Bruce K. MacLaury
Published January 1, 1977
To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
Our 200th year, perhaps more than most years, has generated its share of questions about monetary policy and about the role of the Federal Reserve System—the nation's central bank—in solving our economic problems.
Over the past few years, the dual problems of inflation and unemployment have been especially vexing. And questions about how effectively our money managers are responding to such problems reflect the urgency and complexity of the inflation/unemployment dilemma.
These questions also reflect increasing reliance on monetary policy—managing the supply of money and credit—as a means of assuring national economic health. That emphasis has grown as we have had to cope with large deficits and difficult economic events such as the energy crisis, fluctuating foreign currencies, and continuing Post-Vietnam adjustments.
The focus on monetary policy has generated questions not only about policy actions, but about the structure and power relationships of the Federal Reserve System—questions about its "independence."
Differences of opinion over monetary policy actions are to be expected, regardless of how the System is structured. Given the limits of human wisdom and the incomplete state of our economic knowledge, such differences are normal and inherent. That there is such disagreement does not mean the procedures are wrong or the structure inappropriate.
If, on the other hand, the structural make-up of the System, or its procedures, tends to inhibit development and implementation of good policy decisions, then we can try to improve those structures and procedures.
Since our world is changing and issues seem to be getting more complex, it would be surprising if some adjustments in the mechanisms for monetary management might not prove useful. It's against this background that the various proposals to change the structure and limit the "independence" of the Federal Reserve System deserve to be discussed.
Quite probably the term “independence” has been over-used. It was a key concept in the design of our central banking system—but in a relative sense, not as an absolute.
What does “independence” mean? Is the Federal Reserve accountable? Is it responsive to changing national priorities?
First, let's be clear on what independence does not mean.
It does not mean decisions and actions made without accountability. By law and by established procedures, the System is clearly accountable to congress—not only for its monetary policy actions, but also for its regulatory responsibilities and for services to banks and to the public.
Nor does independence mean that monetary policy actions should be free from public discussion and criticism—by members of congress, by professional economists in and out of government, by financial, business, and community leaders, and by informed citizens.
Nor does it mean that the Fed is independent of the government. Although closely interfaced with commercial banking, the Fed is clearly a public institution, functioning within a discipline of responsibility to the “public-interest.” It has a degree of independence within the government—which is quite different from being independent of government.
Thus, the Federal Reserve System is more appropriately thought of as being “insulated” from, rather than independent of, political—government and banking—special interest pressures. Through their 14-year terms and staggered appointments, for example, members of the Board of Governors are insulated from being dependent on or beholden to the current administration or party in power. In this and in other ways, then, the monetary process is insulated—but not isolated—from these influences.
In a functional sense, the insulated structure enables monetary policy makers to look beyond short-term pressures and political expedients whenever the long-term goals of sustainable growth and stable prices may require “unpopular” policy actions. Monetary judgments must be able to weigh as objectively as possible the merit of short-term expedients against long-term consequences—in the on-going public interest.
Monetary decisions have special importance because of their impact on all other aspects of our economic life. In a very real way, the power to create money also carries the power to destroy its value. Pushed to extremes of misjudgment or ill advised action, misuse of monetary power can erode values and destroy the economic fabric of the society it serves—by inflation, boom-bust depression, immoderate stimulus, or by excessive restraint.
While monetary policymakers have great potential power over the economy, there is misunderstanding about the practical limits of such power. Typically, monetary policy can restrain credit expansion more effectively than it can stimulate borrowing. It can control the supply of money, but not the demand for it. It can influence interest rates, but not control them. The central bank can influence only a few of several factors that determine the course and vigor of economic performance. The problems are complex and constantly changing, our knowledge is never complete, and mechanisms for avoiding harmful policy side-effects are not adequately developed. Finally, the ultimate effects of monetary actions are not precisely known until months later, if at all.
Thus, just as responsible monetary policy must avoid extreme actions—which on balance may be more harmful then helpful to the economy—so must the public be restrained in its expectations as to what monetary policy alone, however well managed, can accomplish.
Politicians, the elected representatives who make our laws and determine public policy, are themselves subject to pressures inherent in our structure of government. They are expected to respond to the desires and needs of their constituents. And constituent expectations tend not to be tempered by such realities as cost and resource limits. In short, politicians are under pressure to accomplish more than available resources permit. That can mean attempting more than we can afford or are willing to pay for. Put another way: it is easier to vote for needed programs than for increased taxes. Such pressures probably give our national policies and goals an inflationary tilt.
