What's wrong with the Fed? What would restore independence?

• Author: Meltzer, Allan H.

On September 1, 1948, Allan Sproul, president of the Federal Reserve Bank of New York, commented on Fed independence:

I don't suppose that anyone would still argue that the central banking system should be independent of the Government of the country. The control which such a system exercises, over the volume and value of money is a right of Government and is exercised on behalf of Government, with powers delegated by the Government. But there is a distinction between independence from Government and independence from political influence in a narrower sense. The powers of the central banking system should not be a pawn of any group or faction or party, or even any particular administration, subject to political pressures and its own passing fiscal necessities [Letter to Robert R. Bowie, in Meltzer 2003: 738].

Few would disagree with Sproul's statement. The greater problem is not agreeing about the desirability of independence. It is finding institutional arrangements to achieve it and retain it if it is achieved.

We all learned, and many repeat, that the Federal Reserve is independent within government. That was certainly true of the Federal Reserve in 1913, but by 1917, it helped to finance the war by lending to finance bank purchases of war debt at concessional rates. After the war, the Treasury secretary insisted on holding low interest rates to support refunding of government debt. (1)

The 1920s were better. Secretary Andrew Mellon started the decade by letting interest rates rise. Benjamin Strong was the dominant personality, strong enough to prevent the Board in Washington from gaining control of policy. But Strong circumvented the clear prohibition against using monetary policy to finance the Treasury by actively purchasing and selling government securities in the open market. And the Fed Board of Governors agreed to modify the prohibition against direct Treasury finance by putting a dollar limit on the amount of direct finance.

One strand of Fed history develops the shift in power and influence toward Washington. President Wilson's compromise made the Board an overseer of the semi-independent Reserve Banks. Wilson's compromise settled the issue long enough to get Congress to pass the Federal Reserve Act. The issue of control reemerged almost at once.

Discussion at the time described the Board as a political body, the regional banks as representing business and possibly consumers. Prohibitions to support independence included the aforementioned prohibition on direct Treasury finances, but 'also gold standard rules, portfolio decisions controlled by Reserve Bank directors, the real bills doctrine, and 14-year terms for Board members. Real bills restricted Federal Reserve purchases to financing commercial paper and acceptances brought at the option of members to the Reserve Banks. The main discretionary action left the banks free to set their discount rates subject to approval by the Board.

By the 1920s, Governor Strong had organized the banks into the open market committee empowered to decide on purchases and sales in the open market subject to Board oversight and portfolio approval by bank directors.

The 1920s are the high point of independence under the managed gold standard. Each financial and economic crisis thereafter shifted influence away from the Reserve Banks and their directors to the Board members and staff. Some of the restrictions in the 1913 act are much weaker; most, but not all, are gone.

Revision of the Federal Reserve Act in 1935 gave the Board the control of open market decisions that their members had wanted for years. Directors no longer controlled portfolio decisions. The discount rate had been centralized earlier. In the inflationary 1970s Congress expanded political influence by extending membership on the Reserve Bank board to a more representative group in the districts. Following the recent crisis, directors lost some of their few remaining responsibilities.

The Federal Reserve now has unrestricted power to do what it chooses. It has vastly expanded its balance sheet; it engages in credit allocation; it holds down market rates on all Treasury securities, in part to recapitalize the money-center banks. It sacrifices independence by responding to pressures from Congress and the administration. It has never announced a lender-of-last-resort policy, and it continues to support too-big-to-fail policies that shift costs to taxpayers.

The Federal Reserve long ago gave up some of its independence. For five years after World War II, it maintained a 2.5 percent ceiling on long-term Treasury rates because it was unwilling to challenge members of Congress. In the 1960s and 1970s, then chairman William McChesney Martin, Jr. said repeatedly, as in the quotation from Allan Sproul at the start, that the Federal Reserve was independent within government. He explained that Congress approved the federal budget. If it authorized deficit spending, the Federal Reserve, within government, should help to finance the Treasury's securities sales. When deficits rose in the 1960s, inflation soon followed.

Arthur Burns succeeded Martin as chairman. Burns was unwilling to pay the political cost of reducing inflation. Inflation rose during his eight year chairmanship. When unemployment rose following each effort to control inflation, the Burns Fed increased money growth. During the 1970s, inflation and unemployment rose. The Board's staff--and many other economists--used models in which higher inflation lowered the unemployment rate. Data for the period show the opposite over time (Brunner, Cukierman, and Meltzer 1980).

Independence increased during the Volcker and Greenspan chairmanships but decreased substantially in 2008 and after. Having shown members of Congress its ability to expand money and credit massively, it will be difficult to avoid repeating such expansions in the future.

Discretionary authority to regulate financial markets and banks has 'always been divided in the United States. Federal Reserve authority has grown and, with it, role by regulators has supplanted reliance on common standards for risks and the rule of law. The Board has often equated the interest of New York's largest banks and the public interest. This, too, subverts independence. Can independence be restored?

The Policy Record

One possible defense of the limits on independence might be that the Fed's policies were more successful as a result. Selgin, Lastrapes, and White (2012) cast doubt on that conclusion. Their comparison suffers from differences in the quality and content of data over two distinctly different periods, under very different political regimes. It seems better to conclude that a largely discretionary policy has not brought clear evidence of superior performance.

My own study of Federal Reserve history (Meltzer "2003, 2010a, 2010b) found that in its (almost) 100 years, the Federal Reserve rarely has achieved sustained periods of relatively stable growth and low inflation. The two periods I identified were both years in which the Fed more or less followed a specific rule. In 1923-28, the Fed followed a weak type of gold standard. From about 1985 to 2003, the Fed closely followed John Taylor's rule (Taylor 1993). In other nonwar years, the Fed caused the Great Depression and did very little during the subsequent slow recovery, 1929-41. Its main action contributed to the serious 1937-38 recession. During the Great Inflation, 1967-1979, it produced a series of cycles that usually ended with higher inflation followed by recession and increased unemployment...