Why the Fed Works

In 1986, Judge Harold Greene rebuffed a challenge from Senator John Melcher of Montana to the constitutionality of the U.S. Federal Reserve System. Melcher had questioned the uniquely American approach to central banking, which involves sharing responsibility between (and among) regional Federal Reserve banks and the Federal Reserve Board in Washington, and pointedly objected to the role of private citizens on the boards of the regional Feds. Greene upheld the system and noted that it struck “an exquisitely balanced approach to an extremely difficult problem.” He went on to reflect that “few issues in the history of this nation have been as thoroughly considered and debated as central banking and the regulation of the money supply, and private participation, or even control, have been hallmarks.

Well, we are at it again, and I have a bird's-eye view from my perch as a director of the Federal Reserve Bank of New York. Despite the robust debate about financial services industry reform that reverberated in Congress after the financial crisis of 2008 and the hard-won compromises that were embedded in the resulting Dodd-Frank legislation, a new wave of Fed reform proposals are circulating on Capitol Hill. The most publicized, of course, is the “Audit the Fed” plan, which would superimpose a layer of oversight onto monetary policy deliberations. Another proposed reform would prescribe specific rules for the formulation of monetary policy. A third proposal would restrict the Fed’s capacity to be the lender of last resort in a financial crisis. A fourth would single out the New York Fed president for nomination not by the New York Fed’s board, but by the U.S. president, with Senate confirmation. The fifth and final reform would dismantle the New York Fed.

A review of the history of the United States’ unique central banking system, however, suggests that these are unwise and impractical and, if adopted, would disturb the exquisite balance that has served the country so well.

BANK ON IT

For as long as the United States has existed, there has been controversy over the role of centralized banking. It was rooted in the debates between Thomas Jefferson and Alexander Hamilton over the federalist system and was manifest in concerns about the balance of power not just between the central government and the states, but also between bankers and merchants in the biggest cities and the agrarian interests in rural precincts. Hamilton understood the importance of a strong, nationwide financial system to future U.S. prosperity and argued for a national bank at the center of the new country’s economy. Jefferson and his allies were deeply suspicious of the accumulation of power not just in the federal government, but also in big banks and among wealthy merchants in the large cities, and so were hostile to the notion of a federal bank that would establish a government monopoly on the creation of money and the regulation of local commerce.

With the eventual support of George Washington, Hamilton prevailed and the First Bank of the United States was built, but only because its creators struck a balance—to which Jefferson still objected—among the conflicting interests. It was agreed that the bank would be one of a kind. It would not buy government bonds, it would have only a 20-year charter, and crucially, it would be privately owned but would be “inspected” by the Treasury Department. Despite the compromise, the controversy dragged on; the charter of the First Bank of the United States lapsed and five years passed before  the Second Bank of the United States was established.

In 1818­–19, the State of Maryland challenged the constitutionality of a national bank, and Daniel Webster defended it before the Supreme Court in McCulloch v. Maryland. Justice John Marshall’s historic deciding opinion is remembered for establishing two foundational principles of constitutional law: the implied powers granted to Congress by the “necessary and proper” clause of the Constitution and the federal legislative preemption of actions by the states. But the practical consequence of Marshall’s ruling was to affirm the legitimacy of the Second Bank of the United States.

Not long after the decision, however, President Andrew Jackson—a Jeffersonian to the core—set out to accomplish politically what had failed judicially. The Second Bank’s charter was revoked in 1832 and its operations curtailed by 1836. Not coincidentally, a banking panic, known today as a financial crisis, erupted in 1837. A deep recession ensued for seven years.

The U.S. suffered periodic panics in 1857, 1873, 1893, and 1907, but the U.S. government, lacking the instruments of central banking, was impotent. Private interests stepped in when government failed to act; notably, Wall Street bankers, coordinated by J.P. Morgan, adroitly handled the Panic of 1907, to the embarrassment of government officials and the consternation of the public.

