09 July 2018

The Myth of Independence

How Congress Governs the Federal Reserve

Sarah Binder and Mark Spindel
2017, Princeton University Press, 282 pages,
ISBN 9780691163192

Reviewer: William Allen

Central bank independence became newly fashionable about thirty years ago. It is now being challenged, for two main reasons. First, central banks are widely blamed for having failed to foresee or prevent the financial crisis (and, in the U.K., for having wilfully neglected their responsibility to act as lender of last resort). Second, in their monetary policy actions since the crisis, they are thought to have trespassed beyond their proper territory, and made decisions, for example on quantitative easing, which have had such momentous consequences that they ought to have been subject to closer democratic control.

Binder and Spindel’s excellent book throws a great deal of light on the position of central banks in the government of democracies, even though its narrative is confined to the United States. It carries the conviction that comes from history, which on matters of this kind is more compelling than either political or macro-economic theory. It claims that the Fed, far from being independent, is in reality subject to Congress. Congressional oversight means, to a large extent, Congressional control.

It supports its claim by reference to formative episodes in the Fed’s development. The setting up of the Fed followed the financial crisis of 1907; after many decades in which the United States had managed without a central bank, the Fed could be set up because ‘lawmakers generally agreed on the underlying goal of currency reform’ (p 58). The regional structure of the Fed was, and still is, essential to its political acceptability.

During the Great Depression, after the financial crisis of 1929 – 33, the Fed was blamed and reformed. The design of the various reforms was determined by Congress. They included empowering the Fed to buy government securities directly from the Treasury, the introduction of Federal deposit insurance, and a degree of centralisation: the Federal Open Market Committee was formally set up.

They also included greater independence of the Fed: the Secretary of the Treasury and the Comptroller of the Currency were removed from the Fed Board, and the Board was given a new building, so that it no longer met in the Treasury building. However, the Exchange Stabilisation Fund, established in 1934 under the Treasury’s control, clearly had the potential to challenge the Fed’s power to implement monetary policy. Treasury Secretary Morgenthau told the Fed they had ‘one more chance’ after the disaster of the early 1930s. ‘If you don’t do it, then the United States Government, through the Treasury, will take over the entire responsibility’ (quoted on p 131).

As it was, the Fed voluntarily agreed from 1942 onwards to maintain a fixed pattern of U.S. government securities yields so as to help war financing. It could hardly have done otherwise. The fixed pattern was maintained, with minor adjustments, long after the war had ended, and made it impossible for monetary policy to resist post-war inflation. The growing tension between the Fed and the Administration was finally resolved by the famous ‘Accord’ of 1951 between the Fed and the Treasury. Binder and Spindel explain how the Fed won the bureaucratic battle: the answer, not recognised by all historians of the Accord, is that Congressional opinion was firmly on the Fed’s side.

Binder and Spindel go on to explain, also by reference to Congressional opinion, how it was that Arthur Burns was unable to resist the inflationary pressures of the 1970s (his valedictory lecture was called ‘the anguish of central banking’), while his successor but one, Paul Volcker, was able to subdue the inflation that had become entrenched by the end of the 1970s. And they conclude with a chapter on the recent financial crisis.

Binder and Spindel’s narrative is carefully researched, detailed and convincing. It fully justifies its description of central bank independence as a ‘myth’, and explains Ben Bernanke’s remark that:

‘If I had learned one thing in Washington, it was that no economic program can succeed, no matter how impeccable the arguments supporting it, if it is not politically feasible.’ (quoted on p 232).

If you get a warm cosy feeling from the news that in the end, democracy prevails over the instincts of central bankers, then it’s time to wake up. Binder and Spindel describe ‘cycles of blame and reform which drive the evolution of the Fed.’ The reform is not always good. Remember that the House of Representatives initially voted down the TARP programme in 2008, not because they thought it was unnecessary but because they knew it was unpopular with their constituents. And since the crisis, the Congress has constrained the Fed’s authority to lend in an emergency, thereby ensuring that if the crisis were to be repeated, the economic consequences would be far worse.

Transparency is one of the weapons that Congress can use to control the Fed:

‘The newly created [in the 1970s] communications regime between the Fed and Congress created incentives for the Fed to heed Congress’s policy views (to the extent that lawmakers could agree). By requiring the Fed to set targets and defend them in public before Congress, the Fed could not ignore the expectations of lawmakers and their constituencies.’ (p 198).

The fact that the central bank has to explain to the representatives of the people what it is doing seems like a reasonable constraint on its discretion. But if the central bank is to be able to do a useful job, the representatives must have realistic expectations. They need to understand that the world is profoundly unpredictable, and that nasty surprises sometimes happen.

If the understanding is lacking, even notionally independent central bankers cannot be entirely responsible for the successes and failures of central banking policy. The merits of democracy are beyond question, but the costs depend crucially on the courage and quality of the people’s’ representatives, who must sometimes be ready to lead rather than follow.

Binder and Spindel’s work casts a bright new light on the public debate on central bank independence. Anyone who is remotely interested in the subject should read it.