REFORMING THE RULES THAT GOVERN THE FED.

AuthorCalomiris, Charles W.

As historians of the Fed such as Allan Meltzer (2003, 2009a, 2009b, 2014) frequently note, the Fed has failed to achieve its central objectives--price stability and financial stability--during about three-quarters of its first 100 years of operation. Although the Fed was founded primarily to stabilize the panic-plagued U.S. banking system, since the Fed's founding the United States has continued to suffer an unusually high frequency of severe banking crises, including during the 1920s, the 1930s, the 1980s, and the 2000s. Unfortunately, research shows that the Fed has played an active role in producing most of those crises, and its failure to maintain financial stability has often been related to its failure to maintain price stability. The Fed-engineered deflation of the 1930s was the primary cause of the banking crises of that era.

The Fed's lax monetary policy produced the Great Inflation of the 1960s and 1970s, which was at the heart of the interest rate spikes and losses in real estate, agricultural, and energy loans during the 1980s, which produced the banking crisis of that period. A combination of accommodative monetary policy from 2002 to 2005, alongside Fed complicity with the debasement of mortgage underwriting standards during the mortgage boom of the 2000s, and Fed failures to enforce adequate prudential regulatory standards, produced the crisis of 2007-09 (Calomiris and Haber 2014: chs. 6-8).

It is worth emphasizing that the U.S. experience with financial crises is not the global norm; according to the IMF's database on severe banking crises, the two major U.S. banking crises since 1980 place our country within the top quintile of risky banking systems in the world--a distinction it shares with countries such as Argentina, Chad, and the Democratic Republic of Congo (Laeven and Valencia 2013, Calomiris and Haber 2014).

In his review of Fed history, Allan Meltzer (2003, 2009a, 2009b, 2014) points to two types of deficiencies that have been primarily responsible for the Fed's falling short of its objectives: (1) adherence to bad ideas (especially its susceptibility to intellectual fads); and (2) politicization, which has led it to purposely stray from proper objectives. Failures to achieve price stability and financial stability reflected a combination of those two deficiencies.

Unfortunately, the failures of the Fed are not merely a matter of history. Since the crisis of 2007-09, a feckless Fed has displayed an opaque and discretionary approach to monetary policy in which its stated objectives are redefined without reference to any systematic framework that could explain those changes, has utilized untested and questionable policy tools with uncertain effect, has been willing to pursue protracted fiscal (as distinct from monetary) policy actions, has grown and maintains an unprecedentedly large balance sheet that now includes a substantial fraction of the U.S. mortgage market, has been making highly inaccurate near-term economic growth forecasts for many years, and has become more subject to political influence than it has been at any time since the 1970s. The same problems that Meltzer pointed to--bad ideas and politicization--now, as before, are driving Fed policy errors. I am very concerned that these Fed errors may result, once again, in departures from price stability and financial stability (Calomiris 2017a, 2017b, 2017c).

In this article, I show that the continuing susceptibility of the Fed to bad thinking and politicization reflects deeper structural problems that need to be addressed. Reforms are needed in the Fed's internal governance, in its process for formulating and communicating its policies, and in delineating the range of activities in which it is involved. I will focus on three types of reforms that address those problems: (1) internal governance reforms that focus on the structure and operation of the Fed (which would decentralize power within the Fed and promote diversity of thinking); (2) policy process reforms that narrow the Fed's primary mandate to price stability and that require the Fed to adopt and to disclose a systematic approach to monetary policy (which would promote transparency and accountability of the Fed, thereby making its actions wiser, clearer, and more independent); and (3) other reforms that would constrain Fed asset holdings and activities to avoid Fed involvement in actions that conflict with its monetary policy mission (which would improve monetary policy and preserve Fed independence).

Together these three sets of reforms would address the two most important recurring threats to monetary policy--short-term political pressures and susceptibility to bad ideas--and thereby improve the Fed's ability to achieve its ultimate long-run goals of price stability and financial stability, which are crucial to promoting full employment and economic growth. Table 1 summarizes the reforms proposed here, and Figure 1 outlines the primary channels through which reforms would improve monetary policy.