When the United States set out in 1913 to create a central bank for the third time, familiar debates erupted and similar balances were struck. The Federal Reserve System, which emerged then and has been evolving ever since, embodied a series of compromises that reflect long-standing principles: the dispersal of control through the country; the incorporation of private-sector involvement; and the insulation of the system from political influence. The Federal Reserve System was expressly designed not to be one huge government agency with regional branches but, instead, to be decentralized and distributed nationwide. Because of its unique history and role, the Fed would operate on a different model than monolithic agencies such as the Securities and Exchange Commission, the Federal Communications Commission, and the Food and Drug Administration. The system would actively represent local interests, dilute the clout of Washington and the influence of politicians, and prevent powerful interests, particularly the big banks, from capturing a central authority.

The Fed’s capacity to make monetary policy decisions independent of political calculation was hard won, but over time it became a sine qua non.

The Federal Reserve Act of 1913 gave the U.S. president the power to appoint governors of the Federal Reserve Board, and the Senate to approve his nominations. The governors had fixed terms and worked in Washington, D.C. from inside the Treasury Department. The 12 regional Federal Reserve banks, which were spread around the country, were entirely privately owned, and their boards were populated by local bankers and merchants who functioned as fiduciaries. The regional banks enjoyed local autonomy, and their decisions would ideally reflect an understanding of local business conditions. A key feature of their autonomy was the power to select their presidents, who also had fixed terms, and senior officers. This reflected a long-standing belief that formal involvement by the private sector and insulation from politics are essential to both the credibility and the functioning of the nation’s central bank.

The Fed’s capacity to make monetary policy decisions independent of political calculation was hard won, but over time it became a sine qua non. In the early life of the Fed, its independence was largely accomplished by the balance between the regions and the center, as well as the role played by the private sector on the regional boards. Over time, as power in the Fed migrated to Washington, the Fed’s independence was buttressed by pushing the Treasury Department off the Federal Open Markets Committee (FOMC), granting the governors 14-year terms, and making the Fed’s charter permanent rather than requiring periodic reauthorization by Congress.

As Janet Yellen, chair of the Federal Reserve Board of Governors, has testified to Congress, academic research and real-world experience have established “beyond the shadow of a doubt” that central bank independence is the foundation of a prosperous economy. World economic history is replete with examples of central banks that were “captured” by politicians and became hostage to political objectives. The mechanisms by which the Fed is insulated from politics do not always sit well with elected officials, but it is in the country’s interest to staunchly protect the principle of Fed independence.

The Federal Reserve Bank of New York, located in the world’s financial capital, has always played a unique role as the Treasury Department’s agent in the financial markets and, more recently, in conducting the operations of the FOMC. However, other important elements of the central banking apparatus are distributed around the country and are skillfully managed by the regional Feds. One representative example is the Richmond Fed’s handling of all information technology for the system, with other important technology functions being performed in Boston, Chicago, Dallas, Kansas City, Philadelphia, and San Francisco.

The system created 100 years ago was not perfect, and it benefited from subsequent reforms. In the 1930s, the Fed took steps to strengthen the Board of Governors, create the FOMC with controlling votes from the governors, end the Treasury Department's role on the Board of Governors, and move the Fed staff physically out of Treasury and into its own building. In the 1950s, the Treasury–Federal Reserve Accord removed the last vestige of the Treasury Department’s influence on monetary policymaking.

In the aftermath of the Panic of 2008 and Dodd-Frank reforms, the Fed is still in the political crosshairs.

In the 1970s, the Humphrey-Hawkins legislation created the now familiar dual mandate (employment and inflation) and required the Fed’s chair to testify before Congress twice a year. Finally, Dodd-Frank placed limits on the Fed’s emergency lending powers, expanded disclosure of lending programs, created a vice chair for supervision, established the Financial Stability Oversight Council (FSOC), and forbade involvement by bankers on the regional Fed boards with regards to the appointment of the Fed president and other officers.

Through all those decades of reform, though, the principle of local autonomy and the unique public-private structure of the system were preserved. A blend of local and national perspectives, insulation from short-term political pressures, and the inclusion of private-sector views into the formulation of central banking policy has made for a delicately calibrated set of checks and balances on the system, durable institutions, and, in the end, better policy.

THE FED'S CRED

In the aftermath of the Panic of 2008 and Dodd-Frank reforms, the Fed is still in the political crosshairs. This is understandable, given the prominent role the Fed played in the response to the financial crisis, but it is important to look to history so as not to repeat it. Were there problems at the Fed uncovered by the financial crisis? Of course. Was governance of the regional Feds one of them? There is no evidence of that.

