Last week, the U.S. House of Representatives passed a law that would allow after-the-fact audits of central bank decisions, after the similar legislation introduced by Ron Paul in the late 2009.
Seeing news like this, I felt it such a joke, and how easy people without knowledge get manipulated by demagogues who hold the flags of “For Freedom”, “For America”, “For Equality”, “For Peace in the Universe”… These things used to, always, wave towards other countries, especially countries with conflicting values/ideologies from American’s; and this time, ridiculously, it is towards its own country, its own central bank.
Why do I say it a joke? Well, when people talk about “audit”, it always referring to some covered, under the board thing must be happening, and that the institution is not showing/presenting the public what is going on. But this is not the case at all in Fed. On the book side, like all the other financial institutions, and even more than that, Fed’s all the administration and all the flow of funds, and borrowing and lending records are subject to private auditing firms’ audit regularly, and also are subject to GAO’s audit. Even after the 2008, all the allocation of stimulation funds have been proved to be clear. On the other side, the monetary policy part, Fed is also subject to the full audit by GAO. Fed has been publishing all the FOMC meeting materials three weeks after each meeting, disclosing documents and stuff, not only to GAO, but also to the general public. The chairman and officials report to the congress and work with the treasury’s department regularly to report the monetary policy decisions as well. It holds press conference, mass media communication, educational programs, and all kinds of channels throughout the whole Federal Reserve System to communicate with the public what is going on. To say transparency, Federal Reserve is one of the most transparent central bank in the world, and the most transparent agency in Washington D.C..
However, where does this “Audit” bill come from? For GAO’s audit, there is one exemption, that is to keep the FOMC meeting not disclosed within the three week period. And this bill is attempting to remove this exemption. Why did they keep this exemption in the past? For many reasons, one of which is for the sake of stability, while one other, and the most important one, is for the sake of independence. Federal Reserve keeps the report undisclosed for a short period to allow a short period adjustment of the market, and to avoid the sudden shock and speculative behaviors. For the sake of independence, one of the main quality Fed has to maintain as a central bank is to make effective monetary policy based on economy, not on politics. This bill directly allows GAO to access to the FOMC, which simply means that Fed’s decision making has to subject to the congress. Politicans may provide different pressure and mandate on Fed based on their personal political goals. This is a direct attack to Federal Reserve’s independent quality.
What did Bernanke say (refer to Reuters):
Bernanke said it would be a “nightmare scenario” if politicians decided to second-guess monetary policy. “That is very concerning because there’s a lot of evidence that an independent central bank that makes decisions based strictly on economic considerations and not based on political pressure will deliver lower inflation and better economic results in the longer term,” Bernanke told the U.S. House of Representatives’ Financial Services Committee.
Paul’s bill would direct the Government Accountability Office, an independent, nonpartisan congressional agency, to conduct a Fed review, and it would remove an exemption monetary policy has enjoyed.
Bernanke said the very notion of a monetary policy audit was misleading. “The term ‘audit the Fed’ is deceptive. The public thinks that auditing means checking the books, looking at the financial statements, making sure that you’re not doing special deals, and that kind of thing. All of those things are (already) completely open,” he said.
What that means is that from now on, congress is going to intervene the monetary policy decision making, which directly means that Federal Reserve is at a turning point of losing its independence of decisions from the political government.
This is serious and important, but why?
To understand why, we have to know what is the function and history of Federal Reserve System:
(Here is a short interesting video introducing the Federal Reserve System that I find really interesting to watch)
The Federal Reserve System is the central banking system of the U.S., created on 12/23/1913 under the Federal Reserve Act. The primary motivation for creating the Federal Reserve System was to address banking panics. Other purposes are stated in the Federal Reserve Act, such as “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes”. Before the founding of the Federal Reserve, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Over time, the roles and responsibilities of the Federal Reserve System have expanded and its structure has evolved.
The Congress established three key objectives for monetary policy—maximum employment, stable prices, and moderate long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve’s dual mandate. Today, its duty includes conducting the nation’s monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed also conducts research into the economy and releases numerous publications, such as the Beige Book.
