Courtesy Reuters

The Fed's Political Problem

How Politics Threatens U.S. Monetary Policy

In the midst of the ongoing financial crisis, Congress is now considering a bill that would subject the Federal Reserve to congressional audits. It would be a shame to let that happen. Some functions of government properly belong in the realm of technocracy (for example, drug approvals), and others belong in the realm of politics (for example, same-sex marriage). I first argued in the November/December 1997 issue of Foreign Affairs that the U.S. government was placing too many decisions in the political realm and too few in the technocratic one. In the 12 years since, I have become increasingly convinced of this.

The thought back then was inspired by the apparent success of the Federal Reserve System. A noteworthy creation of the Progressive Era, the Fed was designed to conduct monetary policy on decidedly nonpolitical grounds: it has only a vague legal mandate from Congress -- to pursue both "stable prices" and "maximum employment" -- and nearly complete discretion to fulfill its mission as it sees fit. Over the years, the Fed, protected from partisan political concerns, has been able to run a very capable -- which is not to say perfect -- monetary policy, almost certainly keeping inflation lower than politicians would have. Yet, despite this success, few, if any, U.S. government agencies today enjoy anything remotely close to the Fed's degree of insulation from politics. Maybe, I suggested in 1997, more should.

Since then, the Fed has scored some spectacular successes. It averted financial calamity in the United States as economies faltered throughout Asia in 1997-98; it steered the country through the post-2000 stock market crash with minimal damage; and, most recently, it took extraordinary measures to avert what its chair, Ben Bernanke, said might have become the Great Depression 2.0. But it has also suffered some spectacular failures. For example, it did not properly supervise banks in the run-up to the current crisis, nor did it protect consumers from predatory mortgage lenders.

Ironically, both the Federal Reserve's failure to prevent the crisis and its remarkable success in pulling the economy back from the brink have fueled Congress' hostility. Since it proved to be a poor regulator, some legislators are reasonably asking why they should give it additional regulatory powers, as the Obama administration's reform plan proposes. Others have accused the Fed of usurping congressional authority by engaging in back-door appropriations of taxpayer funds -- for example, when it used emergency loans to facilitate Bear Stearns' purchase by JPMorgan Chase and propped up AIG in 2008.

Congress' ire cuts across party lines, but it has been crystallized by Ron Paul (R-Tex.), an extreme libertarian and longtime foe of the Fed. He has, incredibly, persuaded almost two-thirds of the House of Representatives to co-sponsor a bill that would jeopardize the Fed's independence. The bill is titled, innocently enough, the Federal Reserve Transparency Act, which sounds like something everyone should favor. In fact, many have long advocated greater Federal Reserve transparency. And, incidentally, the Fed has become substantially more transparent over the past decade, such as by issuing explanatory statements with each policy decision and revealing more about its internal economic forecasts.

But the cutting edge of the Paul bill is not a call for more transparency; it is a proposal to subject the Fed's decisions on monetary policy and its dealings with foreign central banks and foreign governments to audit by Congress' Government Accountability Office (GAO). Up until now, these activities have been explicitly exempted from audit by the U.S. legal code.

On the surface, authorizing such an audit may sound like much ado about nothing. After all, the Fed already gets a regular external audit of its financial statements. (If Chairman Bernanke were living high on the hog at the taxpayer's expense, Congress would know, as it should.) Further, the GAO is already permitted to examine most aspects of the Fed's operations, including such special financial arrangements as the deals with Bear Stearns, AIG, Citigroup, and Bank of America. The Federal Reserve's chair and other officials are frequently called before congressional committees to testify about the body's activities, even its monetary policies -- precisely the area in which it is independent. What is more, those policies are dissected and evaluated by the markets and the media in excruciating detail on an almost daily basis. The Fed, appropriately enough, gets plenty of critical evaluations.

But an audit of its monetary policies by the GAO -- which, remember, works for Congress -- could easily develop into something quite dangerous. Here is a not-so-unlikely hypothetical: sometime in 2010, the Fed, wanting to avoid inflation, will likely begin to abandon the hyper-expansionary monetary policy it adopted during the recent crisis as a way to stave off a depression. As it does so, interest rates will start rising even as unemployment remains high. Predictably, Congress, being more closely attuned to public opinion, will be unhappy with this situation. Until now, the Fed's independence has ensured that it can afford to ignore public opinion and take such necessary but unpopular economic measures. That is precisely why we want an independent monetary policy.

But if the Paul bill passes, angry members of Congress could ask for a GAO audit. And, if the report is critical, they could use it to browbeat members of the Federal Open Market Committee, the Fed's interest-rate-setting body, for killing the country's economic recovery. Congress has always had, but never used, the legal right to override the Fed's decisions. But does anyone believe monetary policy would be better if it were made in the political domain?

In my 1997 article, I invoked the success of the Federal Reserve's monetary policies to argue that perhaps we should adapt the model to other selected government decisions, thereby moving some of them out of the political and into the technocratic realm. I suggested, in particular, that decisions that are more technical in nature (as opposed to laden with value judgments) and those that require a long time horizon were the most likely candidates for such treatment. Watching Congress's handiwork over the past dozen years, I have become increasingly convinced that this is true and that monetary policy should remain firmly in the technocratic realm.

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