Federal Reserve independence: reality or myth?

• Author: Cargill, Thomas F.
• Position: Company overview

The Federal Reserve was founded in 1913 during the Wilson administration to end banking panics and depressions, and was part of the Progressive agenda for a more activist role of government (see Kolko 1963). By the 50th anniversary, the conventional wisdom was that the Fed's performance was overall satisfactory, especially after the Treasury-Federal Reserve Accord of 1951 that permitted independent monetary policy. While the decision to double reserve requirements in 1937 was judged a policy error, the Federal Reserve was not held responsible for the Great Depression.

Federal Reserve independence was judged important for optimal monetary policy outcomes. After the end of World War II through 1951, the Federal Reserve was unable to deal with inflation because of the commitment to support government bond rates. By contrast, the central bank pursued a successful monetary policy aimed at price stability in the 1950s after the Accord.

The 50th anniversary ironically was the year Milton Friedman and Anna J. Schwartz's monumental A Monetary History of the Federal Reserve: 1867-1960 (Friedman and Schwartz 1963) seriously challenged the conventional wisdom about Fed performance, especially during the Great Depression. (1) By the 1980s, the conventional wisdom of a well-performing central bank came under serious question. Research showed the Fed's restrictive policy in the 1930s contributed to the collapse and stagnation of the economy, while the expansionary policy in the late 1960s through the late 1970s contributed to the Great Inflation. Monetary policy performance after the disinflation of the early 1980s and price stability through the end of the 20th century was viewed in more positive terms. However, easy monetary policy during the run-up in real estate prices from 2001 through 2005 and the unprecedented increase in Federal Reserve assets starting in late 2008 have brought new criticism of Fed performance (see Selgin, Lastrapes, and White 2010; Taylor 2009).

Although the belief that the Fed has performed as promised no longer holds sway, the conventional wisdom holds that the Fed is independent, and that independence is important for price stability. The IMF and the OECD place high priority on de jure central bank independence; central bankers emphasize the importance of independence in the conduct of policy (Kohn 2009); references to the importance of independence in news accounts are extensive (Wall Street Journal 2012); and the inverse correlations between measures of central bank independence and inflation are widely accepted and are now becoming standard in textbooks.

The conventional wisdom with regard to Fed independence is not convincing. First, the Federal Reserve, considered to be one of the world's more de jure independent central banks, played a key causative role in the Great Inflation from 1965 to 1985. Allan H. Meltzer's history of the Federal Reserve (Meltzer 2003, 2009) demonstrates the sensitivity of the Fed to political institutions despite its de jure independent status. Moreover, the diary of former Fed chairman Arthur F. Burns from 1969 to 1974 (Ferrell 2010) reinforces Meltzer's analysis and presents a challenge to the modern view.

Second, the methodological and statistical foundation of the widely accepted inverse correlations between measures of central bank independence and inflation are flawed. The juxtaposition between the historical postwar record of the Federal Reserve and the stable and high indexes of independence assigned to the Federal Reserve are difficult to reconcile.

This article argues that Federal Reserve de jure independence is far too uncritically accepted as a foundation for a stable financial and monetary environment. Not only is the foundation weak but its widespread acceptance permits central banks like the Fed to engage in suboptimal policy with political undertones. Independence is more myth than reality.

The Misunderstood 1951 Accord

The 1951 Accord has generated a misconception about Fed independence and established a misdirected concept of central bank independence in general for decades that emphasized de jure independence. The conventional view is that once the Fed regained its independence, and was thus freed from political pressure, it was able to pursue price stability as judged by the inflation record of the 1950s. That view was adopted elsewhere because the United States was the most powerful and influential country in the world and the Fed was the predominant central bank, given the key role of the dollar as a global reserve currency.

The conventional view of the 1951 Accord is incorrect. In no sense was the Federal Reserve freed from political pressure despite dropping the requirement to support government bond prices. Indeed, President Truman forced Fed chairman Thomas B. McCabe to resign several days after the 1951 Accord despite the fact his term as a board member legally extended until 1956 (Meltzer 2003: 712).

The Accord provided the foundation for the modern view of independence--namely, that once the Federal Reserve was no longer required to support government bond prices it was able to focus on price stability. That view, however, ignored the fact that the Fed operated with multiple policy targets, and it failed to recognize that monetary policy was mostly nontransparent (Santoni 1986). The Fed was able to pursue whatever targets seemed appropriate at the time, and there was no guarantee the choice would be invariant to the wishes of politicians. Consequently, there was no guarantee the "independent" Federal Reserve would achieve price stability.

The Post-Accord Federal Reserve: Martin and Burns

Federal budget deficits shrank to comparatively small amounts after the end of the Korean War in 1953. The budget deficit of fiscal year 1955 was half that of 1953. There were budget surpluses in 1956-57 and 1960. Spikes in budget deficits were associated with recessions and did not represent shifts in the structural deficit (Buchanan and Wagner 1977: 43-47).

The era of Keynesian growth-enhancing spending, major social programs, and political pressure on the Federal Reserve did not come until the Kennedy and Johnson administrations (Buchanan and Wagner 1977: 47-50). Meltzer's detailed history clearly shows the increasing politicization of the Fed under Chairman William McChesney Martin from the early 1960s to his retirement in 1970. The 1950s were not much of a challenge to any Fed chairman, or a test of the institution's independence, because that era was one of small budget deficits (or even surpluses) and a relatively non-activist government. Martin was able to use countercyclical monetary policy ("leaning against the wind") to maintain economic growth and keep inflation low (Friedman and Schwartz 1963: 631, 631n33). He was not seriously tested until President Johnson implemented the Great Society program and launched the Vietnam War. Deficits ballooned, which the Federal Reserve at least partially accommodated. Meltzer's history provides ample references to illustrate Martin's vision of independence that placed a rather low priority on price stability. The result was an increase in inflation after 1965 that became the Great Inflation in the 1970s.

Martin's term as chairman ended by statute on January 31, 1970, and President Nixon replaced him with Arthur F. Burns, who had served as chairman of the Council of Economic Advisers in the Eisenhower administration and advised Nixon in his failed run for the presidency in 1960. Nixon trusted Burns and brought him into the administration to serve as counselor to the president. In that position, he attended cabinet meetings and met frequently with the president. On January 31, 1970, Burns was sworn in as the new chairman of the Federal Reserve.

The Fed's performance under Burns has been heavily criticized. Our focus is not on the technical issues of the failure of monetary policy in the 1970s, which have been reviewed in many places. Rather, we are interested in why Burns acted the way he did.

If any scholar had remaining doubts about whether Nixon and Burns politicized the Federal Reserve, Burns's diary is a strong antidote. We now have an account of what happened in Burns's own words. The diary was secret, or as secret as anything is these days, and only opened to the public in 2008 at the Gerald R. Ford library in Ann Arbor (Ferrell 2010: xi). Those who adhere to the modern view of central bank independence will be seriously challenged after a review of the diary.

Not surprisingly, Burns casts his role in the best possible light. In his view, the president is surrounded by men of weak character and intelligence. Martin was a "pathetic slob" (Ferrell 2010: 14). Though he later revised his opinion, he initially held George Shultz in low esteem. Then...