Should the Fed Remain Independent? Becker

Neither former Fed Chairman Alan Greenspan nor the present Chairman Ben Bernanke anticipated the financial crisis that erupted in 2008. In addition, Greenspan helped keep interest rates low for several years after the 9/11 attacks on the United States that contributed to the boom in housing prices, the stock market, and other asset prices. For these and other reasons there is considerable anger and disappointment toward the Fed in Congress and among some economists.

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.

Comments

[Jim]

It seems to me that there was so much liquidity and potential liquidity lost when the housing and derivative market went bust that the Fed replacing bank funds and assets simply replaced what was lost and that therefore the risk of inflation is fairly low. It also seems to me that the Fed simply savethe politcal bacon of a derelict Congress. Removing the Fed independece will also remove any possibility of the Fed ability to bail Congress out the next time.

[Joseph]

Ron Paul's goal for auditing the FED is make the public aware of who the FED has been helping; He's counting on the public's outcry after finding this out, to help him "end the fed" by repealing all legal tender laws. Federal Reserve Notes would quickly lose their value without a police force to back them up. Without legal tender laws, the free market will choose 100% commodity backed currencies to buy and sell with. Fractional reserve banking for on-demand accounts wouldn't be tolerated by the free market either.

[Chicago School and a Denier of MMGW]

We welcome back the voice of the traditional or so-called "intellectual" conservative, BUT...

1) the theory that man's output of carbon is causing the globe to warm is still unsettled science with many differing opinions.

2) carte blanche abortion is still bad policy and forcing people of faith to pay for others to have abortions while cutting medicare benefits on the elderly (Obama/Pelosi-Care) is a form of tyranny.

3) voters still don't want gay marriage - see every election they tried.

Isn't it nice to talk about economics again with such vivid examples of how government is terrible at promoting real growth...? It is nice and everything, but facts are facts, and conservatism is conservatism.

[EKS]

What does the above comment have to do with the post? Probably not even worth taking seriously.

[Ted H]

Becker, I think you are overplaying the inflation angle. Most analysts are expecting inflation to be below 2% well into 2011, to me this actually suggests the Fed should be engaging in greater monetary expansion. Until expected target inflation is nearing 2.5% I'm not even particularly concerned, I think we should actually be buying a lot more long-term treasury bonds, I've thought that for some time. I basically think the plan outlined in the recent paper getting buzz by Gagnon seems spot-on to me ($2 trillion worth of buys in long-term treasury bonds with an average 7 years maturity). Furthermore, once we do begin to see a real recovery and inflation begins to see projections at unacceptable levels, the Fed can simply reduce volume requirements, but pay higher reserve rate to encourage holding of money to keep it at that target 2.5%. Plus, the banks need stronger reserves going into the future anyway. I'm not concerned about inflation if our Fed isn't stupid in that regard. I suppose you may just have a different opinion though.

Also, I think you are entirely wrong about the CRA. What evidence can you point to the CRA even remotely contributed to this crisis? The Federal Reserve blatantly disagrees and presents compelling evidence to make their claim. For example, they found that only 6% of all higher-priced loans were CRA-covered to lower-income borrowers or low-income neighborhoods. Only 2% of higher-priced CRA-eligible mortgages were covered by CRA institutions. They also discovered that delinquency rates for all subprime and alt-A mortgages were very high even when accounting for income, once again questioning the CRA's applicability. Also, consider this Mr. Becker. 50% of subprime loans were made by companies who were not regulated by the CRA, and an additional 25% were only covered by subsidiaries of CRA regulated institutions. I mean CRA-regulated institutions were LESS LIKELY to make subprime loans than banks not CRA regulated.

Mr. Becker, there is mounds of evidence that the CRA had absolutely nothing to do with the crisis. The Federal Reserve and the FDIC both say that claim is nonsense, after doing rigorous analysis, and their is no evidence your counterclaim is correct, why bother pushing it?

I believe the act is an unnecessary manipulation of the mortgage market, but it did not contribute to the financial crisis in any substantial way.

Finally, to get to your main argument. This I actually agree with. The Fed made mistakes, nobody disputes that. I also believe, for Bernanke, there was a bit of "new kid on the block" timidity. He's a brilliant monetary scholar so he surely knew the rates were too low when he entered in 2006, but perhaps new-kid timidity made him more cautious in his actions. However, Congress obviously was just as bad, if not worse, in allowing the crisis to go forward considering their flawed laissez-faire "bankers are perfect" approach to regulation, so to entrust regulatory powers to Congress seems, at best, ironic; at worst, pathetic. I'm very uncomfortable with giving the Congress too great of authority over the Federal Reserve. These guys aren't monetary policy experts, giving them too much authority seems counterproductive. The last thing we need it short-term political influences affecting monetary policy. I think we need to find a "medium ground" between transparency at the Fed and semi-autonomy, I'm not exactly sure where that is right now; but giving Congress greater authority of them isn't the correct approach.

Also, to quickly comment on the creation of a super-regulator. There is this idea that by creating a super-regulator they would do so much better than the Fed as a regulator. My view is, the Federal Reserve likely hired the same type of people to regulate banks that some new super-regulator would hire. There is nothing special about the Fed that makes their regulatory supervision worse. There needs to be a formal review of what went wrong in the regulatory department and then modify it through statues, department shuffling, modification of the regulatory framework etc; but a new agency seems pointless to me.

