October 02, 2011
Monetary policy and democracy
Should presidents of regional Federal Reserve Banks have a vote on the FOMC, the policy-making committee of the Federal Reserve?
Representative Barney Frank (D-MA) thinks they should not:
I have long been troubled by the anomaly of having officials-- selected with absolutely no public scrutiny or confirmation-- voting on some of the most important decisions the federal government makes. Therefore, I introduced H.R. 1512, which eliminates the role of the Federal Reserve's regional presidents as voting members of the Federal Open Market Committee. The Federal Reserve (Fed) regional presidents, 5 of whom vote at all times on the Federal Open Market Committee, are neither elected nor appointed by officials who are themselves elected. Instead, they are part of a self-perpetuating group of private citizens who select each other and who are treated as equals in setting federal monetary policy with officials appointed by the President and confirmed by the Senate.
Would more direct control of U.S. monetary policy by Congress and the President be more consistent with democratic principles than the current system? I can think of several reasons why it might not be.
First, there are some interesting economic arguments why adhering to a long-term commitment to controlling inflation would leave us with something we like better than if we allowed ourselves to decide from scratch the level of inflation that we think we might like for each particular month (see for example Kydland and Prescott (1977) and Barro and Gordon (1983)). An analogy to which some people may be able to relate is the question of how to have the most personal control over your own body shape. If you were to decide anew each day whether you should skip your exercise and add a dessert "just for today", you might think that such day-to-day discretion gives you more personal control over the outcome than if you were to commit to a diet and exercise regime and completely suppress whatever this day's impulses might be. But the practical experience of many of us is that the real way to make sure that the outcome is the one you really want is to surrender your own discretion, and instead commit to a policy and stick with it. Many economists argue that the U.S. economy did much better, and that the American public was much more satisfied with the outcome, during the 1990s when monetary policy was more rule-based and less discretionary than what we tried in the 1970s (see for example Taylor 2011).
The election cycle raises a second reason why giving elected officials more direct control over monetary policy need not serve the public's best interest. By over stimulating the economy today, it might be possible for a president to increase his or her chances in the near-term election. The adverse consequences of that policy may not be perceived by the public until after the election, when it is too late to change the outcome.
Third, historical experience from a number of countries provides ample evidence of what happens when the central bank is allowed to become a key instrument for meeting the government's bills by just printing more money. Such a system has been a complete disaster wherever it has been tried, and people who have lived through such episodes are pretty enthusiastic about the idea of having a politically independent central bank.
There are a number of details of the institutional structure of the Federal Reserve that try to minimize the direct, short-run political control over the institution. I personally feel it's a fortunate outcome that the 4-year term of the Federal Reserve Chairman does not coincide with the term of the U.S. President. The 14-year terms of governors of the Federal Reserve (who are nominated by the President and confirmed by the Senate) serve a similar function, though in practice most governors do not serve for a full term. The presidents of the regional Federal Reserve Banks tend to stay in their jobs for longer than the governors, and this provides an important source of stability to policy-making. The fact that they have a regional base that is beyond the control of elected officials in Washington is in my opinion a valuable feature rather than a bug. Besides, the appointed governors and Fed Chairman always have a majority on the FOMC. If the regional banks actually do see things differently than the Washington appointees, their only real power is to issue a dissenting opinion.
On that last issue, however, I feel that Representative Frank raises a valid point:
Finally, one other factor of our current degraded political atmosphere exacerbates this. That is the refusal of the Republicans in the Senate to do their constitutional duty and treat the confirmation process as it is supposed to be treated-- namely by looking at the merits of each individual nominee. The influence of the regional bank presidents is obviously great when there are seven governors and five presidents voting on the FOMC. In the current situation, we have an equal vote between the presidents and the governors and that greatly adds not simply to the influence that presidents have, but to their ability to effectively constrain or veto items such as further use of unconventional tools to promote growth.
