What's Wrong with the Fed? What Would Restore Independence?

Abstract

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. …

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