In Defense of the Federal Reserve

Apologies, readers, for the long silence between posts! Shap has been threatening bodily violence, among other forms of retaliation, against me for some time (and rightfully too, though I would never admit it to him) for not updating when I should attempt to do so more diligently, especially during these exciting economic times.

Before the actual substance of this post begins, I feel compelled to share a couple of links that have been floating around the economic side of the blogosphere. These links and related discussions are, at this point, admittedly rather dated, but they make excellent reading for anyone interested in learning more about economics (and who isn't, really?). First, The Economist managed to provoke quite the discussion by featuring the state of economics as their cover story. Economics, of course, is a broad discipline, and the two fields whose reputation and credibly have been hit most hard by the global economic crisis are macroeconomics and financial economics. This blog has already covered the basics of the divergences within macro (whereas -- and I think I speak for both Shap and myself here -- we're less up to date on the nature of asset markets), though The Economist provides a fantastic overview of them as well. One of my favourite responses to The Economist's take on macro is this post by Berkeley professor Brad DeLong, whose blog I would highly recommend.

With that out of the way, I'd like to tackle another subject that has been floating around lately: what is the exact nature and size of the role that the U.S. Federal Reserve should play in monetary policy, financial regulation, and oversight of the American economy in general? Suffice to say, the Fed has attracted quite its share of public attention since it found itself at the centre of the effort to stabilise the financial system. It has already deployed monetary policy to its fullest logical extent by slashing short-term interest rates to practically zero, although there is research currently being done to see if it's possible to transcend the so-called zero-bound problem, and President Obama has proposed investing in the Fed greater powers of oversight regarding institutions deemed too big to fail.

Given existing public queasiness about the government's stabilisation efforts, the Fed has become an irresistible target. At the risk of grossly oversimplifying (often the case when speaking of politics), this can hold true for both those on the left, who fear that the Fed will favour Wall Street over Main Street, and the right, who believe that the Fed will produce greater economic distortions through the manipulation of monetary policy than if it simply let business cycles run their course. Representative Ron Paul, who more famously ran for president in 2008, has introduced H.R. 1207, a bill that would give Congress the right to inspect the various comings & goings of the Fed. It is slightly tempting to discuss Paul as a politician on the the partisan fringe -- after all, this is the man who has also sponsored a separate bill to outright abolish the Fed -- but the fact that 282 of his colleagues have signed on as co-sponsors of H.R. 1207 indicates that, on Capitol Hill, his sentiments are shared. Various high-profile media outlets (see: Forbes and Bloomberg) have also nursed this idea of an abolished or reined in Federal Reserve. Fed Chairman Ben Bernanke has clearly been feeling the heat, especially with the end of his term and the possibility of reappointment coming up in January, and held a town hall late last month (though we can only hope that he wasn't heckled à la poor Congressmen on August recess).

Threats to the independence of the Fed are not new -- after all, debates about the concept of a national bank date back to the founding of this country -- but the current complexity of the world of finance has given the Fed an unprecedented level of importance. It is here that defenders of common economic sense must make their stand: the ability of the Federal Reserve to determine monetary policy and to conduct all of the asset transactions required to do so must not be curtailed. Central bank independence is a key tenet of all modern and rational economic systems for good reason. Imagine, for instance, that Congress did indeed have the ability to influence interest rates. If we posit that the primary goal of elected politicians is to be re-elected and that presiding over good economic times is correlated with re-election -- both are fairly reasonable assumptions to make, I should think -- then it is only a step away to assume that Congressmen would set monetary policy to accomplish these ends. Perhaps it would involve lowering interest rates in order to boost growth, or perhaps it would involve raising interest rates if the public frets about inflation. In both cases, though, policy would be set with little regard for actual macroeconomic circumstances and fluctuate in accordance with poll numbers.

All of this would result in an extraordinary level of instability, but the scenario needn't that extreme for a similar outcome to emerge. If Congress has just enough leverage over the Fed so as to make the latter beholden to the former in some manner -- the audits proposed by Ron Paul's bill would be enough to accomplish this -- it could easily give the Fed grief for politically unpopular policies and limit its willingness to pursue them. Central bank independence would be compromised, and the introduction of the fickle mob into the equation would increase uncertainty about the direction of U.S. monetary policy. Uncertainty heightens risk, and, assuming that the majority of actors in the market are risk-averse, the presence of unmitigated risk means that the economy will be performing at a suboptimal level.

An interesting revisionist school of thought argues that the Fed actually isn't an independent institution, and, to an extent, there is some truth in this. The Forbes article that I linked to earlier in this post details the politics that surround such a powerful institution, and to deny that the Fed is apart from domestic and international political considerations altogether is ultimately naive. With that said, however, central bank independence is less about independence from political currents -- for better or worse, politics is the process by which, well, anything is accomplished in government institutions -- than independence of action. The Fed needs space to undertake policies that may not sit well with elected officials but are nonetheless economically necessary. If our legislators wish to affect the course of the economy, then they are welcome to play around with spending and taxation in their own sandbox of fiscal policy, but it would be folly to condemn the whole of our economic fate to such hands.

~ Min