Reining In on the Federal Reserve

Every time the economy begins to falter, pundits and politicians gather before the doorways of the Federal Reserve Board like pilgrims before the temple at Delphi. Are you going to loosen the money supply? they ask the oracles. Will you condemn us to recession? Please, give us some clues!

Paul A. Volcker, Fed chairman, has indeed assumed a virtually godlike role in the U.S. economy. If Volcker disavows the need for easier money, the bond markets reverberate. If Volcker sneezes, the stock market explodes.

However forceful Volcker’s personality and strategic acumen, his power and influence are fundamentally rooted in the political role of the Federal Reserve Board. Although governors of the Federal Reserve Board are appointed by the President, the Fed has a remarkable degree of political autonomy.

The governors’ terms last 14 years, considerably longer than the terms of both the President and members of Congress. A substantial minority of the Federal Open Market Committee, a pivotal policy-making body at the Fed, are presidents of regional Federal Reserve banks, beholden more to their local bankers than to the larger political community. And our political structure and culture have defined the Fed as an “independent” executive agency, theoretically bound to no one but its own collective wisdom and conscience.

This political independence has endowed the Federal Reserve with an enormous amount of control over the U.S. economy. If Congress begins to grieve too openly for the unemployed, the Fed can effectively countermand its fiscal stimulus. If too much money is leaving the country, the Fed can drive up interest rates and try to haul money back into our banks.

Relatively Recent Independence

We tend to take the Fed’s power and independence for granted. If fact, its independence reflects a relatively recent change in institutional understandings.

The Fed was originally established by Congress in 1913 as an independent central bank. But its autonomy was superseded during World War II by an administrative agreement; from World War II through 1951, the Federal Reserve Board was subject to substantial direction by the Department of the Treasury in the executive branch.

That direction ended with the “Treasury-Federal Reserve Accord” of March 4, 1951. Capping a vigorous struggle by the Fed to restore its own independence, the Treasury Department agreed to leave it alone, ceding discretion or authority over money management. Volcker’s power today builds upon that restoration of Fed independence.

If we care about democracy, we should immediately end the independence of the Federal Reserve Board. Our economic problems are too great and the complexity of their management too vast to leave essential economic instruments in the hands of a democratically unaccountable authority. In most other advanced countries, the central bank is subject to direct governmental control. We should follow suit in the United States.

Democratic principles provide one obvious and fundamental justification for movement in this direction. There are two other somewhat more specific reasons for putting a leash around the neck of the Federal Reserve Board.

First, we need an integrated economic policy in this country. It is understandably difficult to pursue any coherent economic objectives when the left hand can take away what the right hand bestows. Fiscal and monetary policy should be determined and implemented by the same authorities.

Second, we should curb the political influence that the banking community has achieved through its formal alliance with the Fed. It is not surprising, of course, that creditors are more interested in relatively tight money and high interest rates than debtors and consumers.

Influence of Bankers

Political tension between bankers and the rest of us is threaded throughout U.S. history--from the Jackson presidency through the Populists into the Great Depression. Over the past 30 years, (1) the Fed has had enormous influence over interest rates, (2) bankers have been typically appreciative of high rates and (3) there has existed the same kind of mutual back-scratching between the banking community and the Fed as has existed between the Pentagon and military contractors.

Conclusion: Bankers have had as much or more influence over economic policy as any other interest group.

Of course, mere whispers of concern about the Fed’s independence immediately elicit torrents of objection. Two major arguments are usually marshaled against direct control over Fed policy.

The first involves the wisdom and reliability of elected officials and their executive deputies. Quite frankly, many bankers and economists don’t trust the President and Congress to manage our money supply (and therefore, in the end, to manage the economy).

Lester Thurow has recently written in “Zero-Sum Solution”: “This argument is both wrong and irrelevant. If the President is competent enough to have his finger on the nuclear button, he is competent enough to control the money supply. If the Congress is competent enough to control taxes and expenditures, it is competent enough to approve changes in the rate of growth of the money supply.”

The second involves the widespread fear about inflation. Some worry that if loose-money advocates run amok in Congress, easing the supply of money and credit, rampant inflation will surely result. But this argument is lopsided and incomplete. Inflation is not determined solely by the supply of money. It is determined by the interaction of the supply of goods and the demand for goods; it occurs, as the old adage observed, when “too much money chases too few goods.”

The most effective long-term solution to inflation is to improve the supply of goods--through improving the rate of productivity growth. Tight money can forestall both growth and investment, impeding rather than enhancing productivity growth and therefore indirectly generating increasing inflationary pressure.

The solution is an integrated set of economic policies that seeks both to foster productivity growth and to manage the supply of money and credit available for those growth policies.

An independent Fed, with its ear to the bankers and its fingers twitching every time a hint of inflation pulses through the economy, makes such coherent economic management impossible.

How could a change in the Fed’s status be effected? Since the Congress created the Fed, it therefore controls the terms of its operation. Congress is legally empowered both to restructure the Fed’s relationship to the rest of the government and to set legally mandated monetary targets.

There are reasonable questions about how practical managerial responsibility for and final control over monetary policy should be distributed between Congress and the President--just as there are reasonable disagreements over the executive/legislative mix in many other areas, such as foreign policy and budgetary authority.

But the debate should be about how and not whether to control the Fed. Paul Volcker and his colleagues should not run our lives. We should defrock the Delphic priests and take responsibility for our own economic destinies.