A separate issue worth mentioning is that just as making a long-term commitment to low inflation can be the best policy in normal times, making a commitment to keep inflation a little higher when the economy initially recovers than the Fed would normally like can be the best policy when the interest rate is stuck at the zero lower bound (e.g., Eggertsson and Woodford, 2003). It's not clear how easy it will be for the present institutions and personalities to make a nimble adjustment to this alternative form of necessary commitment.
Even so, I think a rational voter should much prefer the existing structure of Federal Reserve decision-making to any proposals that would bring the entity under more direct political control.
Posted by James Hamilton at October 2, 2011 09:45 AMdigg this | reddit
"I personally feel it's a fortunate outcome that the 4-year term of the Federal Reserve Chairman does not coincide with the term of the U.D. President."
U.S., not University of Dayton, I presume. ;
Posted by: John B. Chilton at October 2, 2011 10:27 AM
John B. Chilton: Thanks, typo now fixed.
Posted by: JDH at October 2, 2011 10:47 AM
This is kind of like arguing over who should break windows in order to increase GDP.
The Fed is an inherently failed institution, and rearranging the deck chairs is not going to help.
It continues to amaze me that policymakers and economists unquestioningly accept the premise that 1% - 2% annual inflation is both natural and good. Due to technological advances and productivity increases, deflation is the natural condition, and would encourage savings and prudence. Inflation encourages consumption and debt, and is responsible for creating the current economic mess. That anyone would want to encourage more of this is insane.
Posted by: W.C. Varones at October 2, 2011 10:54 AM
The Fed should be independent. It is too pliant as it is, I think. I personally find Frank's attempt to reduce bank independence disturbing.
Does Frank think policy would be different if other technocrats were elected? I'm inclined to think not. This was the experience of my uncle in Hungary, where he served as the only non-affliliated member of the monetary council (the policy board setting interest rates). He notes that the technocrats tended to dominate political appointees--no one wants to really fool around too much with interest rates and inflation if they don't know what they're doing. So the discussions tended to become analytical and data-driven over time. Pick another set of technocrats in the US to run monetary policy, and you probably still get much the same outcome, except in marginal cases.
However, direct political intervention on such a board would be an unmitigated disaster, I think. Allow politicians to print money, and they will.
Posted by: Steven Kopits at October 2, 2011 11:03 AM
Actually, letting the pols print money might not be such a bad idea.
Get rid of the ability to borrow and tax and make them print everything they spend, knowing the voter will hold them accountable for inflation and price distortions. Of course, we currently don't hold them accountable for price distortions, so I might be expecting too much.
Posted by: aaron at October 2, 2011 03:04 PM
And maybe make a hard cap on spending as a percent of private sector gdp.
It'd only take a couple constitutional amendments.
Posted by: aaron at October 2, 2011 03:28 PM
I'm not much in favor of Barney Frank's proposal but you assume a conclusion, that this would increase direct political control and would make monetary policy subject to the political cycle. That's your conclusion. I don't see it; the Fed members appointed by Congress would have the exact same independence as they have today. The only change is what Frank says, that private citizens who don't go through Congressional approval have a vote in the nation's monetary policy. Why should they? The argument for Frank's proposal is that these people have positions off great power because the banking industry has great power and these people essentially represent that industry and not the American people. Good? Bad? It's not as clear as you picture it.
Posted by: jonathan at October 2, 2011 04:24 PM
"Would more direct control of U.S. monetary policy by Congress and the President be more consistent with democratic principles than the current system?"
The Congress shall have Power . . . To coin Money, regulate the Value thereof, "
The answer to your question is "yes." Funny there's nothing here about "Congress shall abrogate its Power to a group of unaccountable private bankers acting mainly in their own interest."
Posted by: moopheus at October 2, 2011 06:56 PM
High inflation is a failed policy.
1) It hits struggling households and does nothing to ease their debt burden.
2) The Fed will not be able to produce inflation except via helicopter drops (which is, in reality, fiscal policy).
