fed Governors vote on the FOMC, but the remaining 5 votes rotate among the Reserve Bank Presidents, who are chosen by the Board’s of the Reserve Banks. People on those Boards are, themselves, mainly chosen by the member banks of the Federal Reserve System. Senator Dodd’s reform bill attempts to fix this problem.

This supposed fix is dangerously naïve and ignores the lessons of the last great financial crisis.

The bill as reported states: “To eliminate potential conflicts of interest at Federal Reserve Banks, the Federal Reserve Act is amended to state that no company, or subsidiary or affiliate of a company that is supervised by the Board of Governors can vote for Federal Reserve Bank directors…”

The current arrangement of the FOMC was framed as a response to the Great Depression. The framers viewed the conflicts of interest over Fed policy as fundamental and saw no way to eliminate them. Historical precedent suggested (and still suggests) that political control of a central bank leads to lack of discipline and inflation. But complete absence of political influence is also inappropriate in a Democracy.

Thus, the FOMC’s framers looked to the uniquely American solution of checks and balances. In particular, they called upon two widely despised groups during the depression—bankers and politicians—to balance each other’s worst impulses.

Representative Glass and Senator Steagall, of Glass-Steagall fame, fought tenaciously over the balance. Steagall proposed that only the politically-appointed governors would vote on the FOMC. Glass responded that Steagall was “without peer in his advocacy of inflation.” After heated debate, Congress arrived at the 7 to 5 split we have today. Senator Glass summarized the reasoning, “[The vote on the FOMC] will stand 5 to 7 giving the people of the country, as contradistinguished from private banking interest, control by a vote of 7 to 5…” There can be no doubt that the Congress sought to achieve a balance of fundamentally conflicting interests.

I am not arguing that Congress got the balance right, and the recent crisis is certainly reason enough to re-visit what the correct balance would be. But naively fiddling with the balance in the name of eliminating conflicts of interest misses the real civics lesson from the founding of the Fed’s FOMC.

I've written about this topic as well. This is from a post at Maximum Utility, my blog at CBS MoneyWatch:

What’s Wrong With the Dodd Proposal to Restructure the Fed?: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal Reserve system, and it would politicize the selection process, both of which are the opposite of where reform should take the system.

The Current Structure of the Federal Reserve System

The Federal Reserve System consists of a Central Bank in Washington and twelve Federal Reserve District (or regional) Banks. The Central Bank's authority resides with the seven member Board of Governors, one of which serves as chair (currently Ben Bernanke). Each of the District Banks has a nine member Board of Directors along with a bank President. It is the selection of the Board of Directors that is at issue.

Currently, the nine member Board of Directors at each of the District Banks consist of three Class A directors, three Class B directors, and three Class C directors. Class A directors are elected by member banks within the district and are professional bankers. Class B directors are also elected by member banks in the district, but these are business leaders, not bankers. Finally, Class C directors are appointed by the Board of Governors and are intended to represent the public interest.

Class B and Class C directors cannot be officers, directors, or employees of any bank, and Class C directors may not be stockholders of any bank. One Class C director is selected by the Board of Governors to serve as Chair of the Board of Directors. The Board of Directors selects the President of each District Bank, but the President must be approved by the Central Bank's Board of Governors.

What is the reasoning behind this structure? When the Fed was created in 1913, there was a concerted attempt to distribute power across geographic regions; between the public and private sectors; and across business, banking, and the public interests. The geographic distinctions were important because it's not unusual for economic conditions to differ regionally -- conditions can be booming in some places and depressed in others -- and the regions would favor different monetary policies. Thus, it's important to bring these different preferences to the table when policy is being determined so that the best overall strategy can be implemented.

Changes in the Distribution of Power over Time

In the early days of the Fed, power over monetary policy -- which at that time was mainly discount rate policy within each Federal Reserve District -- was shared between Washington and the District Banks, so the intent of the system was largely realized.

However, the shared power arrangement within the Federal Reserve system changed after the Great Depression. The Fed did not perform well during the great Depression and one of the problems, it seemed, was that the deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances rather than problems with individual banks (the discount window is well-suited to help individual banks, but it's not an effective tool to combat system wide disruptions; on the other hand, open-market operations -- a policy tool the Fed obtained after the Great Depression -- can inject reserves system-wide and are much more useful to deal with system-wide problems).

The result was that after the Great Depression, power was concentrated in the Central Bank's Board of Governors in Washington D.C., and increasingly over time, in the hands of one person -- the Chair of the Federal Reserve. Thus, over time the Fed has evolved from a democratic, shared power arrangement at its inception to a system that functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.

The Dodd Proposal

How would the Dodd proposal change this? Under the proposal, the Board of Directors for each District Bank would be chosen by the Central Bank's Board of Governors (who are themselves chosen by the President with the advice and consent of the Senate). The chair of the Board of Directors at each District Bank would be chosen by the President and confirmed by the Senate.

This means that the key figures within each District Bank would be chosen by Washington, and unlike the present system, there is no attempt at all to represent geographic, business, banking, and public interests explicitly in this arrangement. In addition, it no longer has the explicit safeguards contained in the current rules to prevent bankers from dominating the directorships (e.g. under the new rules the Chair of the Board of Directors could be a banker, currently that can't happen). Given that the appointments are coming from Washington (as opposed to a vote of banks within the District for six of the nine positions on the Board like we have now), there is no guarantee that the District bank Boards won't be stacked with one special interest or another. Thus one of the main reasons given by Dodd for the change in the selection process -- to remove the influence of bankers -- is actually undermined by his proposal because it removes the safeguards against the Board being dominated by banking interests.

