Friday, March 20, 2009

Losing independence 

The Bernanke Fed has now dropped even the pretense of independence and has made itself an agent of the Treasury, which means of politicians. With its many new credit facilities -- the TALF and the others -- it is making credit allocation decisions across the economy. If a business borrower qualifies for one of these facilities, it gets cheaper money. If it doesn't, it's out of luck. Thus the scramble by so many nonbanks to become bank holding companies, so they can tap the Fed's well of cheap credit.

The question is how the Fed will withdraw from all of this unchartered territory now that it has moved into it. How will it wean companies off easy credit, especially since some companies may need it to survive? What happens when Members of Congress lobby the Fed to keep credit loose for auto loans to help Detroit, or credit cards to help Amex? House Speaker Pelosi yesterday gave a taste, saying the AIG bailout was the Fed's idea "without any prior notification to us." Mr. Bernanke, meet your new partners.

From the Wall Street Journal this morning. Let me add a few thoughts:

The reason central banks were granted independence was that independence provided a bulwark against an inflationary bias that more dependent central banks have. (There's plenty of research on this, including my own here and here.) Dallas Fed President Richard Fisher puts this rather well:
Why do we have independent central banks? To provide a barrier between government and the money supply. Why is this necessary? Because doing the right thing for the long-term interests of the people can be very hard to do. Monetary policymakers often have to make decisions that can cause economic pain for real people in the short term, or decide not to do things that could help people out of an immediate bad situation, in order to preserve the welfare of the people over the long run.

The incentives given to elected officials, even in the most praiseworthy democracies, increase the likelihood of harnessing monetary policy to their political needs. A congressman or a senator or a president who has all the best intentions and works earnestly for long-term prosperity is still subject to reelection and would quickly find himself voted out of a job if he tried to implement some of the stern policies that an independent central banker is often required to carry through.

But that's not the only reason we have the Fed. The Fed, unlike the European Central Bank or the Bank of Mexico (the subject of Fisher's speech), wasn't created in an inflationary world. Its purpose in 1913 was to act as a lender of last resort. It would lend to any and all on the basis of good collateral, following the precepts, I think, of Bagehot's Lombard Street. It does not have, like those other banks, the single goal of price stability. It is thus, in my view, a less independent bank than what 1990s "best practices of central banking" would have created.

Where the Fed is going now is a place we talked about last September when the most serious trouble brewed. Since Treasury seems unable or unwilling to act as a market maker of last resort, it is being left to the Fed to do so. In doing so we are shifting a large amount of risk onto the central bank, and because Congress sees this it is likely to meddle further in the Fed's actions. This is bad, as Fisher argues, for price stability. But it is worse than this. Anne Sibert wrote a short precis of what independent central banks do in liquidity crises, and the answer is quite clear:
The decision to bail out an individual bank is far too political an act for the unelected officials of an operationally independent central bank. It should be left to a separate regulatory agency, which has the expertise, and to the Treasury, which has the power to tax. All that is needed is that the regulators have a credit line with the central bank ... that is guaranteed by the Treasury.
Interestingly, it is Senate Democrats such as Chris Dodd who are expressing this skepticism. While they are undertaking this overhaul, if Dodd and others are concerned about the size of the Fed's balance sheet and risk of inflation, they should consider amending the Federal Reserve Act to give the Fed more strength in the fight against inflation. Of course, that means tying its own hands, and so far this bunch doesn't seem up to that task.

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