Legal Commentary

Is the Federal Reserve Losing Its Independence? Posner

By Richard Posner

Even in a democracy, it is believed that certain government functions should be placed beyond the control of democratic politics. The usual example is the judiciary (though most state judges in the United States are elected, this is a considerable anomaly). But another example is the central bank, which in the case of the United States is the Federal Reserve. A central bank has considerable, often decisive, influence over short-term interest rates, and, through them, over long-run interest rates as well. Typically (and to oversimplify), a central bank reduces short-term interest rates by buying short-term government securities, which pumps cash into the economy when the cash is deposited in bank accounts and then withdrawn and spent. Interest is the price that people or firms demand to part with cash--the more cash there is in the economy, the lower that price will be. In addition, by increasing the demand for these securities, the purchase increases their price, which in turn reduces their yield--the interest that they command. The central bank increases short-term interest rates by the reverse operation--selling short-term government securities, which sucks cash out of the economy, since the central bank can retire the cash rather than having to spend it.

Long-term rates tend to follow the path of short, both because of substitutability and because the more cash the banks have to lend, and so the less they have to pay for the capital that they lend, the lower the interest rates at which they will lend, including lending long term, because competition will tend to keep the spread between the banks' borrowing and lending costs from increasing just because their borrowing costs are falling.

The reason for making the central bank politically independent is that the bank's power over interest rates could be abused for political ends. Suppose the economy, though not in recession, is somewhat sluggish, and the government, perhaps because an election is looming, wants to juice it up. So it orders the central bank to reduce interest rates by buying government securities, thus pumping money into the economy. Reduced interest rates will stimulate lending, borrowing, and therefore economic activity, but the increase in the money supply can (since the economy is merely sluggish, and not in recession) create inflation. Very low interest rates in the early 2000s in the United States caused asset-price inflation, with destructive consequences, as we know.

Inflation can have other political objectives besides stimulating the economy in order to improve a government's popularity. It is a method of taxation. Suppliers are required by law to accept the official currency in payment of debts, so government can buy goods and services just by issuing money to its employees and other suppliers without having to raise the money by borrowing or by (explicit) taxation. The suppliers will respond by raising prices, but if the government refuses to pay (for example, refuses to raise wages), then the suppliers, to the extent dependent on the government for business (or employment), will have to accept the cheapened money.

In addition, inflation can be used to benefit some groups in society at the expense of others. Inflation benefits debtors, when debt is not indexed for inflation, and hurts creditors. A strongly pro-creditor central bank might even engender deflation, which would mean that debtors would be repaying their debts in dollars worth more in purchasing power than when they took out their loans. A central bank might do that (reduce the money supply, so that the purchasing power of a given quantity of money increases) in order to strengthen its currency, which would enable the country to buy imports more cheaply and increase the return on its foreign investments. (That was the ground on which Britain deflated by returning to the gold standard after having gone off it in World War I. That was a government decision; there was no independent central bank.)

Since the harms of inflation are now widely recognized, a central bank that focuses on limiting inflation will be reasonably popular; and since the value of its being independent of political influences so that it will limit inflation (and deflation) will be recognized, its independence will not be challenged. But the independence of the central bank in the United States, as in other countries, is not guaranteed by the Constitution, as the independence of the federal judiciary is. It is a matter of statute, and Congress could eliminate or reduce the Federal Reserve's independence from the normal political process at any time. Its independence is therefore legally precarious.

That is part of the reason why the modern Federal Reserve has focused on controlling inflation, and, specifically, why it did not prick the housing bubble of the early 2000s, as it could have done at any time by pushing up interest rates, until the bubble got completely out of hand in 2006 and 2007. Had it pricked the bubble earlier, precipitating a fall in housing prices with consequent defaults and foreclosures, at a time when it was unclear that the run up in housing prices was a bubble, it would have been blamed for causing a recession, because proof of a bubble is difficult.

