An Attempted Palace Coup At The Fed

by: Kurt Dew


Danielle DeMartino Booth, former advisor to the President of the Dallas Federal Reserve Bank, wants to reform the Fed.

She wants to move its power from Washington and New York.

She wants to rid the Fed of economists.

Maybe not. The Fed did not create the crisis. It helped end it.

I let you know that you're my good thang.

Even if you make a mistake. And do the wrong thang.

- Pretty Willie

When former Chairman Ben Bernanke stepped down, the wolves began to circle the Fed. Most of the resulting proposals to change the Fed are rehashed versions of Wright Patman's old games. Patman was a long-time Chairman of the House Banking Committee. Patman's favorite harassment tactic; "audit the Fed," is still a golden oldie. The proposal was, and is, basically harmless.

But there are other proposals. President-elect Trump is getting much unsolicited advice about how to change government, including the Fed. Each proposed Fed change has the same characteristic: increase the power of the proposers. This article focuses on the most transparent grab for power yet - that of Danielle DeMartino Booth, former advisor to the President of the Dallas Federal Reserve Bank.

Why "change the Fed" proposals are stillborn

But rest assured. There will be no substantive changes to the Fed. The Fed's design is an exquisite combination of substantial Fed protection from the day-to-day vicissitudes of politics, while permitting elected officials to prevent the Fed from escaping the political realities of life, becoming an island unto itself.

Once important politicians, particularly sitting presidents, have spent a year in office, they come to understand that they will be the defining influence on Fed policy, without being held accountable for unpopular Fed decisions. At that point, their interest in Fed modification rapidly wanes.

When we needed the Fed, it was outstanding

Former Chairman Bernanke oversaw what most experts believe was the Fed's outstanding job of separating the United States' post-Financial Crisis economic growth from that of the rest of the globe. His Fed achieved this, impressively, without the cooperation of a dysfunctional Congress. The politicians stepped back from interference with the Fed during Bernanke's tenure, aware that the Fed was playing with live bullets and, thus, that there was no upside to political involvement.

What the Fed is

The structure of the Fed is highly complicated. The primary difference between the Fed and other central banks is the existence of 12 Federal Reserve district banks, apart from the Board of Governors in Washington.

These district banks are an artifact of the primary difference between the United States and other countries. The US was born as a confederation of sovereign states. Because confederations of sovereign states inevitably are dysfunctional when attempting to conduct one fiscal and one monetary policy, the Constitution was written in part to unify the financial governance of the states. But in most affairs of the US government, states are still powerful in the process of government, in comparison to regional units in other countries. The Fed is no exception.

As a matter of practice, there are substantial benefits to having these district reserve banks. Most prominently, research and policy positions at the regional banks (excepting the New York Fed) frequently deviate substantially from the Washington dogma. Also, some banks specialize in particular fields within monetary policy and bank regulation. The Chicago Fed, for example, focuses on exchanges and transaction technology.

How monetary policy works

Monetary policy is decided by the Federal Open Market Committee (FOMC). Who votes on the FOMC and when, is a long story with a short summary. A majority of the FOMC is located in Washington and appointed by the president. Policy is, thus, seldom something other than that desired by the sitting president, after his first year of office. (There is a one year "lame duck" period following the election of a new president, before he can pack the Fed with his chosen governors.) It is often, however, convenient for sitting Presidents to refer to the Fed's "independence" when explaining unpopular policies.

Reflecting on the fact that policy is decided by a committee with a presidentially-appointed majority, one might expect that the presidents of the district reserve banks (always excepting the quite powerful President of the New York Fed) are third wheels, inspiring envy. Evidently so.

I can think of several good reasons for taking a position as a president of a district reserve bank. These officials can develop and articulate a separate vision of appropriate policy. They have substantial research staffs to validate their policy stance. There are celebrated examples, such as the St. Louis Fed in the 1970s and the Minneapolis Fed of the 1980s. Both banks' research had a hand in changing the Fed's policy strategy. But when policy votes are taken, a district bank president will agree with the Washington/New York power base or dissent. In other words, their votes don't matter.

The DeMartino Booth proposal

Rarely though, does a regional Fed bank president attempt a palace coup. The DeMartino Booth proposal is exactly that. To cut to the chase, the proposal recommends that the Fed:

  1. Drop the level of unemployment as a joint objective, limiting the Fed to control of the rate of inflation.
  2. Reduce the number of Federal Reserve districts from twelve to ten, and make the remaining ten presidents permanent members of the FOMC.
  3. Cease hiring PhD economists. Hire lawyers, accountants and quants in their stead.

Why drop unemployment? According to DeMartino Booth, "The single [inflation] mandate would ensure that the Fed is less intrusive than it's been in recent years." She gives the Fed blame for the crisis and no credit for the subsequent recovery.

Her proposed reduction in the number of reserve bank districts is based on state population. But why ten? Wouldn't four be sufficient? One in San Francisco, Dallas, New York, and Atlanta? The reason is obvious. With ten, the district reserve bank presidents, now all voting members of the FOMC, represent a majority of the committee.

A stark choice

DeMartino Booth certainly clarifies why Fed district bank presidents are in a minority on the FOMC. Not only would she not be swayed by politics, she would not be swayed by economics.

Who, according to DeMartino Booth, should determine the district bank presidents? She suggests that Trump "find CEOs who would rather have invested in the future of their companies, thus creating more jobs and opportunities, rather than be pressured to buy back their shares with cheap debt because of regulatory uncertainty." That is both a non-sequitur and a rewriting of history. If CEOs did buy their shares back because of the regulatory uncertainty DeMartino Booth contends is the explanation for our economic problems of the past ten years, how is it wise of a CEO to ignore what she claims is the rational response to this uncertainty? Or is it that there were CEOs who preferred buybacks and dividends to productive investment? Please. There are quite a few CEOs who want to invest in more productive ideas, including the kid who sells lemonade down the street from me.

Precious few economists would agree that the Fed was the source of the Financial Crisis. But then, as she explains, we economists are all being bought off by the Fed. Over the past year, I have objected to the Fed's monetary policy. I have objected to the Fed's implementation of Dodd-Frank. I have had nothing good to say. It takes quite a lot to get me to write an article supportive of the Fed. DeMartino Booth has succeeded.

But then, there have always been mavericks within district reserve banks. As such, they do challenge the status quo. And policy benefits from challenge. But that is also why we don't hand them the policy reins.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.