Here is a list of current functions of the Federal Reserve System:
- To address the problem of banking panics
- To serve as the central bank for the United States
- To strike a balance between private interests of banks and the centralized responsibility of government
- To supervise and regulate banking institutions
- To protect the credit rights of consumers
- To manage the nation’s money supply through monetary policy to achieve the sometimes-conflicting goals of
- To maintain the stability of the financial system and contain systemic risk in financial markets
- To provide financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system
- To facilitate the exchange of payments among regions
- To respond to local liquidity needs
- To strengthen U.S. standing in the world economy
The Federal Reserve System’s structure is composed of the Board of Governors (or Federal Reserve Board), the Federal Open Market Committee (FOMC), twelve regional Federal Reserve Banks, numerous privately owned U.S. member banks and various advisory councils.
The Board of Governors, also known as the Federal Reserve Board, is the national component of the Federal Reserve System. The board consists of the seven governors, appointed by the president and confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and continuity over time. The chairman and vice-chairman are appointed to four-year terms and may be reappointed subject to term limitations. The Board’s most important responsibility is participating in the Federal Open Market Committee (FOMC), which conducts the nation’s monetary policy. Its financial accounts are audited annually by a public accounting firm, and these accounts are also subject to audit by the General Accounting Office. Board members are called to testify before Congress, and they maintain regular contact with other government organizations as well. The chairman reports twice a year to Congress on the Fed’s monetary policy objectives, and testifies on numerous other issues, and meets periodically with the Secretary of the Treasury.
A network of 12 Federal Reserve Banks and 25 branches make up the Federal Reserve System under the general oversight of the Board of Governors. Reserve Banks are the operating arms of the central bank. Reserve Banks conduct research on regional, national and international economic issues. Research plays a critical role in bringing broad economic perspectives to the national policymaking arena and supports Reserve Bank presidents who all attend meetings of the Federal Open Market Committee (FOMC).
The FOMC is the committee responsible for setting monetary policy and consists of all seven members of the Board of Governors and the twelve regional bank presidents, though only five bank presidents vote at any given time. It is the Fed’s monetary policymaking body. It is responsible for formulation of a policy designed to promote stable prices and economic growth. Simply put, the FOMC manages the nation’s money supply. The FOMC typically meets eight times a year in Washington, D.C. At each meeting, the committee discusses the outlook for the U.S. economy and monetary policy options. The FOMC is an example of the interdependence built into the Fed’s structure. It combines the expertise of the Board of Governors and the 12 Reserve Banks. Regional input from Reserve Bank directors and advisory groups brings the private sector perspective to the FOMC and provides grassroots input for monetary policy decisions.
According to the Board of Governors, the Federal Reserve is independent within government in that “its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government.” Its authority is derived from statutes enacted by the U.S. Congress and the System is subject to congressional oversight. The members of the Board of Governors, including its chairman and vice-chairman, are chosen by the President and confirmed by the Senate. The government also exercises some control over the Federal Reserve by appointing and setting the salaries of the system’s highest-level employees. Thus the Federal Reserve has both private and public aspects. The U.S. Government receives all of the system’s annual profits, after a statutory dividend of 6% on member banks’ capital investment is paid, and an account surplus is maintained.
Why do we need independent central banking system? (Courtesy to Federal Reserve Bank of Philadelphia)
After knowing the structure and functions of the Federal Reserve System, it is easy to understand why we stress so much about the independence of the monetary policy decision making. It is the most important of all principles of a sound central banking.
Despite research that indicates countries with independent central banks generally produce more desirable economic outcomes, it strikes many people as odd that in a democratic society we leave monetary policy decisions in the hands of nonelected policymakers who can act with independence.. Central bank independence means that the central bank can make monetary policy decisions without fear of direct political interference. It does not mean that the central bank is not accountable for its policies.
Over the past 30 years, many countries have acted to increase the degree of independence of monetary policymaking from short-term political influences. These moves reflect empirical research that generally shows that developed countries whose central banks have greater independence tend to have lower and more stable inflation without sacrificing employment or output, thus benefiting from more stable economies and better economic performance. Since January 1, 2010, here is a sampling from some news reports of what central bankers have faced in other countries:
Argentina’s president fired the governor of the central bank when he refused to transfer $6.6 billion in foreign-exchange reserves to the government’s coffers to meet fiscal expenses ahead of next year’s election.
South Korea’s president, not surprisingly, has urged the Bank of Korea to go slow on its exit strategy from accommodative monetary policy. However, to underscore the point, he sent a vice minister to attend a Monetary Policy Committee meeting for the first time in a decade.
