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Thursday, May 17, 2012

Reforming the Fed: What Makes Sense?

Reforming the Federal Reserve has gained considerable interest of late in Congress.

Considering the unprecedented actions taken by the Fed over the past few years, indeed it may be time to take a closer look at the Fed’s mission and actions.  The Fed’s ongoing response to the economic and credit mess that hit in late summer 2008 has been extraordinary – from jacking up the monetary base at a rate never even conceived of previously, to helping to bailout banks and the housing industry by buying up bad mortgage debt.   Indeed, to many of us, legislation reforming the Fed is more than three decades late.

Currently, there are six pieces of legislation in the mix to reform the Fed or narrow its responsibilities:

• Introduced by Congressman Mike Pence (R-IN), H.R. 245 would repeal half of Fed’s dual mandate, as imposed in 1978, of maintaining both price stability and full employment, with the lone mandate of price stability remaining.

• Introduced by U.S. Rep. Kevin Brady (R-UT), the Sound Dollar Act (H.R. 4180) would narrow the Fed’s mandate to price stability as well. But it also would expand voting membership on the Federal Open Market Committee, which sets monetary policy, to all twelve regional Federal Reserve Bank presidents.

• Introduced by Congressman Ron Paul (R-TX), the Free Competition in Currency Act (H.R. 1098) would abolish the Fed, and repeal “the federal law establishing U.S. coins, currency, and reserve notes as legal tender for all debts, public charges, taxes, and dues,” thereby privatizing currency in the U.S.

• In H.R. 1512, Congressman Barney Frank (D-MA) would go in the exact opposite direction as Rep. Brady by removing all presidents, or vice presidents, of the Federal Reserve Banks from FOMC membership.

• In H.R. 1401 (the Democratizing the Federal Reserve System Act), Rep. Marcy Kaptur (D-OH) would reduce from 14 years to 7 years the term of office for members of the Fed’s Board of Governors, while also increasing from two years to four years the period a former Fed member must wait before being employed by a bank.

• Finally, according to H.R. 2990 (the National Emergency Employment Defense Act), U.S. Rep. Dennis Kucinich (D-OH) would, in effect, shut down the Fed and move its duties under the Treasury Department.

So, what makes sense and what does not?

Well, if you think that increased politicization of the Fed – i.e., more control of monetary policy by politicians and less independence by the Fed – is a good thing, then the Kaptur, and in particular, Frank and Kucinich bills are for you. Of course, such measures ignore economic realities and history. While central banks obviously must be accountable, independence from the latest political pressures is critical to any central bank getting its primary job accomplished.

In an October 2000 speech, then-Federal Reserve Governor Laurence Meyer put it this way: “The motivation for granting independence to central banks is to insulate the conduct of monetary policy from political interference, especially interference motivated by the pressures of elections to deliver short-term gains irrespective of longer-term costs. The intent of this insulation is not to free the central bank to pursue whatever policy it prefers--indeed every country specifies the goals of policy to some degree--but to provide a credible commitment of the government, through its central bank, to achieve those goals, especially price stability.”

Meyer added later: “An extensive literature examines the relationship between the independence of the central bank and economic performance. The empirical studies generally find an inverse relationship between measures of central bank independence and both average inflation and variability of inflation, at least for developed economies.”

While, as Meyer points out, correlation does not prove causation, understanding the incentives at work in politics and government should seal the causation case. A more politicized Fed will only mean greater uncertainty and increased threats on the inflation front. In fact, as the Bernanke Fed has become more politicized since 2008, we’ve seen uncertainty about where inflation is and is heading increase.

As for Rep. Paul’s proposal for abolishing the Fed and privatizing money, it makes for an interesting academic debate, but holds no real space or ground in the actual policy world.

That leaves the Pence and Brady proposals. And both are spot on correct in removing the Fed’s dual mandate, and having monetary policy focused on maintaining price stability. Inflation is always a monetary phenomenon in the end. At the same time, monetary policy is ill equipped for trying to manipulate economic growth and employment. Indeed, we have seen glaring evidence of this for more than three-and-a-half years now, as the Fed’s efforts to gin up the economy have fallen flat. And by staying focused on price stability, the Fed actually aids economic growth by keeping interest rates low, maintaining a strong currency, limiting uncertainty and allowing investors and businesses to plan for the future with confidence.

The Brady legislation has the added benefit of trying to depoliticize the Fed a bit by expanding the number of regional Federal Reserve Bank presidents, who are appointed by largely local bank and business executives, on the FOMC. That would decrease the relative power held by FOMC members appointed by D.C. politicians in terms of guiding monetary policy.

Reforms that get the Fed focused exclusively on price stability, and decrease, as Meyer put it, the interference “motivated by the pressures of elections to deliver short-term gains irrespective of longer-term costs,” would be beneficial for the economy and, indeed, are long overdue.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His new book is “Chuck” vs. the Business World: Business Tips on TV.

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