I am waiting for someone to explain to me how higher than 2% target inflation is good for anyone other than the government. If the government assumes a lot of bad debt in the economy and then inflates it away, I can see the argument. And that is a BIG if.
Posted by: ReturnFreeRisk at October 3, 2011 02:44 AM
In spite of your claim, nothing you say argues against the idea that getting rid of regional Fed presidents is more in keeping with democratic principles than the present situation. Instead, you present a series of arguments on why democracy might result in worse decisions.
These are the classic arguments against democracy at all times in all circumstances.
Posted by: David Blake at October 3, 2011 02:52 AM
moopheous The Section 8 quote was intended to mean that state governments would no longer have the power to coin money. The Federal Reserve is, technically, a creature of Congress authorized to act as Congress' agent. Not much different than hiring a personal trainer to help you with weight management.
It's not exactly clear to me how turning day-to-day operations over to 40 recalcitrant GOP senators committed to filibuster is anymore "democratic" than a dozen or so bankers and academic types.
Posted by: 2slugbaits at October 3, 2011 05:19 AM
I welcome your reminder of the justification for the political independence of central banks, JDH - well said! Right now though, it seems to be a cabal of prominent academic (eg Krugman), institutional (Blanchard) and journalist (Wolf) economists who are calling for the lessons learned from the 1970s (which should not be detached from the costly repair job of the early 1980s) to be ignored, rather than mainstream politicians. In fact, while I disagree with most of the right wing politicians' policy ideas, I am glad to see some of them holding central bankers' feet to the fire on inflation.
Posted by: RebelEconomist at October 3, 2011 05:56 AM
What is the purpose, at this point in the game, of fetishizing the independence of the Fed? Why are economists so fixated on this? I understand the Fed is the number one source of research grants to the academic economics establishment...is the deeply respectful tone of the economics profession the result of that? If broad popular input into the decisions of the Fed is automatically suspect, how about examining in depth the current governance of the Fed and the state of its (apparently intentional) capture by private Wall Street, banking and large corporate interests? There were a spate of stories about who serves on various input committees to the NY Fed back in 2007-8 when those industries were on life support, a few Google searches will bring up the details. Why so much suspicion of politicians getting anywhere near the Fed, and the complete unconcern with the whole notion of rent-seeking that would seem to be a far more serious issue looking at the current governance of the institution?
Posted by: Bill Meyer at October 3, 2011 06:40 AM
Bill Meyer Do you honestly believe that there would have been less rent-seeking behavior if (say) VP Dick Cheney had been allowed to run the Fed with his heavy, iron fist? Yes, there are some turkeys on the Fed right now...three in particular; but they are turkeys precisely because their views are consistent with many of our most clueless politicians in Congress. An independent Fed does not give us a perfect prophylactic protecting us from idiocy, but rather it's a kind of semi-permeable barrier slowing down the march of the barbarians at the gate. Well, that's a lot of alliteration and mixed metaphors, but you get the idea.
ReturnRiskFree asks someone to explain why a 2% inflation target is good for anyone other than government. There are several reasons. First, a zero deflation target is not good because undershooting the zero-target risks deflation, and the output risks associated with even mild deflation are not symmetric with the risks associated with mild inflation. A 2% inflation rate is stationary, but a 2% deflation rate is unlikely to converge to some kind of equilibrium position. With deflation output is more strongly effected than prices. So the 2% inflation target is a kind of cushion againt deflation. Second, mild inflation in an otherwise stable, full-employment economy is predictable and can be easily incorporated in wage contracts, interest rates, price increases, etc. The issue with inflation is not that prices go up, it's whether prices go up at a predictable and nonaccelerating way.
