WE SHOULD DEMOCRATIZE THE FED
The following is a COMMENTARY delivered by Michael Meeropol on WAMC radio in November of 2005.
WHY DOES ALAN GREENSPAN HAVE SO MUCH POWER? WHY WILL BEN BERNANKE HAVE SO MUCH POWER? A DISCUSSION OF THE INDEPENDENCE OF THE FEDERAL RESERVE.
Alan Greenspan is arguably the second most powerful man in the world. As Chairman of the Federal Reserve – our Central Bank – (known simply as THE FED) he sits as first among equals in crafting Monetary Policy – controlling the level of interest rates.[1]
Interest rates affect the economy greatly. Raising interest rates means it costs more to buy a home, to finance a mortgage. Raising rates means less investment – factories won’t be built, equipment won’t be purchased, businesses won’t be created.[2] When interest rates rise too much -- recessions occur.
President Bush has recently appointed Greenspan’s successor Dr. Ben Bernanke.
I want to pose a question to those responsible for confirming Dr. Bernanke. Why is the FED chairman so powerful? Why isn’t our Central bank controlled democratically, as are other governmental institutions?
You heard me right. The reason Ben Bernanke will step into the second most powerful position in the world is because, by law, the FED is an INDEPENDENT CENTRAL BANK. It is not a branch of the Treasury.
The President can order the military to send troops anywhere in the world and to take military action under many circumstances without Congressional authorization.
But, the President cannot order the head of the FED and his colleagues to lower interest rates in order to stimulate the economy.[3]
Over the past 25 years whenever inflation has been in danger of getting too high, the FED has raised interest rates even if that caused an increase in unemployment.[4] Both of the last recessions (1990 and 2001) occurred as a result of the FED raising interest rates.
If the President had the authority to order the FED to lower interest rates, monetary policy would show more consideration for the people who get thrown out of work when interest rates go up.
So, why is the US Central Bank virtually immune from the democratic process? Our representatives determine how much should be spent on military activities and how high taxes should be. Yet somehow when it comes to setting monetary policy we are willing to surrender the democratic process to a bunch of appointed technocrats who are more beholden to the Banking industry than they are to the country as a whole.[5]
I don’t get it. I have been discussing this issue with my students for 34 years, and I’ve heard all the arguments.
The Central Bank needs to be independent of the politicians.
The people don’t understand finance and economics.
If the Central Bank listened to the people it would do the wrong thing.[6]
Couldn’t we make these arguments against democracy in general??
We could make the military independent.
We could have experts set tax rates.
Maybe we should not have democratic control over ANY important decisions?
Do we believe that? Emphatically NO!![7]
We recognize that there is a role for expertise.
For example, the President needs to consult military leaders with experience and skills in order to set the tactics to pursue military strategies.
However, THE CONSTITUTION explicitly puts the decision of whether to go to war in the hands of the people’s representatives. The Civilian Commander-In-Chief, the President is responsible for the conduct of any military operation.
Why should an unelected group of experts be independent of us?
Bernanke wrote a textbook in which he quotes one study which allegedly demonstrates that an INDEPENDENT Central Bank is more likely to take the difficult steps necessary to reduce inflation. The study concluded that this can be accomplished without increasing unemployment.[8] Bernanke neglected to quote a second study that comes to a contrary conclusion.[9] We can be pretty sure Bernanke believes in the “independence” of the FED – as do the majority of members of Congress.
I, however, think the Independence of the FED is one of those ideas that should be fully discussed and debated. I wish that the Senate Finance Committee while considering Dr. Bernanke’s appointment would widen the scope of its hearings by raising the question of whether the FED should remain independent or not..
I personally think we should actually give democracy a chance.
[1] The Federal Reserve System is composed of a BOARD OF GOVERNORS (seven members) appointed for 14 year terms which oversees the entire system. The system involves 12 Regional Federal Reserve Banks which are technically owned by the Banks in that region who are members of the Federal Reserve System. All 12 of those banks must follow national policy set by the BOARD OF GOVERNORS and an extremely important organization called the FEDERAL OPEN MARKET COMMITTEE (FOMC). The Federal Open Market Committee consists of the seven members of the BOARD OF GOVERNORS plus five Regional Bank Presidents four of whom serve on a rotating basis while the President of the NY Federal Reserve Bank is always on that committee. The BOARD OF GOVERNORS sets the Discount Rate (the rate at which the FED lends money to member banks) and Reserve Ratios (the percentage of bank deposits that must be kept as reserves and not lent out) while the FOMC determines how much government bonds to buy or sell on the “open market” (hence its name) in order to move an important short term interest rate called the Federal Funds Rate (the rate banks charge each other for overnight loans). All of the actions by the FED are designed to either increase or decrease the credit availability in the banking system by increasing or decreasing the money banks have with which to make loans. (Obviously if the reserve ratio rises, banks have less available to lend – if the FED sells government bonds on the open market, banks will have less available to lend). This then causes interest rates to change as a result of the increase or decrease in the supply of funds available to make loans.