I believe that the current structure of the Fed already gives too much power to Washington and not enough to the District Banks, and this has helped to feed the perception that the Fed does not represent the interests of the typical person. Unfortunately, the Dodd proposal further concentrates power in Washington and adds more political elements to the selection process thereby making these problems even worse.

Thus, I agree with this:

Bullard, 48, the St. Louis Fed’s president since April 2008, said ... the Fed is ultimately controlled by political appointees as it stands... “We don’t want to put all the power into Washington and New York,” Bullard said. “That’s just the opposite of what this crisis is teaching us. So you want the input from around the country, and I think it’s really important for informing monetary policy.”

Richmond Fed President Jeffrey Lacker said ... “I wouldn’t want to see the reserve bank governance mechanism politicized in any way,”... Asked if Dodd’s plan would politicize the process, Lacker said: “I think it could.”

Finally, while the proposal claims to insulate the Fed's monetary policy decision from political pressure, this quote from the same article illustrates the dangers of political interference. The quote is in response to another part of the Dodd proposal that would take away some of the power the District Bank Presidents have in setting monetary policy (which is already much less than the power of the Board of Governors):

“I doubt very much that by a year from now Fed presidents are going to have as big a role as they now have,” Financial Services Committee Chairman Barney Frank told reporters... He has said the presidents too often vote in favor of higher interest rates.

That last sentence means he believes the Fed has favored low inflation over low unemployment as it has set interest rate policy. That may or may not be true, but do we really want members of the House setting interest rate policy or changing the structure of the Fed whenever they disagree? I don't.

I fully agree that the selection process for the Directors and the District Bank Presidents could and should be changed (that includes redrawing geographic districts). It's not clear that the present system does the best possible job of representing the array of interests that have a stake in the outcome of policy decisions. But concentrating power in Washington is not the way to solve this problem. Instead we need to redistribute power over a wider range of interests, including geographic interests, and make sure the selection process for key positions within the Federal Reserve system brings those interests to the table when policy is determined.

[Update: See also Alan Blinder's "Threatening the Fed's Independence".]

And one more post from Maximum Utility:

Why The Federal Reserve Needs To Be Independent, by Mark Thoma: There are several bills that have been proposed in Congress directed at the Federal Reserve. The two most prominent proposals are Senate Banking Committee Chairman Christopher Dodd's bill to take away most of the Fed's regulatory authority, and Congressman Ron Paul's bill to force the Fed to allow its monetary policies to be audited by the Government Accountability Office (GAO).

Many people worry, rightly in my opinion, that if these proposals or others like them are passed into law, then the Fed's independence would be threatened.

Political business cycles and inflation

Why is the Fed's independence so important? One reason is the control of inflation. As former Federal Reserve Governor Frederic Mishkin wrote this week in an op-ed coauthored with Anil Kashyup of the University of Chicago:

Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.

What Mishkin and Kashyup are referring to are "political business cycles." The idea is that monetary policy acts faster on output and employment than it does on inflation. To take a concrete example, suppose that the impact of a change in the money supply on output peaks about six months after the change in policy, and then fades after that. And also suppose that the impact of the change in the money supply on prices is delayed six months and is not fully felt until eighteen months after the policy change (these are roughly consistent with econometric estimates of the impact of changes in money on output and prices).

This situation opens up the possibility for a politician in control of the money supply to manipulate the economy in an attempt to increase the chances of getting reelected. If votes depend upon output growth, as they seem to, then the politician can pump up the money supply around six months before the election so that output will peak just as the election is held. Then, the politician could plan to reduce the money supply just after the election to avoid having inflation problems down the road.

So the politician implements this strategy, gets reelected, and now comes the time to cut back on the money supply. But there's a problem. Output peaked the month of the election, and has been falling ever since. Will the politician actually cut the money supply and raise interest rates to avoid inflation -- which would reduce output and employment growth even further, something that is sure to bring protests -- or decide to live with the inflation? The choice is often to live with inflation, and as the cycle repeats with each election, inflation slowly ratchets upward.

Budget deficits and inflation

But political manipulation of the money supply is not the problem most people are worried about, it's the expected increase in the government debt that is creating the inflation worry.

When the government purchases goods and services, those purchases must be financed in one of three ways--raising taxes, borrowing from the public (i.e., issuing government debt), or printing new money. Thus, if government spending is much larger than taxes, and if raising taxes is political poison, then the deficit must be financed by either printing money or issuing new government debt. However, increasing the government debt is often a bad choice politically, so when faced with this decision politicians often choose to increase the money supply rather than increase the debt, and the result is inflation. The inflation is a hidden tax--in essence the government spending is paid for by inflating away the value of the dollar, but the blame for the inflation can often be displaced onto things like oil and other commodity prices, and thus the political consequences are not as large as for changes in taxes or in the debt.

The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what's best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.

Independence threatened

Many people are worried that if the US does not get its long-run debt problem under control, a problem driven mainly by escalating health care costs, then politicians worried about their reelection chances will begin pressuring the Fed to finance the debt by printing money. And if the Fed is uncooperative, its independence may be taken away legislatively.

I believe these threats are real, and as noted above, experience shows that once politicians get involved in monetary policy, inflation generally becomes a problem. For that reason, I am very opposed to anything that threatens the Fed's ability to assert its independence and keep the economy on the best long-run path.

(For more discussion of the pros and cons of Fed independence, see here; for more on the degree of the Fed's independence in the U.S., see the bottom of this post.)