Bored by the proceedings at the Republican National Convention in St. Paul one day in 2008, I decided to try to gather some color down the road in Minneapolis, where Ron Paul and fellow dissident conservatives and libertarians were holding a counter-convention at the Target Center. At one point a speaker thundered that Barack Obama and John McCain “both have a lot to learn about Austrian business-cycle theory.” The crowd went delirious with cheers, and soon chants of “end the Fed” echoed throughout the arena.
It was funny at the time. A bunch of cranks talking about their crank monetary theories and espousing a crank prescription.
Today, Paul is the chairman of the House Subcommittee on Monetary Policy.
And though the House GOP presumably won’t be pressing the full Paul agenda of eliminating the Federal Reserve System and returning the United States to the gold standard, his ascension to the job isn’t a pure coincidence, either. House Republicans don’t assign chairmanships by strict seniority, and in the past, GOP leaders had kept Paul away from too prominent a role in monetary matters. Now he’s getting a seat at the table and Paulite views that see the Fed as pursuing dangerously inflationary policies are moving toward the mainstream.
As recently as 2009, the Federal Reserve’s emergency efforts to keep the economy afloat were sufficiently uncontroversial that Time named Chairman Ben Bernanke its Person of the Year. Earlier that summer, Barack Obama chose to reassure markets by leaking—well in advance of the need to make a decision—that Bernanke would be reappointed to lead the central bank. And yet, by the time the confirmation vote was actually held in late January 2010, Bernanke got in by a margin of just 70-30, the slimmest of any Fed chief ever. That nearly half of Senate Republicans voted no is especially striking when you consider that he was originally put in the job by George W. Bush, had previously chaired Bush’s Council of Economic Advisers, and before that had done an earlier stint in a lesser Fed role, again at the behest of Bush.
At the time it was possible to interpret this reversal on the part of so many GOP senators as just another sign of partisanship run amok: They were opposing him simply because Obama was the one doing the nominating. But as the economy slowed again in 2010, and the Fed initiated a new round of so-called “quantitative easing” (QE)—central bank purchases of long-term Treasury bonds to increase the money supply and stimulate the economy—it became clear that Republicans were genuinely moving toward a critique of the whole idea of stimulative monetary policy. This was striking because stimulative monetary policy had been since Milton Friedman’s day the main conservative alternative to Keynesian fiscal stimulus.
In mid-November, the conservative economics think tank e21 released “An Open Letter to Ben Bernanke” complaining that his policies risked currency debasement and inflation. True, e21 is not itself a particularly influential or well-known institution, but the letter was co-signed by influential journalist/tactician Bill Kristol; Kevin Hassett from the American Enterprise Institute; Douglas Holtz-Eakin, founding president of the new American Action Network, intended to be the right’s answer to the Center for American Progress; and other heavy hitters. Shortly thereafter, Indiana Congressman Mike Pence and Tennessee Senator Bob Corker, both Republicans, joined the party, criticizing quantitative easing and urging that the Fed’s mandate be shifted from its current dual focus on inflation and employment to a single focus on price stability.
On the merits, these conservative complaints are absurd. After then-Fed Chairman Paul Volcker and Ronald Reagan beat inflation in the early 1980s, annual increases in the Consumer Price Index (CPI) hovered around 4 percent per year for the rest of the decade. After the recession of the early 1990s, the Fed held inflation mostly below 3 percent for almost 20 years. Since the onset of the Great Recession in December 2007, the CPI’s rate of increase has been steadily lower than even that. At the same time, unemployment has been sky-high, real growth has been first negative and then disappointingly slow, and overall consumer demand has been well below the pre-crisis trend. The idea that a time of unusually high unemployment and unusually low inflation would be a good moment for monetary policy-makers to start caring less about growth and more about price stability, especially when we already have price stability, is bizarre.
In response, Paul Krugman has called on progressives to “denounce Republican attacks on the Federal Reserve and defend the Fed’s independence.” But we need something better than a simple circling of the wagons around the powers that be. After all, people are angry for the very good reason that economic performance is currently very bad. And unlike a lot of the targets of popular anger in the Obama era, from autoworkers to hedge fund managers, America’s central bankers are in fact the ones who are supposed to deliver decent macroeconomic outcomes.