[2] This doesn’t always happen. Sometimes interest rates will increase but businesses are so optimistic they will increase investment anyway. However, it is definitely often the case that increases in interest rates will restrain investment, especially in housing because of the impact of an increase in mortgage rates.
[3] It is true that an Act of Congress could order the FED to do anything. However, Congress has never taken any such action, even at the depths of the Depression in the 1930s. Presidents and members of Congress have made speeches attaching FED policy decisions (though not recently) but there has never been a bill introduced into Congress to reduce the independence of the FED. On the contrary, most political leaders go out of their way to emphasize that they respect and support the independence of the FED.
[4] The most dramatic example of this was in 1979 when the FED began a policy of restraining the growth of money in the hopes that this would reduce inflation without increasing unemployment. Interest rates rose and a recession occurred in 1980. Interest rates fell in response to that recession but in the Fall of 1981, interest rates rose again and this time the FED did not let up until December of 1982. The result was the worst recession since the 1930s which lasted from August 1981 till Decemeber of 1982. Unemployment peaked at 10.8% in December of 1982. After that the FED raised interest rates sometimes even before inflation went up and almost always this was accompanied by at least a temporary increase in unemployment. Such raises occurred in 1984, 1989 (which caused the recession of 1990), 1994, 2000 (which caused the recession of 2001). For Monthly Unemployment Data see www.bls.gov/PDQ/servlet. For the Federal Funds rate (the rate controlled by the FED) see www.federalreserve.gov/releases/h15/data/m/fedfund.txt.
[5] It is said that the Federal Reserve must recognize the wishes of the Financial Community in general but more particularly “the bond market.” The argument is, if “the bond market” loses confidence in the ability of the FED to control inflation they will sell all their bonds (because they carry a fixed interest rate, the value of which will be eroded by inflation) and that will cause a very big increase in interest rates that might trigger a recession (something like this actually happened in late 1981, despite the FED’s anti-inflation stance). Thus, it is not surprising that at least since 1979, the FED has been more interested in controlling inflation than in reducing unemployment. This is despite the fact that under the Full Employment and Balanced Growth Act of 1978 (which amended the Employment Act of 1946) the US government (including the FED) are bound by LAW to take actions to get the unemployment rate to 4% and the inflation rate to 3%. Every President with the exception of Bill Clinton from December 1999 through December 2000 (13 months in 27 years!) and every FED with the same 13-month exception has broken that law with regard to the unemployment rate. They’ve hit the inflation target more frequently (11 out of the 27 years). [For both the unemployment and inflation historical statistics go to www.bls.gov]
[6] These are virtually direct quotes from many different students in my classes over the years. The majority sentiment seems to always support the “independence” of the FED despite my best efforts to argue the contrary.
[7] This is rhetorical and based on hope rather than any deep research into public opinion polling. I’m sure people support the “idea” of democracy but might when pushed be very willing to surrender lots of decision-making to experts in lots of areas, not just the setting of Monetary Policy.
[8] See Andrew B. Abel and Ben S. Bernanke MACROECONOMICS, 5th ed. (Boston: Pearson, Addison Wesley, 2005): 557-558. The study was Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” JOURNAL OF MONEY AND CREDIT, (May 1993): 151-162.
[9] That study was Hiroshi Fujiki, “Central Bank Independence Indexes in Economic Analysis: A Reappraisal,” MONETARY AND ECONOMIC STUDIES, (December 1996): 79-101.
WHY DOES ALAN GREENSPAN HAVE SO MUCH POWER? WHY WILL BEN BERNANKE HAVE SO MUCH POWER? A DISCUSSION OF THE INDEPENDENCE OF THE FEDERAL RESERVE.