The problems that were identified post-crisis were related to regulation, such as capital and liquidity requirements, and supervision, such as risk management practices, are directed by the Board of Governors in Washington and are strictly outside the purview of the boards of the regional Feds.These flaws were debated and addressed in Dodd-Frank, which has led to a new regimen of, among other things, stiffened capital requirement for banks, multiple stress tests, the creation of the FSOC to identify systemically risky issues and actors, and the addition of the vice chair for supervision, who is responsible and accountable for oversight of the supervisory process.

Let’s not forget, meanwhile, that the institutions that failed in the crisis were disproportionately regulated by federal agencies other than the Fed: the Federal Housing Finance Agency (Fannie Mae and Freddie Mac); the Securities and Exchange Commission (Bear Stearns and Lehman Brothers); and the Office of Thrift Supervision (Washington Mutual, Golden West, IndyMac, Bank United, and even AIG). The Office of the Controller of the Currency within Treasury also had joint responsibility with the Fed for oversight of Citibank and Bank of America, among others. The federal, as opposed to regional, status of these many regulators does not seem to have prevented pre-crisis errors of oversight.

Nonetheless, since the regional Fed presidents do oversee the supervisors in their organizations, there is serious concern that their staff can become too cozy with the local banks that they regulate—a phenomenon dubbed “regulatory capture.” Since 2009, the New York Fed has been implementing the recommendations of a study (the Beim Report) of supervisory lessons learned from the financial crisis. These entail transforming financial supervision oversight and remaking the supervisory culture. As a second safeguard, the Board of Governors has created the Large Institution Supervision Coordinating Committee (LISCC) to oversee the supervision of the largest, most systemically important financial institutions in the country. A key goal of the LISCC is to add a layer of oversight from Washington over decision-making by regional supervisors in order to, among other goals, avoid regulatory capture.

The United States simply cannot afford to leave the regional Feds rudderless for extended periods of time.

In actuality, the New York Fed has a good track record of picking exemplary presidents. The walls of our boardroom are lined with portraits of former presidents who offered distinguished service to the United States, often in times of crisis—from Paul Volcker, who went on to to chair the Board of Governors and brought inflation under control in the 1980s, to Tim Geithner, who became Treasury secretary and helped lead the United States out of the most recent crisis.

Further, all appointments by the boards of the regional Feds—which include the president, the first vice president, and the internal auditor—are subject to the approval of the Board of Governors, who are politically appointed and confirmed. This is, once again, a balance wrought by history; private-sector boards situated around the country make a choice with oversight from political appointees in the central government. It is perhaps understandable that elected officials would want to arrogate more power to themselves, but history demonstrates that checks and balances work better than concentrated authority.

Most important, the work of the presidents of the regional Feds is of vital importance to the functioning of both the financial system and the broader economy. The president of the New York Fed runs an organization that, in addition to its supervisory duties, has an enormous scope of responsibility: it finances the U.S. government and serves as the fiscal agent for the Treasury, implements monetary policy for the FOMC, intervenes in foreign exchange markets in coordination with both the Treasury and the Board of Governors, serves as the fiscal agent of foreign central banks in the United States, operates critical parts of the nation’s electronic payments system, lends money through the discount window to banks in the region, keeps currency and cash in circulation, and even stores a large portion of the world’s monetary gold. The New York CEO also serves as vice chair of the FOMC, which formulates American monetary policy. And the New York Fed team stands ready to respond to national crises, as it did on 9/11 and during the panic of 2008.

Clearly, this is a ship that requires an able captain and experienced crew. The United States simply cannot afford to leave the regional Feds rudderless for extended periods of time. Over the past century, the regional Fed boards have been able to move expeditiously to fill vacancies so that their banks are not left to drift. Unfortunately, the politicized process by which the president appoints candidates and the Senate confirms them is often just the opposite. For example, the vice chair of the Board of Governors for Supervision, which was created in 2010, has never been appointed. And it has been the exception rather than the rule that, in recent times, all seven seats on the Board of Governors have been filled. In stark contrast, the New York Fed’s current president, Bill Dudley, was installed at the very moment that his predecessor, Geithner, was sworn in as Treasury secretary. The New York Fed did not go even an hour without a leader.