This is especially true in a democracy where the powers delegated to our elected officials must be affirmed by “back home” constituents every two, four or six years. The need for our elected representatives to be responsive and "tuned in" to their constituents is a vital function in our political process. It provides important guarantees to citizens. But it may also limit the extent to which elected representatives can afford to consider the long-term merits of policies. Policy actions that may lead to defeat in the next election, however valid, are not likely to be seen as attractive options.
Balanced policy therefore requires an institutional structure that insulates monetary policymakers from such short-term pressures—which is to say, one that also insulates elected officials from the negative electoral consequences of policy decisions that may be essential but unpopular.
Obviously, not all policy decisions pose this type of conflict. Not all elected officials yield to short-run pressures or would need to. In any case, the merits of a given policy are seldom unambiguous. But the consequences of persistently expansive monetary policy are too severe to risk procedures that compound a bias in favor of short-run options and produce short-sighted results.
Historically, we have used a variety of mechanisms to manage money—a stock of silver and gold bullion or currency backed by metals. These mechanisms regulated the money supply according to irrelevant changes in our stock of metals and offered little or no consideration of actual needs of the economy, short- or long-term.
Our own history, and the experiences of other nations, are replete with examples of run-away inflation and economic chaos that developed because the lure of superficial solutions outweighed responsible but less popular policy actions.
Out of long experience, our monetary system has evolved so that the supply of money and credit are “managed” at levels intended to be most conducive to stability, growth, and a high level of production and employment in our national economy. That responsibility requires not only a high degree of technical knowledge about the economy and the interaction of its different elements and forces but also requires objective, “independent” judgments about the best monetary adjustments to help achieve those national goals.
Over the years the Federal Reserve System has proved remarkably adaptable to changing needs. Both policies and procedures have been altered when the need for change became clear—sometimes by statutes or amendment to the Federal Reserve Act, often by policy and administrative implementation within the authority of the Act.
The Federal Reserve System was barely in operation when it became apparent that purchases of government securities, now the main mechanism for influencing the money supply, added to bank reserves and thus became an unexpected mechanism for effecting monetary expansion.
The Banking Acts of 1933 and 1935 reaffirmed and strengthened the Federal Reserve's independence from the executive branch—they removed the comptroller of the currency and the Secretary of the Treasury from the Federal Reserve Board—and affirmed its independent budget and income procedures. They delegated to the Fed the power to control stock margin requirements and to regulate savings interest rates.
World War II saw the central bank directly supporting the financing of unprecedented war expenditures with subsequent monetization of that debt after the war. In the famous “accord” of 1951, after lengthy debate both public and within government, it was agreed that the Federal Reserve would no longer support (by its purchases of government securities) the artificially low interest rates and par values for financing government debt. Thus ended the domination of monetary policy by the Treasury's needs to finance its massive war-born debt.
The Employment Act of 1946 affirmed “maximum employment” as one of the goals of Federal Reserve policy, establishing formally that monetary policy has a responsibility to support and help implement national objectives.
In more recent developments, congress has delegated additional authority to the Fed under the consumer Protection Act to regulate “Truth in Lending,” “Equal Credit Opportunity” and other consumer interests.
Over the years, it became clear that monetary policy had to be uniform throughout the nation, that regional variations were not possible. Yet the concept of a “federal” system, with input from various regional perspectives, was important in the policy process. The establishment of the so-called Federal Open Market Committee (FOMC), combining the Board of Governors and five Federal Reserve Bank presidents as the major policymaking body, represented a major structural innovation that accommodated the needed change.
Representative Carter Glass and his congressional contemporaries worked out the remarkably durable provisions of the Federal Reserve Act within the context of our federal system of structural checks and balances. The terms of the seven Federal Reserve Board members (14 years—originally Board terms were 10 years, changed to 12 years in 1933 and to 14 years in 1935) are not so long or unchangeable as the life-time appointments of justices to the Supreme Court, but are long enough to make the partisan political prospects of a next election substantially irrelevant.
Ultimately the System is accountable to congress, not the executive branch, even though Reserve Board members and the chairman are president-appointed. The authority and delegated policy powers are subject to review by the congress not the president, the Treasury Department, nor by banks or other interests.