But I suspect that what you're really asking about are Fed policies to generate a slightly higher inflation target of (say) 4%. Setting aside the feasibility and actual capabilities of the Fed to credibly convince the public that it was serious about a 4% inflation target, if such a thing were possible it would be good for the economy. Yes, many households would be hurt in the sense that real wages would decline and this would put a squeeze on discretionary income; but the key is that more discretionary income would get put back into the economy and that helps the larger economy. If people expect more inflation, they will take money out of the mattresses and start spending it. That will draw down real goods on the shelf and increase aggregate demand. Companies will start hiring because: (1) demand has increased; (2) real wages are lower; and, (3) with inflation they can enjoy negative real interest rates.
It's hard to get people with jobs today to sign up for higher inflation because over the short-run they will be hurt because of a fall in real wages. But this is a false sense of security. If the risk of deflation isn't nipped in the bud and if this economy isn't jump started pretty soon, eventually even people who have jobs today will find themselves unemployed tomorrow. Too much inflation is bad and no one wants to see Carter style inflation again; but at least the economy was growing under Carter. Unemployment was low. In any event, no one is talking about 12% inflation.
Finally, if you're worried about inflation, then you should be pushing for strong fiscal policy instead of monetary policy. It would be good if the federal government soaked up all that excess savings. There's so much excess savings right now that banks are starting to penalize you for having a large savings account. They literally do not want your money. Fiscal policy would solve that problem.
Posted by: 2slugbaits at October 3, 2011 09:57 AM
It would be more productive if politicians focused on real problems than imaginary ones. It is within their power to legalize the money drop. Inflation isn't inflationary if provided with the money to pay for it. Debt isn't debt if not issued. The solution is in their power and blaming others is not it.
Posted by: Lord at October 3, 2011 09:59 AM
You know, the economic news is the US is not that bad. But the DOW is just terrible...
Posted by: Steven Kopits at October 3, 2011 10:21 AM
Is K.Arrow's impossibility theorem not too prevalent in the Federal reserve members votes.
How effective is Mr Bullard vote (Fed St Louis) when made subject "to adequate monetary policy"? (please see Econbrowser post on the subject,post documented by the same fed St louis reseach on the topic)
Same for the ECB
Posted by: ppcm at October 3, 2011 10:58 AM
2slugs--I understand what the Fed is. I didn't mean to suggest eliminating the Fed. That wasn't the question. The question was whether it is undemocratic to have people making decisions on monetary policy who are unaccountable to the democratic institutions that ultimately hold the authority. I don't think having Congress in direct charge of day-to-day monetary operations would be a good idea. There clearly needs to be some administrative agency to do that. But the Fed's "independence" is illusory. If we don't want them to be pressured by Congress, how do we keep them from being unduly pliant to the banks' interest? The Fed often seems to be not independent of Treasury. And Treasury, more often than not, wants a very bank-friendly policy. Paulson and Geithner did all they could to keep their friends from feeling any pain, and Bernanke was right there with them.
The other point was that since Congress has the Constitutional authority, then it is not undemocratic for them to assert that authority, even if Prof. Hamilton thinks it might not result in the best monetary policy.
Posted by: Moopheus at October 3, 2011 11:36 AM
Moopheus and others: I intended to raise the question not of how to get the best monetary policy, but instead of how to get the monetary policy that voters most want.
Posted by: JDH at October 3, 2011 11:45 AM
If it's to be what voters want, clearly the current system is a fail. Did voters want the TARP? No. Bailout AIG? No. Did the voters ask the Fed to provide trillions of dollars in various aid programs to banks and other financial institutions? No. Did voters ask the Fed to engage in programs to inflate financial asset and commodity prices? No. Did the voters ask the Fed to neglect its regulatory duties with regard to bank lending during the bubble? No. Did the Fed help anybody get a job, pay their debts, avoid foreclosure, buy food? No. So why would we prefer the current system, which has frequently worked against the public interest? I mean, the "public interest" is being represented on the Fed's Board of Directors by a shill for banking interests!