But in retrospect the hit that the Federal Reserve would have taken by pricking the bubble would have done less damage to its prospects for continued independence than the current depression, and the Fed's response, may be doing. Had the Fed merely pushed down interest rates when it became apparent last summer that the economy was sliding into a recession or worse, it would have been doing something that it was expected to do: the converse of raising interest rates to prevent inflation is lowering interest rates to prevent recession, and this is consistent with stabilization, which is part of the Fed's explicit statutory mandate. The Fed did lower the federal funds (overnight bank lending) interest rate, which has become the conventional way in which it influences interest rates. That rate is now virtually zero, yet the reduction has not done the trick. The reason is that the impairment of the banks' capital (because of their heavy involvement in home mortgage lending) has discouraged the banks from lending, since lending is risky. And so the fact that they can borrow from one another at essentially a zero rate of interest to meet loan demands has not incited them to lend in amounts necessary to maintain economic activity at a normal level.

The Fed in some desperation therefore began last fall lending substantial sums to banks in an effort to increase their safe capital to a point at which they would increase their lending by relaxing their credit standards and reducing interest rates on their loans. The Fed also began buying up private debt (as distinct from government securities), for example credit card debt, in the hope that the sellers of the debt would use the cash they received for their debt from the Fed to issue more debt, that is, to lend more. It even has begun buying long-term private and public (Treasury) debt.

The dangers to the Federal Reserve's independence that are created by such activities are twofold. First, the scale of the Fed's intervention is so great as to create a serious risk of a future inflation, albeit a risk that, at present, the bond markets (judging from long-term interest rates) do not consider large. The Fed in the last year has expanded the supply of money by about a trillion dollars, and is intending to expand it further. In principle, it can reverse the expansion process by selling Treasury securities (and the other debt that it has bought) and retiring the cash it receives from the sale. The problem is that a sudden large withdrawal of cash from the economy could cause interest rates to spike, bringing on a recession, as when the Fed reduced the money supply in 1979-1982 to break the 1970s inflation, which was getting out of hand (it reached 15 percent in 1979). A gradual withdrawal might be too slow to prevent inflation.

It is true that when the Fed buys short-term debt, such as credit-card debt, the transaction unwinds naturally in a short time: the debt is paid by the debtors, and the cash received from them can be retired. But this assumes that the debt is paid in full, which it may not be, and that the Fed does not immediately buy more short-term debt, and perhaps feel obliged to continue doing so, because the market has become dependent on its participation. And the Fed as I said is buying long-term as well as short-term debt, and that does not unwind automatically in the short term; it can be sold but it might be sold at a loss, depleting the Fed's balance sheet and leaving excess cash in the economy to create inflation.

If the Fed's actions precipitate inflation or have other untoward consequences, there is likely to be a political backlash against the Fed. We live at present in a blame culture, and really the Fed is lucky that so far most of the public's and the Congress's and the media's ire has been directed at the bankers rather than at Greenspan or Bernanke.

Second, and perhaps more ominous, the types of intervention that the Fed is now engaged in can create an impression of politicization of financial policy or even of impropriety. If the Fed merely issues an offer to buy some specified quantity of Treasury bills, or an offer to sell some specified quantity of those bills, it is not picking and choosing among companies or industries. But if it decides, or participates in deciding, whether Bank X should be allowed to fail while Bank Y receives a huge bailout, or when it uses its position as a bank's creditor to alter its management or influence its business decisions, it invites accusations of favoritism or worse. (Or when it decides to buy one type of private debt rather than another.) The latest portent is the allegation that Bernanke, the Fed's chairman, participated with Henry Paulson, the then Secretary of the Treasury, in pressuring Bank of America last December not only to go through with its planned purchase of Merrill Lynch but also to conceal Merrill Lynch's immense losses from Bank of America's shareholders. I have no idea whether the allegation is true; but that it should be made at all is an example of the political danger to the Federal Reserve if it becomes involved in the operation of individual banks.

I am not suggesting that the Federal Reserve is wrong to take radical measures to combat a depression. The Fed's "easy money" monetary policy may have warded off a deflationary spiral, which would have been disastrous (there is still a mild deflation--the Consumer Price Index for example is below what it was a year ago--and it could still get worse). And the Fed's bank bailouts may well have limited the decline in lending touched off by the near collapse of the banking industry last September. I merely contend that such measures pose greater threats to the Fed's political independence than would early intervention to prick the housing bubble and by doing so perhaps have prevented the grave economic situation in which the nation finds itself.

Full post as published by Becker-Posner Blog on April 26, 2009 (boomark / email).