Monday, July 20, 2009

What would you replace the Fed with? 

It appears more people now are upset about that petition for central bank independence. At first David Henderson supported the idea that central bank independence reduced inflation. (See my papers linked at the bottom of the first link of this article.) While it seems reasonable to have a group of unaudited individuals finally be audited, "[t]he whole idea of a having one federal agency audit another typically excites mainly inside-the-Beltway people." Moreover, if we're going to audit the Fed, why not audit all those other agencies that are regulating us to death, like the EPA, or Treasury? Here's a weekly balance sheet; there is an audit it hires someone to do. What the auditing bills propose is to have someone else audit the Fed rather than Deloitte and Touche. Nobody as far as I can tell can explain why a different auditor would be better.

But Henderson appears to have had a change of heart, calling the Fed "illegitimate," even while maintaining it is more transparent than most government agencies. Meanwhile, Arnold Kling and Alex Tabarrok argue that the Federal Reserve suffers from a kind of regulatory capture by commercial banks. Here's Kling:
I perceive signs of what Danny Kaufmann calls "cognitive capture" of the Fed by the banks that it regulates. That is, the Fed sees the world through the eyes of the executives at large banks.
And Tabarrok, at greater length:

The primary reason that independent central banks are better at controlling inflation is that absent direct political control the default selection mechanism favors bankers, i.e. lenders, people whose interests make them more favorable towards lower inflation.

Thus, independence is a political decision that favors lenders in the decisions of monetary policy. Now, depending on the alternatives, there may be good reasons for making this choice but we should not fool ourselves into thinking that we have depoliticized money. We should not be surprised, for example, that "independent" central banks tend to make lender of last resort decisions that protect banks and bankers.

But neither point out that the Federal Reserve is in fact owned by commercial banks, specifically for that reason. The problem with a dependent central bank is a time-consistency problem. (Not long ago we thought enough of it to award a Nobel to its discoverers.) Central banks can promise price stability but, when they are subject to an electoral check, they can't deliver on the promise because of the possibility of temporarily raising output in advance of an election and having inflation come later (the "political business cycle", a topic I first wrote about in graduate school.) Central banks cannot make credible commitments to price stability without overcoming the problem.

It's true that a central bank could find another mechanism to overcome the problem, such as the Reserve Bank of New Zealand's contract that fires a central bank governor if he allows inflation to rise above a certain rate. Tabarrok notes this example as a case where the central bank does NOT have independence. But independence means two different things: It can mean independence of choosing its goals, or it could mean independence in choosing the instruments by which it meets those goals. You can tell me to keep inflation below 2% or I'm fired, but you permit me to use whatever means I wish to meet that target. Tabarrok misfires in calling the New Zealand central bank dependent. See Carlstrom and Fuerst [2006].

In the absence of a contract, one can choose instead to delegate monetary policy to someone who can overcome the time inconsistency problem. The old story we use in classrooms is to think about a father taking his two sons to a baseball game; the family goes once a year; the stadium is a three-hour drive from home. Brothers often fight in back seats, so the father turns around and tells them "stop or we won't go to the game." Of course the sons don't believe Dad, because Dad loves baseball, they know he does, and turning the car around is too painful for Dad. Delegation means giving the tickets to Mom, who let's say doesn't like baseball. "If you don't behave, Mom will not give us the tickets to go to the game." (I can't take credit for this metaphor -- it was in an intermediate macro text I read and used, but I can't find where I got it on my bookshelf. Apologies to the originator of that story.)

A government official cannot make a credible commitment to price stability, because if some price shock happens the cost of keeping the commitment is high unemployment which is painful to the government official. So he delegates monetary policy to someone who cares less about unemployment than he does, and cares perhaps more about price stability. That is in fact exactly what a commercial banker prefers.

Federal Reserve governors are chosen by the president subject to confirmation by the Senate. But Federal Reserve bank presidents (of the twelve branches) are chosen by the members of the Fed, the commercial banks. They are typically more inflation averse than the governors (see Havrilesky and Gildea [2007], for example.) In some cases the central bank's board is entirely chosen by bankers (see Swiss National Bank for example.)

The reasons for central bank independence at this particular time in history are, I believe, profound. James Hamilton writes:
The reason I find that loss of Fed independence to be a source of alarm is the observation that every hyperinflation in history has had two ingredients. The first is a fiscal debt for which there was no politically feasible ability to pay with tax increases or spending cuts. The second is a central bank that was drawn into the task of creating money as the only way to meet the obligations that the fiscal authority could not. Every historical hyperinflation has ended when the fiscal problems got resolved and independence of the central bank was restored.
I return to the question I asked before: if you abolish the Fed, what do you replace it with? Tabarrok's complaint that even delegating to commercial bankers makes it political would seem to lead to a complaint about governments maintaining a monopoly over money. Would only competitive money satisfy the objections? I suspect it would prevent hyperinflation, but multiple monies are also likely to sacrifice many scale economies that allow our current level of financial sophistication.

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