Alan Greenspan is arguably the second most powerful man in the world. As Chairman of the Federal Reserve – our Central Bank – (known simply as THE FED) he sits as first among equals in crafting Monetary Policy – controlling the level of interest rates.[1]
Interest rates affect the economy greatly. Raising interest rates means it costs more to buy a home, to finance a mortgage. Raising rates means less investment – factories won’t be built, equipment won’t be purchased, businesses won’t be created.[2] When interest rates rise too much -- recessions occur.
President Bush has recently appointed Greenspan’s successor Dr. Ben Bernanke.
I want to pose a question to those responsible for confirming Dr. Bernanke. Why is the FED chairman so powerful? Why isn’t our Central bank controlled democratically, as are other governmental institutions?
You heard me right. The reason Ben Bernanke will step into the second most powerful position in the world is because, by law, the FED is an INDEPENDENT CENTRAL BANK. It is not a branch of the Treasury.
The President can order the military to send troops anywhere in the world and to take military action under many circumstances without Congressional authorization.
But, the President cannot order the head of the FED and his colleagues to lower interest rates in order to stimulate the economy.[3]
Over the past 25 years whenever inflation has been in danger of getting too high, the FED has raised interest rates even if that caused an increase in unemployment.[4] Both of the last recessions (1990 and 2001) occurred as a result of the FED raising interest rates.
If the President had the authority to order the FED to lower interest rates, monetary policy would show more consideration for the people who get thrown out of work when interest rates go up.
So, why is the US Central Bank virtually immune from the democratic process? Our representatives determine how much should be spent on military activities and how high taxes should be. Yet somehow when it comes to setting monetary policy we are willing to surrender the democratic process to a bunch of appointed technocrats who are more beholden to the Banking industry than they are to the country as a whole.[5]
I don’t get it. I have been discussing this issue with my students for 34 years, and I’ve heard all the arguments.
The Central Bank needs to be independent of the politicians.
The people don’t understand finance and economics.
If the Central Bank listened to the people it would do the wrong thing.[6]
Couldn’t we make these arguments against democracy in general??
We could make the military independent.
We could have experts set tax rates.
Maybe we should not have democratic control over ANY important decisions?
Do we believe that? Emphatically NO!![7]
We recognize that there is a role for expertise.
For example, the President needs to consult military leaders with experience and skills in order to set the tactics to pursue military strategies.
However, THE CONSTITUTION explicitly puts the decision of whether to go to war in the hands of the people’s representatives. The Civilian Commander-In-Chief, the President is responsible for the conduct of any military operation.
Why should an unelected group of experts be independent of us?
Bernanke wrote a textbook in which he quotes one study which allegedly demonstrates that an INDEPENDENT Central Bank is more likely to take the difficult steps necessary to reduce inflation. The study concluded that this can be accomplished without increasing unemployment.[8] Bernanke neglected to quote a second study that comes to a contrary conclusion.[9] We can be pretty sure Bernanke believes in the “independence” of the FED – as do the majority of members of Congress.
I, however, think the Independence of the FED is one of those ideas that should be fully discussed and debated. I wish that the Senate Finance Committee while considering Dr. Bernanke’s appointment would widen the scope of its hearings by raising the question of whether the FED should remain independent or not..
I personally think we should actually give democracy a chance.
[1] The Federal Reserve System is composed of a BOARD OF GOVERNORS (seven members) appointed for 14 year terms which oversees the entire system. The system involves 12 Regional Federal Reserve Banks which are technically owned by the Banks in that region who are members of the Federal Reserve System. All 12 of those banks must follow national policy set by the BOARD OF GOVERNORS and an extremely important organization called the FEDERAL OPEN MARKET COMMITTEE (FOMC). The Federal Open Market Committee consists of the seven members of the BOARD OF GOVERNORS plus five Regional Bank Presidents four of whom serve on a rotating basis while the President of the NY Federal Reserve Bank is always on that committee. The BOARD OF GOVERNORS sets the Discount Rate (the rate at which the FED lends money to member banks) and Reserve Ratios (the percentage of bank deposits that must be kept as reserves and not lent out) while the FOMC determines how much government bonds to buy or sell on the “open market” (hence its name) in order to move an important short term interest rate called the Federal Funds Rate (the rate banks charge each other for overnight loans). All of the actions by the FED are designed to either increase or decrease the credit availability in the banking system by increasing or decreasing the money banks have with which to make loans. (Obviously if the reserve ratio rises, banks have less available to lend – if the FED sells government bonds on the open market, banks will have less available to lend). This then causes interest rates to change as a result of the increase or decrease in the supply of funds available to make loans.
