Some Thoughts on Federal Reserve Independence

Federal Reserve independence must be protected to achieve a stable economy. It can’t be said clearer than that. There has been considerable discussion on the Fed’s ability to remain outside strict governmental control, whether the trillions in support cash they have given away in various facilities over the past six months violates the public trust, and whether they should continue to be so separate or be brought under tight Congressional supervision.

One of the core threats to Fed independence comes from the proposed increased in its powers. The Federal Reserve System is a unique type of central bank, and has the core role of setting monetary policy for the country, independent of legislators or White House control. I fear that if the Fed gets powers to manage systemic risk it will be subject to increased Congressional oversight. There are others who fear the Fed will be shackled closer to other agencies and unable to respond to market situations as swiftly or independently. The Fed officials say they can do the new work fine without being captured by other agencies.

Another reform proposal comes from Rep. Ron Paul, who wants the GAO to audit the Fed. (Six part interview on the bill here.) The idea is to add accountability. Some fear, though, that giving Congress power to look into Fed books will eventually evolve into giving them a direct say in monetary policy. It would be an epic tragedy to have the Fed lose this kind of independence (though I don’t totally buy the argument that power to audit leads to Congressional take over)

Last Friday, Fed Vice Chair Donald Kohn defended the Fed independence. He observed:

Operational independence—that is, independence to pursue legislated goals — reduces the odds on two types of policy errors that result in inflation and economic instability. First, it prevents governments from succumbing to the temptation to use the central bank to fund budget deficits. Second, it enables policymakers to look beyond the short term as they weigh the effects of their monetary policy actions on price stability and employment. (HT: David Zaring)

Here’s the thing: the Fed isn’t perfect. In fact, they have had a lot to do with bringing about the current recession, not to mention the Great Depression. I don’t buy into Judge Napolitano’s conspiracy theory that the Fed will use the threat of high interest rates to keep Congress from getting more involved, but I do think the economists there are just as flawed as elsewhere. They went to the same schools as Wall Street executives. They have the same potential to fail and be just plain wrong. However, Congress is worse. They don’t have close of the knowledge the Fed has. They are trapped in the political game. If you are worried about the Fed from historical accounts of their failures, just imagine that increased 10 fold by Congressional intervention.