28 June 2016

The power and independence of the Federal Reserve

Peter Conti-Brown
2016, Princeton University Press, 368 pages,
ISBN 9780691164007

Reviewer: Bill Allen, Economic Consultant

The governance of central banks, and in particular how far their managers should be left alone to get on with their jobs and how far they should be subject to detailed political oversight, is a delicate issue. It is sometimes referred to as the issue of central bank independence, but the notion of ‘independence’ as commonly understood is quite unrealistic when applied to most central banks in the era of fiat money; ‘autonomy’ perhaps would be a better word. The European Central Bank is in a uniquely uneasy position in this respect.

After the collapse of the gold standard in the 1930s, and even more after the second world war, central banks became legally more subject to government control, but central banking became technically much more complicated, because of the proliferation of controls and the widespread use of intervention in financial markets as a policy device. Despite the change in their legal positions, central banks retained a degree of autonomy: nobody else could really understand what they were doing, and had to trust them to do the right thing.

From the 1980s onwards, controls and intervention were gradually relaxed and then abandoned, and during the late, lamented ‘Great Moderation’, central banking seemed to have become much simpler. All that central banks had to do was to determine, with the help of the best models available to the human race, what level of short-term interest rates would be required to achieve their inflation targets. It was in that era that the idea central bank autonomy was desirable as a matter of principle came back into fashion: everybody knew that price stability was a public benefit, nobody believed in an enduring trade-off between inflation and output, and everybody understood that governments, if left in charge of monetary policy, had an incentive to pursue more inflation than was socially desirable. If central banks had discretion over monetary policy, constrained by a government-determined inflation target, the public could expect a good monetary policy.

As Conti-Brown rightly points out in this book, the late 20th-century argument for central bank autonomy was entirely confined to monetary policy, as narrowly interpreted during the Great Moderation. It was crucial to the argument that central banks were not believed to have the power to affect anything in the ‘real’ economy, such as output and employment, at least temporarily, so that they were not making choices that ought to be left to elected politicians.

All that came to an end with the financial crisis, even though some central bankers tried to push their claims to autonomy beyond monetary policy as previously understood. Since that time, the governance arrangements of central banks have come in for much more scrutiny, of which Conti-Brown’s book is an example. Conti-Brown himself is an assistant professor of legal studies and business ethics. His criticisms of current Federal Reserve governance arrangements are based partly on their legal form, which is certainly questionable: for example, commercial bankers have an overt role in the appointment of regional Federal Reserve Bank presidents. They are also based partly on their practical results: in particular, he clearly thinks, though he doesn’t quite say so, that Edwin Truman, the former Chief of the Federal Reserve Division of International Finance, and Scott Alvarez, the Fed’s General Counsel, have more power than is appropriate for people whose appointments have not been politically approved.

As to the Reserve Bank presidents, an interesting fact that Conti-Brown doesn’t mention is that seven of the current twelve are former Fed staff members. It is true that three of the others worked at some time for Goldman Sachs, one of whom, Neel Kashkari, was interim Assistant Secretary of the Treasury for financial stability at the peak of the financial crisis. None of the twelve, as far as I can see, are ex-commercial bankers. Whatever you think of the current group of Reserve Bank presidents, it would be hard to sustain a case that the bankers’ role in the appointment process is corrupting the selection process.

As to the power of individual staff members, Conti-Brown’s suggestions that Mr Alvarez has wielded too much power are not convincing. Mr Alvarez’ job is to interpret the law as it applies to the Fed and to advise the Fed on what it can and can not do. It would seem odd, and a little sinister, if the appointment of someone to such a job were to require the approval of the legislature. Legislators make the laws, and should leave it to others to interpret them. And the fact that staff members can take decisions, of which Conti-Brown makes great play, means very little; they may simply be faithfully following guidelines laid down by the board. More generally, the power of individual staff members in all central banks depends to a very great extent on patronage. The issue is therefore not really the power of the staff members, but rather the sources of patronage, and the extent to which the sources of patronage are subject to checks and balances. This is an important issue in the management of central banks, one which Conti-Brown doesn’t explore.