Most important, for all the flaws in the right’s current critique of the Fed, they’re correct to point to the need for accountability. The idea of a central bank that’s “independent” of day-to-day politics is a good one, but too often that’s come to mean a central bank that’s immune from criticism or meaningful supervision. The Federal Reserve System’s current vague mandate needs to be replaced with a specific target, defined in law. The public and the politicians we elected need to be prepared to hold the system accountable for achieving the target, and Congress needs to accept responsibility for picking a target that leads to good outcomes. Most of all, progressives need to start caring about the Fed and engaging in the debate over what it does.
The Fed and Its Works
Everybody knows that the Federal Reserve chairman has an important job, but few people understand what the institution he supervises actually does. The overall system undertakes a variety of activities, of which by far the most important is to set monetary policy: adjusting the quantity of money available to the economy.
This is done by the Federal Reserve’s Open Market Committee (FOMC), which is composed of the seven members of the Federal Reserve Board of Governors (the chair, the vice-chair, and five other governors), plus the president of the New York Fed and, on a rotating basis, the presidents of four of the other 11 regional Fed banks.
Each of the regional Feds has its president selected by its own board of directors. These boards, in turn, are composed of three classes of directors. Class C directors are appointed by the Board of Governors in Washington. The Class A and Class B directors are appointed by the member banks, with Class A directors representing banking interests and Class B directors representing local economic interests. The governors who sit in Washington are appointed by the president and confirmed by the Senate.
The FOMC’s mandate, as defined by the Federal Reserve Act, is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” This is conventionally called a “dual mandate” in that it references both employment and inflation. (Foreign central banks often have a single mandate to focus on inflation. Some describe the mandate in qualitative terms—like the United States does—whereas others have specific numerical targets.) The Fed pursues its mandate through so-called “open-market operations”—the buying and selling of bonds. In normal times, the Fed sets a target for short-term interest rates, announcing an intention to make them either higher or lower. Then it follows up with sales or purchases of short-term bonds. Buying bonds drives rates down, and selling them pushes rates up. But just as crucial as the Fed’s actions—if not more so—is the body’s announcement of its actions. After a meeting, the FOMC releases a statement describing its intention to shift rates up or down by a certain amount. Since market participants know exactly what the Fed is trying to do, private traders start buying or selling on the assumption that the Fed will hit its target, meaning that the quantity of bonds actually bought or sold by the Fed is rather modest in practice because private investors do most of the lifting. Purchasing bonds puts more money into the economy, creating conditions of “easy money,” and is known as “easing.” Selling bonds makes money “tight” by pulling it out of the economic system.
When short-term rates are nearly zero, as has been the case recently, the Fed can’t generate looser money through this method. But it does at such a moment have the option of buying or selling longer-dated bonds and trying to influence the economy. When the Fed does this, it sets not a target interest rate but a target quantity of bonds to be purchased—hence the term “quantitative easing.” By misguided journalistic convention, a “normal” action to reduce rates from 3.75 percent to 3.50 percent is termed “cutting interest rates,” whereas recent QE measures were reported by some in the media in near-apocalyptic terms as the Fed printing billions of dollars and purchasing vast amounts of bonds. These descriptions are not inaccurate, exactly, but they lack context—printing money and buying and selling bonds are what the Fed does all the time.
The Unaccountable Fed
Politicians talk about jobs all the time. President Obama seems to talk about them in every other speech, while Republicans constantly talk of the “job-killing” effect of Democratic policies. The truth is that questions about creating jobs ought to be directed at the Federal Reserve, the federal agency that’s been charged with primary responsibility for stabilizing the economy. Recessions normally come about because the Fed raised interest rates to curb inflation, and they normally end when the Fed cuts interest rates to spur growth. At times, fiscal policy—such as the stimulus passed in 2009—enters the picture as an additional means to stoke demand.
But even then the monetary authorities are crucial. Most of the time one would worry that demand created by a higher federal deficit would be offset by the fact that more borrowing raises interest rates, stifling growth. This is the technical version of the man on the street’s objection to stimulus that “the money has to come from somewhere.” Appealing though this idea may be, it is in fact false. As Bernanke put it in a 2002 speech, “[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” By using this technology, the Fed can ensure that interest rates stay low even in the face of large deficits.