It is well understood that the appointments process in Washington is deeply flawed and in need of fundamental reform. Moving to political appointments for regional bank presidents and senior staff would equate to replacing something that is working with something that is broken.

Further, political appointees also often bring their own loyal staffs with them—customarily veterans of political campaigns. The United States cannot afford to politicize the staffing of the regional Feds. The Fed staff is uniquely professional, not just among government staffs but generally. They are uncommonly experienced, careful, diligent, analytical, technical, and resourceful—and completely apolitical. The jobs they do are not only important to the functioning of the U.S. economy but require enormous expertise and, frequently, decades of very specific training. Many dedicate their entire careers to the Fed because of the importance of the work, the quality of the colleagues, and the prospects for career advancement. Superimposing a layer of political appointees without the same experience or qualifications on top of these professionals would be demotivating and potentially dangerous.

In the aftermath of the crisis measures, monetary policy has been the only consistently functional economic policy tool.

Suggestions for more political involvement in the Fed likely emanate from a legitimate expectation that the regional Feds be transparent and accountable. But the “Audit the Fed” catchphrase has created the impression that the regional Feds are not already audited, which could not be further from the truth. At the New York Fed, for example, there are multiple channels of accountability. Internally, it has an independent auditor and an ethics office, both of which meet with the board regularly. Externally, the New York Fed is reviewed by an independent accounting firm (which prepares financial statements that are published on the Fed’s website); the Board of Governors (all political appointees); the Board of Governors Inspector General (an independent office); and the Government Accountability Office (also led by a political appointee). In the aftermath of the financial crisis, the New York Fed’s actions were also scrutinized by the Congressional Oversight Panel, the Financial Crisis Inquiry Commission, and the Special Inspector General for TARP. Appropriate oversight, accountability, and transparency are constant—and welcome—features of daily life at the New York Fed and at all the regional Feds.

If there is one takeaway from the recent past, it is that the United States managed to avert a another Great Depression because of the Fed’s bold and persistent actions in collaboration with Treasury, the FDIC, and others. The trio of Ben Bernanke, who was chair of the Fed at the time; Hank Paulson, who was secretary of the Treasury; and Geithner, who was president of the New York Fed, leapt into action and led a team that, without a playbook and under great duress, cobbled together a rescue package that succeeded in arresting a global stampede and creating conditions under which a recovery could begin. This near-death experience caused many casualties and left deep wounds, but the United States largely avoided the grim fate of the 1930s.

Observers should also understand that, in the aftermath of the crisis measures, monetary policy has been the only consistently functional economic policy tool. Elected politicians wrangled year after year about fiscal policy and ended up adopting the sequester, which was purposefully designed to be intolerable but inadvertently became the de facto fiscal policy regimen. Congress cut back on basic research, failed to invest in the country’s aging infrastructure, and did not address corporate tax or immigration reform—and it shut down the government and flirted with a default on U.S. national debt. Fortunately, the Fed, which was independent of politics and so could act, implemented a series of unconventional policy measures—primarily composed of unusually low rates combined with quantitative easing)—that, despite all manner of dire warnings, nurtured a steady, if anemic, recovery.

REAL REFORM

To evaluate today’s crop of reform proposals, it is necessary to keep a steady eye on three objectives: ensuring that the Fed earns the public’s trust, which means increasing transparency and accountability; preserving the local-national and private-public balances that have been key elements of the Fed’s success; and safeguarding the independence of the Fed and its powers to manage the economy. As in the past, appropriate solutions to the issues of the day will be those that can achieve an exquisite balance among this trio of enduring imperatives.

On that score, today’s proposed reforms simply do not measure up. First, the “Audit the Fed” suggestion has next to nothing to do with accountability. And it would compromise the Fed’s independence by adding a layer of oversight on monetary policy deliberations. This is a dangerous idea because central bank independence is globally understood to be a best practice. 

Second, the proposal to make specific rules for the formulation of monetary policy would put a straitjacket on the policymakers. This is a bad idea because flexibility and agility are essential to effective policymaking. 

