|We know Congress is Wall St's puppet. Is the Fed captured, too? Simon Black think so.|
Daron Acemoglu is Elizabeth and James Killian Professor of Economics at the Massachusetts Institute of Technology and co-author of “Why Nations Fail: The Origins of Power, Prosperity and Poverty.” Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
A hundred years ago, monetary policy – control over interest rates and the availability of credit – was viewed as a highly contentious political issue. People on the left of the political spectrum feared the central bank would be used to prop up Wall Street banks; those on the right thought it would unduly expand the role of government, giving too much power to politicians.
Perspectives from expert contributors.
In the 1980s we entered a phase in which the Federal Reserve, along with other major central banks around the world, was seen as independent and run by technocrats supposedly immune from political pressure.
But in the light of the crisis of 2008 and its aftermath, we have to ask: Has our central bank fallen back under the influence of special interests?
The origins of the Federal Reserve System lie in an emotional debate, conducted more than 100 years ago, about whether the government should seek to affect interest rates – and support the credit of Wall Street firms during times of crisis – and, if so, how.
The Panic of 1907 convinced many people that the United States needed a central bank of some kind. A complete collapse of the financial system was too scary a prospect. But there was also a longstanding American aversion against ceding too much power to big banks.
At the dawn of the republic, Thomas Jefferson railed against the risks posed by government backing for concentrated power in the financial sector. President Andrew Jackson fought to abolish the Second Bank of the United States in the 1830s, the leading private bank of his day, which helped manage public finances and the banking system. Consequently, there was nothing resembling a central bank in the United States for much of the 19th century.
The Federal Reserve System, created in 1913, was a uniquely American compromise, trying to balance public and private interests. Banks controlled the boards of the 12 regional Feds – with big Wall Street firms holding great sway over the New York Fed, which had a disproportionate influence within the system as a whole — and still does.
This version of the system presided over a crazed and highly leveraged stock market boom in the 1920s and the catastrophic collapse of credit in the early 1930s, while protecting the big Wall Street firms.
Under Franklin Delano Roosevelt, the role of the Federal Reserve Board of Governors, based in Washington, was strengthened, and Wall Street was more generally constrained by effective changes to a wide range of banking and securities laws. These reforms and the effects of World War II pulled the central bank away from powerful bankers and further into the orbit of elected officials.
Unfortunately, as the United States and other countries learned after 1945, clever politicians can use central banks to manipulate the business cycle, boosting output growth and cutting unemployment ahead of elections. Richard Nixon, for example, famously pushed the Fed to ease monetary policy when it suited him.
The chairman of the Federal Reserve is nominated by the president to a four-year term (subject to confirmation by the Senate); anyone who would like be reappointed needs to please the White House.
The high inflation of the 1970s was interpreted by many observers as partly due to politicized central banks’ trying to help their elected masters and failing to control inflation expectations. The anticipated rate of increase in prices has a big impact on the actual rate of increase.
When monetary policy is not credible, meaning no one believes that the central bank will keep inflation under control because that might hurt the president’s party at the polls, wages and prices can easily spiral out of control.
In 1979 Paul A. Volcker became chairman of the Fed and tamed inflation by raising interest rates and inducing a sharp recession. The more general lesson was simple: Move monetary policy further from the hands of politicians by delegating it to credible technocrats.
Thus was born the idea of independent central bankers, steering the monetary ship purely on the basis of disinterested, objective and scientific analysis. When inflation is too high, they are supposed to raise interest rates. When unemployment is too high, they should make it cheaper and easier to borrow, all the while working to make sure that inflation expectations remain under control.
Increasingly, however, it seems that technocratic policy-making is just a myth. We have come full circle, and the Wall Street banks are calling the shots again.
Crucially, the idea that politics is just about electioneering misses the point. Politics is about getting what you want, not just through the ballot box but by persuading people in public office to take actions that help you. So declaring the central bank independent doesn’t move it outside the orbit of politics.
Monetary policy has an impact on inflation, output and employment. But it also has a major impact on stock market prices. Any central banker raising interest rates is reducing stock market values and thus eroding the bonuses of top bankers and other chief executives.
Those people will lobby, asserting that higher interest rates will undermine the economy and cause us to plummet into recession, or worse.
In principle, the Fed could stand up to the bankers, pushing back against all specious arguments. In practice, unfortunately, the New York Fed and the Board of Governors are quite deferential to financial-sector “experts.” Bankers are persuasive; many are smart people, armed with fancy models, and they offer very nice income-earning opportunities to former central bankers.
We have lost track of the number of research notes from major banks pleading for easier credit, lower capital requirements, delay in implementing financial reforms or all of the above.
In recent decades the Fed has given way completely, at the highest level and with disastrous consequences, when the bankers bring their influence to bear – for example, over deregulating finance, keeping interest rates low in the middle of a boom after 2003, providing unconditional bailouts in 2007-8 and subsequently resisting attempts to raise capital requirements by enough to make a difference.
As the American economy begins to improve, influential people in the financial sector will continue to talk about the need for a prolonged period of low interest rates. The Fed will listen.
This time will not be different.