Fed’s Independence Vital for a Stable Economy
CBS’s moneywatch.com site recently released an article by Mark Thoma on the independence of the Federal Reserve, and those very real political conditions that threaten it. This situation is dangerously close to a Catch-22 scenario. Here’s the problem: When politicians get involved with monetary policy, manipulating it in their favor in order to be reelected, inflation usually results, along with a cycle of debt perpetuated in the economy. If the Fed resists such manipulation, asserting their independence, politicians could in turn place legislative restrictions on its independence — penalizing the Fed’s independence by taking it away. If that’s not a Catch-22, I don’t know what is.
Thoma’s article mentions that this very problem is currently becoming manifest in the U.S. Congress. Two pending bills are circulating in Congress, one that seeks to eliminate much of the Fed’s regulatory authority and the other to allow its monetary policy to be audited. These bills were developed as a safeguard against the Fed putting the brakes on the political business cycle, during which monetary policy plays out quicker with regard to output and unemployment than it does with regard to inflation.
So, if an incumbent politician wants to increase his chances of getting reelected, he may want output to peak right around the time of the election. To do this, he increases the money supply months before the election to reap the benefits of increased output; however, the consequent inflation will not hit until months after output peaks. This politician has begun a cycle of manipulation. It would be a wise next step to tighten monetary policy after the election to avoid inflation, but more often than not this step is not taken, because cutting the money supply will decrease output, and output is already in a state of decline after having peaked. So, rather than being perceived as responsible for a decline in output, in order to to avoid inflation, the politician lets inflation take the lead.
In addition to this sort of scenario, there is the added problem of government debt. Of the three ways to finance government purchases — increasing taxes, issuing government debt, and increasing the money supply — the most beneficial choice from a politician’s perspective would be to increase the money supply, because its drawbacks aren’t as easily seen by constituents. This also results in inflation, and can be referred to as monetizing the debt. Luckily for the politician, the blame for this inflation can be readily placed on increased prices for oil and other commodities.
As health care costs rise, and the public debt becomes more of a problem, worried politicians are resorting to the application of pressure to the Fed to act in ways that will make their political skills seem more attractive to their constituents. Consequently, it is a real possibility that the price for Fed independence — which is vital to upholding a healthy economy from the yo-yo effect of political whims — may, in the end, be that very independence.
The temptation to help politicians already exists.
Arthur Burns did Richard Nixon some favors when Nixon ran in ‘72. Not that he needed it. Paul Volcker did Jimmy Carter no favors in ‘80. Carter probably couldn’t have pulled it off, but, in doing the right thing, Volcker did not help Carter’s cause.
Comment by Papillon — November 18, 2009 @ 2:58 p.m.
As luck would have it, there is an elegantly simple solution: eliminate the Fed altogether!
Comment by Dave Roland — November 18, 2009 @ 3:40 p.m.
The whole notion that we can have a monopolized central bank without any political influence is a myth and a half. The Fed is under the dictation of the president and other politicians. Having a degree of transparency so we know how the Fed is ripping us off is an important step in cutting off their unregulated control over the money supply, and would at least have them answerable to someone. Before we can abolish it, we need to be able to audit it. It’s an important step along the way.
I highly recommend the Mises Institute’s “Money, Banking and the Federal Reserve” documentary, which is available for free on Google video.
http://video.google.com/videoplay?docid=-466210540567002553&ei=AnEES8PSMZLiqgKUm_C6CQ&q=money+banking+and+the+federal+reserve#
Comment by Joe Nonnenkamp — November 18, 2009 @ 4:12 p.m.
I’m with Dave and Joe:
http://www.cato.org/pub_display.php?pub_id=10419
http://fee.org/articles/bankers-bank/
Comment by Eric D. Dixon — November 18, 2009 @ 7:01 p.m.
Here’s a good piece from the Wall Street Journal today.
http://online.wsj.com/article/SB10001424052748704782304574542280971009044.html#
Comment by Joe Nonnenkamp — November 19, 2009 @ 1:15 p.m.
“Fed’s Independence Vital for a Stable Economy”
You’re doing it wrong. Fed is the singular cause of an unstable economy.
Comment by vroman — November 19, 2009 @ 4:20 p.m.
I have a feeling I will get dogpiled for this, and I should start out by saying that I tend to agree with the “abolish the fed” crowd, but I have to point out a problem I’ve not really heard addressed.
Ostensibly the Fed exists as a government appointed group which will maintain a “sound fiscal policy” or something equally vague. The problem that I and others have with it is that it’s history has been one of persistent inflation (a rather insidious form of taxation on holders of currency and a way for the government to spend money ex nihilo) and bad behavior exacerbating business cycles, such as cranking up the heat in 1930 on an already struggling economy.
Here’s my question: If we get rid of the Fed, ostensibly the powers of the Fed will fall back to congress, right? Is this desirable in the eyes of anyone who is currently unhappy with how the Fed operates? Am I viewing this problem in the wrong way?
Comment by Josh Smith — November 20, 2009 @ 12:04 p.m.
Josh makes a good point. The root problem is that such coining and banking powers are granted to the government in the first place. The government shouldn’t be in the money business any more than it should be in the business of manufacturing and distributing hot sauce or screwdrivers.
So, I think Alyssa’s points are useful. For the time being, we’re stuck with a government that controls money. We’re also stuck with the Federal Reserve. Given those constraints, it’s probably better to allow the Fed to operate with a significant degree of independence from political whims.
I made some similar points a couple of years ago in my own blog entry about the Federal Reserve. Looking back at it now, I gave the Fed far more credit than it deserved, claiming that “the people running the Federal Reserve today understand the damage that irresponsible Fed policy can bring.” The intervening two years have demonstrated otherwise.
Later in that piece, though, I quoted a Reason interview with Milton Friedman, in which he said:
That pretty much holds true for me today. If we can get rid of the Fed, so much the better. Its scholars may provide us with good economic research, but there’s no reason to bundle academic inquiry with the power to set (or disproportionately influence) monetary policy.
But we have a Fed, and as long as it still exists, we’re probably better if politicians keep their grubby mitts off of it.
Comment by Eric D. Dixon — November 23, 2009 @ 5:23 p.m.
I like what both Josh and Eric have said. The problem in my mind always comes back to politics…the Fed would be most effective if as independent as possible from politics, but unfortunately it exists within a political system, and policies had to be written to bring it into existence. if the Fed were to be abolished, it would be after Congressmen developed policies to that end.
The Fed is made up of three parts, and two of those three parts are valid and essential – its role as the government’s bank, and its role as local bank auditor. Even the research aspect of the monetary policy branch of the Fed is important. If the Fed did not set monetary policy, then Congress would find a way to control it. The Fed gets a bad rap for its perceived effect on interest rates, but it does still have some very important responsibilities – and remember, the Fed was created because local banks weren’t quite cutting it on their own.
Comment by Alyssa Curran — November 24, 2009 @ 3:27 p.m.