Posted by: Moopheus at October 3, 2011 02:05 PM
I am sorry but, even if your argument is accepted, your conclusion does not follow. It is clear that banks and other elites have different concerns from ordinary Americans a significant percentage of the time. Independence from politicians is useless if it is not followed by independence from other actors who want to corrupt monetary policy (such as the deflationists). The current FOMC is making a mockery of their oaths of office by focusing on fighting inflation and ignoring the other half of the dual mandate. Such lawless behavior demonstrates that the current system is broken and needs reform.
While having the Federal Reserve Governors insulated from political influence is beneficial, nothing in this post supports the proposition that the bank presidents add anything except that they are more likely to be biased to do what some elites want. That is not democracy.
Posted by: jalrin at October 3, 2011 02:31 PM
JDH, your economic analysis is excellent, e.g., your comments on oil are among the best. Who gets appointed to the Board of the Fed is a political question (who gets the power?, right). Your continual style in political issues is to raise a strawman, and then beat the tar out of it. This is not political analysis, it is dogmatic declaration. I much prefer your economics, but if you have an unquenchable urge to use this pulpit for political commentary, it would be more effective if you stopped the "strawman dogmatics", and used data, cross section comparison, historical comparison, and similar logical analysis that is used by the best political researchers at universities. It would reflect better on you and your university, and could become interesting to read.
Your current effort has hoisted you on your own pitard. In your second paragraph you raise the strawman of the Fed's purported long term dedication to inflation targets rather than switching about, which you assert will happen with others in power. Long term currency stability is a laudable goal, but one that the Fed in its current Board power structure has not achieved. When one looks at the long term value of the US dollar over several decades, it clearly shows the Fed has allowed inflation in the long run. The dollar has declined over 90% when you measure in 50,75, 90 year time frames. Your argument that the current power structure of the Fed will limit inflation "over the long term" has no credibility in factual experience.
I can get political dogma that is not based on fact at hundreds of web sites. I'd like to see better than that here. I've come to expect it from the quality of your economic analysis.
Posted by: Mike Laird at October 3, 2011 02:51 PM
Moopheous The question was whether it is undemocratic to have people making decisions on monetary policy who are unaccountable to the democratic institutions that ultimately hold the authority.
First, this is an old argument going back to the early days of the republic. I recently read Sean Wilentz' book on the fist 60 years of the 19th century and the ghost of the Second Bank of the United States haunted the political debate for decades.
But addressing your point about Fed actors not being accountable, I think you might want to revisit the personal trainer analogy. In theory you always have the right to dismiss the trainer as soon as you're told to put down that donut. But here you have to distinguish between your immediate goal of eating the donut and your longer run goal of losing weight. Voters and politicians always have conflicted goals. It's the job of the trainer to spoil the party and remind you of your longer goal. Ultimately the trainer is accountable and you can always fire the trainer, but the time to consider firing the trainer is when you're calmly evaluating your progress toward weight loss and not when you're drooling over that cream filled donut calling you like a siren. Long and staggered Fed terms mean that over the long run they are accountable to politicians, who are ultimately accountable to voters. But we deliberately insert some dampener between our impulses and reasoned judgments. The role of democracy is to provide the broad strategic guidance that the Fed should follow. The Fed's job is to work the technical and tactical problems.
BTW, I happen to be one of those voters who thought TARP was ultimately the right thing to do, although it was mainly a Treasury operation rather than a Fed operation. And I supported QE1 & QE2 and I'd like to support QE3-on-steroids. So I think you presume too much when you claim to speak for voters.
Posted by: 2slugbaits at October 3, 2011 03:47 PM
Due to technological advances and productivity increases, deflation is the natural condition.
Sometimes, I think I am the only person who realizes this.
2% of World GDP now comprises products tied to Moore's Law, which was not the case in the 20th century. The major central banks of the world (US, EU, PRC) have to print at least $1.5T a year just to avoid deflation. This number will keep rising over time.
This is not a bad thing.