This free lunch is available amidst deep recessions because such events are defined by the widespread idling of resources. A recession means the country has able-bodied people who aren’t working, factories that aren’t running, and office space and storefronts that are vacant. Fiscal and monetary stimulus aims to mobilize that excess capacity. When there is no excess capacity, printing money to keep rates low will simply lead to inflation. The country’s ability to produce money may not be limited, but its ability to produce goods and services is, and inflation is what happens when the government attempts to stimulate demand above the country’s ability to produce. Increasing productive capacity is the key to long-term prosperity, but adequately matching demand to current capacity is the key to the short-term employment and economic growth picture.
Clearly, the Fed bears enormous responsibility for the health of the economy. But the way the current system works, the Fed’s members are hardly ever held accountable when the Fed fails to live up to that responsibility. The current Great Recession is, like all passing economic disasters, a major failure of macroeconomic stabilization. On the one hand, in its role as bank regulator, the Fed clearly failed to prevent widespread misbehavior. On the other hand, as a monetary policymaker, the Fed let inflation expectations fall well below customary levels even as output and employment were plummeting. Yet so far the key monetary policy-makers have been reappointed, and discussion of the issue has been dominated by cranks warning of nonexistent inflation and pushing for antiquated ideas like a gold standard. And the Fed did, in fact, engage in a flurry of unfamiliar activity to support the economy. So at the very time the collapse in output suggested the need for even more unorthodox monetary expansion, the aggressive expansion itself invited criticism that too much money was being created or that the Fed was simply continuing an unduly cozy relationship with the banking sector.
Much of the blame lies with the Fed’s current statutory mandate. Simply put, it is maddeningly vague. The interpretation of both “maximum employment” and “stable prices,” as well as the correct balance between the two, is up for grabs. Some FOMC members (or some members of Congress) may decide that 2 percent inflation is too high and the concept of “stable prices” should be re-interpreted to mean something closer to 1 percent or 0 percent inflation. Alternatively, many or most FOMC members may believe that the kind of more drastic QE measures that would be necessary to boost growth and inflation to target levels would be too politically damaging to undertake. Most plausible of all is that we’re currently experiencing some combination of the two. Some members probably regard sky-high unemployment as a price worth paying for the goal of a reduced rate of inflation, while others would prefer to do more but worry about the politics. The result is to leave the FOMC semi-paralyzed and unable to offer a fully coherent account of its own conduct. A candid description of internal disagreements and the resulting policy compromise would ameliorate the communication problem, but at the cost of undermining the aura of unanimity that the Fed relies upon to preserve its credibility and independence.
Nobody can say the FOMC is doing a bad job because nobody can say definitely what its job is. Not only the committee itself, but each individual member thereof, is free to define the FOMC’s mission freelance. Policy-making is essentially an accountability-free zone.
But while FOMC members are overempowered to set their own goals, they’re underempowered to push back against outside critics who don’t like the smell of certain unorthodox measures or who simply have partisan political motivations. Without an unambiguous mandate to follow, critics and interested parties can easily politicize unfamiliar moves.
Conversely, failing to define a clear mission for the Fed is a convenient way for Congress to duck responsibility for economic decisions. A clearer mandate for the Fed would make it easier for Congress to hold the central bank accountable for poor performance, but it would also force politicians to focus more clearly on who is responsible for what. Past economic calamities have, appropriately, prompted rethinking of monetary policy—the key lever for providing macroeconomic stability. Amidst the Great Depression, FDR’s Administration took the dollar off the gold standard, creating, in effect, an enormous expansion in the money supply and setting the stage for recovery. And after the tremendous inflation of the 1970s, the Fed was refocused on fighting price increases and was distanced from the president’s short-term political interests. The economic calamity of our generation ought to provoke a similar rethinking—one aimed at empowering the central bank to respond forcefully to a big crash while also demanding that it deliver results. There’s no reason we should listen to the cranks, but we should at least hear them and recognize that they’re gaining credibility for the very good reason that the powers that be have failed and nobody else is talking.
One step in this direction would be to start taking Federal Reserve governance more seriously. Currently the chairman of the system tends to be a quasi-celebrity post, but the other members of the Board of Governors languish in obscurity. It’s like forgetting that the associate justices of the Supreme Court have important jobs. Even worse, the regional bank presidents are, in part, selected by private banks in a way that wreaks havoc on any notion that policy should be accountable to the public interest.
Time for Accountability
The first step toward reform should be fixing the appointment process so that accountability is at least possible. Contemporary American politics is shot through with accusations that policy is unduly dominated by the financial-services industry, and nowhere is this truer than in the bizarre status of the regional Federal Reserve Bank presidents.