As in the past, there are opportunities to modernize the Fed in targeted ways that address specific concerns.

Third, the idea that the Fed’s capacity to be the lender of last resort in a crisis should be curtailed would take away what Ben Bernanke has characterized as the Fed’s “most essential power.” After intense debate, Dodd-Frank proscribed the Fed’s lending power but added authority for the orderly liquidation of failing firms. Bernanke has strongly cautioned against further shackles on the Fed’s capacity to protect the economy in a financial panic.

Fourth, the proposal to dismantle the New York Fed would remove a central and irreplaceable player in the U.S. financial system, one that was indispensable in extinguishing the Panic of 2008. It is encouraging that this misguided suggestion has garnered virtually no support.

Finally, the suggestion to single out the New York Fed’s president for nomination by the U.S. president, with Senate confirmation, would undermine the Fed’s legitimacy and effectiveness. The role of the private sector in the regional Feds is a key means by which Fed independence is secured. Independence must be guaranteed, even if it occasionally makes elected officials uneasy.

That said, thoughtful debate and judicious reform are part of the history of central banking in the United States, and there is no reason for history to stand still now. As in the past, there are opportunities to modernize the Fed in targeted ways that address specific concerns.

First, if Congress is concerned about the fitness of regional bank presidents, particularly in their supervisory role, then it could prescribe a broad set of qualifications that the regional boards would take into account in their appointments and that the Board of Governors would consider in its oversight. The Board of Governors could also periodically report on these criteria, which could include provisions designed to avoid regulatory capture, such as restrictions on past employment by a regulated bank or systemically significant institution. 

Second, if there continue to be concerns about transparency and accountability within the New York Fed, its president could be required to testify before Congress regularly. This testimony might address not only the conduct of the New York Fed, but could also include an assessment of financial markets and related risks. As the Fed’s eyes and ears in the markets, the New York Fed president could offer useful, practical insights to Congress that would supplement the more policy-oriented perspective from Washington. 

Third, if there is concern that the ownership of the regional Feds by the local banks looks like a conflict of interest, then the ownership of the stock of the regional Feds—which serves no substantive purpose these days—could be transferred to the Board of Governors.

Fourth, to address discomfort with the optics of six of the directors on the regional bank boards being voted in by the local bankers, all nine director appointments could be overseen by the Board of Governors in coordination with the regional boards.

Fifth, to alleviate concerns about the residual role of bankers on the board of the regional Feds, these bankers could be selected by the Board of Governors rather than by each region’s banks. The bankers could even be made advisory directors. The bankers do, however, offer an important perspective on local, national, and even global financial market conditions, and so their involvement needs to be preserved in some form.

Finally, if Congress believes that the Fed’s structure needs updating, it could establish a commission to study the question. Although the public-private, regional-central structure reflects the U.S. national ethos and continues to serve the country well, the United States has grown substantially in the past hundred years, and the composition of its economy has changed materially. In that light, it might well be sensible to reexamine bank districts and to do so periodically, perhaps every 25 years.

As has been the case for centuries, the United States’ central bank is at the center of economic, political, and social crosscurrents. The Fed’s massive interventions in the economy helped to arrest the terrifying plunge of 2008­–09 and, in combination with the subsequent rounds of unconventional policy, have sustained a recovery that has been frustratingly slow and uneven.

Six years on, the equity markets are booming, housing prices have recovered, and jobs are growing modestly. But wages are stagnant, labor markets are weak, economic uncertainty is high, and poverty has increased—all giving rise to a renewed focus on inequality. Consequently, age-old suspicions have resurfaced that powerful financial interests are in league with policymakers in Washington to gain advantage for themselves—and that the Fed is ensnared in the web.

When evaluating the reforms on offer, however, it is important to draw a clear distinction between politics and purpose, between optics and substance. The Fed’s crisis measures clearly raised questions of appearance, but they equally clearly saved the economy. The antidote for purely optical problems is transparency and accountability, not counterproductive “reform.” The public and policymakers alike ought to be open-minded about the continuing evolution of the Federal Reserve System but insist that reforms address real problems and offer practical solutions.