Posted by: GK at October 3, 2011 11:38 PM
I would probably be more democratic to pass the Barney bill, but it would be in the public's best interest to have no career beaurocrats in such positions at all.
Posted by: baychev at October 4, 2011 12:18 AM
Almost every other advanced economy in the world has a central bank in which the relevant committee is appointed by elected officials, often with a public confirmation hearing. I have never seen any serious anlysis that suggests monetary policy would be better if this process was avoided.
So I really don't see why the Federal Reserve should be an exception!
Posted by: Jackson Cage at October 4, 2011 01:26 AM
The problem with your personal trainer analogy is that the Fed is telling us that we aren't eating enough donuts, because Fred the Donut Man is on the Board.
This is more how the Fed acts as personal trainer:
Posted by: Moopheus at October 4, 2011 06:19 AM
"Democracy" today is as Spengler predicted 80 years ago: "rule by money men", which he further predicted (as did Sarkar/Batra) would be followed by "Caesarism" or military dictatorship once the rentier-parasite caste's rule collapses after the entire society (households, firms, and gov'ts) is so indebted to the top 0.1-1% that growth is impossible and collapse of the debt-money system is inevitable.
And along with the collapse of the debt-money system will be the loss of legitimacy and authority of the institutions that arose coincident with, and enabled, militarist Anglo-American rentier-financier oil empire, including the Fed and fractional (fictional) reserve banking, deficit spending in perpetuity, state and private universities, supra-national corporations, the welfare-state, and the religion of perpetual growth of population and consumption on a finite planet.
Consider that today the total US credit market debt owed is equivalent to $5.5 of debt to $1 of private GDP. (China recently surpassed $7 to $1.) Total US credit grew $22 trillion since '00-'01 or 4-5 times the growth of GDP during the same period. We need over $1.7 billion/yr. in new debt (11-12% of nominal GDP or $12,000 of new debt per working American each year) to achieve the long-term avg. trend of private GDP.
But it's worse. The total compounding interest claims at the current rates and average term is now equivalent to nearly 100% of GDP hereafter. Growth of debt-money, gov't deficit spending, asset prices, and private GDP is no longer possible. Debt-money, bank loans, gov't spending, and GDP per capita must decline at least 30% over the next 5-10 years, and as much as 50% or more in real per capita terms over the next 10-20 years at the long-term CPI trend.
As part of the secular debt-deflationary contraction, the combined losses to real estate and stock values will reach and exceed $20 trillion (the amount of debt added just since '00-'10, recall), wiping out all household, unincorporated business, and farm equity wealth after mortgage and consumer credit liabilities, leaving 80-90% of US households with no or negative net wealth in the years ahead.
The loss figure above does not count losses to commercial real estate, business equity, junk bonds, personal durable goods, and collectibles, for example; therefore, the total loss to US households could reach $25 trillion, which is half of financial wealth, 165-170% of GDP, and well over 200% of private GDP.
That the loss of per capita GDP will generally speaking track a similar decline in per capita crude oil production/consumption (from the peak in '70 and '85) and implied loss of private investment, production, payrolls, and income, the bottom 80-90% of US households will experience a decline to an equivalent real per capita consumption level last seen in the 1960s-70s (before the peak Boomer unreal estate, stock market, debt, and consumer goods orgy), whereas the bottom 50% will experience real per capita consumption of the 1930s to as far back as the early 20th to late 19th centuries for the poorest.
To most readers, this will sound incredible to just plain nonsensical; unfortunately, it is not. One is unlikely to even consider such a scenario because no economist, politician, CEO, or mass-media influential would dare suggest (in public) that it is even possible, let alone inevitable.
Yet, the global structural effects of Peak Oil, population overshoot, and falling net energy and oil exports will combine to prevent Keynesian, supply-side, monetarist, Austrian, socialist, "austerity", or any other policies from keeping business as usual going.
Posted by: Bruce at October 4, 2011 02:04 PM