[2] This doesn’t always happen. Sometimes interest rates will increase but businesses are so optimistic they will increase investment anyway. However, it is definitely often the case that increases in interest rates will restrain investment, especially in housing because of the impact of an increase in mortgage rates.
[3] It is true that an Act of Congress could order the FED to do anything. However, Congress has never taken any such action, even at the depths of the Depression in the 1930s. Presidents and members of Congress have made speeches attaching FED policy decisions (though not recently) but there has never been a bill introduced into Congress to reduce the independence of the FED. On the contrary, most political leaders go out of their way to emphasize that they respect and support the independence of the FED.
[4] The most dramatic example of this was in 1979 when the FED began a policy of restraining the growth of money in the hopes that this would reduce inflation without increasing unemployment. Interest rates rose and a recession occurred in 1980. Interest rates fell in response to that recession but in the Fall of 1981, interest rates rose again and this time the FED did not let up until December of 1982. The result was the worst recession since the 1930s which lasted from August 1981 till Decemeber of 1982. Unemployment peaked at 10.8% in December of 1982. After that the FED raised interest rates sometimes even before inflation went up and almost always this was accompanied by at least a temporary increase in unemployment. Such raises occurred in 1984, 1989 (which caused the recession of 1990), 1994, 2000 (which caused the recession of 2001). For Monthly Unemployment Data see www.bls.gov/PDQ/servlet. For the Federal Funds rate (the rate controlled by the FED) see www.federalreserve.gov/releases/h15/data/m/fedfund.txt.
[5] It is said that the Federal Reserve must recognize the wishes of the Financial Community in general but more particularly “the bond market.” The argument is, if “the bond market” loses confidence in the ability of the FED to control inflation they will sell all their bonds (because they carry a fixed interest rate, the value of which will be eroded by inflation) and that will cause a very big increase in interest rates that might trigger a recession (something like this actually happened in late 1981, despite the FED’s anti-inflation stance). Thus, it is not surprising that at least since 1979, the FED has been more interested in controlling inflation than in reducing unemployment. This is despite the fact that under the Full Employment and Balanced Growth Act of 1978 (which amended the Employment Act of 1946) the US government (including the FED) are bound by LAW to take actions to get the unemployment rate to 4% and the inflation rate to 3%. Every President with the exception of Bill Clinton from December 1999 through December 2000 (13 months in 27 years!) and every FED with the same 13-month exception has broken that law with regard to the unemployment rate. They’ve hit the inflation target more frequently (11 out of the 27 years). [For both the unemployment and inflation historical statistics go to www.bls.gov]
[6] These are virtually direct quotes from many different students in my classes over the years. The majority sentiment seems to always support the “independence” of the FED despite my best efforts to argue the contrary.
[7] This is rhetorical and based on hope rather than any deep research into public opinion polling. I’m sure people support the “idea” of democracy but might when pushed be very willing to surrender lots of decision-making to experts in lots of areas, not just the setting of Monetary Policy.
[8] See Andrew B. Abel and Ben S. Bernanke MACROECONOMICS, 5th ed. (Boston: Pearson, Addison Wesley, 2005): 557-558. The study was Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” JOURNAL OF MONEY AND CREDIT, (May 1993): 151-162.
[9] That study was Hiroshi Fujiki, “Central Bank Independence Indexes in Economic Analysis: A Reappraisal,” MONETARY AND ECONOMIC STUDIES, (December 1996): 79-101.
posted by WNECONOMICS at 4:24 PM
2 Comments:
Michael,
What form of democracy would you like to see? Would you prefer a direct election? Or something like our military where the president must approve of any Federal Reserve action?
My preference is always for decentalized decision-making that permits direct elections.
However, given the realities of the US, I would prefer that the Federal Reserve be a branch of the Treasury Department. That way, if the people disapprove of monetary policy they can express themselves through direct pressure on the President and of course in electing a President.
My general rule is that even though Democratic structures can be perverted and subverted at times (witness the current Administration on virtually all of their policies which are at variance with the [polling] preferences of the people) the solution to problems with democracy is MORE democracy not less.
Mike Meeropol
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