Streetwise Professor

Reuters has a story in which several prominent economists lament the alleged Republican threat to Fed independence:

Increasing political encroachment on the Federal Reserve, particularly from the Republican Party, could threaten the central bank’s hard-won independence and undermine confidence in the nearly 100-year old institution.

That was the pervasive sentiment among economists gathered at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming. Against the dramatic backdrop of the Grand Teton mountain, many said a closely-contested presidential race has turned the monetary authority into a political football.

“I do fear for it a bit if the election comes out that way, especially if some of the more radical voices, that happen to be Republican voices nowadays, get reelected,” said Alan Blinder, Princeton economics professor and a former Fed vice chairman, adding that historically opposition to the U.S. central bank had come predominately from the left.

“Independence” is something of a red herring.  The key issue is the scope of the Fed’s discretion in which it can exert its independence.  And as John Cochrane notes in the WSJ, the Fed has greatly expanded its activities:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks’ main task is to guide the economy by setting interest rates. Central banks’ main tools used to be “open-market” operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These “nontraditional” interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see “credit constraints” and “segmented markets” throughout the economy, which the Fed’s standard tools don’t address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that “we should not rule out the further use of such [nontraditional] policies if economic conditions warrant.”

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

As Cochrane notes, it is utterly impossible for any entity to undertake such breathtakingly broad responsibilities without engendering a political reaction.

And can you really think that it is a good idea to have an institution exercise such incredible power without accountability?  The Fed, like any human institution, is fallible.  Look at the Great Depression.  Look at the 1970s stagflation.  Big mistakes that led to huge adverse consequences.

Yes, perhaps the Fed has learned from its past mistakes-but the markets have become much more complex too, and the Fed is dealing with different problems.  It is now going where no central bank has gone before: can you be confident that it is not going to commit new mistakes when dealing with new problems?  And given that its role is more all encompassing than ever, the consequences of such mistakes will be even weightier than ever.

Hayek’s dictum applies with special force to the Fed: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

You also cannot overlook the political economy angle.  Even now, the putatively independent Fed is subject to political pressures, from the White House, from Congress.  Moreover, it is an odd creature.  The regional Fed banks participate in policymaking, and private banks that “own” the regional Federal reserve branches select some of their directors.  In addition to these formal roles in governing the Federal Reserve System, banks also influence its operation in the way that other regulated industries influence their regulators: through the provision of information that the Fed uses to make decisions.  Fed decision making is therefore not Spock-like and disinterested, but human, and subject to interested influence.  Some form of accountability is necessary.

The current controversy over control of the Fed is a natural consequence of understandable fears that the Fed is out of control, and exercising powers that could be misused. The currency doesn’t say “In Ben We Trust.”  Not yet, anyways.

Yes, some of the proposals to rein in the Fed are crackbrained.  But the concerns that motivate these proposals are not crackbrained.  A degree of independence makes sense if that independence is exercised within a relatively well-defined and circumscribed set of responsibilities.  Independence-that is, vast discretion with attenuated accountability-is much more dangerous, and much more ominous, when it is exercised in a much broader realm, and when the Fed has considerable power in asserting its authority in new, unprecedented areas.