Because the Federal Reserve System finances its operations from internally generated income, it does not depend on congressional budget appropriations. This is an essential element of “insulation,” since the power to appropriate budgets is the power to control. This principle was reaffirmed in the Banking Act of 1935 and again in the Government Corporation Control Act of 1954.
The check and balance structure extends in other ways. Directors of regional banks are required to represent borrowers and the general public as well as banks and lenders. The regional structure itself ensures the representation of varied regional interests in economic research and policy formulation, as well as directly on the FOMC. Members of the Board of Governors must themselves be geographically representative.
Finally, an important element of insulation results from the ability to have policy deliberations conducted in a manner and climate that ensures maximum candor by all staff and officials involved. Alternative policies cannot be discussed fully and realistically without such candor.
Pressures for reform of the Federal Reserve System stem from three kinds of concerns: (a) disagreement with monetary policy, (b) disagreement with how the System functions in a procedural context, and (c) disagreement as to its accountability—to Congress, to the executive branch, to the public.
Disagreements over monetary policy are inherent. Knowledgeable monetary experts and economic professionals can and often do disagree over appropriate action, timing, methods of implementation and degree of emphasis. Typically, there is more disagreement over the precise degree of restraint or stimulus than over the direction of policy, whether restraint or stimulus. But disagreement over policy is normally healthy disagreement. It does not in itself justify reform unless policies are clearly bad, and clearly bad for reasons of structural dysfunction.
Critics of monetary policy often cite the need to coordinate monetary with other national economic policies: the various agencies of government should not work at “cross-purposes.” Working at cross- purposes can be wasteful and inefficient. It may be an indication of bad policy on the part of one agency or on the part of all. But agreed-upon policy objectives often conflict in implementation—as when we seek more “good things” than limited resources can provide, or when lower interest rates also mean more inflation. The populist goals of readily available credit at low interest on the one hand, and the dangers of rising prices, inflation and subsequent recession on the other, are the classic issues of monetary/economic policy debate, about which there is not only honest argument but also inherent conflict.
At times, rapid increases in federal expenditures—and deficits—have forced over-reliance on monetary restraint to curtail inflation. In the context of checks and balances, it can be prudent to have a system where not all agencies or branches of government are required to arrive at the same judgment concerning the nation's economic needs and prospects.
Other criticisms stem from the fact that the Federal Reserve System, as our central bank, is institutionally related to banking—especially member banks. Member banks elect six of the nine directors of each regional Federal Reserve Bank. And each member bank owns nominal stock in its district Federal Reserve Bank. Boards of regional Federal Reserve Banks have been, de facto, largely representative of banking, financial and business interests—more or less by deliberate policy. Understandably, the boards of regional Reserve Banks must include knowledgeable banking and business leaders, since one of the regional Bank's major functions is to work jointly with and through member commercial banks in providing financial services to business, government, agriculture and the district economy. In practice, this has meant that they have not been specifically representative of the interests of consumers, organized labor, minorities, or women—however those interests may be defined. But this is in process of change.
Several suggestions for reform of the Federal Reserve System have been proposed, some of which seem acceptable, even if not offering substantive improvements. Collectively, they might enhance the public's understanding of the Federal Reserve as a public institution and its functioning as the “supreme court” of monetary policy. Among the recent proposals are:
Being “independent within” the government means a monetary function that is insulated from, yet fully aware of, other essential needs such as national defense, foreign policy and trade, resource development, housing, and employment. Constructive policy derives from a structure which can be both coordinative and independent, within government and also beyond government.
It will be helpful, then, to examine such cooperative/independent relationships between the Federal Reserve System and the other elements with which it must coordinate. These include:
Independence from the executive branch of government was a main concern during the development of the Federal Reserve System, as it has been since. Yet it is essential that the monetary function work in cooperation with the president and his economic advisors and with the major agencies of the executive branch, principally the Treasury Department.
Given the power and influence of the presidency, that office can exert strong pressure and influence on any agency. By and large, presidents have been careful not to abuse this power, respecting the need for an independent monetary authority.
Following World War II it appears that President Truman did, for a time, support the Treasury Department in its need to finance the public debt and approved the then subordinate role of the Federal Reserve System in supporting that effort. When this impasse was resolved, the Federal Reserve's responsibility and accountability for monetary actions were restored. Since then, the “independent” relationship between the two agencies has functioned well.
