Since its inception in 1913, the Federal Reserve has faced questions over its independence from the political sphere. For the most part, such efforts of politicians and bureaucrats seeking to direct monetary policy have been rebuffed. As Harvard economics professor N. Greg Mankiw told the HPR, “Congress decided that it made sense to have monetary policy set by an independent institution that was not under direct political control.” Former House Budget Committee member Bob Inglis (R-SC) added, “The best rationale for having an independent Fed is that it is not subject to the political pressures of the administration or of Congress.” In the wake of the financial crisis of 2008, however, members of both major parties have increasingly challenged the Fed’s independence, criticizing levels of transparency and lack of accountability.
In principle, most economists advocate for an independent central bank, free from political exigencies. Harvard economics professor Benjamin Friedman commented, “[The Constitution] gives Congress monetary policy power. Congress has now delegated this responsibility to the Federal Reserve.” Indeed, most nations of the world enjoy similar arrangements. Yet the institution’s expanding role in backstopping the U.S. financial system remains more controversial. Jeremy Stein, also a professor of economics at Harvard, explained, “The Fed does a better job with its traditional mandate of maintaining price stability when it is relatively free of political interference. Thus, in a world where the Fed was doing nothing more than setting interest rates, this would argue for considerable independence from short-term political pressure…However, when in its role as a lender of last resort, the Fed gets in the business of taking credit risk on a meaningful scale, there absolutely needs to be transparency and accountability.”
The Federal Reserve’s expansion of its balance sheet throughout the financial crisis has brought the scrutiny of Congress upon the institution. Some members, most notably Congressman Ron Paul (R-TX), used the upheaval to call for the Fed’s dismantling, or at least increased scrutiny. Yet the expansion of the Fed’s mandate may also have led previous supporters to grow more skeptical. Even Barney Frank (D-MA), former chairman of the House Financial Services Committee, has stated that the Fed must be accountable to voters. As Frank told the Washington Times, “There is a problem with too much power going to an entity that is not subject to democratic powers.”
The Inflation Dilemma
Nonetheless, where Paul’s criticisms blame the Fed for excessive inflation, the executive branch may soon find fault in the institution for insufficient growth in the money supply. With federal debt at 60 percent of the gross domestic product and growing, America faces few easy fiscal options. Yet the Federal Reserve enjoys the power of monetizing the debt, that is, weakening the value of a dollar to diminish the relative debt owed. While such would benefit short-term budgets, there exist longer-term concerns. As Mankiw states, “The Fed chairman is always aware of what Congress and the President are thinking. But his long-run legacy is to do the right thing and not to cave to political pressure.” Nonetheless, Friedman is ultimately sanguine about the possibilities of congressional input, “As long as members of the Congress do not have a majority on their side on a particular issue, the Fed chairman listening to them is no different than paying attention to what the Wall Street Journal, the New York Times, or the commentators on Bloomberg say.”
The epicenter of these political flashpoints remains the program of quantitative easing. Quantitative easing aims to encourage lending for the purpose of investment by pumping liquidity, namely cash, into the financial markets. Analysts recognize that extra money, all else equal, creates the risk of higher inflation, yet a low-interest rate environment like the present may mitigate those risks. Nonetheless, political conservatives have excoriated the quantitative easing program, labeling it an unnecessary waste, while political liberals, notably Paul Krugman, indict the program for being insufficient stimulus. Nonetheless, for all the criticism, the Fed’s response may be to make the best of bad options. According to Inglis, “If you don’t have an independent Fed led by brilliant economists like Ben Bernanke, then you have politicians setting monetary policy. That is a dangerous setup.”
The lessons of the past year further call into question the Federal Reserve’s relationship with its counterpart, the Treasury department. Both bear responsibility for the economy; the Fed overseeing monetary policy and the Treasury fiscal. Nonetheless, nothing guarantees that the two will continue to work as well as they have so far. Throughout most of the 2000s, the Fed and Treasury operated in tandem to boost the mortgage market through low interest rates and easy credit. In the wake of the bubble bursting, however, it is conceivable that the Treasury Secretary would pursue a policy which involves low interest rates to incentivize investment, while the Federal Reserve might be concerned with raising interest rates to curb inflation.
As such, the relationship between Fed and Treasury might prove a major source of conflict. Friedman suggests that, unlike the Fed, the Treasury Secretary does the work of the President, and reiterates, “Why do we have an independent agency with people who are not appointed and reappointed every month, for example? The idea is to insulate it from day to day political pressures.”
Return to Normalcy
Despite criticisms, the future of the Federal Reserve appears much the same as in the past. According to Mankiw, “We will return to a time of normalcy when the distinction between monetary and fiscal policy becomes clearer.” Over the long run, the Fed will continue to operate as the institution that deals primarily with monetary policy. Nonetheless, the difficulties of the economic crisis will likely continue to keep the Federal Reserve at the center of debates about the role of government in the economy. The Fed’s future mission may well engender further conflict. Indeed, as House Republicans prepare to advocate for substantial savings to slash the federal deficit, the Obama administration may rely heavily on the Fed to execute expansionary economic policy.
Ultimately, no matter the economic times, the Federal Reserve operates best as an independent institution. A combination of increased independence from political pressure and greater accountability and transparency to the public will improve the Fed’s operations, and may even finally affect its public standing. Maintaining relative performance in these categories will prove difficult, no doubt, but the combination should ultimately ensure that the Fed fulfills its dual mandate of maintaining steady price levels and fostering long-term economic stability.
Thomas Gaudett ‘14 is the Circulation Manager.