This hostility explains the grilling that Bernanke received this past Thursday in the hearings before the Senate Banking Committee on his nomination for a second term as Chairman. It also explains the drive by many members of Congress to have Congress exercise greater control over the Fed’s behavior, and to take away from the Fed its power to supervise banks. As part of this Congressional pressure, Republican Congressman Ron Paul of Texas has introduced a bill to have the policies of the Fed audited by the Government Accountability Office (GAO).
The problem with these attacks and proposals is not that the Fed behaved perfectly either during or before the crisis-far from it- but rather that closer Congressional supervision and oversight is likely to make matters much worse rather than better. For example, although the Fed is criticized for not foreseeing the financial crisis and for its low interest rate policies, at the time there was no outcry in Congress against these policies. In addition, few, if any, Congressmen warned that a financial crisis would develop unless the Fed tightened up its supervision of banks, and also raised interest rates.
Members of Congress also directly contributed to the unsustainable housing boom. Barney Frank, one of the most knowledgeable Congressmen about financial matters, urged banks to increase their mortgages to subprime borrowers. The Community Reinvestment Act of 1977, extended further in 1995, also basically forced banks to increase their mortgage lending to consumers in poorer areas who were not likely to be in a financial position to meet their mortgage payments.
The Fed clearly made some serious mistakes as it struggled to cope with a financial crisis that was far more serious than Bernanke and other members of its governing Board had anticipated. By not letting Bear Sterns collapse, the Fed probably raised expectations that it would do the same for Lehman Brothers and other major investment banks if they got into serious trouble. All hell broke loose in financial markets when the Fed then let Lehman go under.
Perhaps too the Fed should not have put so many resources into saving AIG, the major commercial insurance company that also became a major insurer in the credit default swaps market. Other decisions by the Fed can be legitimately questioned, but there is little support for the view that the Fed would have behaved better if Congress had been more closely supervising Fed policies. In any case, Congress already has considerable supervisory powers over the Fed. This central bank has to produce an annual report on its activities, and the Chairman must testify at least twice a year before Congress. During this testimony, he has to explain what actions the Fed has taken, and to justify them when questioned by members of Congress. The minutes of the Board’s eight meetings each year are made publicly available-with a lag- so that everyone can see what the members are discussing, and any disagreements.
Central Banks in many countries have fought over decades and even centuries for the type of independence in their decision-making that the Fed enjoys. The problem usually with dependent central banks is that they engage in considerable inflationary printing of money under the urging of the executive or legislative bodies that control them. The increased money supply is an inflation tax, with the revenues used to finance greater government spending that would not have been feasible with the income tax and other tax revenue raised from companies and households.
The potential for inflation in a few years in the United States is considerable because of the Fed’s extensive and unprecedented open market operations as it tried to shore up the financial system. These operations created over a trillion dollars of banks excess reserves. When the upswing in the economy gains momentum, banks will use these reserves to lend much more to companies and households, a process that will increase currency and demand deposits, and thereby inflate prices. In order to subdue this inflation, the Fed will have to sell many of the securities that it purchased in open market operations, and find other ways to withdraw reserves and some of the inflationary potential from the American banking system.
Such Fed actions will raise interest rates, and put downward pressure on the economy’s growth, and contribute to increased unemployment. History shows that such inflation-fighting actions are far less likely when central banks are not independent, and legislative or executive branches control their policies. Even the oversight that Congress already has over the Fed is likely to induce the Fed to rein in its inflationary fighting policies. It would be an unpleasant and ironic prospect if increased Congressional control of Fed policies led the Fed to engage in more of the “easy” money policies that many members of Congress are rightly criticizing this central bank for promoting during earlier years of the decade.