There are any number of linkages between the Federal Reserve and the economic agencies of the executive branch. They are formal and informal and they function at both the policy and staff levels. The chairman of the Board of Governors, for example, joins the Secretary of the Treasury, the chairman of the Council of Economic Advisors, and the director of the Office of Management and Budget in meetings of the so-called Quadriad. When the Federal Open Market Committee takes policy actions which it believes to be in the best interest of the nation, it does so with full knowledge of the administration's plans and objectives.
The central bank is in constant contact with the Treasury Department which, among other things, is responsible for the management of the public debt and its various cash accounts.
Prior to the existence of the Federal Reserve System, the Treasury actually carried out many monetary functions. And even since, the Treasury has often been deeply involved in monetary functions, especially during the earlier years.
At the beginning of World War II, it appeared desirable that the Treasury be able to issue debt at relatively low interest cost and also on a basis that assured purchasers that securities would be marketable at near face value. Because of the urgency of this need, the policy was agreed to and continued after the war until 1951. During this period, the Treasury was, in effect, deciding the monetary policy of the country as it made its decisions as to how much debt needed to be funded. Because the central bank supported the market for government securities, it was forced to purchase amounts of securities necessary to maintain low interest rates and the par value of securities. Thus, as the Treasury issued additional debt, the central bank was forced to acquire part of that debt. This process resulted in direct addition to bank reserves.
Following the 1951 accord between the Treasury and the Federal Reserve System, the central bank was no longer required to support the securities market at any particular level. In effect, the accord established that the central bank would act independently and exercise its own judgment as to the most appropriate monetary policy. But it would also work closely with the Treasury and would be fully informed of and sympathetic to the Treasury's needs in managing and financing the public debt. In fact, in special circumstances the Federal Reserve would support financing if unusual conditions in the market caused an issue to be poorly accepted by private investors.
The Treasury and the central bank also work closely in the Treasury's management of its substantial cash payments and withdrawals of Treasury Tax and Loan account balances deposited in commercial banks, since these cash flows affect bank reserves.
A second major relationship, of course, is with the Congress—the branch of government that specifically delegated, in the form of the Federal Reserve Act, the responsibility for managing monetary policy in the interests of the nation. At the same time, Congress retained responsibility for the taxing and spending decisions of the federal government.
When the balance between spending and taxation results in government deficits, the Treasury has to issue additional public debt. In a monetary sense, the failure to tax adequately to cover the expenditures of the Federal government is an invitation for “printing money” through the issuance of federal debt. Depending on the phase of the business cycle, this tends to increase the money supply and, without offsetting action by the central bank, can result in an inflationary rise in prices. The result is “hidden taxation”— which takes away from taxpayers in the form of lower purchasing power (higher prices) what they would have paid in additional taxes had the expended funds been obtained through that source.
Thus there is an important linkage between the taxing and spending powers of Congress and the monetary powers as delegated to the Federal Reserve System. In principle, it is the job of Congress and the executive branch jointly to define the economic policy objectives of our national government, and to support those objectives with appropriate fiscal measures. Then the central bank can coordinate monetary policy in a manner which serves those national objectives.
When fiscal policy does not match spending appropriately to tax revenues, then the monetary authority is faced with a difficult choice: (a) how severely should it restrain the inflationary forces that may develop, and (b) to what extent should it permit inflationary forces to have their effect in higher prices? When the failure to provide appropriate tax revenues generates acute forces of inflation, then even the best compromise may require severe monetary restraint. This has the effect of appearing to be at cross-purposes with congressional intent and can also produce severe disruptions in some areas of the private sector such as housing.
Thus, the Congress and the Federal Reserve System may not always appear to agree in their policy actions, but they have a substantial common interest in coordinating such policies. Monetary policy can be less extreme when fiscal policy is doing “its share.”
Another reason for delegating the monetary responsibility to an authority not directly a part of the government is the high degree of technical expertise required to analyze economic data, trends, and other information related to appropriate monetary decisions. While the Federal Reserve has been called the monetary “agent” of Congress and is subject to its ultimate control, its special responsibilities require a separation in carrying out its unique functions. Congress cannot effectively legislate day-to-day monetary decisions, nor even provide operating mandates.