The Need for Internal Governance Reforms

The Fed needs broad and fundamental changes to its internal governance. Internal governance reform should make the Fed more institutionally democratic and more diverse in its thinking. Those improvements, in turn, would make the Fed less susceptible to political pressure--because centralization of power in the chair invites more political pressures on the chair. They also would make the Fed less likely to adhere to bad ideas, because of a reduced likelihood of "group think." My proposed changes are unlikely to have strong internal advocates within the Fed system (at the very least inside the beltway, at the Board of Governors), and therefore will require legislation. Ironically, although the Fed has been a champion of governance reform for banks as a means of improving their performance, it is much less receptive to recognizing its own governance problems.

In recent years, there has been an unhealthy increase in the centralization of power within the Fed, which has two parts: (1) the power of the Fed chair over the Federal Reserve Board; and (2) the concentration of power within the Federal Reserve System at the Board of Governors.

Daniel Thornton and David Wheelock (2014), both economists who have served for many years at the Federal Reserve Bank of St. Louis, provide some heuristic evidence on the need to reduce the power of the Fed chair over the Board of Governors. Thornton and Wheelock report that Federal Reserve Board governors have dissented from the chair only two times from 1995 to 2014. This compares to 65 dissents during the same period of time by Federal Reserve Bank presidents. Interestingly, presidents and governors had a similar pattern of dissents from 1957-95, about eight dissents per year for each group.

Surely, a well-informed and diligent group of six independent (nonchair) governors would find reason to disagree from time to time with the chair. Federal Reserve Bank presidents dissent frequently, and Supreme Court justices dissent with aplomb. Dissents remain common at the Bank of England. But somehow, Fed governors in recent years have become restrained from expressing their dissenting views.

This lack of dissent would seem strange to architects of the current Fed structure. When then-Fed chair Marriner Eccles testified before the Senate Banking Committee on March 4, 1935, regarding the proposed structure of the Federal Open Market Committee (FOMC), he complained that including only three Federal Reserve Board governors ran the risk that "a minority of the Board [of Governors] could adopt a policy drat would be opposed to one favored by the majority [of the seven board members]." That argument convinced Congress to structure the FOMC to include all seven governors. Clearly, Eccles envisioned a healthy degree of potential dissent within the Board of Governors about monetary policy. That is no longer the case.

Three possible explanations emerge for this unhealthy trend toward uniformity at the Board of Governors, each of which indicates a need for reform. One possibility is that governors are selected based on their willingness to compromise and "to go along, to get along." The chair has substantial discretionary power that can be wielded against uncooperative governors. This possibility, if true, is indicative of an unhealthy internal governance system that quashes independent thinking.

A second possibility is that many of the governors have become, de facto, short-timers who may not have a permanent stake in the system's long-run management or performance. Why bother to dissent if you are leaving soon after arriving? If this explanation has merit, it indicates that Fed governors are not playing the role intended by the Federal Reserve Act, which entrusted them with significant authority, gave them long-term (14-year) appointments, and envisioned them as important contributors to shaping the policies of the Fed.

Finally, a third possibility is that governors may not have the information or background needed to support the formation of independent decisions. This is quite possible given that (nonchair) governors do not have any staff to support their own lines of research and inquiry, and historically their access to the Board's staff has been limited. To the extent that limits are sometimes relaxed by the chair, this is a discretionary decision that can be reversed (and perhaps would be reversed if governors made use of staff to support positions that opposed the chair). Fed governors have complained publicly about the lack of independent staff to advise them, or the inability to speak to staff without permission. Former vice chairman Alan Blinder frequently complained about the limitations placed on his ability to communicate with Fed staff, and also complained about the "real reluctance to advance alternative points of view" at the Fed. Former governor Laurence Meyer said that he was "frustrated...

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