The initial setup of the Federal Reserve System was intended as a decentralized compromise between big business’s desire for monetary authority and American populism’s traditional suspicion of central banks. But by dividing authority among 12 regional banks and then placing the regional banks substantially under the control of local member banks, we’ve gotten the worst of both worlds—diffuse authority that’s still substantially under the thumb of the structural interests of the banking industry. During the current crisis, for example, the most skeptical voices from inside the Fed about why it shouldn’t be doing more to fight unemployment have consistently come from the regional bank presidents in Dallas, Minneapolis, and especially Kansas City. It was precisely this fear of creditor interests crushing the economy with anti-inflation zeal that populist opponents of central banking worried about a century ago.
Monetary policy is a public function, and it should be conducted by public officials who are accountable to other public officials. There are two possible paths to reform on this point. One would be to take away the regional bank presidents’ rotating seats on the Open Market Committee, cutting them out of any role in making monetary policy. This would limit them to conducting the business of regional banking services and economic research, leaving monetary policy in the hands of the Board of Governors.
In addition to reducing the corrupting influence of private banks, this would also take account of the reality that monetary policy is not the primary function of the regional bank presidents. Consequently, regional bank presidents are typically not monetary economists, and in some cases aren’t economists at all.
Another approach, closer to the decentralized spirit of the original setup, would be to maintain—or even strengthen—the regional presidents’ current role but eliminate member banks from their role in selecting the board members. Class A and Class B board members could be selected by the governors of the states within a bank’s jurisdiction. Or instead of governors, responsibility could be vested with senators or state legislatures. The point, in any case, should be to ensure that public power is accountable to public officials who, in turn, are accountable to the voters rather than to private firms who are accountable to shareholders.
But beyond changing the process by which its members are selected, Congress ought to give the Fed a new and clearer mission. Instead of treating central bankers like mystical figures (“maestro”), they should be seen as what they are—technicians who hit targets by manipulating interest rates and public expectations. That means giving the central bank a single, unequivocal target. If the FOMC hits the target, then Congress should give its members a nice round of applause. If the committee falls wide of the mark, then it’s time to break out the denunciations and make sure not to reappoint anyone until they do better. If the FOMC feels that extreme measures are necessary to hit the target, then they can point panicking pundits and whining politicians to the congressionally approved target and get on with the job. And if targets are being hit but members of Congress don’t like the results, then lawmakers will have to take responsibility and either tweak the target or change something else in the policy environment to improve matters.
As for the crucial matter of what the target should be, there are a number of options. One would be to copy the Bank of England, which has an explicit mandate to achieve inflation of roughly 2 percent. That would approximate the Federal Reserve’s practice in the 1990s and 2000s, when nobody seemed bothered by the inflation rate. Indeed, such a target would have legitimated all the expansionary activities the Bernanke-era Fed has undertaken thus far, and would have even mandated additional monetary stimulus. Concurrently, people worried by the recent unorthodox measures would be reassured that these are undertaken with reference to the same old goals under new conditions.
Other ideas more exotic than current practice exist in the economics literature, including targeting the price level rather than the inflation rate or attempting to directly target overall aggregate demand. The details are interesting to debate, but for our purposes the main point is that whatever target is chosen, the job of monetary policy should be to hit it—to keep market expectations anchored near the target. That, of course, leaves open the possibility that an economy steadily hitting its targets will suffer from serious problems. Maybe people will find the inflation rate troublingly high. Or perhaps real output will be troublingly low. This, then, becomes a problem for America’s elected officials, who will need to take responsibility for the consequences of the mandate they handed to the central bank.
The appropriate response to a dragging economy might involve anything in the familiar litany of policy changes—lower taxes, more infrastructure spending, better education, changes to trade or energy policy, etc.—but policy-makers would also be asked to confront the possibility that the problem lies with monetary policy. Encouraging Congress to do so cuts against the grain of the fetishizing of central bank independence that came into vogue during the so-called “great moderation” of the pre-crisis years. On the assumption that a great moderation had been achieved, the fetish was understandable. But if a catastrophic failure of macroeconomic stability doesn’t cause a rethink of our approach to stabilization, then what would?