In the dialogue between the Congress and the central bank, both the intent of the national policy and the rationale for appropriate monetary policy must be communicated. To accomplish this, the Federal Reserve System reports regularly to the Congress with regard to its conduct of monetary policy. Over the years, exhaustive hearings have been held by the Senate and House banking committees regarding the functions and procedures of the Federal Reserve System. The Joint Economic Committee and other committees of Congress frequently call on Federal Reserve representatives to discuss both policy and operational matters.
A third area of independence relates to commercial banking and other private financial institutions.
It was no accident that the Federal Reserve System was structured to include direct representation from commercial banking, for without a sound banking system monetary policy could not operate. When the central bank takes action to restrict or expand the money supply, the multipliers set in motion are leveraged through the banking system—often to the discomfort of bankers themselves. When monetary policy is restrictive, the restrictive action takes place at the loan desks of commercial banks where, with greater demand for funds and limited money to lend because of the restrictive policy, bankers are forced to decline some loans that both they and their customers might otherwise consider prudent. Thus is expansion of the money supply restrained.
All national banks and many state-chartered banks are members of the Federal Reserve System. It is essential that the majority of bank deposits in the country be subject to Federal Reserve requirements in order that the reserve mechanisms for controlling the money supply can function well and equitably. In addition, the central bank is charged to perform other services for member banks such as supplying coin and currency, clearing checks, transferring funds, and making loans to member banks under special circumstances. These services require direct working relationships with commercial banks. The Federal Reserve's supervisory role (and also the central bank's ultimate role as the lender of last resort) reflects both the public need and the monetary need for sound banking.
Through all these close ties and relationships, it is essential that the central bank deal “at arm's length” with commercial banking in general and that it not be dominated or made subservient to banking interests. This also has been a major concern of Congress over the years and is a concern that is reflected in its design of the Federal Reserve Act. It is one of the reasons why the Federal Reserve's bank supervision and regulatory functions are structurally accountable to the Federal Reserve Board rather than to regional bank boards.
One other area in which separateness and independence have significant meaning is within the Federal Reserve System itself.
As originally conceived, the regional Federal Reserve Banks were largely autonomous: a federation of regional institutions made up the Federal Reserve System. As time and experience brought changes, it became necessary to coordinate monetary policy on the national level, while continuing to perform central bank services for member banks, including the discount (lending) function at the regional level.
Regional Federal Reserve banks are regularly examined by the Board of Governors to confirm the internal quality and integrity of each Bank's operations and also to ensure that regional Banks are complying with all statutory regulatory requirements of the System.
An important feature within the Federal Reserve is that the chairman of the Board of Governors, though spokesman for both the seven-man Board and the Federal Open Market Committee, does not have independent authority. He cannot establish policy himself nor control policy decisions. He is subject to and limited by the majority vote of the councils of which he is part.
Thus, there exists within the System itself checks and balances which limit the authority and the power of its different elements. These relationships are significant when structural changes are under consideration.
Our central bank structure—functioning in an environment reasonably insulated from the day-to-day pressures of partisan politics and short-term expediency—was born out of decades of experience with boom/bust recessions, financial panics, and monetary instability.
Over the years, the System and its vital monetary function have been under constant scrutiny and review by Congress, by professional economists, by banks and financial experts as well as by the public. Hearings by Senate and House banking committees on Federal Reserve responsibilities and procedures have been exhaustive.
Such studies have produced innumerable changes in responsibilities, authority and procedures. It is through such efforts that our monetary mechanisms have kept pace with the changing needs of the times. While many problems persist, it is also true that over the past three decades—and despite some pretty difficult times—recessions have been moderate, and severe panics and disruptions have been largely avoided.
Whether the proposals currently suggested are useful remains to be seen. But the role of the Federal Reserve System in carrying out the exacting responsibilities of managing the nation's monetary policy requires the best structural and procedural framework possible to do that job. The record suggests that a degree of “independence” is essential for effective execution of its monetary role. There is a recognized need for professionalism in analysis and formulation of policy —free of partisan/expediency considerations and free of distraction from other responsibilities.
Urgent and changing economic needs call for frequent review, evaluation, and suggestions for reform—relying on the tested lessons of past experience as we learn to understand and cope with new changes.
A System that provides responsible policy must serve the broad public interest, remaining objective and removed from special interest, yet ultimately accountable to and in dialogue with the realities of changing times, human values, and economic conditions.
* Robert W. Worcester, vice president at the Federal Reserve Bank of Minneapolis, provided valuable assistance in preparing this text for publication.