Japan’s new administration has put increasing pressure on the Bank of Japan to increase lending. This month, the new finance minister said he was looking for even more cooperation from Japan’s central bank.
Mexico’s president has appointed a new governor for the Bank of Mexico, after clashing with its former governor over the central bank’s reluctance to cut interest rates.
It is important to remember that the Federal Reserve does not select its own goals. Instead, Congress sets the goals it wants the Fed to pursue with monetary policy. The Federal Reserve Act states that the Fed should conduct monetary policy to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Since moderate long-term interest rates generally result when prices are stable and the economy is operating at full employment, it is often said that Congress has given the Fed a dual mandate.
What central bank independence does mean is that Congress has left the decisions of how best to achieve this mandate to Fed policymakers. Why did Congress design the Fed this way? There are two very good reasons.
First, monetary policy affects the economy with sometimes long and variable lags, but elected politicians, and even the public, often have shorter time horizons. Monetary policy actions taken today will not have their full effect on the economy for at least several quarters and perhaps as long as several years. That is why monetary policy choices today must focus on the intermediate to long term and anticipate what the economy might look like over the next one to three years.
Moreover, there can be a conflict between what monetary policy may be able to achieve over the short term versus its impact over the long term. For example, in the short term, it might seem expedient or even desirable to try to spur economic growth and employment by setting excessively accommodative monetary policy. Yet, this will only lead to very bad economic outcomes in the long term — including higher inflation, higher interest rates, and an eventual tightening of policy to control inflation that may be detrimental to the economy. These outcomes would be inconsistent with the long-term goals set by Congress. Delegating the decision-making to an independent central bank that can focus on long-term policy goals is a way of limiting the temptation for short-term gains at the expense of the future.
The second important reason to give monetary policy decision-making to an independent central bank is to separate the authority of those in government responsible for making the decisions to spend and tax from those responsible for printing the money. This lessens the temptation for the fiscal authority to use the printing press to fund its public spending, thereby substituting a hidden tax of inflation in the future for taxes or spending cuts.
This can be especially important when governments face huge deficits and may choose to look to the monetary printing press to improperly fund fiscal needs — as in Argentina today. The fiscal authorities should not think of the central bank as a source of funds or a piggy bank simply to avoid the difficult choices of cutting spending or raising taxes. Efforts to politicize central banks can be seen as a way for the fiscal authorities to strengthen their influence on the printing press to avoid difficult fiscal choices.
History is replete with examples in which central banks became agents for a nation’s fiscal policy or a means for a political party to remain in power. Just in the 20th century think of the hyperinflation in Germany between the World Wars; think of Italy before the euro; think of the numerous financial crises in Latin America, and the current economic chaos in Zimbabwe to name just a few. The consequences — higher inflation, currency crises, and economic instability — are not good.
Indeed, we live in a world of highly mobile capital and financial markets that are constantly assessing the credibility of governments and their central banks to maintain price and economic stability. In such a world, the mere threat that monetary policy might become politicized can damage the nation’s credibility. It can raise fears of inflation that send interest rates higher and currencies falling.
How does Ron Paul’s Bill hurt Fed’s independency?
The bill does not refer to an “audit” in the usual accounting sense of the term, since the Fed’s financial statements and controls are already subject to extensive outside audits by the GAO and a public accounting firm. Rather, this proposal is an attempt to reduce the independence of the central bank through the threat of a political action. In particular, the GAO could be called on to investigate a monetary policy decision whenever any member of Congress opposes a decision to change interest rates. This would undermine the Fed’s credibility and its ability to conduct monetary policy in the long-term interests of the American public. It would allow any legislator to demand the Government Accountability Office, or GAO, to “audit” the Fed’s monetary policy decisions.
In a conclusion, these efforts that would politicize the Federal Reserve here in the U.S., are deeply troubling. While many try to interpret these efforts as logical or inconsequential, they are not — they are misguided and potentially damaging to the nation’s economic well-being. From an economic standpoint, since the passage of this “Audit the Fed” Bill, it would be interesting for an economist to standby and watch what is happening towards the “New Age” of the American Central Banking.
Further Reading: Independence + Accountability: Why the Fed Is a Well-Designed Central FAQs: Fed Basics Ron Paul’s Latest “Audit the Fed” Bill Passes the House, 327-98
Articonomics 