But yeah, Congress doing a better job at managing the financial system than the Fed (no matter how bad their performance was) is just laughable.

[Jack]

Put me down with Jim and Ted. In the near future, where could inflation possibly come from? Leaving out for now the, most likely manipulated "oil market", price gouging which is simply an external price increase that must be absorbed by folks doing w/o something else, (if we aren't willing to do something about the scam) I see no sector likely to cause demand driven inflation.

Consider; even during the lowest rates of unemployment in post WWII of the late 90's there was little inflation of prices or wages, due, in my view, to the nearly infinite supply of labor abroad and uncontrolled immigration at home.

Indeed! Dumping on CRA is but a partisan attempt divert attention from a financial sector completely taken over by greed, spotting a huge hole in regulation and running amok with the aid of bond rating firms selling off century old reputations for short term gain.

Congress? Yes! If Phil Gramm was able to sneak the repeal of GlassSteagal past a sleepy Congress headed home for the holidays, what excuse do they have for not looking around at the obvious signs of a world gone mad beginning in 2000? If Steagal was "outdated" would it not be replaced by a modernized version instead of being tossed and the excesses we've seen and are paying for not noticed?????

I don't think Bernanke was far off track to leave rates low in 2006 as job creation had been soft since the early 2000 recession and he must have had a housing chart that looked something like this:

http://mysite.verizon.net/vzeqrguz/housingbubble/

If Fed rates had tightened a bit would it have done anything to slow the trillions being shoveled out banker's doors on the flakiest of applications? No, they'd have simply gone to more "teaser rates" irrational ballooners and the like.

As for regulation of banks I don't see this being "rocket science". Were the housing chart above extended back to the 50's we've done well by lending something on the order of 2.5 times median income on median homes. That's not by accident but by that history including bankers lending on reasonable ratios and verifiable incomes. Just this graph alone should have rung bells all over the financial sector AND the regulators since 2002 or so.

Going forward? I can't think of a sector that isn't suffering from 20 - 40% over capacity with skilled labor at the ready on the sidelines. With an "internet Christmas" coming we'll see more retailers pulling the plug and triggering the next crisis of building owners defaulting with commercial banks being next? Or just after a batch of "private equity" vultures stuck with the companies they've been selling back and forth and sucking the guts out of them heading for the long lines at bankruptcy court.

In addition to the Fed buying those $2 trillion and hoping we'll not crash into the next mountain Congress should pass the jobs bill being discussed with a strong emphasis on the conservation of energy, alternative energy and beginning to address some trillion plus of delayed infrastructure maintenance and upgrading. We'll come out of this mess far better if our people are working and creating assets for the future than if we lose our nerve and leave them home collecting unemployment, losing homes purchased a decade or more ago and ending up on welfare, even if that means a pile of debt. Inflation? Ha!

[strainer3]

In my view the programs developed and put in place by the US government (and other governments that have followed in their footsteps) in their attempts to "improve" the global economic system are quite irresponsible and wreckless. They have used terrible Keynesian policies and wasted trillions of dollars bailing out creditors and shareholders of failed institutions with broken business models rather than addressing the structural flaws in the system of too much debt. And these actions are going to lead to massive problems down the road with regard to our currency and interest rates, in my opinion. Furthermore, I think that the gold price breaking out to a new high is a strong indication of the reduction in faith and confidence that people have in governments and their fiat currencies. I recently read a good article called Gold Price Wobbles Under $1,130 But U.S. Dollar Future Bleak at that discusses the Federal Reserve's easy monetary policies in order to try to prevent any sort of deflation from occurring and to try to reflate assets prices. There are also many more articles here that I think are very helpful for any investor to read because they help to explain the investment implications for the dollar, the gold price, and gold mining companies who I believe will continue to benefit from central banks' inflationary programs.

[Dr, CliffordJohnson]

Congress would at least do a better job than the Fed in that there would be no national debt attached to the money it orders be printed. That's such a huge advantage, it's difficult to conceive that its performance on behalf the people could be so much worse as to outweigh this advantage. In fact,it's difficult for me to conceive how Congress could be any worse than the Fed, given the moronic recent levels of Fed performance, and the transparent conduct of monetary policy that would result.

[James Wong]

I'd love to hear your opinion on whether Wall Street needs reform. Do you like the Volcker rule? What to do with "Too big to fail"?

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Congress would at least do a better job than the Fed in that there would be no national debt attached to the money it orders be printed. That's such a huge advantage, it's difficult to conceive that its performance on behalf the people could be so much worse as to outweigh this advantage. In fact,it's difficult for me to conceive how Congress could be any worse than the Fed, given the moronic recent levels of Fed performance, and the transparent conduct of monetary policy that would result.

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There is this idea that by creating a super-regulator they would do so much better than the Fed as a regulator. My view is, the Federal Reserve likely hired the same type of people to regulate banks that some new super-regulator would hire. There is nothing special about the Fed that makes their regulatory supervision worse. There needs to be a formal review of what went wrong in the regulatory department and then modify it through statues, department shuffling, modification of the regulatory framework etc; but a new agency seems pointless to me.

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