PoliticoBy John Dearie
The new House Republican majority has focused the crosshairs of reform on the Federal Reserve. The Fed, the nation’s central bank, has been controversial since its creation in 1913. But its actions during the financial crisis and its recent $600 billion bond-buying program — known as quantitative easing or “QE2” — have triggered a level of political scrutiny not seen since President Andrew Jackson abolished the Second Bank of the United States in 1832.
The long-time Fed critic Rep. Ron Paul (R-Texas), author of the bestseller “End the Fed,” is likely to use his authority as the new chairman of the House Domestic Monetary Policy and Technology Subcommittee to pursue his goal of requiring an annual audit of the central bank, its operations and monetary policy decisions by the Government Accountability Office.
Meanwhile, House Republicans recently introduced legislation to repeal the Fed’s “maximum employment” mandate — which Congress added to the original mandate of price stability in 1977. A narrower focus on price stability, the argument goes, would make stimulative policies like QE2 – which many Republicans consider unnecessary and even inappropriate – less likely.
Efforts to overhaul the Federal Reserve and its responsibilities are understandable following the tumultuous events of the past three years. But auditing the Fed’s monetary policy decisions, or narrowing its mandate, risk undermining the Fed’s effectiveness as the central bank rather than enhancing it.
The Fed might well be the most transparent central bank in the world. Federal Reserve Board governors and Reserve Bank presidents give frequent speeches and congressional testimony about economic circumstances and their policy implications. The Federal Open Market Committee – the Fed’s monetary policy arm – releases a statement after each meeting explaining the committee’s policy decisions, publishes the minutes three weeks later, and eventually provides full meeting transcripts.
The Fed also regularly publishes detailed information about the size and structure of its balance sheet, and the special liquidity programs introduced during the recent crisis.
Short of broadcasting FOMC meetings on C-SPAN, it’s difficult to imagine how much more transparent the Fed could be. It’s also difficult to understand how intrusive investigation of monetary policy can be consistent with maintaining price stability when academic studies and centuries of experience around the world make clear that a central bank’s relative independence and its effectiveness in fighting inflation are closely linked.
It’s also difficult to see the appeal – political or substantive – of dropping the Fed’s maximum employment mandate when the nation has just endured an unemployment rate north of 9 percent for almost two years, and with 40 percent of unemployed Americans out of work for six months or longer.
Moreover, as Marc Sumerlin, a former National Economic Council deputy director under President George W. Bush, recently write in a Wall Street Journal op-ed, an FOMC focused only on price stability in recent years might well have proved even more stimulative.
Between 1995 and 2006, the FOMC repeatedly cited low or falling prices as justification for reducing short-term interest rates, even as economic growth, asset prices and aggregate debt levels surged.
This suggests that the Fed’s mandate should not be narrowed — but broadened. Specifically, in making monetary policy decisions, the FOMC might pursue maximum employment in a context of price stability, while seeking to avoid highly unusual or dangerous distortions in debt levels or asset prices — or language to that effect.
When asked during congressional testimony about asset bubbles, Fed Chairman Ben Bernanke has been quick to point out that avoiding bubbles is not part of the Fed’s mandate.
In other words: It’s not his job. Well, Congress might make it his job.
Another meaningful change – or modernization – that would make monetary policy more responsive to the needs and priorities of a highly diverse U.S. economy would be to re-structure the system of regional Federal Reserve Banks.
In creating the Federal Reserve, policymakers established a system of 12 regional Reserve Banks, presided over by a seven-member Board of Governors in Washington. The FOMC, in turn, has 12 members — including the seven governors in Washington and five of the regional Bank presidents on a rotating basis.
This cumbersome system was deliberate – Congress wanted to ensure that interest rate policy would reflect economic conditions and priorities from across the nation, and not be dictated from Washington.
Thirty-seven cities applied in 1914 to the Reserve Board Organization Committee for one of the eight to 12 regional Reserve Banks stipulated by the Federal Reserve Act. Politics no doubt played a role in the distribution of the banks – Sen. James A. Reed of Missouri, a prominent Senate Banking Committee member, managed to locate two in his state, in Kansas City and St. Louis. But placement of the 12 Reserve Banks generally reflected the distribution of population and economic activity at the time.
The result was a Federal Reserve System with a decidedly Eastern tilt. Eight of the 12 Reserve Banks are east of the Mississippi River — six within 600 miles of Washington — while 1,700 miles separate the San Francisco Reserve Bank from the next closest in Dallas, Texas.
The United States has changed significantly since 1914. As of 2008, 41 percent of the population – and, presumably, a similar portion of economic activity – lives west of the Mississippi River.
This simple metric suggests that if the interests and priorities of the entire nation are to be fairly represented in monetary policy deliberations, at least five regional Reserve Banks should now be in Western cities. Given the political improbability of uprooting an existing bank, a better option might be to expand the number from 12 to 14 — placing the additional two in Western cities.
The FOMC might also be amended by increasing the number of voting bank presidents from five to seven, producing an FOMC of 14 members, split evenly between the Washington-based Board of Governors and the rotating regional Reserve Banks.
Whatever reform alternatives Congress considers, potential changes to the Fed, its structure or duties must be deliberated with great care.
Jackson, a Jeffersonian in his hatred of the central bank, took tremendous satisfaction in killing “that monster bank” in 1832. But it is worth recalling that a severe financial panic followed in 1837, plunging the nation into a five-year economic depression. Six more financial crises occurred over the next 70 years, culminating with the Panic of 1907 — which led to the creation of the Federal Reserve.
The Fed is not a perfect institution and remains controversial. Reform may be appropriate — and is worth considering. But, ultimately, the United States needs a strong, credible and independent central bank.
John Dearie, executive vice president of the Financial Services Forum, is a former officer of the Federal Reserve Bank of New York . The views expressed are his own.
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