The day-to-day operational independence of the Fed should be maintained, but respectable opinion has gone too far in construing independence to entail a lack of accountability. No public institution can or should be truly independent of the political process. The Supreme Court is an independent branch of government, and rightly so. But its decisions are subject to hot political debate, and the nomination of judges to sit on the high court is considered an important presidential power. This, too, is as it should be. The assumption that monetary policy is too important to hold central bankers accountable through the political process should have come to an end along with the illusory great moderation.
The Challenge to Progressives
Large-scale change is unlikely to emerge in the near term. But for starters, progressives need to get in the game. The failure to control inflation in the 1970s served to substantially discredit the postwar Keynesian mixed economic synthesis. Progressives were initially optimistic that the great crash of 2008 would discredit the Reaganite paradigm, but as poor economic conditions linger into a Democratic presidency, there’s a real and growing risk that the reverse will happen. Central banks and monetary policy are the primary determinant of short-term economic conditions—of the unemployment rate, and thus of workers’ ability to bargain for wages. This is, clearly, a hugely important subject in its own right. But it’s also a critical determinant of overall political conditions.
Think back to the late 1990s and the booming economy under Bill Clinton. It’s little-remembered today, but as of the first half of that decade, the conventional wisdom in many circles held that to allow the unemployment rate to fall below 7 percent would be to risk dangerous inflation.
Alan Greenspan, no particular friend of progressive politics, disagreed. The result was an extension of the boom and the only period of sustained wage growth for working people in 30 years. As a bonus, the Democratic Party’s credibility on economic management was restored and Clinton’s popularity soared high enough to let him survive a major sex scandal.
But when Barack Obama was elected in 2008, he rather hastily chose to reappoint Bernanke, creating a situation in which no Democrat has held the most important domestic policy job in the land since 1987. He inherited two vacancies on the Board of Governors that he left open for over a year, only putting names forward after a third vacancy emerged in 2010. Once the nominees were picked, neither the Administration nor the Senate leadership made confirming them a matter of urgency, and they languished for months before the Senate Banking Committee. After months of delay, two of Obama’s picks were confirmed unanimously on September 30, but as of this writing, his third choice, MIT economist Peter Diamond, is still in limbo thanks to objections from Republican Senator Richard Shelby of Alabama, who deems him unqualified. Somewhat absurdly, while waiting to pass Shelby’s muster, Diamond won a Nobel Prize in Economics.
And yet throughout a period in which both Obama and Senate Republican obstructionism have taken hefty criticism from the left, little has been said about this situation. Of course, no one can know for sure what the Fed would have done had Obama picked someone other than Bernanke to chair it or filled the vacancies more rapidly. But it’s certainly plausible that different personnel would have led to swifter and more forceful moves toward monetary stimulus, a more rapid end to the recession, and a lower unemployment rate. The consequences of such a scenario for the American worker, for the president’s approval ratings, for the 2010 midterms, and for the entire progressive agenda would have been dramatic. These were, in other words, likely much more serious miscalculations than are generally realized.
Few people realize it in part because progressives in general aren’t accustomed to thinking about monetary issues. That, in turn, is largely because in the progressive movement monetary policy doesn’t seem to be anyone’s job. Climate change, health care, labor unions, women’s rights, gay and lesbian equality, and poverty, among other causes, all have their advocates. And faced with an economic downturn, fiscal stimulus is an appealing prospect to liberals. After all, it offers a political free lunch—an opportunity to spend money on key priorities without doing the tough work of coming up with offsetting tax increases. And it’s easy enough to dial around to a dozen interest groups and come up with a laundry list of stimulative fiscal measures. But the vast majority of recessions are fought primarily with monetary tools rather than fiscal ones. And even in especially steep downturns, fiscal policy can work as a stabilization tool only to the extent that monetary policy accommodates it. What’s more, most liberals claim to care about things like wage stagnation but seem to have remarkably little interest in the institution charged with determining when “too much” increase in compensation is risking inflation.
In our stovepiped movement, nobody is watching the basics of economic stability. This is a major lacuna in the progressive institution-building of the past ten years. Unless people are so naïve as to think we’re currently living through the last major recession in world history, it’s a gap that needs to be filled. Putting a non-conservative in the Fed chairman’s seat would be a nice start. And more programmatic emphasis is needed in our think tanks and journals to bridge the gap between academic research on monetary policy and the political world. The institution that failed us so badly in the current crisis is bound to fail again, and it’s crucially important that next time, there’s someone out there ready to talk about it other than Ron Paul.