On (Too Much) Fed Independence

Former Secretary of Labor Robert Reich (hat tip: Economist's View) offered some thoughts Friday about democracy and the Federal Reserve. Both his insights and his errors are instructive.

Reich writes:

You probably learned in school the United States government has three branches. Actually there's a fourth, in some ways more powerful than the other three. It's called the Fed, and it pretty much runs the American economy.

I agree with Reich that the Fed is important, but to say it "pretty much runs the American economy" is I hope intentional hyperbole. The Fed does not produce a drop of gasoline nor an ounce of wheat. Its core responsibility is to decide how much money to allow in circulation. The notion that in doing so it somehow runs the economy, or could be tapped to eliminate the business cycle, seems to have become one of the urban myths of our time.

Furthermore, the power to create money is precisely the kind of power we never want to have in the hands of Congress or the President. If the politicians had the ability to pay for their programs simply by printing money, there is no question that the outcome would be ferocious inflation. One of the clearest lessons of history is that a central bank that lacks strong independence from the fiscal authorities is a recipe for disaster.

The ability to create money to pay for whatever you might deem worthwhile is one that few human beings are capable of exercising responsibly. For this reason, the key institutional premise on which an independent central bank is founded is that it in fact does not have the power to create wealth or direct its allocation at all. Instead, the Fed is supposed to increase the money supply by purchasing a previously issued Treasury security on the open market, buying from whoever is willing to sell at the best price. The seller of the security is no richer or poorer than before, having acquired cash but surrendered a bond of equivalent value. But the seller's bank ends up with the reserves (electronic credits for cash, if desired) that the Fed has just created, while the Fed now owns the Treasury securities. The seller's bank could lend those reserves to any other bank on the federal funds market. Through this arms-length process, the reserves would end up in the hands of whoever wanted them most and interest rates could adjust, without anyone in the Federal Reserve ever making a decision to favor one group over another.

Since August, however, the Fed has been pursuing a different vision of its mandate. Francisco Torralba covers some of the background on exactly what the Fed has been up to. To take one example, in a standard repurchase agreement, the Fed makes a loan to a counterparty in the private sector, crediting the counterparty's bank with newly created reserves. The Fed recently has been substantially increasing the volume of its repo operations, and simultaneously selling Treasury securities from its existing holdings in order to drain the newly created reserves back out of the system. Thus unlike traditional repurchase agreements, the operations do not affect the supply of reserves at all, but have the net effect of swapping out the Fed's Treasury holdings for the collateral offered against the loans, which might be mortgage-backed securities issued by Fannie or Freddie.

Although repos have always been a tool that the Fed could use to alter the composition of its asset holdings in this way, to my knowledge the Fed had not made much use of such simultaneous dual operations prior to last fall, and the magnitude of its current holdings of repo assets (up to $100 billion last week) is enormous by historical standards. We now have a whole lexicon of new Fed acronyms for different measures that all have the same bottom line, of swapping out Fed Treasury holdings for riskier loans to private borrowers, including the TAF (Term Auction Facility), PDCF (Primary Dealer Credit Facility), and TSLF (Term Securities Lending Facility). The combined increase since August 1 in the assets held by the Federal Reserve under this new alphabet soup is $302 billion, which represents 38% of the Fed's holdings of Treasury securities on August 1.

Selected Fed assets by class, weekly averages as of Wednesdays, in billions of dollars. Data source: FRB Release

And this is where I feel that Robert Reich raises an excellent point:

the Fed can expose taxpayers to hundreds of billions of dollars of potential losses without a single appropriation hearing, as it did recently when it allowed Wall Street's major investment banks to exchange tainted mortgage-backed securities for nice clean loans from the Treasury. And the Fed can do amazing things-- like decide one big bank, JP Morgan, is going to take over another, Bear Stearns, backed by $29 billion of taxpayer money.

Reich is exactly correct-- the Fed's recent behavior does expose U.S. taxpayers to a risk of default on these assets. While some may argue that the Treasury is exposed to risks in the current situation no matter what the Fed does, it seems to me that this decision is ultimately a matter for fiscal policy. And just as I don't want Congress deciding how much money to print, I don't want the Fed deciding how much taxpayer money is appropriate to pledge for purposes of promoting financial stability.

Whether or not it is wise for the Fed to be making decisions of a fundamentally fiscal nature, former Federal Reserve Chair Paul Volcker (hat tip: Calculated Risk) questions the legal authority and historical precedent for measures such as the Fed adopted in the case of Bear Stearns:

The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.

Although I shudder at Reich's suggestion that we need to get Congress involved in the Fed's decision of what interest rate to set, I agree very much that Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume. Congress's statutory limit on the quantity of debt that the Treasury can issue is something I have previously derided as political circus. But a statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio. Indeed, Greg Ip speculates on the possibility that the Fed could "ask Treasury to issue more debt than it needs to fund government operations." Surely that would be something that should require congressional approval. Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

In any case, I agree with both Reich and Volcker on this much-- these are not decisions that the Federal Reserve should be making on its own, nor on the basis of behind-the-scene consultations with the President or congressional leaders. Bernanke needs to ask for explicit statutory authorization for his plans.

Comments

[crowdofcheerleaders]

All you're really advocating is the complete codification of all the Fed's current actions into full law. While at first you sound like you're advocating curbing any sort of power the FR wields, your solution will ensure that no one can successfully resist the FR and its role in our money in the future.

[pissed offJ6P]

"Although I shudder at Reich's suggestion that we need to get Congress involved in the Fed's decision of what interest rate to set,"

i'd like one particular Congressman from Texas who sits on the House Financial Services Committee to decide what mechanism decides interest rates. in other words, let market forces determine risk premiums. if we're going to have ordinary men & women at the FRB decide interest rates, then why not have all the ordinary men & women of our country in the aggregate decide interest rates via their own actions? i guess that's just crazy talk and Wall Street should ultimately decide and implement thru their neutered lapdog, the FRB. then Wall Street can get their bonuses for short-term performance and retire while their man-made debacles are guaranteed by the taxpayers. sounds like a great idea!

[sbenard]

Ditto to my colleagues. It seems that this author ignores that Congress already does just spend like they'll die tomorrow and the Fed kindly obliges by printing with the same style. M3 is up 15% in the past year, far more than productivity or GDP would justify. Is it any wonder inflation is going higher and higher, with oil hitting another new record tonight? The last thing we need is a Fed with more power and zero oversight from the people's representatives!

[bearfund]

I'd be thrilled if Congress could print money. Then I could buy a basket of groceries with a silver coin while my countrymen are struggling with wheelbarrows full of franked 100,000,000 dollar bills. I'd be wealthy, they'd be broke, and we'd all have exactly what we deserve. Isn't that what an efficient market would deliver?