It’s no secret that libertarians love to hate the Federal Reserve. After all, we tend to regard power with suspicion, and no institution wields more power over the economy than the Fed. Given the unprecedented actions of the Fed in response to the financial crisis and the overall mystery and complexity that veils monetary policy, it’s understandable that more than just libertarians are now concerned. More transparency in monetary policy and a clearer definition of the Fed’s powers are clearly needed. There are already methods in place to do this, but they need to be reformed for both economic and practical reasons.
The Federal Reserve System was created in 1913 with the goal of providing a more stable and flexible monetary and financial system at a time when banking panics were a common occurrence and caused a lot of economic distress. The Fed has evolved over time, and its current objectives of maximum employment, stable prices, and moderate long-term interest rates are mandated by statute. Although the Fed and its statutory goals were created by Congress, the Fed has a great deal of independence in the policies choices it makes in pursuit of these goals.
Since the financial crisis, the public and Congress have demanded more accountability and transparency, a worthy cause as monetary policy has entered uncharted territory. The Federal Reserve Transparency Act (FRTA) has been proposed to deal with these issues.
This type of audit, while well-intentioned, is misguided and frankly bad economics.
Currently, the Fed’s financial statements are independently audited annually, the Fed Chairman and other Fed officials are required to testify before Congress on a regular basis, and an annual report is provided to Congress. Additionally, the Federal Open Market Committee (FOMC) publishes a statement right after each FOMC meeting that describes the Committee’s views on the economic outlook, and explaining its policy decisions.
In addition to mandating a more thorough one-time audit of the Fed, the FRTA would require the Fed publish its transactions with banks online and would expand the regular audits to include the internal deliberations, communications, and details of monetary policy activities. If this bill were passed, there is great potential that the unintended consequences would actually create more economic problems. There are already concerns over the current politicization of the Fed, and the expanded scope of audits proposed in this bill would only insert more political influence into the monetary policy decision making process, go beyond accountability for goals, and threaten the independence of the Federal Reserve.
Why is the independence of the Federal Reserve important? Why shouldn’t Congress have a hand in monetary policy actions? The Fed was specifically designed to maintain as much independence from the political process as possible… and with good reason! Effective monetary policy must be concerned with long-run goals, not short-term political gain. Although the Fed ultimately does answer to Congress and the people in terms of its mandated goals, there is a difference between being accountable for achieving goals and actually allowing Congress to insert itself into the monetary policy making process.
When political concerns begin to impact monetary policy makers, they will behave more like politicians. The incentive to set policy that is in the long-term interest of the public is reduced. Monetary policy makers will instead behave in the interests of the politicians in power. While monetary policy is certainly not free of political influence, the potential for political influence under the FRTA is decidedly more pronounced.
If you have followed politics for any length of time, you don’t need me to tell you that the short-sighted bias of this political influence has negative consequences. If you don’t believe me, just check out the empirical evidence showing that decreased central bank independence leads to inflationary monetary policy, while central bank independence is key to long-term price stability (low and stable inflation). That’s because political influence tends to be biased towards stimulating the economy in the short-term with inflationary policy even at the expense of long-term goals. Still, Congressional proponents of the Federal Reserve Transparency Act continue to cite concerns about inflation as a reason to give them more control of the Fed!
What we shouldn’t forget is that although concern over long-term inflation is the hot topic of today, we can’t trust that it will always override other political goals for Congress. Given increased influence over monetary policy, the temptation to use that power for personal gain would always be present. For more of an elaboration about that concern, read this.
While there is definitely a strong argument for reforming the Fed, there is no reason to resort to the politicization of the monetary policy-making process. I genuinely sympathize with many of the sentiments towards the Fed and its lack of accessibility and accountability, but there are some things that just shouldn’t be democratic. The making of monetary policy is one of them. No matter how much you dislike the Fed, you can be certain that giving Congress more power over it will not be an improvement. The changes proposed under the Federal Reserve Transparency Act do not address the real problems, and the potential unintended consequences of inserting more political influence into monetary policy are too dangerous to justify the risks associated with them.
That doesn’t mean that Congress and the public should do nothing. There are alternative actions that can be taken to improve the Fed. In his article, “What Should Central Banks Do?”, the prominent and well-respected economist Frederic Mishkin offers some constructive policy suggestions that take great strides in addressing the concerns of accountability and transparency without threatening the valuable independence of the Fed.
Among these suggestions are making long-run price stability the overriding mandated goal of monetary policy and establishing an explicit inflation goal. These two changes are a great start that would address inflation concerns and provide a means for accountability. The idea advocated by Mishkin to balance independence with accountability is with a central bank that is goal-dependent (the goals are determined by Congress), yet instrument-independent (the instruments used to achieve those goals are determined by the central bank without meddling by Congress). This distinction is important because although Congress and the American people have an interest in specifying the goals of monetary policy, neither has expertise in actually conducting that policy and the incentives are different when political motivation is involved.
Mishkin’s ideas are just one possibility to be considered. The FTRA is facing the likely fate of a quick death in the Senate, but with public sentiment on the side of reforming the Fed, now is the time to introduce reasonable alternatives with a solid economic basis to make progress towards resolving the problems. That means abandoning idealistic ramblings about ending the Fed and instead focusing on using economic data to propose feasible reform that will improve the institution in tangible ways.