Thomas F. Cooley: The Rocky History Of Fed Independence
[Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes. He is a contributor to a new book on the financial crisis entitled Restoring Financial Stability (Wiley, 2009).]
My fellow columnist John Tamny wrote an excellent column last week arguing that the notion of an independent Fed is a myth. I come to a different conclusion than he does about the evidence and the implications. But on the underlying message--the difficulty of achieving and maintaining independence--we absolutely agree.
There are three main contradictions in the very structure of the Federal Reserve. First, the Fed answers to Congress and its top officials are nominated by the executive branch and confirmed by Congress. It is tough to be politically independent under those circumstances. Secondly, the 12 regional Federal Reserve Banks are governed by independent boards and are essentially owned by the member banks. Thus the Fed is also subject to capture by the very banks it is supposed to regulate. Finally, the Fed must work closely with the Treasury, particularly in times of crisis. And there you have it, a system that is, appearances and rhetoric to the contrary, truly independent only under the very best of circumstances. Thus the Fed is both dependent and independent, apolitical and bound by the political structure.
The system is the result of decades of evolution and haggling and the need to balance the mistrust of bankers and the mistrust of politicians. John Tamny correctly recounts the history of Arthur Burns' compromised relationship with Richard Nixon. Nixon appointed Burns as chairman and made it clear that he wanted the Fed to keep interest rates low particularly in the run-up to the 1972 election. We know that Nixon thought the Fed "already screwed him once," (in 1960) and he wasn't going to let it happen again. In some sense, Nixon, in all his dysfunctional rage, embodied what happens when the Fed loses its independence from the political branch.
Here is Nixon unedited, preaching to Burns: "[B]etween now and the election in November, there must be one paramount consideration. And that paramount consideration is not the responsibility of the U.S. in the world, it isn't outgoing policy, it isn't the fact that in foreign policy we've done this, that or the other thing, the main thing is that we have to create the impression that the president of the United States, finally, at long last, after 25 years with blood, sweat, and tears is […] looking after [America's] interests."
Whatever Arthur Burns was thinking at the time, Nixon got what he wanted. We know what a mess that created: an expanding economy in the period before the election and subsequent runaway inflation that took a decade to contain. It was eliminated by the policies of a Fed chairman with courage and integrity (Paul Volcker), albeit at a very high cost in terms of lost output and jobs.
But there is some earlier history that provides a good contrast to the Burns episode (thanks to Peter Rupert, who steered me to this.) William McChesney Martin became the chairman of the Fed in 1951 and served until 1970 when Nixon replaced him with Arthur Burns. He is famous for having defended the independence of the Fed through five administrations. In the mid-1960s the pressure on Martin from the Congress and from Johnson's own Council of Economic Advisors to act less independently was extreme. Everyone was on his case.
After much deliberation and in the midst of great pressure to leave things be, in late 1965 the Federal Reserve raised the discount rate for the first time in several years. The raise infuriated President Lyndon Johnson, who feared that the increase would slow the economy and jeopardize his plans for the Vietnam War and the War on Poverty...
Read entire article at Forbes.com
My fellow columnist John Tamny wrote an excellent column last week arguing that the notion of an independent Fed is a myth. I come to a different conclusion than he does about the evidence and the implications. But on the underlying message--the difficulty of achieving and maintaining independence--we absolutely agree.
There are three main contradictions in the very structure of the Federal Reserve. First, the Fed answers to Congress and its top officials are nominated by the executive branch and confirmed by Congress. It is tough to be politically independent under those circumstances. Secondly, the 12 regional Federal Reserve Banks are governed by independent boards and are essentially owned by the member banks. Thus the Fed is also subject to capture by the very banks it is supposed to regulate. Finally, the Fed must work closely with the Treasury, particularly in times of crisis. And there you have it, a system that is, appearances and rhetoric to the contrary, truly independent only under the very best of circumstances. Thus the Fed is both dependent and independent, apolitical and bound by the political structure.
The system is the result of decades of evolution and haggling and the need to balance the mistrust of bankers and the mistrust of politicians. John Tamny correctly recounts the history of Arthur Burns' compromised relationship with Richard Nixon. Nixon appointed Burns as chairman and made it clear that he wanted the Fed to keep interest rates low particularly in the run-up to the 1972 election. We know that Nixon thought the Fed "already screwed him once," (in 1960) and he wasn't going to let it happen again. In some sense, Nixon, in all his dysfunctional rage, embodied what happens when the Fed loses its independence from the political branch.
Here is Nixon unedited, preaching to Burns: "[B]etween now and the election in November, there must be one paramount consideration. And that paramount consideration is not the responsibility of the U.S. in the world, it isn't outgoing policy, it isn't the fact that in foreign policy we've done this, that or the other thing, the main thing is that we have to create the impression that the president of the United States, finally, at long last, after 25 years with blood, sweat, and tears is […] looking after [America's] interests."
Whatever Arthur Burns was thinking at the time, Nixon got what he wanted. We know what a mess that created: an expanding economy in the period before the election and subsequent runaway inflation that took a decade to contain. It was eliminated by the policies of a Fed chairman with courage and integrity (Paul Volcker), albeit at a very high cost in terms of lost output and jobs.
But there is some earlier history that provides a good contrast to the Burns episode (thanks to Peter Rupert, who steered me to this.) William McChesney Martin became the chairman of the Fed in 1951 and served until 1970 when Nixon replaced him with Arthur Burns. He is famous for having defended the independence of the Fed through five administrations. In the mid-1960s the pressure on Martin from the Congress and from Johnson's own Council of Economic Advisors to act less independently was extreme. Everyone was on his case.
After much deliberation and in the midst of great pressure to leave things be, in late 1965 the Federal Reserve raised the discount rate for the first time in several years. The raise infuriated President Lyndon Johnson, who feared that the increase would slow the economy and jeopardize his plans for the Vietnam War and the War on Poverty...