The Fed attracts great suspicion, not only from members of the public who are angry about the financial crisis, but also from political scientists like Conti-Brown who are concerned about the formal structures of governance and accountability. Happy is the country that has the leisure to worry about such things. In such an atmosphere, responsible critics need to be sure that they understand the issues properly and get the facts right. Conti-Brown is in places defective in this respect.

For example he is critical of the New York Fed – clearly his least favourite among the Reserve Banks – for being too close to the financial industry, and sharing its ideology. He writes of ‘cognitive capture’ or ‘cultural capture’. I don’t entirely understand what these terms mean, and of course it is possible that the New York Fed is too close to the financial industry. However, it is impossible to regulate the financial industry effectively if you remain at arm’s length. This was something that the U.K. discovered early this century. When the Financial Services Authority was set up in 1998, its strategy was to set out its rules, and to say to the banks ‘stay within the rules, and we won’t bother you’. The strategy was impeccable in its formal structure, but it failed on a grand scale. The rules needed to be continuously adapted to changing behaviour, and rule-makers can’t make the necessary adaptations if they don’t know how behaviour is changing.

As another example, Conti-Brown’s discussion of the swap lines that the Fed provided to foreign central banks during the crisis demonstrates that he hasn’t understood why they were provided. He suggests that they were provided for the benefit of foreigners; in fact, as Richhild Moessner and I have demonstrated, they were a shining example of enlightened self-interest on the part of the United States.[1] They certainly benefited foreigners, but they benefited the United States as well. Not much wrong with that. What is wrong is that the Fed has not been given the enormous credit it deserves for its courageous and decisive intervention.

Conti-Brown explores, all too briefly, the relationship between the Fed and the community of economists. As Conti-Brown says, economists have come to, “Dominate the scene at the Fed,” and they have done likewise at many other central banks. But, he continues, “The Fed has a horse in the race for producing economic ideas about its policy mission. Like members of any other institution, those within the Fed want both to perform their task well and, importantly, for others to think that they are performing their task well. In acting as gatekeeper for the production of economic ideas, both inside and outside the Fed, there is a conflict of interest here: assessing the Fed’s performance will sometimes mean that the assessment comes out the wrong way.” Conti-Brown is on to a very important point here. Economists in central banks have an incentive not to criticize their bosses; and economists outside central banks have an incentive not to criticize central banks if they want central banks to hire them. This can lead to the intellectual analogue of in-breeding. It would be better if central banks employed far fewer economists and if universities employed far more.

Central bankers feel justifiable anxiety about accountability. Legislators specialize in communicating with the public, and are good at it. They have the power to humiliate people who are obliged to testify before them, even if those people have been doing a good job, and they sometimes abuse their power. Central bankers need to protect themselves against such treatment. The governing bodies of central banks can help by being ready to commission their own ex-post reviews of policy actions, whether the actions are deemed to have succeeded or failed. The IMF, with its Internal Evaluation Office, has been a pioneer in this. In Britain, the House of Commons Treasury Committee recommended in 2011 that the governing body of the Bank of England should commission such reviews, and since then a few have been commissioned.[2] Such reviews not only make it easier for central banks to learn from experience, but also provide some defence against ill-informed attacks by legislators and others. In the Fed, any such reviews would have to be commissioned by the Board of Governors, preferably with but if necessary without the agreement of the Chair.

Conti-Brown makes a number of recommendations for changing the constitutional position of the Fed. I do not know enough about the structure of the Fed and the politics of central banking in the United States to assess the specifics. Whatever their particular merits, they are addressed to an important though elusive objective, namely sustaining public confidence in the central bank.  Conti-Brown demonstrates clear insights into how central banks work and has made an interesting and powerful contribution to the understanding of how central banking can be reconciled with democracy. To suggest that he has not written the last word is merely to acknowledge the complexity of the subject.

[1] ‘Central bank co-operation and international liquidity in the financial crisis of 2008-09’, Bank for International Settlements Working Paper no. 310, 2010.

[2] House of Commons Treasury Committee, Accountability of the Bank of England, HC874, 19th October 2011.